Week 4 & 5 Discussion 1 & 2 Plus Journal

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Chapter Contents Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Chapter 9 Current Liabilities, Contingencies, and the Time Value of Money

Chapter Introduction

Module 1 Current Liabilities Accounts Payable

Notes Payable

Current Maturities of Long-Term Debt

Taxes Payable

Other Accrued Liabilities

IFRS and Current Liabilities

Module 2 Cash Flow Effects

Module 3 Contingent Liabilities Contingent Liabilities That Are Recorded

Contingent Liabilities That Are Disclosed

Contingent Liabilities versus Contingent Assets

IFRS and Contingencies

Module 4 Time Value of Money Simple Interest

Compound Interest

Interest Compounding

Present Value and Future Value: Single Amounts Future Value of a Single Amount

Present Value of a Single Amount

Present Value and Future Value of an Annuity Future Value of an Annuity

Present Value of an Annuity

Solving for Unknowns

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Chapter Review Appendix Accounting Tools: Using Excel for Problems Involving Interest

Calculations

Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Multi-Concept Exercises

Problems

Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

© 2020 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means - graphic, electronic, or mechanical, or in any other manner - without the written permission of the copyright holder.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Chapter Introduction Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Chapter Introduction

Making Business Decisions

Jonathan Larsen/Diadem Images/Alamy Stock Photo

Starbucks Corporation

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When you think of coffee, Starbucks Corporation may come to mind. The company's objective is to establish itself as one of the most recognized and respected brands in the world. It took only a few years for the company to be well on its way to achieving that goal. The company offers brewed coffees, espresso beverages, cold blended beverages, various complementary food items, coffee-related accessories and equipment, a selection of premium teas, and a line of compact discs through its retail stores.

Starbucks' balance sheet reveals that it must monitor liquidity carefully. A significant portion of the company's assets are current assets because most of its sales involve cash, credit card, and debit card. Starbucks also has a significant amount of current liabilities. The company realizes the importance of maintaining its current liabilities at a level that will allow them to be paid when they are due. In short, the company's long-term profitability goals are directly linked to its ability to effectively manage its current liabilities and liquidity.

The accompanying partial balance sheet presents Starbucks Corporation's current assets and liabilities.

The financial statements of Starbucks, and other companies, will aid in your understanding of the important concepts related to current and contingent liabilities.

Source: Starbucks, Inc., Form 10-K, For the Fiscal Year Ended September 27, 2015.

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LO 1 - Identify the components of the Current Liability category of the balance sheet.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 1 Current Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 1 Current Liabilities The balance sheet generally presents two categories of liabilities: current and long term. A current liability (Accounts that will be satisfied within one year or the current operating cycle. Alternate term: Short-term liability.) is an obligation that will be satisfied within one year. The face amount is generally used for all current liabilities because the time period involved is short enough that it is not necessary to record or calculate an interest factor.

Some companies list the accounts in the Current Liability category in the order of payment due date. That is, the account that requires payment first is listed first, the account requiring payment next is listed second, etc. This allows users of the statement to assess the cash- flow implications of each account. Starbucks presents the Accounts Payable account as the first current liability and that account likely requires payment first.

The current liability classification is important because it is closely tied to the concept of liquidity. Management of a firm must be prepared to pay current liabilities within a short time period. Therefore, management must have access to liquid assets, cash, or other assets that can be converted to cash in amounts sufficient to pay the current liabilities. Firms that do not have sufficient resources to pay their current liabilities are often said to have a liquidity problem.

Connect to the Real World 9-1

Starbucks: Reading the Balance Sheet

Refer to Starbucks' September 27, 2015, balance sheet in the chapter opener. What accounts are listed as current liabilities? How much did Accounts Payable change from 2014 to 2015?

A handy ratio to help creditors or potential creditors determine a company's liquidity is the current ratio—the ratio of current assets to current liabilities. A current ratio of 2 to 1 is usually a comfortable margin. If the firm has a large amount of inventory, it is sometimes

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useful to exclude inventory (prepayments are also excluded) when computing the ratio. That provides the “quick” ratio. Usually, a quick ratio of at least 1.5 to 1 would be preferred so that the company could pay its bills on time. Of course, the guidelines given for the current ratio 2 to 1 and the quick ratio 1.5 to 1 are only rules of thumb. The actual current and quick ratios of companies vary widely and depend on the company, the management policies, and the type of industry. Exhibit 9-1 presents the current and quick ratios for Starbucks and two of its competitors. The ratios vary from company to company, yet all are solid companies without liquidity problems. Note especially that the current ratio for Starbucks is less than 2 to 1 because of the nature of its business and because of the efficient use of its current assets.

Exhibit 9-1

Current and Quick Ratios of Selected Companies for 2015

Accounting for current liabilities is an area in which U.S. accounting standards are similar to those of most other countries. Nearly all countries encourage firms to provide a breakdown of liabilities into current and long term to allow users to evaluate liquidity.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Accounts Payable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Accounts Payable

Accounts payable (Amounts owed for inventory, goods, or services acquired in the normal course of business.) represent amounts owed for the purchase of inventory, goods, or services acquired in the normal course of business. Accounts payable usually do not require the payment of interest, but terms may be given to encourage early payment. For example, terms may be stated as 2/10, n/30, which means that a 2% discount is available if payment occurs within the first ten days and that if payment is not made within ten days, the full amount must be paid within 30 days.

Timely payment of accounts payable is an important aspect of cash-flow management. Generally, it is to the company's benefit to take advantage of available discounts. If your supplier is going to give you a 2% discount for paying on Day 10 instead of Day 30, that means you are earning 2% on your money over 20/360 of a year. If you took the 2% discount throughout the year, you would be getting a 36% annual return on your money, since there are 18 periods of 20 days each in a year. Therefore, the accounts payable system must be established in a manner that alerts management to take advantage of discounts offered.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Notes Payable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Notes Payable

How is a note payable different from an account payable? The most important difference is that an account payable is not a formal contractual arrangement, whereas a note payable (Amounts owed that are represented by a formal contract.) is represented by a formal agreement or note signed by the parties to the transaction. Notes payable may arise from dealing with a supplier or from acquiring a cash loan from a bank or creditor. Those notes that are expected to be paid within one year of the balance sheet date should be classified as current liabilities.

The accounting for notes payable depends on whether the interest is paid on the note's due date or is deducted before the borrower receives the loan proceeds. With the first type of note, the terms stipulate that the borrower receives a short-term loan and agrees to repay the principal and interest at the note's due date.

How Will I Use Accounting?

If you are a broker in a real estate firm, you will need to understand current liabilities.

If your company needs a bank loan, the bank will analyze your liabilities carefully to see if you can pay back the loan.

Example 9-1

Recording the Interest on Notes Payable

Assume that Hot Coffee Inc. receives a one-year loan from First National Bank on January 1. The face amount of the note of $1,000 must be repaid on December 31 along with interest at the rate of 12%. Hot Coffee could identify and analyze the effect of the loan as follows:

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Banks also use another form of note, one in which the interest is deducted in advance. This is sometimes referred to as discounting a note.

Example 9-2

Discounting a Note

Suppose that on January 1, 2017, First National Bank granted to Hot Coffee a $1,000 loan, due on December 31, 2017, but deducted the interest in advance and gave Hot Coffee the remaining amount of $880 ($1,000 face amount of the note less interest of $120). On January 1, Hot Coffee could identify and analyze the effect of the loan as follows:

The Discount on Notes Payable (A contra-liability that represents interest deducted from a loan in advance.) account should be treated as a reduction of Notes Payable. If a balance sheet was developed immediately after the January 1 loan, the note would appear in the Current Liability category as follows:

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Study Tip

Discount on Notes Payable is a contra- liability account and will have a debit balance.

The original balance in the Discount on Notes Payable account represents interest that must be transferred to interest expense over the life of the note. Refer to Example 9-2. Before Hot Coffee presents its year-end financial statements, it must make an adjustment to transfer the discount to interest expense. The effect of the adjustment on December 31 is as follows:

Thus, the balance of the Discount on Notes Payable account is zero and $120 has been transferred to interest expense. When the note is repaid on December 31, 2017, Hot Coffee must repay the full amount of the note. The effect could be identified and analyzed as follows:

In the previous two examples, the stated interest rate on each note was 12%. The dollar amount of interest incurred in each case was $120. However, the interest rate on a discounted note, the second example, is always higher than it appears. Hot Coffee received the use of only $880, yet it was required to repay $1,000. Therefore, the interest rate incurred on the note was actually $120/$880, or approximately 13.6%.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Current Maturities of Long-Term Debt Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Current Maturities of Long-Term Debt

Some companies may have an account that is titled Current Portion of Long-Term Debt. On other companies' balance sheets, this item may appear as Current Maturities of Long- Term Debt (The portion of a long-term liability that will be paid within one year. Alternate term: Long-term debt, current portion.) . This account should appear when a firm has a long-term liability and must make periodic payments.

Example 9-3

Recording Current Maturities of Long-Term Debt

Assume that on January 1, 2017, your firm obtained a $10,000 loan from the bank. The terms of the loan require you to make payments in the amount of $1,000 per year for ten years payable each January 1 beginning January 1, 2018. On December 31, 2017, an entry should be made to classify a portion of the balance as a current liability. The effect could be identified and analyzed as follows:

The December 31, 2017, balance sheet should indicate that the liability for the note payable is classified into two portions: a $1,000 current liability that must be repaid within one year and a $9,000 long-term liability.

Refer to the information in Example 9-3. On January 1, 2018, the company must pay $1,000. The effect could be identified and analyzed as follows:

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On December 31, 2018, the company should again record the current portion of the liability. Therefore, the 2018 year-end balance sheet should indicate that the liability is classified into two portions: a $1,000 current liability and an $8,000 long-term liability. The process should be repeated each year until the bank loan has been fully paid. When an investor or a creditor reads a balance sheet, he or she wants to distinguish between debt that is long term and debt that is short term. Therefore, it is important to segregate the portion of the debt that becomes due within one year.

The balance sheet account labeled Current Portion of Long-Term Debt should include only the amount of principal to be paid. The amount of interest that has been incurred but is unpaid should be listed separately in an account such as Interest Payable.

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LO 2 - Examine how accruals affect the Current Liability category.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Taxes Payable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Taxes Payable

Corporations pay a variety of taxes, including federal and state income taxes, property taxes, and other taxes. Taxes are an expense of the business and should be accrued in the same manner as any other business expense. A company that ends its accounting year on December 31 is not required to calculate the amount of tax owed to the government until the following March 15 or April 15, depending on the type of business. Therefore, the business must make an accounting entry, usually as one of the year-end adjusting entries, to record the amount of tax that has been incurred but is unpaid. Normally, the effect could be identified and analyzed as follows:

The calculation of the amount of tax a business owes is very complex. For now, the important point is that taxes are an expense when incurred (not when paid) and must be recorded as a liability as incurred.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Other Accrued Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Other Accrued Liabilities

Starbucks' 2015 balance sheet listed an amount of $1,269.3 million as current liability under the category of Accrued Liabilities. What items might be included in this category? Accrued liabilities (A liability that has been incurred but has not yet been paid.) include any amount that has been incurred due to the passage of time but has not been paid as of the balance sheet date. A common example is salary or wages payable.

Example 9-4

Recording Accrued Liabilities

Suppose that your firm has a payroll of $1,000 per day Monday through Friday and that employees are paid at the close of work each Friday. Also, suppose that December 31 is the end of your accounting year and that it falls on a Tuesday. The effect of the adjusting entry for salaries could be identified and analyzed as follows:

The amount of the salary payable would be classified as a current liability and could appear in a category such as Other Accrued Expenses.

Interest is another item that often must be accrued at year-end. Assume that you received a one-year loan of $10,000 on December 1. The loan carries a 12% interest rate. On December 31, an accounting entry must be made to record interest even though the money may not actually be due. The effect could be identified and analyzed as follows:

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The Interest Payable account should be classified as a current liability, assuming that it is to be paid within one year of the December 31 date.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money IFRS and Current Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

IFRS and Current Liabilities The accounting for current liabilities in U.S. and international standards is generally similar, but there are a few important differences. In this chapter, we have presented classified balance sheets with liabilities classified as either current or long term. Interestingly, U.S. standards do not require a classified balance sheet, and financial statements of some U.S. companies may list liabilities in order by size or by order of liquidity.

International accounting standards require companies to present classified balance sheets with liabilities classified as either current or long term. An unclassified balance sheet based on the order of liquidity is acceptable only when it provides more reliable information.

Module 1

Test Yourself

Question

1. What is the definition of current liabilities? Why is it important to distinguish between current and long-term liabilities?

2. Is the account Discount on Notes Payable an income statement or a balance sheet account? Does it have a debit or credit balance?

3. A firm's year ends on December 31. Its tax is computed and submitted to the U.S. Treasury on March 15 of the following year. When should the taxes be reported as a liability?

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Apply

1. A company has the following current assets: Cash, $10,000; Accounts Receivable, $70,000; and Inventory, $20,000. The company also has current liabilities of $40,000. Calculate the company's current ratio and quick ratio.

2. You receive an invoice from a supplier for $5,000 on January 1 with terms 3/15, n/30. If you pay between January 1 and January 16, how much must you pay? If you pay after January 16, how much must you pay?

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LO 3 - Explain how changes in current liabilities affect the statement of cash flows.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 2 Cash Flow Effects Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 2 Cash Flow Effects It is important to understand the impact that current liabilities have on a company's cash flows. Exhibit 9-2 illustrates the placement of current liabilities on the statement of cash flows (using the indirect method) and their effect. Most current liabilities are directly related to a firm's ongoing operations. Therefore, the change in the balance of each current liability account should be reflected in the Operating Activities category of the statement of cash flows. A decrease in a current liability account indicates that cash has been used to pay the liability and should appear as a deduction on the cash-flow statement. An increase in a current liability account indicates a recognized expense that has not yet been paid.

Exhibit 9-2

Current Liabilities on the Statement of Cash Flows

A partial statement of cash flows of Starbucks Corporation is presented in Exhibit 9-3. In 2015, the company has a positive amount of $137.7 million for Accounts Payable on the statement of cash flows and a positive amount of $87.6 million for Income Taxes Payable and a positive amount of $124.4 for Accrued Liabilities and Insurance Reserves. This is an indication that those accounts increased, resulting in an increase in cash.

Exhibit 9-3

Starbucks Corporation Partial Consolidated Statement of Cash Flows (In millions)

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Source: Starbucks, Inc., Form 10-K, For the Fiscal Year Ended September 27, 2015.

Almost all current liabilities appear in the Operating Activities category of the statement of cash flows, but there are exceptions. If a current liability is not directly related to operating activities, it should not appear in the Operating Activities category. For example, if Starbucks uses some notes payable as a means of financing, distinct from operating activities, those borrowings and repayments are reflected in the Financing Activities rather than the Operating Activities category.

Module 2

Test Yourself

Question

If a company has current liabilities that have increased during the year, how will they appear on the statement of cash flows? In what category?

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Will they appear as positive or negative amounts?

Apply

A company has the following current liabilities at the beginning of the period: Accounts Payable, $30,000; Taxes Payable, $10,000. At the end of the period, the balances of the account are as follows: Accounts Payable, $20,000; Taxes Payable, $15,000. What amounts will appear in the cash-flow statement? In what category of the statement will they appear?

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LO 4 - Determine when contingent liabilities should be presented on the balance sheet or disclosed in notes and how to calculate their amounts.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 3 Contingent Liabilities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 3 Contingent Liabilities Accountants must exercise a great deal of expertise and judgment in deciding what to record and in determining the amount to record. This is certainly true regarding contingent liabilities. A contingent liability (An existing condition for which the outcome is not known but depends on some future event. Alternate term: Contingent loss.) is an obligation that involves an existing condition for which the outcome is not known with certainty and depends on some event that will occur in the future. The actual amount of the liability must be estimated because we cannot clearly predict the future. The important accounting issues are whether contingent liabilities should be recorded and, if so, in what amounts.

This judgment call is normally resolved through discussions between a company's management and its outside auditors. Management would rather not disclose contingent liabilities until they come due because investors and creditors judge management based on the company's earnings, and the recording of a contingent liability must be accompanied by a charge to (reduction in) earnings. Auditors, on the other hand, want to see as much information as possible because they essentially represent the interests of investors and creditors who want to know as much as possible.

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Study Tip

Contingent liabilities are recorded only if they are probable and if the amount can be reasonably estimated.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Contingent Liabilities That Are Recorded Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Contingent Liabilities That Are Recorded

A contingent liability should be accrued and presented on the balance sheet if it is probable and if the amount can be reasonably estimated. But when is an event probable, and what does reasonably estimated mean? The terms must be defined based on the facts of each situation. A financial statement user would want the company to err on the side of full disclosure. On the other hand, the company should not be required to disclose every remote possibility.

Product Warranties and Guarantees: Common Contingent Liabilities That Are Recorded

A common contingent liability that firms must present as a liability involves product warranties and guarantees. Many firms sell products for which they provide the customer a warranty against potential defects. If a product becomes defective within the warranty period, the selling firm ensures that it will repair or replace the item.

At the end of each period, the selling firm must estimate how many of the products sold in the current year will become defective in the future and the cost of repair or replacement. This type of contingent liability is often referred to as an estimated liability (A contingent liability that is accrued and reflected on the balance sheet.) to emphasize that the costs are not known at year-end and must be estimated.

Example 9-5

Recording a Liability for Warranties

Assume that Quickkey Computer sells a computer product for $5,000 with a one- year warranty in case the product must be repaired. Assume that in 2017, Quickkey sold 100 computers for a total sales revenue of $500,000. At the end of 2017, Quickkey must record an estimate of the warranty costs that will occur on 2017 sales. Using an analysis of past warranty records, Quickkey estimates that repairs will average 2% of total sales. The effect of the recording of warranty costs at the end of 2017 could be identified and analyzed as follows:

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The amount of warranty costs that a company presents as an expense is of interest to investors and potential creditors. If the expense as a percentage of sales begins to rise, a logical conclusion is that the product is becoming less reliable.

Warranties are an excellent example of the matching principle. In Example 9-5, the warranty costs related to 2017 sales were estimated and recorded in 2017. This was done to match the 2017 sales with the expenses related to those sales. When actual repairs of the computers occur in 2018, they do not result in an expense. The repair costs incurred in 2018 should be treated as a reduction in the liability that had been estimated previously. The ending balance of the Estimated Liability account can be calculated as:

A company must analyze past warranty records carefully and incorporate any changes in customer buying habits, usage, technological changes, and other changes. Still, even with careful analysis, the actual amount of the expense is not likely to equal the estimated amount. Generally, firms do not change the amount of the expense recorded in past periods for such differences. They may adjust the amount recorded in future periods, however.

Premiums or Coupons: Other Contingent Liabilities That Are Recorded

Another example of a contingent liability is premium or coupon offers that accompany many products. Cereal boxes often allow customers to purchase a toy or game at a reduced price if the purchase is accompanied by cereal box tops or proof of purchase. The offer given to cereal customers represents a contingent liability. At the end of each year, the cereal company must estimate the number of premium offers that will be redeemed and the cost involved and must report a contingent liability for that amount.

Some Lawsuits and Legal Claims Are Contingent Liabilities That Must Be Recorded

Legal claims that have been filed against a firm are also examples of contingent liabilities. Lawsuits and legal claims represent a contingent liability because an event has occurred but the outcome of that event, the resolution of the lawsuit, is not known. The defendant must make a judgment about the lawsuit's outcome to decide whether the item should be recorded on the balance sheet or disclosed in the notes. When the legal claim's outcome is likely to be unfavorable, a contingent liability should be recorded on the balance sheet. Exhibit 9-4 contains footnote disclosure of Burger King Corporation. Burger King was

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involved in a lawsuit that began in 2008 and continued through 2011. It appears that the company is facing an unfavorable outcome. In such cases, the company must decide when the liability should be recorded.

Exhibit 9-4

Note Disclosure of Contingencies for Burger King Corporation

On September 10, 2008, a class action lawsuit was filed against the Company in the United States District Court for the Northern District of California. The complaint alleged that all 96 Burger King restaurants in California leased by the Company and operated by franchisees violate accessibility requirements under federal and state law. In September 2009, the court issued a decision on the plaintiffs' motion for class certification. In its decision, the court limited the class action to the 10 restaurants visited by the named plaintiffs, with a separate class of plaintiffs for each of the 10 restaurants and 10 separate trials. In March 2010, the Company agreed to settle the lawsuit with respect to the 10 restaurants and, in July 2010, the court gave final approval to the settlement. In February 2011, a class action lawsuit was filed with respect to the other 86 restaurants. The plaintiffs sought injunctive relief, statutory damages, attorneys' fees and costs. In January 2012, BKC agreed to settle the lawsuit. The parties are finalizing the terms of the proposed settlement which will be submitted to the court for approval.

Source: Burger King Corporation, Form 10-K, For the Fiscal Year Ended December 31, 2011.

As you might imagine, firms are not eager to record contingent lawsuits as liabilities because the amount of loss is often difficult to estimate. Also, some may view the accountant's decision as an admission of guilt when a lawsuit is recorded as a liability before the courts have finalized a decision. Accountants often must consult with lawyers or other legal experts to determine the probability of the loss of a lawsuit. In cases involving contingencies, the accountant must make an independent judgment based on the facts and not be swayed by the desires of other parties.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Contingent Liabilities That Are Disclosed Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Contingent Liabilities That Are Disclosed

Any contingent liability that is probable and that can be reasonably estimated must be reported as a liability. We now must consider contingent liabilities that do not meet the probable criterion or cannot be reasonably estimated. In either case, a contingent liability must be disclosed in the financial statement notes but not reported on the balance sheet if the contingent liability is at least reasonably possible. Most lawsuits are not recorded as liabilities because the risk of loss is not considered probable or the amount of the loss cannot be reasonably estimated. If a company does not record a lawsuit as a liability, it still must consider whether the lawsuit should be disclosed in the notes to the financial statements. When the risk of loss is at least reasonably possible, the company should provide note disclosure. This is the course of action taken for most contingent liabilities involving lawsuits. Readers of the financial statements and analysts must read the notes carefully to determine the impact of such contingent liabilities.

The amount and the timing of the cash outlays associated with contingent liabilities are especially difficult to determine. Lawsuits, for example, may extend several years into the future, and the dollar amount of possible loss may be subject to great uncertainty.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Contingent Liabilities versus Contingent Assets Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Contingent Liabilities versus Contingent Assets

Contingent liabilities that are probable and can be reasonably estimated must be presented on the balance sheet before the outcome of the future events is known. This accounting rule applies only to contingent losses or liabilities. It does not apply to contingencies by which the firm may gain. Generally, contingent gains or contingent assets (An existing condition for which the outcome is not known but by which the company stands to gain. Alternate term: Contingent gain.) are not reported until the gain actually occurs. That is, contingent liabilities may be accrued but contingent assets are not accrued. Remember that accounting is a discipline based on a conservative set of principles. It is prudent and conservative to delay the recording of a gain until an asset is actually received but to record contingent liabilities in advance.

Even though the contingent assets are not reported, the information still may be important to investors. Investment analysts try to place a value on contingent assets that they believe will result in future benefits. By buying stock of a company that has unrecorded assets (or advising their clients to do so), analysts hope to make money when those assets become a reality.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money IFRS and Contingencies Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

IFRS and Contingencies There are very important differences between U.S. and international standards regarding contingencies. In international standards, the term contingent liability is used only for those items that are not recorded on the balance sheet but are disclosed in the notes that accompany the statements. International standards use the term provision for those items that must be recorded on the balance sheet. As in U.S. standards, an item should be recorded if the loss or outflow is probable and can be reasonably estimated. But the meaning of the term probable is somewhat different. In international standards, probable means the loss or outflow is “more likely than not” to occur. This is a lower threshold than in U.S. standards and may cause more items to be recorded as liabilities. Also, international standards require the amount recorded as a liability to be “discounted” or recorded as a present value amount, while U.S. standards do not have a similar requirement.

Module 3

Test Yourself

Question

1. What is a contingent liability? Why are contingent liabilities accounted for differently than contingent assets?

2. Assume that a lawsuit has been filed against your firm. Your legal counsel has assured you that a loss is not probable. How should the lawsuit be disclosed on the financial statements?

Apply

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Omega Company is involved in two unrelated lawsuits, one as the plaintiff and one as the defendant. As a result of these two lawsuits, the company has a contingent asset and a contingent liability. How should Omega record these on its balance sheet?

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LO 5 - Explain the difference between simple and compound interest.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money: Module 4 Time Value of Money Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 4 Time Value of Money This section will discuss the impact that interest has on decision making because of the time value of money. The time value of money (An immediate amount should be preferred over an amount in the future.) concept means that people prefer a payment at the present time rather than in the future because of the interest factor. If an amount is received at the present time, it can be invested and the resulting accumulation will be larger than if the same amount is received in the future. Thus, there is a time value to cash receipts and payments.

Exhibit 9-5 indicates some of the personal and accounting decisions affected by the time value of money concept. In your personal life, you make decisions based on the time value of money concept nearly every day. When you invest money, you are interested in how much will be accumulated and you must determine the future value based on the amount of interest that will be compounded. When you borrow money, you must determine the amount of the loan payments. The amount of the loan payment is based on the present value of the loan, another time value of money concept.

Exhibit 9-5

Importance of the Time Value of Money

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Time value of money is also important because of its implications for accounting valuations. Chapter 10 explains that the issue price of a bond is based on the present value of the cash flows that the bond will produce. The valuation of the bond and the recording of the bond on the balance sheet are based on this concept. Further, the amount that is considered interest expense on the financial statements is also based on time value of money concepts. The bottom portion of Exhibit 9-5 indicates that the valuations of many other accounts, including Notes Receivable and Leases, are based on compound interest calculations.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Simple Interest Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Simple Interest

Simple interest (Interest is calculated on the principal amount only.) is interest earned on the principal amount. If the amount of principal is unchanged from year to year, the interest per year will remain the same. Interest can be calculated using the following formula:

where

For example, assume that a firm has signed a two-year note payable for $3,000. Interest and principal are to be paid at the due date with simple interest at the rate of 10% per year. The amount of interest on the note would be $600, calculated as $3,000 × 0.10 × 2. The firm would be required to pay $3,600 on the due date: $3,000 principal and $600 interest.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Compound Interest Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Compound Interest

Compound interest (Interest calculated on the principal plus previous amounts of interest. Alternate term: Interest on interest.) means that interest is calculated on the principal plus previous amounts of accumulated interest. Thus, interest is compounded, or there is interest on interest.

A comparison of the note payable with 10% simple interest with the note payable with 10% compound interest in Example 9-6 clearly indicates that the amount accumulated with compound interest is a higher amount because of the interest-on-interest feature.

Example 9-6

Calculating Compound Interest

Assume a $3,000 note payable for which interest and principal are due in two years with interest compounded annually at 10% per year. Interest would be calculated as follows:

We would be required to pay $3,630 at the end of two years, $3,000 principal and $630 interest.

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LO 6 - Calculate amounts using the future value and present value concepts.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Interest Compounding Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Interest Compounding

For most accounting problems, we will assume that interest is compounded annually. In actual business practice, compounding usually occurs over much shorter intervals. This can be confusing because the interest rate is often stated as an annual rate even though it is compounded over a shorter period. If compounding is not done annually, you must adjust the interest rate by dividing the annual rate by the number of compounding periods per year.

Example 9-7 illustrates that compounding more frequently results in a larger amount accumulated. In fact, many banks and financial institutions now compound interest on savings accounts on a daily basis.

Example 9-7

Compounding Interest Semiannually

Assume that the note payable from the previous example carried a 10% interest rate compounded semiannually for two years. The 10% annual rate should be converted to 5% per period for four semiannual periods. The amount of interest would be compounded, as in the previous example, but for four periods instead of two. The compounding process is as follows:

In the remainder of this section, we will assume that compound interest is applicable. The following four compound interest calculations must be understood:

Future value of a single amount

Present value of a single amount

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Future value of an annuity

Present value of an annuity

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value and Future Value: Single Amounts Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Present Value and Future Value: Single Amounts

Future Value of a Single Amount

A future amount or future value is the amount of interest plus principal that will be accumulated at a future time. The future amount is always larger than the principal amount (payment) because of the interest that accumulates. In some cases, we will use time diagrams to illustrate the relationships. A time diagram to illustrate a future value would be of the following form:

The formula to calculate the future value of a single amount (Amount accumulated at a future time from a single payment or investment.) is as follows:

where

Example 9-8

Calculating Future Values with Formula

Your three-year-old son Robert inherits $50,000 in cash and securities from his grandfather. If the funds are left in the bank and in the stock market and receive an annual return of 10%, how much will be available in 15 years when Robert starts college?

Solution:

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Consider a $2,000 note payable that carries interest at the rate of 10% compounded annually. The note is due in two years, and the principal and interest must be paid at that time. The amount that must be paid in two years is the future value. The future value can be calculated in the manner used in the previous examples:

The future value can also be calculated by using the following formula:

Instead of a formula, other methods can be used to calculate future value. Tables can be constructed to assist in the calculations. Table 9-1 indicates the future value of $1 at various interest rates for various time periods. To find the future value of a two-year note at 10% compounded annually, you read across the line for two periods and down the 10% column, which gives you an interest rate factor of 1.21000. Because the table has been constructed for future values of $1, we would determine the future value of $2,000 as follows:

Table 9-1

Future Value of $1

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A second method is to use the built-in functions of a computerized spreadsheet. The appendix to this chapter will illustrate how to use a common spreadsheet, Microsoft Excel , to perform the same calculations. The numbers produced by each method may differ by a few dollars because of rounding differences.

Remember that compounding does not always occur annually. How does this affect the calculation of future value amounts?

Example 9-9

Calculating Future Values with Quarterly Compounding

Suppose we want to find the future value of a $2,000 note payable due in two years. The note payable requires interest to be compounded quarterly at the rate of 12% per year. To calculate the future value, we must adjust the interest rate to a quarterly basis by dividing the 12% rate by the number of compounding periods per year, which in the case of quarterly compounding is four:

Also, the number of compounding periods is eight—four per year times two years.

The future value of the note can be found in two ways. First, we can insert the proper values into the future value formula:

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We can arrive at the same future value amount with the use of Table 9-1. Refer to the interest factor in the table indicated for eight periods and 3%. The future value would be calculated as follows:

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Study Tip

When interest rates increase, present values decrease. This is called an inverse relationship.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value of a Single Amount Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Present Value of a Single Amount

In many situations, we want to determine the present amount that is equivalent to an amount at a future time. This is the present value concept. The present value of a single amount (The amount at a present time that is equivalent to a payment or an investment at a future time.) represents the value today of a single amount to be received or paid at a future time. This can be portrayed in a time diagram as follows:

The time diagram portrays discount rather than interest because we often speak of “discounting” the future payment back to the present time.

Example 9-10

Calculating Present Value of a Single Amount

Suppose you know that you will receive $2,000 in two years. If you had the money now, you could invest it at 10% compounded annually. What is the present value of the $2,000? In other words, what amount must be invested today at 10% compounded annually to have $2,000 accumulated in two years?

The formula used to calculate present value is as follows:

where

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We can use the present value formula to solve for the present value of the $2,000 note as follows:

Tables have also been developed to determine the present value of $1 at various interest rates and number of periods. Table 9-2 presents the present value or discount factors for an amount of $1 to be received at a future time. To use the table for Example 9-10, you must read across the line for two periods and down the 10% column to the discount factor of 0.82645. The present value of $2,000 would be calculated as follows:

Table 9-2

Present Value of $1

The example illustrates that the present value amount is always less than the future payment. This happens because of the discount factor. In other words, if we had a smaller amount at the present (the present value), we could invest it and earn interest that would

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accumulate to an amount equal to the larger amount (the future payment). Also, study of the present value and future value formulas indicates that each is the reciprocal of the other. When we want to calculate a present value amount, we normally use Table 9-2 and multiply a discount factor times the payment. However, we could also use Table 9-1 and divide by the interest factor. Thus, the present value of the $2,000 to be received in the future could also be calculated as follows:

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value and Future Value of an Annuity Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Present Value and Future Value of an Annuity

Future Value of an Annuity

Annuity (A series of payments of equal amounts.) means a series of payments of equal amounts. Suppose you are to receive $3,000 per year at the end of each of the next four years. Also, assume that each payment could be invested at an interest rate of 10% compounded annually. How much would be accumulated in principal and interest by the end of the fourth year? This is an example of an annuity of payments of equal amounts. A time diagram would portray the payments as follows:

Because we are interested in calculating the future value, we could use the future value of $1 concept and calculate the future value of each $3,000 payment using Table 9-1 as follows:

Note that four payments would be received but that only three of them would draw interest because the payments are received at the end of each period.

Fortunately, there is an easier method to calculate the future value of an annuity (The amount accumulated in the future when a series of payments is invested and accrues interest. Alternate term: Amount of an annuity.) . Table 9-3 has been constructed to indicate the future value of a series of payments of $1 per period at various interest rates and number of periods. The table can be used for the previous example by reading across the four-period line and down the 10% column to a table factor of 4.64100. The future value of an annuity of $3,000 per year can be calculated as follows:

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Table 9-3

Future Value of Annuity of $1

Example 9-11

Calculating Future Value of an Annuity

Your cousin had a baby girl two weeks ago and is already thinking about sending her to college. When the girl is 15, how much money would be in her college account if your cousin deposited $2,000 into it on each of her 15 birthdays? The interest rate is 10%. The future value could be calculated as follows.

What if the scenario was modified so that $1,000 was deposited semiannually and the interest rate was 10% compounded semiannually (or 5% per period) for 15 years? Table 9-3 could be used by reading across the line for 30 periods and down the column for 5% to obtain a table factor of 66.43885. The future value would be calculated as follows:

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Comparing the two scenarios illustrates once again that more frequent compounding results in larger accumulated amounts.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Present Value of an Annuity Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Present Value of an Annuity

Many accounting applications of the time value of money concept concern situations for which we want to know the present value of a series of payments that will occur in the future. This involves calculating the present value of an annuity. An annuity is a series of payments of equal amounts.

Suppose you will receive an annuity of $4,000 per year for four years, with the first received one year from today. The amounts received can be invested at a rate of 10% compounded annually. What amount would you need at the present time to have an amount equivalent to the series of payments and interest in the future? To answer that question, you must calculate the present value of an annuity (The amount at a present time that is equivalent to a series of payments and interest in the future.) . A time diagram of the series of payments would appear as follows:

Because you are interested in calculating the present value, you could refer to the present value of $1 concept and discount each of the $4,000 payments individually using table factors from Table 9-2 as follows:

Tables have been constructed to ease the computational burden. Table 9-4 provides table factors to calculate the present value of an annuity of $1 per year at various interest rates and number of periods. The previous example can be solved by reading across the four- year line and down the 10% column to obtain a table factor of 3.16987. The present value would then be calculated as follows:

Table 9-4

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Present Value of Annuity of $1

Example 9-12

Calculating Present Value of an Annuity

You just won the lottery. You can take your $1 million in a lump sum today, or you can receive $100,000 per year over the next 12 years. Assuming a 5% interest rate, which would you prefer, ignoring tax considerations? The present value of the series of payments can be calculated as follows:

Solution:

Because the present value of the payments over 12 years is less than the $1 million immediate payment, you should take the immediate payment.

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LO 7 - Apply the compound interest concepts to some common accounting situations.

Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Solving for Unknowns Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Solving for Unknowns

In some cases, the present value or future value amounts will be known but the interest rate or the number of payments must be calculated. The formulas presented thus far can be used for such calculations.

Example 9-13

Solving for an Interest Rate

Assume that you have just purchased an automobile for $14,419 and must decide how to pay for it. Your local bank has graciously granted you a five-year loan. Because you are a good credit risk, the bank will allow you to make annual payments on the loan at the end of each year. The amount of the loan payments, which include principal and interest, is $4,000 per year. You are concerned that your total payments will be $20,000 ($4,000 per year for five years) and want to calculate the interest rate that is being charged on the loan.

Because the market or present value of the car, as well as the loan, is $14,419, a time diagram of the example would appear as follows:

The interest rate we must solve for represents the discount rate that was applied to the $4,000 payments to result in a present value of $14,419. Therefore, the applicable formula is the following:

In this case, PV is known, so the formula can be rearranged as follows:

You need to use Table 9-4 to find the interest rate. You must read across the five- year line until you find a table factor that is near the value of 3.605. In this case, that

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table factor of 3.60478 is found in the 12% column. Therefore, the rate of interest being paid on the auto loan is approximately 12%.

Example 9-14

Solving for the Number of Years

Assume that you want to accumulate $12,000 as a down payment on a home. You believe that you can save $1,000 per semiannual period, and your bank will pay interest of 8% per year, or 4% per semiannual period. How long will it take you to accumulate the desired amount?

The accumulated amount of $12,000 represents the future value of an annuity of $1,000 per semiannual period. Therefore, we can use the interest factors of Table 9- 3 to assist in the solution. The applicable formula in this case is the following:

The future value is known to be $12,000, and we must solve for the interest factor or table factor. Therefore, we can rearrange the formula as follows:

You need to use Table 9-3 and the 4% column to find a table value that is near 12.00. The closest table value you find is 12.00611. That table value corresponds to ten periods. Therefore, if $1,000 is deposited per semiannual period and the money is invested at 4% per semiannual period, it will take ten semiannual periods (five years) to accumulate $12,000.

Module 4

Test Yourself

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Question

1. What is the meaning of the terms present value and future value? How can you determine whether to calculate the present value or the future value of an amount?

2. What is the meaning of the word annuity? Can the present value of an annuity be calculated as a series of single amounts? If so, how?

3. Assume that you know the total dollar amount of a loan and the amount of the monthly payments. How can you determine the interest rate as a percentage of the loan?

Apply

1. You invest $1,000 at the beginning of the year. How much will be accumulated in five years if you earn 10% interest compounded annually?

2. You invest $1,000 per year at the end of each year for five years. How much will be accumulated in five years if you earn 10% interest compounded annually?

3. You will receive $1,000 in five years. What is the present value of that amount if you earn 10% interest compounded annually?

4. You will receive $1,000 per year at the end of each year for five years. What is the present value of that amount if you earn 10% interest compounded annually?

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Chapter Review Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Appendix Accounting Tools: Using Excel for Problems Involving Interest Calculations

The purpose of this appendix is to illustrate how the functions built in to the Excel spreadsheet can be used to calculate future value and present value amounts. The use of Excel will be illustrated with the same examples that are used in this chapter.

To view the Excel functions, click on the PASTE function of the Excel toolbar (the paste function is on the top of the Excel toolbar and is noted by the symbol fx); then choose the FINANCIAL option. Several different calculations are available. We will illustrate two of them: FV and PV.

Example 9-15

Using Excel for Future Values

Solution: In Excel , use the FV function and enter the values as follows:

® ®

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Note that the future value of $208,862 is slightly different from that given in the body of the text because of rounding when using the table factors.

Example 9-16

Using Excel for Annual Compounding

Consider a $2,000 note payable that carries interest at the rate of 10% compounded annually. The note is due in two years, and the principal and interest must be paid at that time. What amount must be paid in two years?

Solution: In Excel , use the FV function and enter the values as follows:

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The future value is $2,420.

Example 9-17

Using Excel for Quarterly Compounding

Suppose we want to find the future value of a $2,000 note payable due in two years. The note payable requires interest to be compounded quarterly at the rate of 12% per year. What future amount must be paid in two years?

Solution: In Excel , use the FV function and enter the values as follows:

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The future value is $2,534 (rounded to the nearest dollar).

Example 9-18

Using Excel for Present Values

Suppose you know that you will receive $2,000 in two years. If you had the money now, you could invest it at 10% compounded annually. What is the present value of the $2,000?

Solution: Since this problem requires the calculation of a present value, the PV function of Excel should be chosen and used as follows:

The present value is $1,653 (rounded to the nearest dollar).

Example 9-19

Using Excel for Future Value of an Annuity

Suppose you are to receive $3,000 per year at the end of each of the next four years. Also, assume that each payment could be invested at an interest rate of 10% compounded annually. How much would be accumulated in principal and interest by the end of the fourth year?

Solution: This problem involves the calculation of the future value of an annuity; you should use the FV function of Excel as follows:

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The future value of the series of payments is $13,923. Note that the payments are simply entered as the Pmt variable in the spreadsheet.

Example 9-20

Using Excel for Semiannual Compounding Annuities

Solution: Use the Excel FV function as follows:

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The future value amount is $63,545 (rounded to the nearest dollar).

What if the scenario was modified so that $1,000 was deposited semiannually and the interest rate was 10% compounded semiannually (or 5% per period) for 15 years?

Solution Because the compounding is semiannual, use the FV function of Excel as follows:

The future value is $66,439 (rounded to the nearest dollar).

Example 9-21

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Using Excel for Present Value of an Annuity

Solution: Use the PV function of Excel as follows:

Because the present value of the payments over 12 years is $886,325 (rounded to the nearest dollar) and is less than the $1 million available immediately, you should choose the immediate payment.

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Chapter 9: Current Liabilities, Contingencies, and the Time Value of Money Ratio Review Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Chapter Review

Ratio Review

*Working capital is defined and discussed in Chapter 2.

**Quick assets are those assets that can be converted into cash quickly. They may be measured differently by different companies but generally are measured as Total Current Assets − Inventory − Prepaid Expenses.

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Chapter 10 Long-Term Liabilities

Chapter Introduction

Module 1 Long-Term Liabilities Including Bonds Payable

Bonds Payable: Characteristics

Issuance of Bonds Factors Affecting Bond Price

Premium or Discount on Bonds

Module 2 Bond Amortization and Bond Retirement Effective Interest Method: Impact on Expense

Redemption of Bonds Retired Early at a Gain or a Loss

Financial Statement Presentation of Gain or Loss

Module 3 Liability for Leases Leases

IFRS and Leasing

Module 4 Analysis of Long-Term Liabilities and Cash Flow Issues

How Long-Term Liabilities Affect the Statement of Cash Flows

Chapter Review Module 5 Appendix: Deferred Tax

Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Multi-Concept Exercises

Problems

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Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

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Chapter Introduction

Making Business Decisions

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iStockphoto.com/asbe

Coca-Cola

Coca-Cola is truly a global corporation with more than 500 brands in almost 200 countries. While it began many years ago in the United States, now more than 70% of The Coca-Cola Company's income comes from business outside the United States.

To meet long-term growth objectives, Coca-Cola must make significant investments to support its products. The process also involves investment to develop new global brands and to acquire local or global brands when appropriate. In addition, the company makes significant marketing investments to encourage consumer loyalty. Coca-Cola has developed relationships with many sports organizations, including the NBA and NASCAR, to enhance consumer awareness and promote sales of its products. Outside the United States, there is a strong push to sell in many other markets, including India, Brazil, Africa, and Europe.

To expand profitably, Coca-Cola requires more money than it generates in profits. Therefore, it uses a common financing tool: long-term debt. The company monitors interest rate conditions carefully and in 2015 retired nearly $38 billion in long-term debt and replaced it with $40 billion in other debt. Because it is a global company, Coca-Cola has access to key financial markets around the world, which allows it to borrow at the lowest possible rates. While most of its loans are in U.S. dollars, management continually adjusts the composition of the debt to accommodate shifting interest rates and currency exchange rates to minimize the overall cost.

The accompanying balance sheet presents the Liabilities and Shareowners' Equity portion of the balance sheet for The Coca-Cola Company and its subsidiaries.

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Source: The Coca-Cola Company, Form 10-K, For the Fiscal Year Ended December 31, 2015.

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LO 1 - Identify the components of the Long- Term Liability category of the balance sheet.

Chapter 10: Long-Term Liabilities: Module 1 Long-Term Liabilities Including Bonds Payable Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 1 Long-Term Liabilities Including Bonds Payable In general, long-term liabilities are obligations that will not be satisfied within one year. Essentially, all liabilities that are not classified as current liabilities are classified as long term. We will concentrate on the long-term liabilities of bonds or notes, leases, and deferred taxes. For example, the Noncurrent Liabilities section of PepsiCo, Inc.'s balance sheet is highlighted in Exhibit 10-1. PepsiCo has acquired financing through a combination of long-term debt, stock issuance, and internal growth or retained earnings. Exhibit 10-1 indicates that long-term debt is one portion of the Long-Term Liability (An obligation that will not be satisfied within one year or the current operating cycle.) category of the balance sheet. But the balance sheet also reveals two other items that must be considered part of the Long-Term Liability category: deferred income taxes and other liabilities. We will concentrate on these long-term liabilities:

Bonds or notes

Leases

Deferred taxes

Exhibit 10-1

PepsiCo's Balance Sheet

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Source: PepsiCo, Inc., Form 10-K, For the Fiscal Year Ended December 26, 2015.

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LO 2 - Define the important characteristics of bonds payable.

Chapter 10: Long-Term Liabilities Bonds Payable: Characteristics Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Bonds Payable: Characteristics A bond is a security or financial instrument that allows firms to borrow money and repay the loan over a long period of time. The bonds are sold, or issued, to investors who want a return on their investment. The borrower (issuing firm) promises to pay interest on specified dates, usually annually or semiannually. The borrower also promises to repay the principal on a specified date, the due date or maturity date.

A bond certificate, illustrated in Exhibit 10-2, is issued at the time of purchase and indicates the terms of the bond. Unlike the bond in the exhibit, bonds are issued usually in denominations of $1,000. The denomination of the bond is usually referred to as the face value (The principal amount of the bond as stated on the bond certificate. Alternate term: Par value.) or par value. This is the amount that the firm must pay at the maturity date of the bond.

Exhibit 10-2

Bond Certificate

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Firms issue bonds in very large amounts, often in millions in a single issue. After bonds are issued, they may be traded on a bond exchange in the same way that stocks are sold on the stock exchanges. Therefore, bonds are not always held until maturity by the initial investor, but may change hands several times before their eventual due date. Because bond maturities are as long as 30 years, the market for bonds already issued is a critical factor in a company's ability to raise money. Investors in bonds may want to sell them if interest rates paid by competing investments become more attractive or if the issuer becomes less creditworthy. Buyers of these bonds may be betting that interest rates will reverse course or that the company will get back on its feet.

How Will I Use Accounting?

If you are a financial advisor or bond fund manager, you will use accounting every day to analyze the creditworthiness, price, and yield of bonds. The most successful managers determine risk on a continual basis using their accounting and finance expertise.

Risk analysis is an art, not a science.

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Following are some important features that often appear in the bond certificate.

Collateral

The bond certificate should indicate the collateral of the loan. Collateral represents the assets that back the bonds in case the issuer cannot make the interest and principal payments and must default on the loan. Debenture bonds (Bonds that are not backed by specific collateral.) are not backed by specific collateral of the issuing company. Rather, the investor must examine the general creditworthiness of the issuer. If a bond is a secured bond, the certificate indicates specific assets that serve as collateral in case of default.

Due Date

The bond certificate specifies the date that the bond principal must be repaid. Normally, bonds are term bonds, meaning that the entire principal amount is due on a single date. Alternatively, bonds may be issued as serial bonds (Bonds that do not all have the same due date; a portion of the bonds comes due each time period.) , meaning that not all of the principal is due on the same date. For example, a firm may issue serial bonds that have a portion of the principal due each year for the next ten years. Issuing firms may prefer serial bonds because a firm does not need to accumulate the entire amount for principal repayment at one time.

Other Features

Some bonds are issued as convertible or callable bonds. Convertible bonds can be converted into common stock at a future time. This feature allows the investor to buy a security that pays a fixed interest rate but that can be converted at a future date into an equity security (stock) if the issuing firm is growing and profitable. The conversion feature is also advantageous to the issuing firm because convertible bonds normally carry a lower rate of interest.

Callable bonds (Bonds that may be redeemed or retired before their specified due date.) may be retired before their specified due date. Callable generally refers to the issuer's right to retire the bonds. If the buyer or investor has the right to retire the bonds, they are referred to as redeemable bonds. Usually, callable bonds stipulate the price to be paid at redemption; this price is referred to as the redemption price or the reacquisition price.

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LO 3 - Determine the issue price of a bond using compound interest techniques.

Study Tip

Issuance of Bonds

Factors Affecting Bond Price

With bonds payable, two interest rates are always involved: the face rate and the market rate.

1. The face rate of interest (The rate of interest on the bond certificate. Alternate term: Stated rate, nominal rate, contract rate, coupon rate.) (also called the stated rate, nominal rate, contract rate, or coupon rate) is the rate specified on the bond certificate. It is the amount of interest that will be paid each interest period.

For example, if $10,000 worth of bonds was issued with an 8% annual face rate of interest, interest of $800 ($10,000 × 8% × 1 year) would be paid at the end of each annual period.

Alternatively, bonds often require the payment of interest semiannually. If the bonds in the example required the 8% annual face rate to be paid semiannually (at 4%), interest of $400 ($10,000 × 8% × 1/2 year) would be paid each semiannual period.

2. The market rate of interest (The rate that investors could obtain by investing in other bonds that are similar to the issuing firm's bonds. Alternate term: Effective rate, bond yield.) (also called the effective rate or bond yield) is the rate that bondholders could obtain by investing in other bonds that are similar to the issuing firm's bonds.

The market rate of interest is determined by the bond market on the basis of many transactions for similar bonds. The market rate incorporates all of the “market's” knowledge about economic conditions and all of its expectations about future conditions. Normally, issuing firms try to set a face rate that is equal to the market rate. However, because the market rate changes daily, small differences usually occur between the face rate and the market rate at the time bonds are issued.

In addition to the number of interest payments and the maturity length of the

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Calculating the issue price of a bond always involves a calculation of the present value of the cash flows.

bond, both the face rate and the market rate of interest must be known to calculate the issue price of a bond. The bond issue price (The present value of the annuity of interest payments plus the present value of the principal.) equals the present value of the two types of cash flows that the bond will produce for the investor:

1. Interest receipts

2. Repayment of principal (face value)

The interest receipts constitute an annuity of payments each interest period over the life of the bonds. The repayment of principal (face value) is a one-time receipt that occurs at the end of the term of the bonds. The present value of the interest receipts (using Table 9-4) plus the present value of the principal amount (using Table 9-2) equals the issue price of the bond.

Example 10-1

Calculating Bond Issuance at a Discount

Suppose that on January 1, 2017, Discount Firm wants to issue bonds with a face value of $10,000. The face, or coupon, rate of interest has been set at 8%. The bonds will pay interest annually, and the principal amount is due in four years. Also, suppose that the market rate of interest for other similar bonds is currently 10%. Because the market rate of interest exceeds the coupon rate, investors will not be willing to pay $10,000. We want to calculate the amount that will be obtained from the issuance of Discount Firm's bonds.

Discount's bond will produce two sets of cash flows for the investor:

1. An annual interest payment of $800 ($10,000 × 8%) per year for four years.

2. Repayment of the principal of $10,000 at the end of the fourth year.

To calculate the issue price, we must calculate the present value of the two sets of cash flows. A time diagram portrays the cash flows as follows:

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We can calculate the issue price by using the compound interest tables found in Chapter 9, as follows:

The factors used to calculate the present value represent four periods and 10% interest.

The issue price of a bond is always calculated using the market rate of interest. The face rate of interest determines the amount of the interest payments, but the market rate determines the present value of the payments and the present value of the principal (and therefore the issue price).

The example of Discount Firm reveals that the bonds with a $10,000 face value amount would be issued for $9,366. The bond markets and the financial press often state the issue price as a percentage of the face amount. The percentage for Discount's bonds can be calculated as ($9,366/$10,000) × 100, or 93.66%.

Exhibit 10-3 illustrates how bonds are actually listed in the reporting of the bond markets. The exhibit lists two types of IBM bonds that were traded on a particular day. The portion immediately after the company name (e.g., 6⅜ 27) indicates that the face rate of interest is 6⅜% and the due date of the bonds is the year 2027. The next column, (e.g., 6.5) indicates that the bond investor who purchased the bonds on that day will receive a yield of 6.5%. The column labeled “Vol” indicates the number of bonds, in thousands that were bought and sold during the day. The column labeled “Close” indicates the market price of the bonds at the end of the day. For example, the first issue of IBM bonds closed at 98¾%, which means that the price was 98¾% of the face value of the bonds. These bonds are trading at a discount because the face rate (6⅜%) is less than the market rate of 6.5%. The bonds in the second issue (7¼%) have a face rate of 7¼%; will become due in the year 2028; and closed at 101½, or at a premium. The Net Chg column indicates the change in the bond price that occurred for the day's trading.

Exhibit 10-3

Listing of Bonds on the Bond Market

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Connect to the Real World 10-1

Coca-Cola: Reading the Balance Sheet

Coca-Cola lists three items as long-term liabilities on its 2015 balance sheet (shown in Coca-Cola's 2015 Consolidated Partial Balance Sheets). What are those items? Did they increase or decrease?

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LO 4 - Show that you understand the effect on the balance sheet of the issuance of bonds.

Chapter 10: Long-Term Liabilities Premium or Discount on Bonds Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Premium or Discount on Bonds Premium (The excess of the issue price over the face value of the bonds.) or discount (The excess of the face value of bonds over the issue price.) represents the difference between the face value and the issue price of a bond. The relationship is stated as follows:

In other words, when issue price exceeds face value, the bonds have sold at a premium and when the face value exceeds the issue price, the bonds have sold at a discount.

We will continue with the Discount Firm in Example 10-1 to illustrate the accounting for bonds sold at a discount. Discount Firm's bonds sold at a discount calculated as follows:

Discount Firm would identify and analyze the effect of the issuance of the bonds as follows:

The Discount on Bonds Payable account is shown as a contra liability on the balance sheet as a deduction from Bonds Payable. If Discount Firm prepared a balance sheet immediately after the bond issuance, the following would appear in the Long-Term Liabilities category of the balance sheet:

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Now we will examine the opposite situation, when the face rate exceeds the market rate.

Example 10-2

Calculating Bond Issuance at a Premium

Suppose that on January 1, 2017, Premium Firm wants to issue the same bonds as in Example 10-1: $10,000 face value bonds with an 8% face rate of interest and with interest paid annually each year for four years. Assume, however, that the market rate of interest is 6% for similar bonds. The issue price is calculated as the present value of the annuity of interest payments plus the present value of the principal at the market rate of interest. The calculations are as follows:

We have calculated that the bonds would be issued for $10,693. The amount of the premium is calculated as follows:

Premium Firm could identify and analyze the effect of the issuance of the bonds as follows:

The account Premium on Bonds Payable is an addition to the Bonds Payable account. If Premium Firm presented a balance sheet immediately after the bond issuance, the Long- Term Liabilities category of the balance sheet would appear as follows:

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Study Tip

When interest rates increase, present values decrease. This is called an inverse relationship.

Note two important points from Discount Firm in Example 10-1 and Premium Firm in Example 10-2:

You should be able to determine whether a bond will sell at a premium or a discount by the relationship that exists between the face rate and the market rate of interest. Premium and discount do not mean “good” and “bad,” respectively. Premium or discount arises solely because of the difference that exists between the face rate and the market rate of interest for a bond issue. The same relationship always exists, so the following statements hold true:

The relationship between interest rates and bond prices is always inverse. The bonds of the two firms in Examples 10-1 and 10-2 are identical in all respects except for the market rate of interest. When the market rate was 10%, the bond issue price was $9,366 (Example 10-1). When the market rate was 6%, the bond issue price increased to $10,693 (Example 10-2). These examples illustrate that as interest rates decrease, prices on the bond markets increase and that as interest rates increase, bond prices decrease.

Module 1

Test Yourself

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Question

1. Which interest rate, the face rate or the market rate, should be used when calculating the issue price of a bond? Why?

2. What is the tax advantage that companies experience when bonds are issued instead of stock?

3. Does the issuance of bonds at a premium indicate that the face rate is higher or lower than the market rate of interest?

Apply

1. A bond payable is dated January 1, 2017, and is issued on that date. The face value of the bond is $100,000, and the face rate of interest is 8%. The bond pays interest semiannually. The bond will mature in five years.

a. What will be the issue price of the bond if the market rate of interest is 6% at the time of issuance?

b. What will be the issue price of the bond if the market rate of interest is 8% at the time of issuance?

c. What will be the issue price of the bond if the market rate of interest is 10% at the time of issuance?

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2. A bond with a face value of $10,000 is issued at a discount of $800 on January 1, 2017. The face rate of interest on the bond is 7%.

a. Was the market rate at the time of issuance greater than 7% or less than 7%?

b. If a balance sheet is presented on January 1, 2017, how will the bonds appear on the balance sheet?

c. If a balance sheet is presented on December 31, 2017, will the amount for the bonds be higher or lower than on January 1, 2017?

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LO 5 - Find the amortization of premium or discount using the effective interest method.

Chapter 10: Long-Term Liabilities: Module 2 Bond Amortization and Bond Retirement Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 2 Bond Amortization and Bond Retirement The amount of interest expense that should be reflected on a firm's income statement for bonds payable is the true, or effective, interest. The effective interest should reflect the face rate of interest as well as interest that results from issuing the bond at a premium or discount. To reflect that interest component, the amount initially recorded in the Premium on Bonds Payable or the Discount on Bonds Payable account must be amortized, or spread over the life of the bond.

Amortization refers to the process of transferring an amount from the discount or premium account to interest expense each time period to adjust interest expense. One commonly used method of amortization is the effective interest method.

To illustrate amortization of a discount, the issue price of the bond in Example 10-1 could be calculated as $9,366, resulting in a contra-liability balance of $634 in the Discount on Bonds Payable account. But what does the initial balance of the Discount account really represent? The discount should be thought of as additional interest that Discount Firm must pay over and above the 8% face rate. Remember that Discount received only $9,366 but must repay the full principal of $10,000 at the bond due date. For that reason, the $634 discount is an additional interest cost that must be reflected as interest expense by the process of amortization.

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Chapter 10: Long-Term Liabilities Effective Interest Method: Impact on Expense Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Effective Interest Method: Impact on Expense

The effective interest method of amortization (The process of transferring a portion of the premium or discount to interest expense; this method results in a constant effective interest rate. Alternate term: Interest method.) amortizes discount or premium in a manner that produces a constant effective interest rate from period to period, but the dollar amount of interest expense will vary from period to period. The interest rate is referred to as the effective interest rate and is equal to the market rate of interest at the time the bonds are issued. The effective interest rate is represented by the following:

The carrying value (The face value of a bond plus the amount of unamortized premium or minus the amount of unamortized discount. Alternate term: Book value.) of bonds is represented by the following:

The carrying value of the bonds for Discount Firm in Example 10-1 as of the date of issuance of January 1, 2017, could be calculated as follows:

In those situations in which there is a premium instead of a discount, carrying value is represented by the following:

The carrying value of the bonds for Premium Firm in Example 10-2 as of the date of issuance of January 1, 2017, could be calculated as follows:

As illustrated in Exhibit 10-4, the effective interest method of amortization for Discount Firm in Example 10-1 is based on several important concepts. The relationships can be stated in equation form as follows:

Exhibit 10-4

Discount Amortization: Effective Interest Method of Amortization

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Column 1 indicates that the cash interest to be paid is $800 ($10,000 × 8%). Column 2 indicates the annual interest expense at the effective rate of interest. The interest expense is calculated by multiplying the carrying value as of the beginning of the period by the market rate of interest. In 2017, the interest expense is $937 ($9,366 × 10%). Note that the amount of interest expense changes each year because the carrying value changes as discount is amortized. The amount of discount amortized each year in Column 3 is the difference between the cash interest in Column 1 and the interest expense in Column 2. Also, note that the amount of discount amortized changes in each of the four years. Finally, the carrying value in Column 4 is the previous year's carrying value plus the discount amortized in Column 3. When bonds are issued at a discount, the carrying value starts at an amount less than face value and increases each period until it reaches the face value amount.

Example 10-3

Recording Amortization of Discount

Exhibit 10-4 is the basis for determining the effect of amortization on the firm's financial statements. The effect of the payment of interest and amortization of discount is as follows:

The balance of the Discount on Bonds Payable account as of December 31, 2017, would be calculated as follows:

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Study Tip

Amortization of a discount increases interest expense. Amortization of a premium reduces interest expense.

In Example 10-3, the December 31, 2017, balance represents the amount unamortized, or the amount that will be amortized in future time periods. On the balance sheet presented as of December 31, 2017, the unamortized portion of the discount appears as the balance of the Discount on Bonds Payable account as follows:

The process of amortization would continue for four years, until the balance of the Discount on Bonds Payable account has been reduced to zero. By the end of 2020, all of the balance of the Discount on Bonds Payable account will have been transferred to the Interest Expense account and represents an increase in interest expense each period.

The amortization of a premium has an impact opposite that of the amortization of a discount. In Example 10-2, recall that on January 1, 2017, Premium Firm issued $10,000 face value bonds with a face rate of interest of 8%. At the time the bonds were issued, the market rate was 6%, resulting in an issue price of $10,693 and a balance in the Premium on Bonds Payable account of $693.

The amortization table in Exhibit 10-5 illustrates effective interest amortization of the bond premium for Premium Firm. As the exhibit illustrates, the following relationships still hold true:

Exhibit 10-5

Premium Amortization: Effective Interest Method of Amortization

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Column 1 indicates that the cash interest to be paid is $800 ($10,000 × 8%). Column 2 indicates the annual interest expense at the effective rate. In 2017, the interest expense is $642 ($10,693 × 6%). Note, however, two differences between Exhibits 10-4 and 10-5. In the amortization of a premium, the cash interest in Column 1 exceeds the interest expense in Column 2. Therefore, the premium amortized is defined as follows:

Also, note that the carrying value in Column 4 starts at an amount higher than the face value of $10,000 ($10,693) and is amortized downward until it reaches face value. Therefore, the carrying value at the end of each year is the carrying value at the beginning of the period minus the premium amortized for that year. For example, the carrying value in Exhibit 10-5 at the end of 2017 ($10,535) was calculated by subtracting the premium amortized for 2017 ($158 in Column 3) from the carrying value at the beginning of 2017 ($10,693).

Example 10-4

Recording Amortization of a Premium

Exhibit 10-5 is the basis for determining the effect of amortization of a premium on the firm's financial statements. Premium Firm could identify and analyze the effect of the payment of interest and amortization of premium as follows:

The balance of the Premium on Bonds Payable account as of December 31, 2017, would be calculated as follows:

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In Example 10-4, the December 31, 2017, balance represents the amount unamortized, or the amount that will be amortized in future time periods. On the balance sheet presented as of December 31, 2017, the unamortized portion of the premium appears as the balance of the Premium on Bonds Payable account as follows:

The process of amortization would continue for four years, until the balance of the Premium on Bonds Payable account has been reduced to zero. By the end of 2020, all of the balance of the Premium on Bonds Payable account will have been transferred to the Interest Expense account and represents a reduction of interest expense each period.

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LO 6 - Find the gain or loss on retirement of bonds.

Redemption of Bonds The term redemption refers to retirement of bonds by repayment of the principal. When bonds are retired on their due date, the accounting entry is not difficult. Refer again to Discount Firm from Examples 10-1 and 10-3. If Discount Firm retires its bonds on the due date of December 31, 2020, it must repay the principal of $10,000 and Cash is reduced by $10,000. No gain or loss is incurred because the carrying value of the bond at that point is $10,000.

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Chapter 10: Long-Term Liabilities Retired Early at a Gain or a Loss Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Retired Early at a Gain or a Loss

A firm may want to retire bonds before their due date for several reasons. A firm may simply have excess cash and determine that the best use of those funds is to repay outstanding bond obligations. Bonds also may be retired early because of changing interest rate conditions. If interest rates in the economy decline, firms may find it advantageous to retire bonds that have been issued at higher rates. Of course, what is advantageous to the issuer is not necessarily so for the investor. Early retirement of callable bonds is always a possibility that must be anticipated. Large institutional investors expect such a development and merely reinvest the money elsewhere. Many individual investors are more seriously inconvenienced when a bond issue is called.

Bond terms generally specify that if bonds are retired before their due date, they are not retired at the face value amount, but at a call price or redemption price indicated on the bond certificate. Also, the amount of unamortized premium or discount on the bonds must be considered when bonds are retired early. The retirement results in a gain or loss on redemption (The difference between the carrying value and the redemption price at the time bonds are redeemed.) that must be calculated as follows:

If the carrying value is higher than the redemption price, the issuing firm must record a gain. If the carrying value is lower than the redemption price, the issuing firm must record a loss.

Example 10-5

Calculating a Gain on Bond Redemption

Refer to Premium Firm from Example 10-4. Assume that on December 31, 2017, Premium Firm wants to retire its bonds due in 2020. Assume, as in the previous section, that the bonds were issued at a premium of $692 at the beginning of 2017. Premium Firm has used the effective interest method of amortization and has recorded the interest and amortization entries for the year. This has resulted in a balance of $535 in the Premium on Bonds Payable account as of December 31, 2017. Also, assume that Premium Firm's bond certificates indicate that the bonds may be retired early at a call price of 102 (meaning 102% of face value). Thus, the redemption price is 102% of $10,000, or $10,200.

Premium Firm's retirement of bonds would result in a gain. The gain can be calculated using two steps:

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Step 1.

Calculate the carrying value of the bonds as of the date they are retired. The carrying value of Premium Firm's bonds at that date is calculated as follows:

Note that the carrying value calculated is the same amount indicated for December 31, 2017, in Column 4 of the effective interest amortization table of Exhibit 10-5.

Step 2.

Calculate the gain:

When bonds are retired, the balance of the Bonds Payable account and the remaining balance of the Premium on Bonds Payable account must be eliminated from the balance sheet.

Example 10-6

Calculating a Loss on Bond Redemption

Refer to Premium Firm from Example 10-4. Assume that Premium Firm retires bonds at December 31, 2017, as in the previous section. However, assume that the call price for the bonds is 107 (or 107% of face value).

Again, the calculations can be performed in two steps:

Step 1.

Calculate the carrying value:

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Step 2.

Compare the carrying value with the redemption price to calculate the amount of the loss:

In Example 10-6, a loss of $165 means that Premium Firm paid more to retire the bonds than the amount at which the bonds were recorded on the balance sheet.

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Chapter 10: Long-Term Liabilities Financial Statement Presentation of Gain or Loss Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Financial Statement Presentation of Gain or Loss

The accounts Gain on Bond Redemption and Loss on Bond Redemption are income statement accounts. A gain on bond redemption increases Premium Firm's income; a loss decreases its income. While gains and losses should be treated as part of the company's operating income, some statement users may consider them as “one-time” events and choose to exclude them when predicting a company's future income. For that reason, it is helpful if companies present their gains and losses separately on the income statement so that readers can determine whether such amounts will affect future periods.

Module 2

Test Yourself

Question

1. How does the effective interest method of amortization result in a constant rate of interest?

2. Does amortization of a premium increase or decrease the bond carrying value? Does amortization of a discount increase or decrease the bond carrying value?

3. Is there always a gain or loss when bonds are redeemed? How is the gain or loss calculated?

Apply

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1. Bonds payable are dated January 1, 2017, and are issued on that date. The face value of the bonds is $100,000, and the face rate of interest is 8%. The bonds pay interest semiannually. The bonds will mature in five years. The market rate of interest at the time of issuance was 6%.

a. Using the effective interest amortization method, what amount should be amortized for the first six-month period? What amount of interest expense should be reported for the first six-month period?

b. Using the effective interest amortization method, what amount should be amortized for the period from July 1 to December 31, 2017? What amount of interest expense should be reported for the period from July 1 to December 31, 2017?

2. Refer to the previous exercise. Assume that the bonds are redeemed on December 31, 2017, at 102.

a. Calculate the gain or loss on bond redemption.

b. Identify and analyze the effect of the bond redemption.

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LO 7 - Determine whether a lease agreement must be reported as a liability on the balance sheet.

Chapter 10: Long-Term Liabilities: Module 3 Liability for Leases Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 3 Liability for Leases Leases are a major source of financing for many companies. Another liability, deferred taxes, is introduced in the appendix at the end of this chapter. In some cases, these liabilities are required to be reported on the financial statements and are important components of the Long-Term Liabilities section of the balance sheet. In other cases, the items are not required to be presented in the financial statements and can be discerned only by a careful reading of the notes to the financial statements.

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Leases

A lease, a contractual arrangement between two parties, allows one party, the lessee, the right to use an asset in exchange for making payments to its owner, the lessor. A common example of a lease arrangement is the rental of an apartment. The tenant is the lessee, and the landlord is the lessor.

Lease agreements are a form of financing. In some cases, it is more advantageous to lease an asset than to borrow money to purchase it. The lessee can conserve cash because a lease does not require a large initial cash outlay. Lease arrangements are popular because of their flexibility. The terms of a lease can be structured in many ways to meet the needs of the lessee and lessor. This results in difficult accounting questions:

1. Should the right to use property be reported as an asset by the lessee?

2. Should the obligation to make payments be reported as a liability by the lessee?

3. Should all leases be accounted for in the same manner regardless of the terms of the lease agreement?

The answers are that some leases should be reported as an asset and a liability by the lessee and some should not. The accountant must examine the terms of the lease agreement and compare those terms with an established set of criteria.

Lease Criteria

From the viewpoint of the lessee, there are two types of lease agreements: operating and capital. In an operating lease (A lease that does not meet any of the four criteria and is not recorded as an asset by the lessee.) , the lessee acquires the right to use an asset for a limited period of time. The lessee is not required to record the right to use the property as an asset or to record the obligation for payments as a liability. Therefore, the lessee is able to attain a form of off-balance-sheet financing. That is, the lessee has attained the right to use property but has not recorded that right, or the accompanying obligation, on the balance sheet. By escaping the balance sheet, the lease does not add to debt or impair the debt-to- equity ratio that investors usually calculate. Management has a responsibility to make sure that such off-balance-sheet financing is not, in fact, a long-term obligation.

In the second type of lease agreement, a capital lease (A lease that is recorded as an asset by the lessee.) (also called a finance lease), the lessee has acquired sufficient rights of ownership and control of the property to be considered its owner. The lease is called a capital lease or finance lease because it is capitalized (recorded) on the balance sheet by the lessee.

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A lease should be considered a capital lease or finance lease by the lessee when certain criteria are met.

If the criteria are met, the lease agreement is accounted for as an operating lease. In some cases, firms may take elaborate measures to evade or manipulate the criteria that would require lease capitalization. The accountant should determine what is full and fair disclosure based on an unbiased evaluation of the substance of the transaction.

Operating Leases

You have already accounted for operating leases in previous chapters when recording rent expense and prepaid rent. A rental agreement for a limited time period is also a lease agreement.

Example 10-7

Recording an Operating Lease

Suppose that Lessee Firm wants to lease a car for a new salesperson. A lease agreement is signed with Lessor Dealer on January 1, 2017, to lease a car for the year for $4,000, payable on December 31, 2017. Typically, a car lease does not transfer title at the end of the term, does not include a bargain-purchase price, and does not last for more than 75% of the car's life. In addition, the present value of the lease payments is not 90% of the car's value. Because the lease does not meet any of the specified criteria, it should be presented as an operating lease. Lessee Firm would simply record lease expense (or rent expense) of $4,000 for the year.

Although operating leases are not recorded on the balance sheet by the lessee, the FASB requires note disclosure of the amount of future lease obligations for leases that are considered operating leases. Exhibit 10-6 provides a portion of the note from Target's annual report of January 31, 2016, contained in the Form 10-K. Target has used operating leases as an important source of financing and has significant off-balance-sheet commitments in future periods as a result. An investor might want to add this off-balance- sheet item to the debt on the balance sheet to get a conservative view of the company's obligations.

Exhibit 10-6

Target's Note Disclosure of Leases, January 31, 2015

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Study Tip

It is called a capital lease because the lease is capital or put on the books of the lessee as an asset.

Source: Target, Form 10-K, For the Fiscal Year Ended January 31, 2015.

Capital Leases

Capital leases are presented as assets and liabilities by the lessee because they meet certain lease criteria.

Example 10-8

Calculating the Amount to Capitalize for a Lease

Suppose that Lessee Firm in Example 10-7 wanted to lease a car for a longer period of time. Assume that on January 1, 2017, Lessee signs a lease agreement with Lessor Dealer. The terms of the agreement specify that Lessee will make annual lease payments of $4,000 per year for five years, payable each December 31. Also, assume that the lease specifies that at the end of the lease agreement, the title to the car is transferred to Lessee Firm.

The lease should be treated as a capital lease by Lessee because it meets at least one of the four criteria. (It meets the first criteria concerning transfer of title.) A capital lease must be recorded at its present value by Lessee as an asset and as an obligation. As of January 1, 2017, we must calculate the present value of the annual payments. If we assume an interest rate of 8%, the present value of the payments is $15,972 (rounded) ($4,000 × an annuity factor of 3.99271 from Table 9-7).

The contractual arrangement between Lessee Firm and Lessor Dealer is called a lease agreement, but clearly the agreement is much different than a year-to-year lease arrangement. Essentially, Lessee Firm has acquired

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the right to use the asset for its entire life and does not need to return it to Lessor Dealer. Lessee has actually purchased the asset, with payments made over time.

For Example 10-8, the first entry is made on the basis of the present value. The effect of the lease could be identified and analyzed as follows:

The Leased Asset account is a long-term asset similar to plant and equipment and represents Lessee's right to use and retain the asset. Because the leased asset represents depreciable property, depreciation (or amortization) must be reported for each of the five years of asset use as follows. On December 31, 2017, Lessee records depreciation of $3,194 ($15,972/5 years), assuming that the straight-line method is adopted. The effect of the depreciation is as follows.

On December 31, Lessee Firm also must make a payment of $4,000 to Lessor Dealer. A portion of each payment represents interest on the obligation (loan), and the remainder represents a reduction of the principal amount. An effective interest table can be established using the same concepts used to amortize a premium or discount on bonds payable.

Exhibit 10-7 illustrates the effective interest method applied to Lessee Firm in Example 10-8. Note that the table begins with an obligation amount equal to the present value of the payments of $15,972. Each payment is separated into principal and interest amounts so that the amount of the loan obligation at the end of the lease agreement equals zero. The amortization table is the basis for the amounts that are reflected on the financial statement. Exhibit 10-7 indicates that the $4,000 payment in 2017 should be considered as interest of

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$1,278 (8% of $15,972) and reduction of principal of $2,722. On December 31, 2017, the effect of the annual lease payment is as follows:

Exhibit 10-7

Lease Amortization: Effective Interest Method of Amortization

For a capital lease, Lessee Firm must record both an asset and a liability. The asset is reduced by the process of depreciation. The liability is reduced by reductions of principal using the effective interest method. According to Exhibit 10-7, the total lease obligation as of December 31, 2017, is $13,250. This amount must be separated into Current and Long- Term categories. The portion of the liability that will be paid within one year of the balance sheet should be considered a current liability. Exhibit 10-7 indicates that the liability will be reduced by $2,940 in 2018 and that amount should be considered a current liability. The remaining amount of the liability, $10,310 ($13,250 – $2,940), should be considered long- term. On the balance sheet as of December 31, 2017, Lessee Firm reports the following balances related to the lease obligation:

Notice that the depreciated asset does not equal the present value of the lease obligation. This is not unusual. For example, an automobile may be completely depreciated but still

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have payments due on it.

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IFRS and Leasing

The accounting for leases is an excellent example of the differences in how U.S. and IFRS accounting standards are applied. Earlier in the text, we indicated that U.S. standards are often “rule-based” and international standards are “principles-based.” In the United States, the criteria to determine whether a lease contract should be considered a capital lease are applied in a rather rigid way. If a lease meets certain criteria, it must be accounted for as a capital lease. If it does not meet the criteria, even by a small margin, then it is considered an operating lease. The international accounting standards provide lease criteria that are similar to the U.S. standards. However, the criteria are used as “guidelines” rather than rigid rules. Therefore, there is much more flexibility in applying the lease standards when using the international standards.

Module 3

Test Yourself

Question

What are the reasons that not all leases are accounted for in the same manner? Do you think it would be possible to develop a new accounting rule that would treat all leases in the same manner? Explain.

Apply

You have signed an agreement to lease a car for four years and will make annual payments of $4,000 at the end of each year. (Assume that the lease meets the criteria for a capital lease.)

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a. Calculate the present value of the lease payments assuming an 8% interest rate.

b. Record the journal entry for the signing of the lease.

c. When the first lease payment is made, what portion of the payment will be considered interest?

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LO 8 - Explain how investors use ratios to evaluate long-term liabilities.

Chapter 10: Long-Term Liabilities: Module 4 Analysis of Long-Term Liabilities and Cash Flow Issues Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 4 Analysis of Long-Term Liabilities and Cash Flow Issues Long-term liabilities are a component of the “capital structure” of the company and are included in the calculation of the debt-to-equity ratio:

Most investors would prefer to see equity rather than debt on the balance sheet. Debt and its interest charges make up a fixed obligation that must be repaid in a finite period of time. In contrast, equity never has to be repaid and the dividends that are declared on it are optional. Stock investors view debt as a claim against the company that must be satisfied before they get a return on their money.

Another ratio used to measure the degree of debt obligation is the times interest earned ratio:

Lenders want to be sure that borrowers can pay the interest and repay the principal on a loan. This ratio reflects the degree to which a company can make its debt payment.

Making Business Decisions

PepsiCo

A.The Ratio Analysis Model

1. Formulate the Question

The use of debt is a good management strategy, but sometimes a company may have too much debt. The important questions to ask are:

What is the amount of debt in relation to the total equity of the company?

Will the company be able to meet its obligations related to the debt? That is, when an interest payment comes due, will the company have the ability to make the payment?

2. Gather the Information from the Financial Statements

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For those questions to be addressed, information from the balance sheet and the income statement needs to be collected and analyzed.

Total debt and total equity: From the balance sheet

Income before interest and tax: From the income statement

Interest expense from the income statement

3. Calculate the Ratios for PepsiCo, Inc.

4. Compare the Ratio with Others

PepsiCo's debt-to-equity ratio and times interest earned ratio should be compared to those of prior years and to those of companies in the same industry.

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5. Interpret the Results

PepsiCo and Coca-Cola are strong companies with a very safe balance of debt to equity. Both companies had a debt-to-equity ratio that increased from 2015 to 2014. This is probably the result of the low interest rates that existed during the year. Both companies have a small amount of interest obligations compared to their income available to meet those obligations. PepsiCo has 8.67 times more income than its interest expense for 2015, while Coca-Cola has 12.22. These ratios indicate that the creditors for both companies are confident that each company will be able to meet its interest obligations on its long-term debt.

B.The Business Decision Model

1. Formulate the Question

If you were a lender, would you be willing to lend money to PepsiCo, Inc., based on its use of debt?

2. Gather Information from the Financial Statements and Other Sources

This information will come from a variety of sources, not limited to but including:

The balance sheet provides information about the amount of debt and equity, the income statement regarding interest, and the statement of cash flows on inflows and outflows of cash.

The outlook for the industry, including consumer trends, foreign markets, labor issues, and other factors.

The outlook for the economy in general.

Alternative uses for the money.

3. Analyze the Information Gathered

Compare PepsiCo's ratios in (A) above with Coca-Cola's as well as with industry averages.

Look at trends over time in the use of debt by the companies.

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Review projections for the economy and the industry.

4. Make the Decision

Taking into account all of the various sources of information, decide either to

Lend money to PepsiCo or

Find an alternative use for the money

5. Monitor Your Decision

If you decide to lend money to the company, you will need to monitor your investment periodically. During the time of the investment, you will want to assess the company's debt levels as well as other factors you considered before making the investment.

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LO 9 - Explain the effects that transactions involving long-term liabilities have on the statement of cash flows.

Chapter 10: Long-Term Liabilities How Long-Term Liabilities Affect the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

How Long-Term Liabilities Affect the Statement of Cash Flows Exhibit 10-8 indicates the impact that long-term liabilities have on a company's cash flow and their placement on the cash flow statement. Most long-term liabilities are related to a firm's financing activities. Therefore, the change in the balance of each long-term liability account should be reflected in the Financing Activities category of the statement of cash flows. The decrease in a long-term liability account indicates that cash has been used to pay the liability. Therefore, in the statement of cash flows, a decrease in a long-term liability account should appear as a subtraction, or reduction. The increase in a long-term liability account indicates that the firm has obtained additional cash via a long-term obligation. Therefore, an increase in a long-term liability account should appear on the statement of cash flows as an addition.

Exhibit 10-8

Long-Term Liabilities on the Statement of Cash Flows

The statement of cash flows of The Coca-Cola Company is presented in Exhibit 10-9. Note that the Financing Activities category contains two items related to long-term liabilities. In 2015, long-term debt was issued for $40,434 million and is an addition to cash. This indicates that Coca-Cola increased its cash position by borrowings. Second, the payment of debt is listed as a deduction of $37,738 million. This indicates that Coca-Cola paid long-term liabilities, resulting in a reduction of cash.

Exhibit 10-9

The Coca-Cola Company and Subsidiaries' 2015 Consolidated Statements of Cash Flows

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Source: The Coca-Cola Company, Form 10-K, For the Fiscal Year Ended December 31, 2015.

Although most long-term liabilities are reflected in the Financing Activities category of the statement of cash flows, the Deferred Tax account (discussed in the appendix at the end of this chapter) is reflected in the Operating Activities category. This presentation is necessary because the Deferred Tax account is related to an operating item, income tax expense. For example, in Exhibit 10-9, Coca-Cola listed an addition of $73 million in the Operating Activities category of the 2015 statement of cash flows. This indicates that $73 million more was recorded as expense than was paid out in cash. Therefore, the amount is a positive amount in the Operating Activities category.

Module 4

Test Yourself

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Question

In what category of the statement of cash flows should the following items be shown? Should they appear as a positive or negative amount on the statement of cash flows?

Increase in long-term liabilities

Decrease in long-term liabilities

Interest expense

Depreciation expense on leased assets

Increase in deferred tax

Apply

Will Able Corporation's balance sheet showed the following amounts: Current Liabilities, $10,000; Bonds Payable, $3,000; Lease Obligations, $4,000; and Notes Payable, $600. Total stockholders' equity was $12,000. The debt-to-equity ratio is:

a. 0.63.

b. 0.83.

c. 1.42.

d. 1.47.

Chapter 10: Long-Term Liabilities How Long-Term Liabilities Affect the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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LO 10 - Explain deferred taxes and calculate the deferred tax liability.

Chapter Review

Module 5 Appendix: Deferred Tax

The financial statements of most major firms include an item titled Deferred Income Taxes or Deferred Tax. (See PepsiCo's deferred taxes in Exhibit 10-1 and Coca-Cola's in the chapter opening.) In most cases, the account appears in the Long-Term Liabilities section of the balance sheet, and the dollar amount may be large.

Deferred tax (The account used to reconcile the difference between the amount recorded as income tax expense and the amount that is payable as income tax.) is an amount that reconciles the differences between the accounting done for purposes of financial reporting to stockholders (“book” purposes) and the accounting done for tax purposes. U.S. firms are allowed to use accounting methods for financial reporting that differ from those used for tax calculations. The reason is that the IRS defines income and expense differently than does the FASB. As a result, companies tend to use accounting methods that minimize income for tax purposes but maximize income in the annual report to stockholders. This is not true in some foreign countries where financial accounting and tax accounting are more closely aligned. Firms in those countries do not report deferred tax because the difference between methods is not significant.

When differences between financial and tax reporting do occur, the differences can be classified into two types: permanent and temporary. Permanent differences (A difference that affects the tax records but not the accounting records, or vice versa.) occur when an item is included in the tax calculation and is never included for book purposes—or vice versa, when an item is included for book purposes but not for tax purposes. For example, the tax laws allow taxpayers to exclude interest on certain investments, usually state and municipal bonds, from their income. When a corporation buys these tax-exempt bonds, it does not have to declare the interest as income for tax purposes. When the corporation develops its income statement for stockholders (book purposes), however, the interest is included and appears in the Interest Income account. Therefore, tax-exempt interest represents a permanent difference between tax and book calculations.

Temporary differences (A difference that affects both book and tax records but not in the same time period. Alternate term: Timing difference.) occur when an item affects both book and tax calculations but not in the same time period. A difference caused by depreciation methods is the most common type of temporary difference. In previous chapters, you

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learned that depreciation may be calculated using a straight-line method or an accelerated method such as the double-declining-balance method. Most firms do not use the same depreciation method for book and tax purposes, however. Generally, straight-line depreciation is used for book purposes and an accelerated method is used for tax purposes because accelerated depreciation lowers taxable income—at least in early years—and therefore reduces the tax due. The IRS's Modified Accelerated Cost Recovery System (MACRS) is similar to other accelerated depreciation methods in that it allows the firm to take larger depreciation deductions for tax purposes in the early years of the asset and smaller deductions in the later years. Over the life of the depreciable asset, the total depreciation using straight-line is equal to that using MACRS. Therefore, this difference is an example of a temporary difference between book and tax reporting.

The Deferred Tax account is used to reconcile the differences between the accounting for book purposes and for tax purposes. It is important to distinguish between permanent and temporary differences because the FASB has ruled that not all differences should affect the Deferred Tax account. The Deferred Tax account should reflect temporary differences but not items that are permanent differences between book accounting and tax reporting.

Example 10-9

Calculation and Reporting Deferred Tax

Assume that Startup Firm begins business on January 1, 2017. During 2017, the firm has sales of $6,000 and has no expenses other than depreciation and income tax at the rate of 40%. Startup has depreciation on only one asset. That asset was purchased on January 1, 2017, for $10,000 and has a four-year life. Startup has decided to use the straight-line depreciation method for financial reporting purposes. Startup's accountants have chosen to use MACRS for tax purposes, however, resulting in $4,000 depreciation in 2017 and a decline of $1,000 per year thereafter.

The depreciation amounts for each of the four years for Startup's asset are as follows:

Startup's tax calculation for 2017 is based on the accelerated depreciation of $4,000, as follows:

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For 2017, Startup owes $800 of tax to the IRS. This amount is ordinarily recorded as tax payable until the time it is remitted.

What amount should be shown as tax expense on the income statement? Remember that the tax payable amount was calculated using the depreciation method that Startup chose for tax purposes. The income statement must be calculated using the straight-line method, which Startup uses for book purposes. Therefore, Startup's income statement for 2017 appears as follows:

In Example 10-9, Startup must make an accounting entry to record the amount of tax expense and tax payable for 2017. The effect is as follows:

The Deferred Tax account is a balance sheet account that is used to reconcile the differences between the accounting for book purposes and tax purposes. A balance in it reflects the fact that Startup has received a tax benefit by recording accelerated depreciation, in effect delaying the ultimate obligation to the IRS. The amount of deferred tax still represents a liability of Startup. The Deferred Tax account balance of $600 represents the amount of the 2017 temporary difference of $1,500 times the tax rate of 40%

What can you learn from Startup Firm in Example 10-9?

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First, when you see a firm's income statement, the amount listed as tax expense does not represent the amount of cash paid to the government for taxes. Accrual accounting procedures require that the tax expense amount be calculated using the accounting methods chosen for book purposes.

Second, when you see a firm's balance sheet, the amount in the Deferred Tax account reflects all of the temporary differences between the accounting methods chosen for tax and book purposes. The accounting and financial communities are severely divided on whether the Deferred Tax account represents a “true” liability. The FASB has taken the stance that deferred tax is an amount that results in a future obligation and meets the definition of a liability.

Module 5

Test Yourself

Question

1. Why do firms have a Deferred Tax account? Where should that account be shown on the financial statements?

2. How can you determine whether an item should reflect a permanent or a temporary difference when calculating the deferred tax amount?

Apply

On January 1, 2017, Deng Company purchased an asset for $100,000. For financial accounting purposes, the asset will be depreciated on a straight-line basis over five years with no residual value at the end of that time. For tax purposes, the asset will be depreciated as follows: 2017,

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$40,000; 2018, $30,000; 2019, $20,000; 2020, $10,000; and 2021, $0. Assume that the company is subject to a 40% tax rate.

a. What is the amount of deferred tax at December 31, 2017?

b. Does the deferred tax represent an asset or a liability?

c. What is the amount of deferred tax at December 31, 2021?

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Chapter Review

Ratio Review

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Chapter 11 Stockholders' Equity

Chapter Introduction

Module 1 Stockholders' Equity, Issuance of Stock, and Treasury Stock Stockholders' Equity on the Balance Sheet

How Income and Dividends Affect Retained Earnings

Identifying Components of the Stockholders' Equity Section of the Balance Sheet

IFRS and Stockholders' Equity

Preferred Stock

Issuance of Stock Stock Issued for Cash

Stock Issued for Noncash Consideration

What Is Treasury Stock? Retirement of Stock

Module 2 Cash Dividends, Stock Dividends, and Stock Splits Cash Dividends

Cash Dividends for Preferred and Common Stock

Stock Dividends

Stock Splits

Module 3 Analysis and Cash Flow Issues What Is Comprehensive Income?

What Analyzing Stockholders' Equity Reveals About a Firm's Value Calculating Book Value When Preferred Stock Is Present

Market Value per Share

How Changes in Stockholders' Equity Affect the Statement of Cash Flows

Chapter Review

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Module 4 Sole Proprietorships and Partnerships

Ratio Review

Accounts Highlighted

Key Terms Quiz

Review Problem & Solution

Exercises

Problems

Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

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Chapter Introduction

Making Business Decisions

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E.J. Baumeister Jr./Alamy

Southwest Airlines

The airline industry is very volatile and has certainly experienced difficulties over the past few years. With reduced revenues, weak demand, high fixed costs, high fuel costs, and increasing expenses for security and insurance, the results for many of the airline companies have been grim. United Airlines and several other airlines declared bankruptcy in order to restructure, but throughout all of the bad times, Southwest Airlines has performed fairly well and has become the model for the future of the industry. The other airlines know that they must cut costs and become more efficient in order to compete with Southwest.

How does Southwest do it? Southwest Airlines Company provides short-haul, high- frequency, point-to-point, low-fare air transportation services. The company's operating strategy also permits Southwest to achieve high-asset utilization. Aircraft are scheduled to minimize the amount of time they sit at the gate, pegged at approximately 25 minutes, consequently reducing the number of aircraft and gate facilities that would otherwise be required.

Southwest Airlines has consistently been an innovator in the industry. In January 1995, Southwest introduced a ticketless travel option, eliminating the need to print and then process a paper ticket. Recently, Southwest has resisted the move by other airlines to charge flyers for checking a bag, thereby maintaining its identity for quality, customer- friendly service at a low cost.

All of the company's efforts are consistent with its financial strategy to build shareholder value, which contributes to the Stockholders' Equity portion of the balance sheet shown here.

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The company experienced a loss during the economic downturn of 2008 but has recovered and has been consistently profitable. As a result, the stockholders have benefited, and shareholder value will likely continue to grow.

This chapter, and the accompanying financial statements of Southwest Airlines and other companies, will help you to understand the Stockholders' Equity section of the balance sheet.

Source: Southwest Airlines Co., Form 10-K, For the Fiscal Year Ended December 31, 2015.

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LO 1 - Understand the concept of stockholders' equity and identify the components of the Stockholders' Equity category.

Chapter 11: Stockholders' Equity: Module 1 Stockholders' Equity, Issuance of Stock, and Treasury Stock Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 1 Stockholders' Equity, Issuance of Stock, and Treasury Stock

Financing can be divided into two general categories: debt (borrowing from banks or other creditors) and equity (issuing stock). The company's management must consider the advantages and disadvantages of each alternative. Exhibit 11-1 indicates a few of the factors that must be considered.

Exhibit 11-1

Advantages and Disadvantages of Stock versus Debt Financing

Issuing stock is a popular method of financing because of its flexibility. It provides advantages for the issuing company and the investors (stockholders). Investors are primarily concerned with the return on their investment. With stock, the return might be in the form of dividends paid to the investors but might also be the price appreciation of the stock. Stock is popular because it generally provides a higher rate of return (but also a

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higher degree of risk) than can be obtained by creditors who receive interest from lending money. Stock is popular with issuing companies because higher dividends can be paid when the firm is profitable; lower dividends, when it is not. Interest on debt financing, on the other hand, is generally fixed and is a legal liability that cannot be adjusted when a company experiences lower profitability.

There are several disadvantages in issuing stock. Stock usually has voting rights, and issuing stock allows new investors to vote. Existing investors may not want to share the control of the company with new stockholders. From the issuing company's viewpoint, there is also a serious tax disadvantage to stock versus debt. As indicated in Chapter 10, interest on debt is tax-deductible and results in lower taxes. Dividends on stock, on the other hand, are not tax-deductible and do not result in tax savings to the issuing company. Finally, issuing stock has an impact on the company's financial statements. Issuing stock decreases several important financial ratios, such as earnings per share. Issuing debt does not have a similar effect on the earnings per share ratio.

Management must consider many other factors in deciding between debt and equity financing. The company's goal should be financing the company in a manner that results in the lowest overall cost of capital to the firm. Usually, companies attain that goal by having a reasonable balance of both debt and equity financing.

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Chapter 11: Stockholders' Equity Stockholders' Equity on the Balance Sheet Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Stockholders' Equity on the Balance Sheet

Connect to the Real World 11-1

Southwest Airlines: Reading the Financial Statements

Refer to the Retained Earnings account of Southwest Airlines. Did the account increase or decrease from 2014 to 2015? What factors may cause the account to change?

The basic accounting equation for a corporation is as follows:

Stockholders' equity is viewed as a residual amount. That is, the owners of a corporation have a claim to all assets after the claims represented by liabilities to creditors have been satisfied.

The Stockholders' Equity category of all corporations has two major components or subcategories:

Contributed capital represents the amount the corporation has received from the sale of stock to stockholders. Retained earnings is the amount of net income the corporation has earned but not paid as dividends. Within these two categories, corporations use a variety of accounts that have several different titles.

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Chapter 11: Stockholders' Equity How Income and Dividends Affect Retained Earnings Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

How Income and Dividends Affect Retained Earnings

The Retained Earnings account serves as a link between the income statement and the balance sheet. The term articulated statements refers to the fact that the information on the income statement is related to the information on the balance sheet. The bridge (or link) between the two statements is the Retained Earnings account. Exhibit 11-2 presents this relationship graphically. As the exhibit indicates, the income statement is used to calculate a company's net income for a given period of time. The amount of the net income is transferred to the statement of retained earnings and is added to the beginning balance of retained earnings (with dividends deducted) to calculate the ending balance of retained earnings. The ending balance of retained earnings is portrayed on the balance sheet in the Stockholders' Equity category. That is why you must prepare the income statement before the balance sheet, as you discovered when developing financial statements in previous chapters of the text.

Exhibit 11-2

Retained Earnings Connects the Income Statement and the Balance Sheet

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Chapter 11: Stockholders' Equity Identifying Components of the Stockholders' Equity Section of the Balance Sheet Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Identifying Components of the Stockholders' Equity Section of the Balance Sheet

All corporations begin the Stockholders' Equity category with a list of the firm's contributed capital. In some cases, there are two categories of stock: common stock and preferred stock. (The latter is discussed later in this chapter.) Common stock normally carries voting rights. The common stockholders elect the corporation's officers and establish its bylaws and governing rules. Corporations often have more than one type of common stock, each with different rights or terms.

Number of Shares

It is important to determine the number of shares of stock for each stock account. Corporate balance sheets report the number of shares in three categories: authorized (The maximum number of shares a corporation may issue as indicated in the corporate charter.) , issued (The number of shares sold or distributed to stockholders.) , and outstanding shares (The number of shares issued less the number of shares held as treasury stock.) .

To become incorporated, a business must develop articles of incorporation and apply to the proper state authorities for a corporate charter. The corporation must specify the maximum number of shares that it will be allowed to issue. This maximum number of shares is called the authorized stock. A corporation applies for authorization to issue many more shares than it will issue immediately to allow for future growth and other events that may occur over its long life. For example, as shown, Southwest Airlines has 2,000,000,000 shares of common stock authorized, but only 807,611,634 shares had been issued as of December 31, 2015.

The number of shares issued indicates the number of shares that have been sold or transferred to stockholders. The number of shares issued does not necessarily mean, however, that those shares are currently outstanding. The term outstanding indicates shares actually in the stockholders' hands. Shares that have been issued by the corporation and then repurchased are counted as shares issued but not as shares outstanding. Quite often, corporations repurchase their own stock as treasury stock (explained in more detail later in this chapter). Treasury stock reduces the number of shares outstanding. The number of Southwest Airlines' shares of common stock outstanding at December 31, 2015, could be calculated as follows:

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Study Tip

Treasury stock is included in the number of shares issued. It is not part of the number of shares outstanding.

Par Value: The Firm's “Legal Capital”

The Stockholders' Equity category of many balance sheets refers to an amount as the par value of the stock. For example, Southwest Airlines' common stock has a par value of $1 per share. Par value (An arbitrary amount that represents the legal capital of the firm.) is an arbitrary amount stated on the face of the stock certificate and represents the legal capital of the corporation. Most corporations set the par value of the stock at very low amounts because there are legal difficulties if stock is sold at less than par. Therefore, par value does not indicate the stock's value or the amount that is obtained when the stock is sold on the stock exchange; it is simply an arbitrary amount that exists to fulfill legal requirements. A company's legal requirement depends on its state of incorporation. Some states do not require corporations to indicate a par value; other states require corporations to designate the stated value of the stock. A stated value is accounted for in the same manner as a par value and appears in the Stockholders' Equity category in the same manner as a par value.

The amount of the par value is the amount that is presented in the stock account. That is, the dollar amount in a firm's stock account can be calculated as its par value per share times number of shares issued. For Southwest Airlines, the dollar amount appearing in the Common Stock account can be calculated as follows:

Additional Paid-In Capital

The dollar amounts of the stock accounts in the Stockholders' Equity category do not indicate the amount that was received when the stock was sold to stockholders. The Common Stock and Preferred Stock accounts indicate only the par value of the stock. When stock is issued for an amount higher than the par value, the excess is reported as additional paid-in capital (The amount received for the issuance of stock in excess of the par value of the stock. Alternate term: Paid-in capital in excess of par.) . Several different titles are used for this account, including Capital in Excess of Par Value and Premium on Stock. Regardless of the title, the account represents the amount received in excess of par when stock was issued.

Southwest Airlines' balance sheet indicates paid-in capital of $1,374 million at December 31, 2015. The company, like many other corporations, presents only one amount for additional paid-in capital for all stock transactions. Therefore, we are unable to determine whether the amount resulted from the issuance of common stock or other stock transactions.

Connect to the Real World 11-2

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Chipotle: Reading the Financial Statements

Refer to Chipotle balance sheet for 2015 reproduced at the end of this book. Determine the number of shares of common stock authorized, issued, and outstanding at the balance sheet date.

Retained Earnings: The Amount Not Paid as Dividends

Retained earnings (Net income that has been made by the corporation but not paid out as dividends. Alternate term: Retained income.) represents net income that the firm has earned but has not paid as dividends. Remember that retained earnings is an amount that is accumulated over the entire life of the corporation and does not represent the income or dividends for a specific year. A balance in retained earnings does not indicate that the company had a net income of this amount in the current year; it simply means that over the life of the corporation, the company has retained more net income than it paid out as dividends to stockholders.

It is also important to remember that the balance of the Retained Earnings account does not mean that liquid assets of that amount are available to the stockholders. Corporations decide to retain income because they have needs other than paying dividends to stockholders. The needs may include the purchase of assets, the retirement of debt, or other financial needs. Money spent for those needs usually benefits the stockholders in the long run, but liquid assets equal to the balance of the Retained Earnings account are not necessarily available to stockholders.

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Chapter 11: Stockholders' Equity IFRS and Stockholders' Equity Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

IFRS and Stockholders' Equity

The accounting for stockholders' equity under U.S. accounting rules is similar in most respects to the accounting under international accounting rules. However, there is one important difference regarding items that have characteristics of both debt and equity. For example, a convertible bond (discussed in Chapter 10) is in some ways similar to debt, but because it will become stock if converted, it also has the characteristics of equity. Under international accounting rules, an item such as this must be separated into two parts and one portion shown in the Liability category and another in the Stockholders' Equity category. U.S. accounting standards do not require such an item to be recorded as a separate amount. It is recorded as either a liability or an amount in stockholders' equity.

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LO 2 - Show that you understand the characteristics of common and preferred stock and the differences between the classes of stock.

Preferred Stock Many companies have a class of stock called preferred stock. One of the advantages of preferred stock is the flexibility it provides because its terms and provisions can be tailored to meet the firm's needs. Generally, preferred stock offers holders a preference to dividends declared by the corporation. That is, if dividends are declared, the preferred stockholders must receive dividends first, before the holders of common stock.

The dividend rate on preferred stock may be stated two ways:

1. It may be stated as a percentage of the stock's par value. For example, if a stock is presented on the balance sheet as $100 par, 7% preferred stock, its dividend rate is $7 per share ($100 × 7%).

2. The dividend may be stated as a per-share amount. For example, a stock may appear on the balance sheet as $100 par, $7 preferred stock, meaning that the dividend rate is $7 per share.

Investors in common stock should note the dividend requirements of the preferred shareholder. The greater the obligation to the preferred shareholder, the less desirable the common stock becomes.

In the event that a corporation is liquidated, or dissolved, preferred stockholders have a right to the company's assets before the common stockholders. Following are additional terms and features that may be associated with preferred stock:

Convertible (Allows preferred stock to be exchanged for common stock.) Preferred stock may allow stockholders the right to convert the stock into common stock.

Redeemable (Allows stockholders to sell stock back to the company.) Preferred stock may allow stockholders to redeem their stock at a specified price.

Callable (Allows the firm to eliminate a class of stock by paying the stockholders a specified amount.) Preferred stock may be callable at the option of the company. In this case, the company can choose to pay a specified amount to the stockholders in order to redeem or retire the stock.

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Cumulative (The right to dividends in arrears before the current-year dividend is distributed.) The dividend on preferred stock may be cumulative. When this is the case, dividends that are not paid are considered to be in arrears. Before a dividend on common stock can be declared in a subsequent period, the dividends in arrears as well as the current year's dividend must be paid to the preferred stockholders.

Participating (Allows preferred stockholders to share on a percentage basis in the distribution of an abnormally large dividend.) When preferred stock carries a participating feature, it allows the preferred stockholders to receive a dividend in excess of the regular rate when the firm has been particularly profitable and declares an abnormally large dividend.

Preferred stock is attractive to many investors because it offers a return in the form of a dividend at a level of risk that is lower than that of most common stocks. Usually, the dividend available on preferred stock is more stable from year to year; as a result, the market price of the stock is also more stable. In fact, when preferred stock carries certain provisions, the stock is very similar to bonds and notes payable. Management must evaluate whether such securities represent debt and should be presented in the Liability category of the balance sheet or whether they represent equity and should be presented in the Equity category. Such a decision involves the concept of substance over form. That is, a company must look not only at the legal form but also at the economic substance of the security to decide whether it is debt or equity.

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LO 3 - Determine the financial statement impact when stock is issued for cash or for other consideration.

Issuance of Stock

Stock Issued for Cash

When stock is issued for cash, the amount of its par value should be reported in the Stock account and the amount in excess of par should be reported in the Additional Paid-In Capital account.

As noted earlier, the Common Stock account and the Additional Paid-In Capital account are both presented in the Stockholders' Equity category of the balance sheet and represent the contributed capital component of the corporation.

If no-par stock is issued, the corporation does not distinguish between common stock and additional paid-in capital. If the firm in Example 11-1 had issued no-par stock on July 1 for $15 per share, the entire amount of $15,000 would have been presented in the Common Stock account.

Example 11-1

Recording Stock Issued for Cash

Assume that on July 1, a firm issued 1,000 shares of $10 par common stock for $15 per share. The effect of the issuance could be identified and analyzed as follows:

Chapter 11: Stockholders' Equity Issuance of Stock Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Chapter 11: Stockholders' Equity Stock Issued for Noncash Consideration Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Stock Issued for Noncash Consideration

Occasionally, stock is issued in return for something other than cash. For example, a corporation may issue stock to obtain land or buildings. When such a transaction occurs, the company faces the difficult task of deciding what value to place on the transaction. According to the general guideline, the transaction should be reported at fair market value. Market value may be indicated by the value of the consideration given (stock) or the value of the consideration received (property), whichever can be most readily determined.

Example 11-2

Recording Stock for Noncash Consideration

Assume that on July 1, a firm issued 500 shares of $10 par preferred stock to acquire a building. The stock is not widely traded, and the current market value of the stock is not evident. The building has recently been appraised by an independent firm as having a market value of $12,000. In this case, the issuance of the stock could be identified and analyzed as follows:

In other situations, the market value of the stock might be more readily determined and should be used as the best measure of the value of the transaction. The company should attempt to develop the best estimate of the market value of the noncash transaction and should neither intentionally overstate nor intentionally understate the assets received by the issuance of stock.

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LO 4 - Describe the financial statement impact of stock treated as treasury stock.

Chapter 11: Stockholders' Equity What Is Treasury Stock? Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

What Is Treasury Stock? The Stockholders' Equity category of Southwest Airlines' balance sheet in the chapter opener includes treasury stock (Stock issued by the firm and then repurchased but not retired.) in the amount of $3,182 million. The Treasury Stock account is created when a corporation buys its own stock sometime after issuing it. For an amount to be treated as treasury stock:

1. It must be the corporation's own stock.

2. It must have been issued to the stockholders at some point.

3. It must have been repurchased from the stockholders.

4. It must not be retired, but must be held for some purpose. Treasury stock is not considered outstanding stock and does not have voting rights.

A corporation might repurchase stock as treasury stock for several reasons. The most common reason is to have stock available to distribute to employees for bonuses or to make available as part of an employee benefit plan. Firms also might buy treasury stock to maintain a favorable market price for the stock or to improve the appearance of the firm's financial ratios. More recently, firms have purchased their stock to maintain control of the ownership and to prevent unwanted takeover or buyout attempts. Of course, the lower the stock price, the more likely a company is to buy back its own stock and wait for the shares to rise in value before reissuing them.

The two methods to account for treasury stock transactions are the cost method and the par value method. We will present the more commonly used cost method.

Example 11-3

Recording the Purchase of Treasury Stock

Assume that the Stockholders' Equity section of Rezin Company's balance sheet on December 31, 2017, appears as follows:

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Assume that on February 1, 2018, Rezin buys 100 of its shares as treasury stock at $25 per share. The effect of the purchase of treasury stock is as follows:

The purchase of treasury stock does not directly affect the Common Stock account. The Treasury Stock account is considered a contra account and is subtracted from the total of contributed capital and retained earnings in the Stockholders' Equity section. Treasury Stock is not an asset account. When a company buys its own stock, it is contracting its size and reducing the equity of stockholders. Therefore, Treasury Stock is a contra-equity account, not an asset.

The Stockholders' Equity section of Rezin's balance sheet on February 1, 2018, after the purchase of the treasury stock, appears as follows:

Corporations may choose to reissue stock to investors after it has been held as treasury stock. When treasury stock is resold for more than it cost, the difference between the sales price and the cost appears in the Additional Paid-In Capital—Treasury Stock account. For example, if Rezin resold 100 shares of treasury stock on May 1, 2018, for $30 per share, the

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Treasury Stock account would be reduced by $2,500 (100 shares times $25 per share) and the Additional Paid-In Capital—Treasury Stock account would be increased by $500 (100 shares times the difference between the purchase price of $25 and the reissue price of $30).

When treasury stock is resold for an amount less than its cost, the difference between the sales price and the cost is deducted from the Additional Paid-In Capital—Treasury Stock account. If that account does not exist, the difference should be deducted from the Retained Earnings account. For example, assume that Rezin Company had resold 100 shares of treasury stock on May 1, 2018, for $20 per share instead of $30 as in the previous example. Since Rezin has had no other treasury stock transactions, no balance existed in the Additional Paid-In Capital—Treasury Stock account. Rezin would then reduce the Treasury Stock account by $2,500 (100 shares times $25 per share) and would reduce Retained Earnings by $500 (100 shares times the difference between the purchase price of $25 and the reissue price of $20 per share). Thus, the Additional Paid-In Capital—Treasury Stock account may have a positive balance, but entries that result in a negative balance in the account should not be made.

Note that income statement accounts are never involved in treasury stock transactions. Regardless of whether treasury stock is reissued for more or less than its cost, the effect is reflected in the Stockholders' Equity accounts. It is simply not possible for a firm to engage in transactions involving its own stock and have the result affect the performance of the firm as reflected on the income statement.

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Retirement of Stock

Retirement of stock (When the stock is repurchased with no intention of reissuing at a later date.) occurs when a corporation buys back stock after it has been issued to investors and does not intend to reissue the stock. Retirement often occurs because the corporation wants to eliminate a particular class of stock or a particular group of stockholders. When stock is repurchased and retired, the balances of the Stock account and the Paid-In Capital account that were created when the stock was issued must be eliminated. When the original issue price is higher than the repurchase price of the stock, the difference is reflected in the Paid- In Capital from Stock Retirement account. When the repurchase price of the stock is more than the original issue price, the difference reduces the Retained Earnings account. The general principle for retirement of stock is the same as for treasury stock transactions. No income statement accounts are affected by the retirement. The effect is reflected in the Cash account and the Stockholders' Equity accounts.

Module 1

Test Yourself

Question

1. What are the two major components of stockholders' equity? Which accounts generally appear in each component?

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2. If a firm has a net income for the year, will the balance in the Retained Earnings account equal the net income? What is the meaning of the balance of the account?

3. What is treasury stock? Where does it appear on a corporation's financial statements?

Apply

1. Nash Company has the following accounts among the items on its balance sheet at December 31, 2017:

Develop the Stockholders' Equity section of the balance sheet for Nash Company at December 31, 2017.

2. Morris had the following transactions during 2017:

a. Issued 2,000 shares of $10 par common stock for cash at $17 per share.

b. Issued 1,000 shares of preferred stock to acquire land. The preferred stock has a par value of $5 per share. The land has been appraised at $7,000.

c. Issued 5,000 shares of $10 par common stock as payment to a company that provided advertising for the company. The stock was selling on the stock exchange at $12 per share at the time of issuance.

Record a journal entry for each transaction.

3. Indicate whether the following transactions increase, decrease, or have no effect on (a) total assets and on (b) total stockholders' equity.

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a. Issue 1,000 shares of common stock at $10 per share

b. Purchase 500 shares of common stock as treasury stock at $15 per share

c. Reissue 400 shares of treasury stock at $18 per share

d. Reissue 100 shares of treasury stock at $12 per share

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LO 5 - Compute the amount of cash dividends when a firm has issued both preferred and common stock.

Chapter 11: Stockholders' Equity: Module 2 Cash Dividends, Stock Dividends, and Stock Splits Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 2 Cash Dividends, Stock Dividends, and Stock Splits

Cash Dividends

Corporations may declare and issue several different types of dividends, the most common of which is a cash dividend to stockholders. Cash dividends may be declared quarterly, annually, or at other intervals. Normally, cash dividends are declared on one date, referred to as the date of declaration, and are paid out on a later date, referred to as the payment date. The dividend is paid to the stockholders who own the stock as of a particular date, the date of record.

Generally, two requirements must be met before the board of directors can declare a cash dividend. First, sufficient cash must be available by the payment date to pay to the stockholders. Second, the Retained Earnings account must have a sufficient positive balance, because dividends reduce the balance of the account. Most firms have an established policy concerning the portion of income that will be declared as dividends. The dividend payout ratio (The annual dividend amount divided by the annual net income; the percentage of earnings paid out as dividends.) is calculated as the annual dividend amount divided by the annual net income. The dividend payout ratio for many firms is 50% or 60% and seldom exceeds 70%. Typically, utilities pay a high proportion of their earnings as dividends. In contrast, fast-growing companies in technology often pay nothing to stockholders.

Cash dividends become a liability on the date they are declared. An accounting entry should be recorded on that date to acknowledge the liability and reduce the balance of the Retained Earnings account.

Example 11-4

Recording the Declaration of a Dividend

Assume that on July 1, the board of directors of Grant Company declared a cash dividend of $7,000 to be paid on September 1. The effect of the declaration of the dividend is as follows:

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Study Tip

A dividend is not an expense on the income statement. It is a reduction of retained earnings and appears on the retained earnings statement. If it is a cash dividend, it also reduces the cash balance when paid.

The Cash Dividend Payable account is a liability and is normally shown in the Current Liabilities section of the balance sheet.

Dividends reduce the amount of retained earnings when declared. When dividends are paid, the company reduces the liability to stockholders reflected in the Cash Dividend Payable account.

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Chapter 11: Stockholders' Equity Cash Dividends for Preferred and Common Stock Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Cash Dividends for Preferred and Common Stock

When cash dividends involving more than one class of stock are declared, the corporation must determine the proper amount to allocate to each class of stock. As indicated earlier, the amount of dividends to which preferred stockholders have rights depends on the terms and provisions of the preferred stock. The proper allocation of cash dividends is illustrated with an example of a firm that has two classes of stock: preferred and common.

Example 11-5

Computing Dividend Payments for Noncumulative Preferred Stock

Assume that on December 31, 2017, Stricker Company has outstanding 10,000 shares of $10 par, 8% preferred stock and 40,000 shares of $5 par common stock. Stricker was unable to declare a dividend in 2015 or 2016 but wants to declare a $70,000 dividend for 2017.

If the terms of the stock agreement indicate that the preferred stock is not cumulative, the preferred stockholders do not have a right to dividends in arrears. The dividends that were not declared in 2015 and 2016 are simply lost and do not affect the distribution of the dividend in 2017. Therefore, the cash dividend declared in 2017 is allocated between preferred and common stockholders as follows:

Example 11-6

Computing Dividend Payments for Cumulative Preferred Stock

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If the terms of the stock agreement in Example 11-5 indicate that the preferred stock is cumulative, the preferred stockholders have a right to dividends in arrears before the current year's dividend is distributed. Therefore, Stricker performs the following steps:

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LO 6 - Show that you understand the difference between cash and stock dividends and the effect of stock dividends.

Stock Dividends

Cash dividends are the most popular and widely used form of dividend, but at times, corporations may use stock dividends instead of or in addition to cash dividends. A stock dividend (The issuance of additional shares of stock to existing stockholders.) occurs when a corporation declares and issues additional shares of its own stock to existing stockholders. Firms use stock dividends for several reasons.

1. Stock dividends do not require the use of cash. A corporation may not have sufficient cash available to declare a cash dividend.

2. Stock dividends reduce the market price of the stock. The lower price may make the stock more attractive to a wider range of investors.

3. Stock dividends do not represent taxable income to recipients and may be attractive to some wealthy investors.

Similar to cash dividends, stock dividends are normally declared by the board of directors on a specific date and the stock is distributed to the stockholders at a later date. The corporation recognizes the stock dividend on the date of declaration.

Example 11-7

Recording a Small Stock Dividend

Assume that Shah Company's Stockholders' Equity category of the balance sheet appears as follows as of January 1, 2017:

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Assume that on January 2, 2017, Shah declares a 10% stock dividend to common stockholders to be distributed on April 1, 2017. Small stock dividends (usually those of 20% to 25%) normally are recorded at the market value of the stock as of the date of declaration. Assume that Shah's common stock is selling at $40 per share on that date. Therefore, the total market value of the stock dividend is $20,000 (10% of 5,000 shares outstanding, or 500 shares, times $40 per share). Shah records the transaction on the date of declaration and the effect is as follows:

The Common Stock Dividend Distributable account represents shares of stock to be issued; it is not a liability account because no cash or assets are to be distributed to the stockholders. Thus, it should be treated as an account in the Stockholders' Equity section of the balance sheet and is a part of the contributed capital component of equity.

Note that the declaration of a stock dividend does not affect the total stockholders' equity of the corporation, although the retained earnings are reduced. That is, the Stockholders' Equity section of Shah's balance sheet on January 2, 2017, is as follows after the declaration of the dividend:

The account balances are different, but total stockholders' equity is $150,000 both before and after the declaration of the stock dividend. In effect, retained earnings has been capitalized (transferred permanently to the contributed capital accounts). When a corporation actually issues a stock dividend, an amount from the Stock Dividend Distributable account must be transferred to the appropriate stock account.

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When a large stock dividend is declared (a stock dividend of more than 20% to 25% of the number of shares of stock outstanding), the stock dividend is reported at par value rather than at fair market value. Retained Earnings is decreased in the amount of the par value per share times the number of shares to be distributed.

Example 11-8

Recording the Declaration of a Large Stock Dividend

Refer to the Shah Company in Example 11-7. Assume that instead of a 10% dividend, on January 2, 2017, Shah declares a 100% stock dividend to be distributed on April 1, 2017. The stock dividend results in 5,000 additional shares being issued and certainly meets the definition of a large stock dividend. The effect of the declaration of the large stock dividend is as follows:

The effect when the stock is actually distributed is as follows:

The Stockholders' Equity category of Shah's balance sheet as of April 1 after the stock dividend is as follows:

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Again, note that the stock dividend has not affected total stockholders' equity. Shah has $150,000 of stockholders' equity both before and after the stock dividend. The difference between large and small stock dividends is the amount transferred from retained earnings to the Contributed Capital portion of equity.

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LO 7 - Determine the difference between stock dividends and stock splits.

Stock Splits

A stock split (The creation of additional shares of stock with a reduction of the par value of the stock.) is similar to a stock dividend in that it results in additional shares of stock outstanding and is nontaxable. In fact, firms may use a stock split for nearly the same reasons as a stock dividend: to increase the number of shares, reduce the market price per share, and make the stock more accessible to a wider range of investors. There is an important legal difference, however. Stock dividends do not affect the par value per share of the stock, whereas stock splits reduce the par value per share. There also is an important accounting difference. An accounting transaction is not recorded when a corporation declares and executes a stock split. None of the Stockholders' Equity accounts are affected by the split. Rather, the note information accompanying the balance sheet must disclose the additional shares and the reduction of the par value per share.

Note in Example 11-9 that the par value per share has been reduced from $10 to $5 per share of stock as a result of the split. Like a stock dividend, the split does not affect total stockholders' equity because no assets have been transferred. Therefore, the split simply results in more shares of stock with claims to the same net assets of the firm.

Example 11-9

Reporting a Stock Split

Refer to the Shah Company in Examples 11-7 and 11-8. Assume that on January 2, 2017, Shah issued a 2-for-1 stock split instead of a stock dividend. The split results in an additional 5,000 shares of stock outstanding but is not recorded in a formal accounting transaction. Therefore, the Stockholders' Equity section of Shah Company immediately after the stock split on January 2, 2017, is as follows:

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Module 2

Test Yourself

Question

1. What is a stock dividend? How should it be recorded?

2. Would you rather receive a cash dividend or a stock dividend from a company? Explain.

3. What is the difference between stock dividends and stock splits? How should stock splits be recorded?

Apply

1. At December 31, 2017, White Company has the following:

Common Stock, $10 par, 10,000 shares authorized, 9,000 issued, 8,000 outstanding

Indicate whether the following would increase, decrease, or have no effect on (a) assets, (b) retained earnings, and (c) total stockholders' equity.

a. A company declares and pays a cash dividend of $25,000.

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b. A company declares and issues a 10% stock dividend.

2. At December 31, 2017, Green Company and Blue Company have identical amounts of common stock and retained earnings as follows:

Common Stock, $10 par, 50,000 shares authorized, 9,000 issued, 9,000 outstanding

Retained Earnings, $500,000

At December 31, 2017, Green Company declares and issues a 100% stock dividend, while Blue Company declares and issues a 2-for-1 stock split.

Determine for each company the following amounts as of January 1, 2018:

Number of shares of common stock outstanding

Par value per share of the common stock

Total amount reported in Common Stock account

Retained earnings

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LO 8 - Show that you understand the statement of stockholders' equity and comprehensive income.

Chapter 11: Stockholders' Equity: Module 3 Analysis and Cash Flow Issues Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 3 Analysis and Cash Flow Issues In addition to a balance sheet, an income statement, and a cash flow statement, many annual reports contain a statement of stockholders' equity (Reflects the differences between beginning and ending balances for all accounts in the Stockholders' Equity category of the balance sheet.) . This statement explains the reasons for the difference between the beginning and ending balance of each account in the Stockholders' Equity category of the balance sheet. Of course, if the only changes are the result of income and dividends, a statement of retained earnings is sufficient. When other changes have occurred in Stockholders' Equity accounts, this more complete statement is necessary.

The statement of stockholders' equity of Fun Fitness, Inc., is presented in Exhibit 11-3 for the year 2017. The statement starts with the beginning balances of each of the accounts as of December 31, 2017.

Exhibit 11-3

Fun Fitness's Statement of Stockholders' Equity, 2017

The statement of stockholders' equity indicates the items or events that affected stockholders' equity during 2017. The items or events were as follows:

Item or Event Effect on Stockholders' Equity

Net earnings _________ Increased retained earnings by $64.0 million

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Item or Event Effect on Stockholders' Equity

Dividends _________ Decreased retained earnings by $25.0 million

Shares issued _________ Increased common stock by $5.0 million and

Increased paid-in capital by $39.0 million

The last line of the statement of stockholders' equity indicates the ending balances of the stockholders' equity accounts as of the balance sheet date, December 31, 2017. Note that each of the stockholders' equity accounts increased during 2017. The statement of stockholders' equity is useful in explaining the reasons for the changes that occurred.

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Chapter 11: Stockholders' Equity What Is Comprehensive Income? Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

What Is Comprehensive Income?

There has always been some question about which items or transactions should be shown on the income statement and included in the calculation of net income. Generally, the accounting rule-making bodies have held that the income statement should reflect an all- inclusive approach. That is, all events and transactions that affect income should be shown on the income statement. This approach prevents manipulation of the income figure by those who would like to show “good news” on the income statement and “bad news” directly on the retained earnings statement or the statement of stockholders' equity. The result of the all-inclusive approach is that the income statement includes items that are not necessarily under management's control, such as losses from natural disasters, meaning that the income statement may not be a true reflection of a company's future potential.

The FASB has accepted certain exceptions to the all-inclusive approach and has allowed items to be recorded directly to the Stockholders' Equity category. This text discussed one such item: unrealized gains and losses on investment securities. Exhibit 11-4 presents several additional items that are beyond the scope of this text. Items such as these have been excluded from the income statement for various reasons. Quite often, the justification is a concern for the volatility of the net income number.

Exhibit 11-4

The Relationship between the Income Statement and the Statement of Comprehensive Income

Comprehensive income (The total change in net assets from all sources except investments by or distributions to the owners.) is the net assets increase resulting from all

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transactions during a time period (except for investments by owners and distributions to owners). Exhibit 11-4 presents the statement of comprehensive income and its relationship to the traditional income statement. It illustrates that comprehensive income encompasses all of the revenues and expenses that are presented on the income statement and includes items that are not presented on the income statement but affect total stockholders' equity.

The comprehensive income measure is truly all-inclusive because it includes transactions such as unrealized gains that affect stockholders' equity. Firms are required to disclose comprehensive income because it provides a more complete measure of performance.

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LO 9 - Understand how investors use ratios to evaluate stockholders' equity.

Chapter 11: Stockholders' Equity What Analyzing Stockholders' Equity Reveals About a Firm's Value Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

What Analyzing Stockholders' Equity Reveals About a Firm's Value Users of financial statements are often interested in computing the value of a corporation's stock. This is a difficult task because value is not a well-defined term and means different things to different users. One measure of value is the book value of the stock. Book value per share (Total stockholders' equity divided by the number of shares of common stock outstanding.) of common stock represents the rights that each share of common stock has to the net assets of the corporation. The term net assets refers to the total assets of the firm minus total liabilities. In other words, net assets equal the total stockholders' equity of the corporation. Therefore, when only common stock is present, book value per share is measured as follows:

The book value per share is the amount per share of net assets to which the company's common stockholders have the rights. Book value per share does not indicate the price that should be paid by those who want to buy or sell the stock on the stock exchange. Book value also is an incomplete measure of value because the corporation's net assets are normally measured on the balance sheet at the original cost, not at the current value of the assets.

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Chapter 11: Stockholders' Equity Calculating Book Value When Preferred Stock Is Present Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Calculating Book Value When Preferred Stock Is Present

The focus of the computation of book value per share is always on the value per share of the common stock. Therefore, the computation must be adjusted for corporations that have both preferred and common stock. The numerator of the fraction, total stockholders' equity, should be reduced by the rights that preferred stockholders have to the corporation's net assets. Normally, this can be accomplished by deducting the redemption value or liquidation value of the preferred stock along with any dividends in arrears on cumulative preferred stock. The denominator should not include the number of shares of preferred stock.

To illustrate the computation of book value per share when both common and preferred stock are present, we refer to the Stockholders' Equity category of Workout Wonders, presented in Exhibit 11-5. When calculating book value per share, we want to consider only the common stockholders' equity. The company had total stockholders' equity in 2017 of $13,972 million, but preferred stockholders had a right to $500 million in the event of liquidation. Therefore, $500 million must be deducted to calculate the rights of the common stockholders:

Exhibit 11-5

Workout Wonders' Stockholders' Equity Section

The number of shares of common stock outstanding for the company is 1,782 million issued less 103 million of treasury stock. Therefore, the computation of book value per share is as follows:

If the company was liquidated and the assets sold at their recorded values, the common stockholders would receive $8.02 per share. Of course, if the company went bankrupt and had to liquidate assets at distressed values, stockholders would receive something less than book value.

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Study Tip

Transactions affecting the Stockholders' Equity category of the balance sheet will appear in the Financing Activities category of the cash flow statement. Dividends are included in the cash flow statement when they are paid rather than when they are declared.

Chapter 11: Stockholders' Equity Market Value per Share Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Market Value per Share

The market value of the stock is a more meaningful measure of the value of the stock to those financial statement users interested in buying or selling shares of stock. The market value per share (The selling price of the stock as indicated by the most recent transactions.) is the price at which stock is currently selling. For example, the listing for Nike Inc. stock on the Internet may indicate the following:

The two left-hand columns indicate the stock price for the last 52-week period. Nike Inc. sold as high as $68.17 and as low as $39.17 during that time period. The right-hand portion indicates the high and low for the previous day's trading and the closing price. Nike sold as high as $43.30 per share and as low as $42.01 per share and closed at $42.93. For the day, the stock increased by 1.13%, or $0.48 per share.

The market value of the stock depends on many factors. Stockholders must evaluate a corporation's earnings and liquidity as indicated in the financial statements. They also must consider a variety of economic factors and project all of the factors into the future to determine the proper market value per share of the stock. Many investors use sophisticated investment techniques, including large databases, to identify factors that affect a company's stock price.

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LO 10 - Explain the effects that transactions involving stockholders' equity have on the statement of cash flows.

Chapter 11: Stockholders' Equity How Changes in Stockholders' Equity Affect the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

How Changes in Stockholders' Equity Affect the Statement of Cash Flows

It is important to determine the effect that the issuance of stock, the repurchase of stock, and the payment of dividends have on the statement of cash flows. Exhibit 11-6 indicates how these stockholders' equity transactions affect cash flow and where the items should be placed on the statement of cash flows.

Exhibit 11-6

The Effect of Stockholders' Equity Items on the Statement of Cash Flows

The issuance of stock is a method to finance business. Therefore, the cash inflow from the sale of stock to stockholders should be reflected as an inflow in the Financing Activities section of the statement of cash flows. Generally, companies do not disclose separately the amount received for the par value of the stock and the amount received in excess of par. Rather, one amount is listed to indicate the total inflow of cash.

The repurchase or retirement of stock also represents a financing activity. Therefore, the cash outflow should be reflected as a reduction of cash in the Financing Activities section of the statement of cash flows. Again, companies do not distinguish between the amount paid for the par of the stock and the amount paid in excess of par.

How Will I Use Accounting?

If you are a portfolio manager, you will help clients meet their investing needs.

The income statement and the statement of cash flows are very useful in the analysis of companies because they tell the story of how a company's decisions have affected the value of that company. There is a great deal of information to be

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gleaned from these two statements—they provide a wealth of information to users of financial statements.

Dividends paid to stockholders represent a cost of financing the business with stock. Therefore, dividends paid should be reflected as a cash outflow in the Financing Activities section of the statement of cash flows. It is important to distinguish between the declaration of dividends and the payment of dividends. The cash outflow occurs at the time the dividend is paid and should be reflected on the statement of cash flows in that period.

The 2015 partial statement of cash flows for Southwest Airlines Co. is shown in Exhibit 11-7. During 2015, the company had considerable cash outflows associated with its long-term debt and capital lease obligations of $213 million. The company had additional cash outflows for payments of dividends of $180 million and repurchases of common stock of $1,180 million.

Exhibit 11-7

Southwest Airlines Co.'s Partial Statement of Cash Flows

Source: Southwest Airlines Co., Form 10-K, For the Fiscal Year Ended December 31, 2015.

Module 3

Test Yourself

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Question

1. How is the book value per share calculated? Does the amount calculated as book value per share mean that stockholders will receive a dividend equal to the book value?

2. Can the market value per share of stock be determined by the information on the income statement?

3. What is the difference between a statement of stockholders' equity and a retained earnings statement?

Apply

1. Deer Company has the following amounts in the Stockholders' Equity category of the balance sheet at December 31, 2017:

Determine the book value per share of the Deer Company stock.

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2. For each of the following items, indicate (a) in what category of the statement of cash flows the item will be reported and (b) whether it will appear as a cash inflow, cash outflow, or neither.

Issuance of common stock for cash

Purchase of treasury stock

Issuance of a stock dividend

Reissuance of treasury stock

Issuance of common stock to acquire land

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LO 11 - Describe the important differences between the sole proprietorship and partnership forms of organization versus the corporate form (Appendix).

Chapter Review

Module 4 Sole Proprietorships and Partnerships

The focus of Chapter 11, as with the rest of the text, has been on the corporate form of organization. Most of the large, influential companies in the United States are organized as corporations. They have a legal and economic existence that is separate from that of the owners of the business, the stockholders. Yet many other companies in the economy are organized as sole proprietorships or partnerships. The purpose of this appendix is to show briefly how the characteristics of such organizations affect the accounting, particularly the accounting for the Owners' Equity category of the balance sheet.

Sole Proprietorships

A sole proprietorship (A business with a single owner.) is a business owned by one person. Most sole proprietorships are small in size, with the owner serving as the operator or manager of the company. The primary advantage of the sole proprietorship form of organization is its simplicity. The Owners' Equity category of the balance sheet consists of one account, the owner's capital account. The owner answers to no one but himself or herself. A disadvantage of the sole proprietorship is that all responsibility for the success or failure of the venture attaches to the owner, who often has limited resources.

There are three important points to remember about this form of organization:

1. A sole proprietorship is not a separate entity for legal purposes. This means that the law does not distinguish between the assets of the business and those of its owner. If an owner loses a lawsuit, for example, the law does not limit an owner's liability to the amount of assets of the business, but extends liability to the owner's personal assets. Thus, the owner is said to have unlimited liability.

2. Accountants adhere to the entity principle and maintain a distinction between the owner's personal assets and the assets of the sole proprietorship. The balance sheet of a sole proprietorship should reflect only the “business” assets and liabilities, with the difference reflected as owner's capital.

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3. A sole proprietorship is not treated as a separate entity for federal income tax purposes. That is, the sole proprietorship does not pay tax on its income. Rather, the business income must be declared as income on the owner's personal tax return, and income tax is assessed at the personal tax rate rather than the rate that applies to companies organized as corporations. This may or may not be advantageous depending on the amount of income involved and the owner's tax situation.

Typical Transactions

When the owners of a corporation, the stockholders, invest in the corporation, they normally do so by purchasing stock. When investing in a sole proprietorship, the owner simply contributes cash or other assets to the business.

Example 11-10

Recording Investments in a Sole Proprietorship

Assume that on January 1, 2017, Peter Tom began a new business by investing $10,000 cash. The effect of the investment by the owner is as follows:

The Peter Tom, Capital account is an owner's equity account and reflects the rights of the owner to the business assets.

An owner's withdrawal of assets from the business is recorded as a reduction of owner's equity. Assume that on July 1, 2017, Peter Tom took an auto valued at $6,000 from the business to use as his personal auto. The effect of the withdrawal is as follows:

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The Peter Tom, Drawing account is a contra-equity account. Sometimes a drawing account is referred to as a withdrawals account, as in Peter Tom, Withdrawals. An increase in the account reduces the owner's equity. At the end of the fiscal year, the drawing account should be closed to the capital account and the effect is as follows:

The amount of the net income of the business also should be reflected in the capital account. Assume that all revenue and expense accounts of Peter Tom Company have been closed to the Income Summary account, resulting in a balance of $4,000, the net income for the year. The Income Summary account is closed to capital and the effect is as follows:

The Owner's Equity section of the balance sheet for Peter Tom Company consists of one account, the capital account, calculated as follows:

Partnerships

A partnership (A business owned by two or more individuals that has the characteristic of unlimited liability that has the characteristic of unlimited liability.) is a company owned by two or more people. Like sole proprietorships, most partnerships are fairly small businesses formed when individuals combine their capital and managerial talents for a common

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business purpose. Other partnerships are large, national organizations. For example, the major public accounting firms are very large, national companies but are organized in most states as partnerships.

Partnerships have characteristics similar to those of sole proprietorships. The following are the most important characteristics of partnerships:

1. Unlimited liability

Legally, the assets of the business are not separate from the partners' personal assets.

Each partner is personally liable for the debts of the partnership.

Creditors have a legal claim first to the assets of the partnership and then to the assets of the individual partners.

2. Limited life

Partnerships do not have a separate legal existence and an unlimited life. The life of a partnership exists only so long as the contract between the partners is valid.

The partnership ends when a partner withdraws or a new partner is added. A new partnership must be created for the business to continue.

3. Not taxed as a separate entity

Partnerships are subject to the same tax features as sole proprietorships.

The partnership itself does not pay federal income tax. Rather, the income of the partnership is treated as personal income on each of the partners' individual tax returns and is taxed as personal income.

All partnership income is subject to federal income tax on the individual partners' returns even if it is not distributed to the partners.

A variety of other factors affects the tax consequences of partnerships versus the corporate form of organization. Those aspects are quite complex and beyond the scope of this text.

A partnership is based on a partnership agreement (Specifies how much the owners will invest, what their salaries will be, and how profits will be shared.) . The agreement should be in writing and should detail items such as how much capital each partner is to invest, how much time each partner is expected to devote to the business, what the salary of each partner is, and how income of the partnership is to be divided. If a partnership agreement is not present, the courts may be forced to settle disputes between partners. Therefore, the

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partners should develop a partnership agreement when the firm is first established and review the agreement periodically to determine if changes are necessary.

Investments and Withdrawals

In a partnership, it is important to account separately for the capital of each partner. A capital account should be established in the Owners' Equity section of the balance sheet for each partner. Investments into the company should be credited to the partner making the investment.

Example 11-11

Recording Investments in a Partnership

Assume that on January 1, 2017, Paige Thoms and Amy Rebec begin a partnership named AP Company. Paige contributes $10,000 cash, and Amy contributes equipment valued at $5,000. The effect of the investment is as follows:

A drawing account also should be established for each owner of the company to account for withdrawals of assets. Assume that on April 1, 2017, each owner withdraws $2,000 of cash from AP Company. The effect of the withdrawl is as follows:

Distribution of Income

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The partnership agreement governs the manner in which income should be allocated to partners. The distribution may recognize the partners' relative investment in the business, their time and effort, their expertise and talents, or other factors. Three methods of income allocation will be illustrated, but be aware that partnerships use many other allocation methods.

One way to allocate income is to divide it evenly between the partners. In fact, when a partnership agreement is not present, the courts specify that an equal allocation must be applied regardless of the relative contributions or efforts of the partners. For example, assume that AP Company has $30,000 of net income for the period and has established an agreement that income should be allocated evenly between the two partners, Paige and Amy. Each capital account would be increased by $15,000. The effect of closing the Income Summary account to the capital accounts is as follows:

An equal distribution of income to all partners is easy to apply but is not fair to those partners who have contributed more in money or time to the partnership.

Another way to allocate income is to specify in the partnership agreement that income be allocated according to a stated ratio. For example, Paige and Amy may specify that all income of AP Company should be allocated in a 2-to-1 ratio, with Paige receiving the larger portion. If that allocation method is applied to Example 11-11, Paige Thoms, Capital would be increased by $20,000 and Amy Rebec, Capital would be increased by $10,000. If that allocation method is applied to Example 11-11, the effect is as follows:

Finally, an allocation method that more accurately reflects the partners' input is illustrated. It is based on salaries, interest on invested capital, and a stated ratio. Assume that the

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partnership agreement of AP Company specifies that Paige and Amy be allowed a salary of $6,000 and $4,000, respectively; that each partner receive 10% on her capital balance; and that any remaining income be allocated equally. Assume that AP Company has been in operation for several years and that the capital balances of the owners at the end of 2017, before the income distribution, are as follows:

If AP Company calculated that its 2017 net income (before partner salaries) was $30,000, income would be allocated between the partners as follows:

Paige Thoms, Capital would be increased by $15,500, and Amy Rebec, Capital, by $14,500. The effect of closing the Income Summary account to the capital accounts is as follows:

This indicates that the amounts of $15,500 and $14,500 were allocated to Paige and Amy, respectively. It does not indicate the amount actually paid to (or withdrawn by) the partners. However, for tax purposes, the income of the partnership is treated as personal income on the partners' individual tax returns regardless of whether the income is actually paid in cash to the partners.

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Module 4

Test Yourself

Question

1. What is an advantage of organizing a company as a corporation rather than a partnership? Why don't all companies incorporate? (Appendix)

2. What are some ways that partnerships could share income among the partners? (Appendix)

Apply

Furyk Company opened business as a sole proprietorship on January 1, 2017. The owner contributed $500,000 cash on that date. During the year, the company had a net income of $10,000. The company purchased equipment of $100,000 during the year. The owner also withdrew $60,000 to pay for personal expenses during 2017.

Determine the company's owner's equity at December 31, 2017.

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Chapter Review

Ratio Review

*When preferred stock is outstanding, the redemption value or liquidation value (disclosed on the preferred stock line or in the notes) of the preferred stock must be subtracted from total stockholders' equity.

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Chapter 12: The Statement of Cash Flows Chapter Contents Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Chapter 12 The Statement of Cash Flows

Chapter Introduction

Module 1 Purpose and Format for the Statement of Cash Flows Purpose of the Statement of Cash Flows

Reporting Requirements for a Statement of Cash Flows

The Definition of Cash: Cash and Cash Equivalents

Classification of Cash Flows Noncash Investing and Financing Activities

Two Methods of Reporting Cash Flow from Operating Activities

Module 2 Preparing the Statement of Cash Flows Using the Direct Method The Accounting Equation and the Statement of Cash Flows

An Approach to Preparing the Statement of Cash Flows: Direct Method

Step 2: Determine the Cash Flows from Operating Activities

Step 3: Determine the Cash Flows from Investing Activities

Step 4: Determine the Cash Flows from Financing Activities

Using the Three Schedules to Prepare a Statement of Cash Flows

Module 3 Preparing the Statement of Cash Flows using the Indirect Method Comparison of the Indirect and Direct Methods

Module 4 Cash Flow Analysis Creditors and Cash Flow Adequacy

Stockholders and Cash Flow per Share

Chapter Review Module 5 Appendix: A Work Sheet Approach to Preparing the Statement of Cash Flows

Ratio Review

Key Terms Quiz

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Alternate Terms

Review Problem & Solution

Exercises

Multi-Concept Exercises

Problems

Multi-Concept Problems

Alternate Problems

Alternate Multi-Concept Problems

Decision Cases

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Chapter 12: The Statement of Cash Flows Chapter Introduction Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Chapter Introduction

Making Business Decisions

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Walgreens Boots Alliance

A statement of cash flows reveals critical information about a company not found on either its income statement or balance sheet. Walgreens Boots Alliance's statement of cash flows shows that in fiscal year 2013, the company borrowed $4,000 million (that is, $4 billion) and two years later another $12,285 million. This is the company that resulted from the merger of U.S. based Walgreen Co. and a large European pharmacy company, Alliance Boots. Note the $4,461 million paid during 2015 to acquire Alliance Boots. Eventually long- term debt has to be repaid. The statement of cash flows also shows that the company made payments on long-term debt of $4,300 million in 2013 and $10,472 million in 2015.

Much of the recent history of this first global pharmancy company in the world can be gleaned by examining its statement of cash flows!

Source: Walgreens Boots Alliance, website and Form 10-K, For the Fiscal Year Ended August 31, 2015.

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LO 1 - Explain the concept of cash flows and accrual accounting and the purpose of a statement of cash flows.

Chapter 12: The Statement of Cash Flows: Module 1 Purpose and Format for the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 1 Purpose and Format for the Statement of Cash Flows All external parties have an interest in a company's cash flows.

Stockholders need some assurance that enough cash is being generated from operations to pay dividends and to invest in the company's future.

Creditors want to know if cash from operations is sufficient to repay their loans along with interest.

This chapter will show you how to read, understand, and prepare the statement of cash flows, which is perhaps the key financial statement for the survival of every business.

In recent years, managers, stockholders, creditors, analysts, and other users of financial statements have become more wary of focusing on any one number as an indicator of a company's overall performance. Most experts now agree that there has been a tendency to rely far too heavily on net income and its companion, earnings per share, and in many cases to ignore a company's cash flows.

To understand the difference between a company's net income and its cash flow, consider the case of Walgreens Boots Alliance in its 2015 fiscal year. The company reported net earnings (income) of $4,279 million. However, during this same time period, its cash increased by only $354 million. Why such a disparity? First, net income is computed on an accrual basis, not a cash basis. Second, the income statement primarily reflects events related to the operating activities of a business, that is, selling products or providing services.

A company's cash position can increase or decrease over a period, and it can report a net profit or a net loss. One of four combinations is possible:

1. A company can report an increase in cash and a net profit.

2. A company can report a decrease in cash and a net profit.

3. A company can report an increase in cash and a net loss.

4. A company can report a decrease in cash and a net loss.

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To summarize, a company with a profitable year does not necessarily increase its cash position, nor does a company with an unprofitable year always experience a decrease in cash.

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Chapter 12: The Statement of Cash Flows Purpose of the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Purpose of the Statement of Cash Flows

The statement of cash flows (The financial statement that summarizes an entity's cash receipts and cash payments during the period from operating, investing, and financing activities.) is an important complement to the other major financial statements. It summarizes the operating, investing, and financing activities of a business over a period of time. The balance sheet summarizes the cash on hand and the balances in other assets, liabilities, and owners' equity accounts, providing a snapshot at a specific point in time. The statement of cash flows reports the changes in cash over a period of time and, most importantly, explains those changes.

The income statement summarizes performance on an accrual basis. Income on this basis is a better indicator of future cash inflows and outflows than is a statement limited to current cash flows. The statement of cash flows complements the accrual-based income statement by allowing users to assess a company's performance on a cash basis. As you will see in Example 12-1, however, it also goes beyond presenting data related to operating performance and looks at other activities that affect a company's cash position.

Example 12-1

Preparing a Statement of Cash Flows

Consider the following discussion between the owner of Fox River Realty and the company accountant. After a successful first year in business in 2016 in which the company earned a profit of $100,000, the owner reviews the income statement for the second year, as presented below.

The owner is pleased with the results and asks to see the balance sheet. Comparative balance sheets for the first two years are presented below.

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Where Did the Cash Go?

At first glance, the owner is surprised to see the significant decline in the Cash account. Why has cash decreased from $150,000 to $50,000 even though income rose from $100,000 in the first year to $250,000 in the second year?

The accountant points out that income on a cash basis is even higher than the reported $250,000. Because depreciation expense is an expense that does not use cash (cash is used when the plant and equipment are purchased, not when they are depreciated), cash provided from operating activities is calculated as follows:

Further, the accountant reminds the owner of the additional $50,000 that she invested in the business during the year. Now the owner is even more bewildered: with cash from operations of $300,000 and her own infusion of $50,000, why did cash decrease by $100,000? The accountant refreshes the owner's memory about three major outflows of cash during the year. First, even though the business earned $250,000, she withdrew $150,000 in dividends during the year. Second, the comparative balance sheets indicate that notes payable with the bank were reduced from $150,000 to $100,000, requiring the use of $50,000 in cash. Finally, the comparative balance sheets show an increase in plant and equipment for the year from $350,000 to $600,000—a sizable investment of $250,000 in new long-term assets.

Statement of Cash Flows

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To summarize what happened to the cash, the accountant prepares a statement of cash flows, shown below.

Although the owner is not particularly happy with the decrease in cash, she is satisfied with the statement as an explanation of where the cash came from and how it was used. The statement summarizes the important cash activities for the year and fills a void created with the presentation of just an income statement and a balance sheet.

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Chapter 12: The Statement of Cash Flows Reporting Requirements for a Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Reporting Requirements for a Statement of Cash Flows

Accounting standards specify both the basis for preparing the statement of cash flows and the classification of items on the statement. First, the statement must be prepared on a cash basis. Second, the cash flows must be classified into three categories:

Operating activities

Investing activities

Financing activities

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LO 2 - Explain what cash equivalents are and how they are treated on the statement of cash flows.

Chapter 12: The Statement of Cash Flows The Definition of Cash: Cash and Cash Equivalents Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

The Definition of Cash: Cash and Cash Equivalents The purpose of the statement of cash flows is to provide information about a company's cash inflows and outflows. Thus, it is essential to have a clear understanding of what the definition of cash includes. According to accounting standards, certain items are recognized as being equivalent to cash and are combined with cash on the balance sheet and the statement of cash flows.

Commercial paper (short-term notes issued by corporations), money market funds, and Treasury bills are examples of cash equivalents. To be classified as a cash equivalent (An item readily convertible to a known amount of cash with a maturity to the investor of three months or less.) , an item must be readily convertible to a known amount of cash and have a maturity to the investor of three months or less. For example, a three-year Treasury note purchased two months before its maturity is classified as a cash equivalent. However, the same note purchased two years before maturity would be classified as an investment.

Example 12-2

Determining What Is a Cash Equivalent

To understand why cash equivalents are combined with cash when a statement of cash flows is prepared, assume that a company has a cash balance of $10,000 and no assets that qualify as cash equivalents. Further assume that the $10,000 is used to purchase 90-day Treasury bills. The effect of the transaction can be identified and analyzed as follows:

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For record-keeping purposes, this transaction is a transfer between cash in the bank and an investment in a government security. In the strictest sense, the investment represents an outflow of cash. However, the purchase of a security with such a short maturity does not involve any significant degree of risk in terms of price changes and thus is not reported on the statement of cash flows as an outflow. Instead, for purposes of classification on the balance sheet and the statement of cash flows, this is merely a transfer within the cash and cash equivalents category. The point is that before the purchase of the Treasury bills, the company had $10,000 in cash and cash equivalents and that after the purchase, it still had $10,000 in cash and cash equivalents. Because nothing changed, the transaction is not reported on the statement of cash flows.

Consider a different transaction in which a company purchases shares of MG common stock for cash. This transaction can be identified and analyzed as follows:

This purchase involves a certain amount of risk for the company making the investment. The MG stock is not convertible to a known amount of cash because its market value is subject to change. Thus, for balance sheet purposes, the investment is not considered a cash equivalent; therefore, it is not combined with cash but is classified as either a short- or long-term investment depending on the company's intent in holding the stock. The investment in stock of another company is considered a significant activity and thus is reported on the statement of cash flows.

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LO 3 - Describe operating, investing, and financing activities and give examples of each.

Chapter 12: The Statement of Cash Flows Classification of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Classification of Cash Flows For the statement of cash flows, companies are required to classify activities into three categories: operating, investing, or financing. These categories represent the major functions of an entity, and classifying activities in this way allows users to look at important relationships. For example, one important financing activity for many businesses is borrowing money. Grouping the cash inflows from borrowing money during the period with the cash outflows from repaying loans during the period makes it easier for analysts and other users of the statements to evaluate the company.

Each of the three types of activities can result in both cash inflows and cash outflows to the company. Thus, the general format for the statement is shown in Exhibit 12-1. Note the direct tie between the bottom portion of this statement and the balance sheet. The beginning and ending balances in cash and cash equivalents, shown as the last two lines on the statement of cash flows, are taken directly from the comparative balance sheets. Some companies end their statement of cash flows with the figure for the net increase or decrease in cash and cash equivalents and do not report the beginning and ending balances in cash and cash equivalents directly on the statement of cash flows.

Exhibit 12-1

Format for the Statement of Cash Flows

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Operating Activities Operating activities (Activities concerned with the acquisition and sale of products and services.) involve acquiring and selling products and services. The specific activities of a business depend on its type. For example, the purchase of raw materials is an important operating activity for a manufacturer. For a retailer, the purchase of inventory from a distributor constitutes an operating activity. For a realty company, the payment of a commission to a salesperson is an operating activity. All three types of businesses sell either products or services, and their sales are important operating activities.

A statement of cash flows reflects the cash effects, inflows or outflows, associated with each of these activities. For example, the manufacturer's payment for purchases of raw materials results in a cash outflow. The receipt of cash from collecting an account receivable results in a cash inflow.

Investing Activities Investing activities (Activities concerned with the acquisition and disposal of long-term assets.) involve acquiring and disposing of long-term assets. Replacing worn-out plant and equipment and expanding the existing base of long-term assets are essential to all businesses. Cash is paid for these acquisitions, often called capital expenditures. The following excerpt from Walgreens Boots Alliance's 2015 statement of cash flows (also shown in the chapter opener) indicates that the company spent $1,251 million for additions to property and equipment during fiscal 2015. (All amounts are in millions of dollars.) As described in the chapter opener, the company spent $4,461 million during 2015 to complete its acquisition of Alliance Boots.

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Study Tip

Later in the chapter, you will learn a technique to use in preparing the statement of cash flows. Recall then the observations

Financing Activities All businesses rely on internal financing, external financing, or a combination of the two in meeting their needs for cash. Initially, a new business must have a certain amount of investment by the owners to begin operations. After this, many companies use notes, bonds, and other forms of debt to provide financing. Issuing stock and various forms of debt results in cash inflows that appear as financing activities (Activities concerned with the raising and repaying of funds in the form of debt and equity.) on the statement of cash flows. On the other side, the repurchase of a company's own stock and the repayment of borrowings are important cash outflows to be reported in the Financing Activities section of the statement. The payment of cash dividends is listed in this section as well. Walgreens Boots Alliance's statement of cash flows lists many of the common cash inflows and outflows from financing activities (amounts in millions of dollars):

In 2015, Walgreens Boots Alliance received $12,285 million from the issuance of long-term debt and spent $10,472 million to pay off long-term debt. The company paid $1,226 million

to buy back stock and another $1,384 million to pay cash dividends.

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made here regarding what types of accounts affect each of the three activities.

Summary of the Three Types of Activities To summarize the operating, investing, and financing activities of a business, refer to Exhibit 12-2. The exhibit lists examples of each of the three activities along with the related balance sheet accounts and the account classifications on the balance sheet.

Exhibit 12-2

Classification of Items on the Statement of Cash Flows

In the exhibit, operating activities center on the acquisition and sale of products and services and related costs, such as wages and taxes. Two important observations can be made about the cash flow effects from the operating activities of a business:

1. The cash flows from operating activities are the cash effects of transactions that enter into the determination of net income. For example, the sale of a product enters into the calculation of net income. The cash effect of this transaction—that is, the collection of the account receivable—results in a cash inflow from operating activities.

2. Cash flows from operating activities usually relate to an increase or decrease in a current asset or in a current liability. For example, the payment of taxes to the government results in a decrease in taxes payable, which is a current liability on the balance sheet.

Investing activities normally relate to long-term assets on the balance sheet. For example, the purchase of new plant and equipment increases long-term assets, and the sale of those same assets reduces long-term assets on the balance sheet. Financing activities usually relate to either long-term liabilities or stockholders' equity accounts.

Chapter 12: The Statement of Cash Flows Classification of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits

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Chapter 12: The Statement of Cash Flows Noncash Investing and Financing Activities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Noncash Investing and Financing Activities

Occasionally, companies engage in important investing and financing activities that do not affect cash.

Example 12-3

Determining Noncash Investing and Financing Activities

Assume that at the end of the year, Wolk Corp. issues capital stock to an inventor in return for the exclusive rights to a patent. Although the patent has no ready market value, the stock could have been sold on the open market for $25,000. The effect of this transaction can be identified and analyzed as follows:

This transaction does not involve cash and therefore is not reported on the statement of cash flows. However, what if the scenario was changed slightly? Assume that Wolk wants the patent but the inventor is not willing to accept stock in return for it. So, instead, Wolk sells stock on the open market for $25,000 and then pays this amount in cash to the inventor for the rights to the patent. Consider the effects of these two transactions. First, the issuance of the stock increases Cash and Stockholders' Equity and can be identified and analyzed as follows:

Next, the acquisition of the patent can be identified and analyzed as follows:

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How would these two transactions be reported on a statement of cash flows? The first transaction appears as a cash inflow in the Financing Activities section of the statement; the second is reported as a cash outflow in the Investing Activities section. Even though the form of this arrangement (with stock sold for cash and then the cash paid to the inventor) differs from the form of the first arrangement (with stock exchanged directly for the patent), the substance of the two arrangements is the same. That is, both involve a significant financing activity, the issuance of stock, and an important investing activity, the acquisition of a patent. Accounting standards require that any significant noncash transactions be reported in a separate schedule or in a note to the financial statements. For the transaction in which stock was issued directly to the inventor, presentation in a schedule is as follows:

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LO 4 - Describe the difference between the direct and indirect methods of computing cash flow from operating activities.

Chapter 12: The Statement of Cash Flows Two Methods of Reporting Cash Flow from Operating Activities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Two Methods of Reporting Cash Flow from Operating Activities Companies use one of two methods to report the amount of cash flow from operating activities. The first approach, called the direct method (For preparing the Operating Activities section of the statement of cash flows, the approach in which cash receipts and cash payments are reported.) , involves reporting major classes of gross cash receipts and cash payments. For example, cash collected from customers is reported separately from any interest and dividends received. Each of the major types of cash payments related to the company's operations follows, such as cash paid for inventory, for salaries and wages, for interest, and for taxes. Under the indirect method (For preparing the Operating Activities section of the statement of cash flows, the approach in which net income is reconciled to net cash flow from operations.) , net cash flow from operating activities is computed by adjusting net income to remove the effect of all deferrals of past operating cash receipts and payments and all accruals of future operating cash receipts and payments.

The FASB prefers the direct method, but it is used much less frequently than the indirect method. To compare and contrast the two methods, assume that Boulder Company begins operations as a corporation on January 1, 2017, with the owners' investment of $10,000 in cash. An income statement for 2017 and a balance sheet as of December 31, 2017, are presented in Exhibits 12-3 and 12-4, respectively.

Exhibit 12-3

Boulder Company's Income Statement

Exhibit 12-4

Boulder Company's Balance Sheet

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Example 12-4

Determining Cash Flows from Operating Activities—Direct Method

To report cash flow from operating activities under the direct method, we look at each of the items on the income statement and determine how much cash each of those activities generated or used. Revenues for the period were $80,000. The balance sheet at the end of the period shows a balance in Accounts Receivable of $13,000; however, Boulder collected only $80,000 – $13,000, or $67,000, from its sales of the period. Thus, the first line on the statement of cash flows in Exhibit 12-5 reports $67,000 in cash collected from customers. Remember that the net increase in Accounts Receivable must be deducted from sales to find cash collected. For a new company, this is the same as the ending balance because the company starts the year without a balance in Accounts Receivable.

Exhibit 12-5

Statement of Cash Flows Using the Direct Method

The same logic can be applied to determine the amount of cash expended for operating purposes. Operating expenses on the income statement are reported at $64,000. According to the balance sheet, however, $6,000 of the expense is unpaid

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at the end of the period as evidenced by the balance in Accounts Payable. Thus, the amount of cash expended for operating purposes as reported on the statement of cash flows in Exhibit 12-5 is $64,000 – $6,000, or $58,000. The other cash payment in the Operating Activities section of the statement is $4,000 for income taxes. Because no liability for income taxes is reported on the balance sheet, we know that $4,000 represents both the income tax expense of the period and the amount paid to the government. The only other item on the statement of cash flows in Exhibit 12- 5 is the cash inflow from financing activities for the amount of cash invested by the owner in return for capital stock.

Example 12-5

Determining Cash Flows from Operating Activities—Indirect Method

When the indirect method is used, the first line in the Operating Activities section of the statement of cash flows as shown in Exhibit 12-6 is the net income of the period. Net income is then adjusted to reconcile it to the amount of cash provided by operating activities. As reported on the income statement, this net income figure includes sales of $80,000 for the period. As we know, however, the amount of cash collected was $13,000 less than this because not all customers paid Boulder the amount due. The increase in Accounts Receivable for the period is deducted from net income on the statement because the increase indicates that the company sold more during the period than it collected in cash.

Exhibit 12-6

Statement of Cash Flows Using the Indirect Method

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The logic for the addition of the increase in Accounts Payable is similar, although the effect is the opposite. The amount of operating expenses deducted on the income statement was $64,000. We know, however, that the amount of cash paid was $6,000 less than this, as the balance in Accounts Payable indicates. The increase in Accounts Payable for the period is added back to net income on the statement because the increase indicates that the company paid less during the period than it recognized in expense on the income statement.

Connect to the Real World 12-1

Chipotle: Reading the Statement of Cash Flows

Does Chipotle use the direct or indirect method in the Operating Activities section of its statement of cash flows? How can you tell?

Two important observations should be made in comparing the two methods illustrated in Examples 12-5 and 12-6:

1. The amount of cash provided by operating activities is the same under the two methods: $5,000; they simply use different computational approaches to arrive at the cash generated from operations.

2. The remainder of the statement of cash flows is the same regardless of which method is used.

Module 1

Test Yourself

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Question

1. What is the purpose of the statement of cash flows? Explain how it differs from the income statement.

2. Hansen Inc. made two purchases during December. One was a $10,000 Treasury bill that matures in 60 days from the date of purchase. The other was a $20,000 investment in Motorola common stock that will be held indefinitely. How should each purchase be treated for purposes of preparing a statement of cash flows?

3. Companies are required to classify cash flows as operating, investing, or financing. Which of these three categories do you think will most likely have a net cash outflow over a number of years? Explain your answer.

4. A fellow student says to you: ‘'The statement of cash flows is the easiest of the basic financial statements to prepare because you know the answer before you start. You compare the beginning and ending balances in cash on the balance sheet and compute the net inflow or outflow of cash. What could be easier?'' Do you agree? Explain your answer.

Apply

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1. For each of the following activities, indicate whether it should appear on the statement of cash flows as an operating (O), investing (I), or financing (F) activity. Assume that the company uses the direct method of reporting in the Operating Activities section.

a. New equipment is acquired for cash.

b. Thirty-year bonds are issued.

c. Cash receipts from the cash register are recorded.

d. The biweekly payroll is paid.

e. Common stock is issued for cash.

f. Land that was being held for future expansion is sold at book value.

2. For each of the following transactions on the statement of cash flows, indicate whether it would appear in the Operating Activities section (O), in the Investing Activities section (I), or in the Financing Activities section (F). Assume the use of the direct method in the Operating Activities section.

a. Repayment of long-term debt

b. Purchase of equipment

c. Collection of customer's account

d. Issuance of common stock

e. Purchase of another company

f. Payment of dividends

g. Payment of income taxes

h. Sale of equipment

3. For each of the following items, indicate whether it would appear on a statement of cash flows prepared using the direct method (D) or the indirect method (I).

a. Net income

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b. Increase in accounts receivable

c. Collections on accounts receivable

d. Payments on accounts payable

e. Decrease in accounts payable

f. Depreciation expense

g. Gain on early retirement of bonds

h. Cash sales

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LO 5 - Prepare a statement of cash flows using the direct method to determine cash flow from operating activities.

Chapter 12: The Statement of Cash Flows: Module 2 Preparing the Statement of Cash Flows Using the Direct Method Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 2 Preparing the Statement of Cash Flows Using the Direct Method

Two interesting observations can be made about the statement of cash flows. First, the “answer” to a statement of cash flows is known before it is prepared. That is, the change in cash for the period is known by comparing two successive balance sheets. Thus, it is not the change in cash that is emphasized on the statement of cash flows but the explanations for the change in cash. That is, each item on a statement of cash flows helps to explain why cash changed by the amount it did during the period. The second important observation relates even more specifically to how this statement is prepared. An income statement and a balance sheet are prepared by taking the balances in each of the various accounts in the general ledger and putting them in the right place on the right statement. In preparing the statement of cash flows, the transactions during the period must be analyzed to (1) determine which of them affected cash and (2) classify each of the cash effects into one of the three categories.

So far in this chapter, the statements of cash flows have been prepared without the use of any special tools. In more complex situations, however, some type of methodology is needed. We will review the basic accounting equation and then illustrate a systematic approach for preparing the statement. The chapter appendix presents a worksheet approach to the preparation of the statement of cash flows.

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Chapter 12: The Statement of Cash Flows The Accounting Equation and the Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

The Accounting Equation and the Statement of Cash Flows

The basic accounting equation is as follows:

Next, consider this refinement of the equation:

The equation can be rearranged so that only cash is on the left side and all other items are on the right side:

Therefore, any changes in cash must be accompanied by a corresponding change in the right side of the equation. For example, an increase or inflow of cash could result from an increase in long-term liabilities in the form of issuing bonds payable. Or an increase in cash could come from a decrease in long-term assets in the form of a sale of fixed assets. The various possibilities for inflows (+) and outflows (−) of cash can be summarized by activity as follows:

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Activity Left Side Right Side ExampleActivity Left Side Right Side Example

Operating

+ Cash − Noncash current assets

Collect accounts receivable

− Cash + Noncash current assets

Prepay insurance

+ Cash + Current liabilities Collect customer's deposit

− Cash − Current liabilities Pay suppliers

+ Cash + Retained earnings Make a cash sale

Investing

+ Cash − Long-term assets Sell equipment

− Cash + Long-term assets Buy equipment

Financing

+ Cash + Long-term liabilities Issue bonds

− Cash − Long-term liabilities Retire bonds

+ Cash + Capital stock Issue capital stock

− Cash − Capital stock Buy capital stock

− Cash − Retained earnings Pay dividends

Those examples show that inflows and outflows of cash relate to increases and decreases in the various balance sheet accounts. We now turn to analyzing these accounts as a way to assemble a statement of cash flows.

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Chapter 12: The Statement of Cash Flows An Approach to Preparing the Statement of Cash Flows: Direct Method Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

An Approach to Preparing the Statement of Cash Flows: Direct Method

The following steps can be used to prepare a statement of cash flows:

1. Set up three schedules with the following headings:

a. Cash Flows from Operating Activities

b. Cash Flows from Investing Activities

c. Cash Flows from Financing Activities

As we analyze the transactions that affect each of the noncash balance sheet accounts, any cash effects are entered on the appropriate master schedule. When completed, the three master schedules contain all of the information needed to prepare a statement of cash flows.

2. Determine the cash flows from operating activities. Generally, this requires analyzing each item on the income statement and in the Current Asset and Current Liability accounts. As cash flows are identified in this analysis, they are entered on the schedule of cash flows from operating activities.

3. Determine the cash flows from investing activities. Generally, this requires analyzing the Long-Term Asset accounts and any additional information provided. As cash flows are identified in this analysis, they are entered on the schedule of cash flows from investing activities. Any significant noncash activities are entered on a supplemental schedule.

4. Determine the cash flows from financing activities. Generally, this requires analyzing the Long-Term Liability and Stockholders' Equity accounts and any additional information provided. As cash flows are identified in this analysis, they are entered on the schedule of cash flows from financing activities. Any significant noncash activities are entered on a supplemental schedule.

In general, the cash effects of changes in current accounts are reported in the Operating section; changes relating to long-term asset accounts are reported in the Investing section; and changes relating to long-term liabilities and stockholders' equity are reported in the Financing section.

To illustrate this approach, we will refer to the income statement in Exhibit 12-7 and to the comparative balance sheets and the additional information provided for Julian Corp. in

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Exhibit 12-8. Assuming we have already set up the three schedules for operating, investing, and financing activities (Step 1), we outline the preparation of the statement of cash flows starting with Step 2.

Exhibit 12-7

Julian Corp.'s Income Statement

Exhibit 12-8

Julian Corp.'s Comparative Balance Sheets

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Chapter 12: The Statement of Cash Flows Step 2: Determine the Cash Flows from Operating Activities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Step 2: Determine the Cash Flows from Operating Activities

To determine the cash flows from operating activities, consider each of the items on the income statement and any related current assets or liabilities from the balance sheet.

Sales Revenue and Accounts Receivable

Sales as reported on the income statement in Exhibit 12-7 amounted to $670,000.

Based on the beginning and ending balances in Exhibit 12-8, Accounts Receivable increased by $6,000, from $57,000 to $63,000. This indicates that Julian had $6,000 more in sales to its customers than it collected in cash from them (assuming that all sales are on credit). Thus, cash collections must have been $670,000 − $6,000, or $664,000. Another way to look at this is as follows:

Solving for X, we can find cash collections:

At this point, note the inflow of Cash for $664,000 as shown on the Schedule of Cash Flows from Operating Activities in Exhibit 12-9.

Exhibit 12-9

Schedule of Cash Flows from Operating Activities

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Interest Revenue

Julian reported interest revenue of $15,000 on the income statement. Did the company actually receive that amount of cash, or was it merely an accrual of revenue not yet received? The answer can be found by examining the Current Assets section of the balance sheet. Because there is no Interest Receivable account, the amount of interest recognized was the amount of cash received.

The amount of cash received should be entered on the Schedule of Cash Flows from Operating Activities, as shown in Exhibit 12-9.

Gain on Sale of Machine

A gain on the sale of machine of $5,000 is reported as the next line on the income statement. Any cash received from the sale of a long-term asset is reported in the Investing Activities section of the statement of cash flows. Thus, we ignore the gain when reporting cash flows from operating activities under the direct method.

Cost of Goods Sold, Inventory, and Accounts Payable

Cost of goods sold, as reported on the income statement, amounts to $390,000. Recall that $390,000 is not the amount of cash expended to pay suppliers of inventory. First, cost of goods sold represents the cost of the inventory sold during the period, not the amount purchased. Thus, we must analyze the Inventory account to determine the purchases of the period. Second, the amount of purchases is not the same as the cash paid to suppliers because purchases are normally on account. Therefore, we must analyze the Accounts Payable account to determine the cash payments.

Based on the beginning and ending balances in Exhibit 12-8, inventory decreased during the year by $8,000, from $92,000 to $84,000. This means that the cost of inventory sold was $8,000 more than the purchases of the period. Thus, purchases must have been $390,000 – $8,000, or $382,000. Another way to look at this is as follows:

Solving for X, we can find purchases:

Note from Exhibit 12-8 the $7,000 net increase in Accounts Payable. This means that Julian's purchases were $7,000 more during the period than its cash payments. Thus, cash

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payments must have been $382,000 – $7,000, or $375,000. Another way to look at this is as follows:

Solving for X, we can find cash payments:

The amount of cash paid of $375,000 should be entered on the schedule in Exhibit 12-9.

Salaries and Wages Expense and Salaries and Wages Payable

The second expense listed on the income statement in Exhibit 12-8 is salaries and wages of $60,000. However, did Julian pay this amount to employees during the year? The answer can be found by examining the Salaries and Wages Payable account in the balance sheet in Exhibit 12-8. From the balance sheet, we note that the liability account decreased by $2,000, from $9,000 to $7,000. This means that the amount of cash paid to employees was $2,000 more than the amount of expense accrued. Another way to look at the cash payments of $60,000 + $2,000, or $62,000, is as follows:

Solving for X, we can find cash payments:

As you can see in Exhibit 12-9, the cash paid of $62,000 appears as a cash outflow on the Schedule of Cash Flows from Operating Activities.

Depreciation Expense

The next item on the income statement is depreciation of $40,000. Depreciation of tangible long-term assets, amortization of intangible assets, and depletion of natural resources are

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different from most other expenses in that they have no effect on cash flow. The only related cash flows are from the purchase and sale of these long-term assets, and these are reported in the Investing Activities section of the statement of cash flows. Thus, depreciation is not reported on the Schedule of Cash Flows from Operating Activities when the direct method is used.

Insurance Expense and Prepaid Insurance

According to the income statement in Exhibit 12-7, Julian recorded insurance expense of $12,000 during 2017. This amount is not the cash payments for insurance, however, because Julian has a Prepaid Insurance account on the balance sheet. Recall from Chapter 4 that as a company buys insurance, it increases the Prepaid Insurance account. As the insurance expires, this account is reduced and an expense is recognized. Note from the balance sheet in Exhibit 12-8 that the Prepaid Insurance account decreased during the period by $6,000, from $18,000 to $12,000. This means that the amount of cash paid for insurance was $6,000 less than the amount of expense recognized. Thus, the cash payments must have been $12,000 – $6,000, or $6,000. Another way to look at the cash payments is as follows:

Solving for X, we can find the amount of cash paid:

Note the cash outflow of $6,000 as entered in Exhibit 12-9 on the Schedule of Cash Flows from Operating Activities.

Interest Expense

The amount of interest expense reported on the income statement is $15,000. Because the balance sheet does not report an accrual of interest owed but not yet paid (an Interest Payable account), we know that $15,000 is also the amount of cash paid. The schedule in Exhibit 12-9 reflects the cash outflow of $15,000 for interest.

Whether interest paid is properly classified as an operating activity is subject to considerable debate. The FASB decided in favor of classification of interest as an operating activity because, unlike dividends, it appears on the income statement. This, it was argued, provides a direct link between the statement of cash flows and the income statement. Many argue, however, that it is inconsistent to classify dividends paid as a financing activity but

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interest paid as an operating activity. After all, both represent returns paid to providers of capital: interest to creditors and dividends to stockholders.

Income Taxes Expense and Income Taxes Payable

The income statement in Exhibit 12-7 reports income tax expense of $50,000. We know, however, that this is not necessarily the amount paid to the government during the year. In fact, note the increase in the Income Taxes Payable account on the balance sheets in Exhibit 12-8. The liability increased by $3,000, from $5,000 to $8,000. This means that the amount of cash paid to the government in taxes was $3,000 less than the amount of expense accrued. Another way to look at the cash payments of $50,000 – $3,000, or $47,000, is as follows:

Solving for X, we can find the amount of cash paid:

As you can see by examining Exhibit 12-9, the cash payment for taxes is the last item on the Schedule for Cash Flows from Operating Activities.

Loss on Retirement of Bonds

A $3,000 loss on the retirement of bonds is reported as the last item under expenses and losses on the income statement in Exhibit 12-7. Any cash paid to retire a long-term liability is reported in the Financing Activities section of the statement of cash flows. Thus, we ignore the loss when reporting cash flows from operating activities under the direct method.

Compare Net Income with Net Cash Flow from Operating Activities

At this point, all of the items on the income statement have been analyzed, as have all of the current asset and current liability accounts. All of the information needed to prepare the Operating Activities section of the statement of cash flows has been gathered.

To summarize, preparation of the Operating Activities section of the statement of cash flows requires the conversion of each item on the income statement to a cash basis. The Current Asset and Current Liability accounts are analyzed to discover the cash effects of each item on the income statement. Exhibit 12-10 summarizes this conversion process.

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Exhibit 12-10

Conversion of Income Statement Items to Cash Basis

Note in the exhibit the various adjustments made to put each income statement item on a cash basis. For example, the $6,000 increase in accounts receivable for the period is deducted from sales revenue of $670,000 to arrive at cash collected from customers. Similar adjustments are made to each of the other income statement items with the exception of depreciation, the gain, and the loss. Depreciation is ignored because it does not have an effect on cash flow. The gain relates to the sale of a long-term asset, and any cash effect is reflected in the Investing Activities section of the statement of cash flows. Similarly, the loss resulted from the retirement of bonds and any cash flow effect is reported in the Financing Activities section. The bottom of the exhibit highlights an important point: Julian reported net income of $120,000, but generated $174,000 in cash from operations.

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Chapter 12: The Statement of Cash Flows Step 3: Determine the Cash Flows from Investing Activities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Step 3: Determine the Cash Flows from Investing Activities

To determine the cash flows from investing activities, we will look at the Long-Term Asset accounts and any additional information available about these accounts. Julian has three long-term assets on its balance sheet: Long-Term Investments, Land, and Property and Equipment.

Long-Term Investments

Item 1 in the additional information in Exhibit 12-8 indicates that Julian purchased $30,000 of investments during the year. The $30,000 net increase in the Long-Term Investments account confirms this. (No mention is made of the sale of any investments during 2017.) The purchase of investments requires the use of $30,000 in cash, as indicated on the Schedule of Cash Flows from Investing Activities in Exhibit 12-11.

Exhibit 12-11

Schedule of Cash Flows from Financing Activities

Land

Note the $50,000 net increase in land. Item 2 in the additional information indicates that Julian purchased land by issuing a $50,000 note payable. This transaction obviously does not involve cash. It has an important financing element and an investing component, however. The issuance of the note is a financing activity, and the acquisition of land is an investing activity. Because no cash was involved, the transaction is reported in a separate schedule instead of directly on the statement of cash flows:

Property and Equipment

Property and equipment increased by $40,000 during 2017. However, Julian acquired equipment and sold a machine (item 3 and item 4, respectively, in the additional information). As was discussed earlier in the chapter, acquisitions of new plant and

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equipment are important investing activities for most businesses. Thus, the $75,000 expended to acquire new plant and equipment appears on the Schedule of Cash Flows from Investing Activities in Exhibit 12-11 as a cash outflow.

As reported in the balance sheets in Exhibit 12-8, the Property and Equipment account increased during the year by only $40,000, from $280,000 to $320,000. Since Julian added to this account $75,000, however, we know that it must have disposed of some assets as well. Item 4 in the additional information in Exhibit 12-8 reports the sale of a machine with an original cost of $35,000. An analysis of the Property and Equipment account confirms this amount:

Solving for X, we can find the cost of the property and equipment sold during the year:

The additional information also indicates that the book value of the machine sold was $20,000. This means that if the original cost was $35,000 and the book value was $20,000, the Accumulated Depreciation on the machine sold must have been $35,000 – $20,000, or $15,000. An analysis similar to the one we just looked at for Property and Equipment confirms this amount:

Solving for X, we can find the accumulated depreciation on the assets disposed of during the year:

Finally, we are told in the additional information that the machine was sold for $25,000. If the selling price was $25,000 and the book value was $20,000, Julian reports a gain on the sale of $5,000, an amount that is confirmed on the income statement in Exhibit 12-7. To

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summarize, the machine was sold for $25,000, an amount that exceeded its book value of $20,000, thus generating a gain of $5,000. The cash inflow of $25,000 is entered on the Schedule of Cash Flows from Investing Activities in Exhibit 12-11.

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Chapter 12: The Statement of Cash Flows Step 4: Determine the Cash Flows from Financing Activities Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Step 4: Determine the Cash Flows from Financing Activities

Cash flows from financing activities generally involve long-term liabilities and stockholders' equity. First, we consider Julian's two long-term liabilities: Notes Payable and Bonds Payable; then, the two stockholders' equity accounts: Capital Stock and Retained Earnings.

Notes Payable

Recall that item 2 in the additional information reported that Julian purchased land in exchange for a $50,000 note payable. This amount is confirmed on the balance sheets, which show an increase in notes payable of $50,000, from $35,000 to $85,000. In the discussion of investing activities, we already entered this transaction on a supplemental schedule of noncash activities because it was a significant financing activity but did not involve cash.

Bonds Payable

The balance sheets in Exhibit 12-8 report a decrease in bonds payable of $60,000, from $260,000 to $200,000. Item 5 in the additional information in Exhibit 12-8 indicates that bonds with a face value of $60,000 were retired by paying $63,000 in cash. The book value of the bonds retired is the same as the face value of $60,000 because there is no unamortized discount or premium on the records. When a company has to pay more in cash ($63,000) to settle a debt than the book value of the debt ($60,000), it reports a loss. Recall the $3,000 loss reported on the income statement in Exhibit 12-7. For purposes of preparing a statement of cash flows with the direct method, however, the important amount is the $63,000 in cash paid to retire the bonds. This amount appears as a cash outflow on the Schedule of Cash Flows from Financing Activities shown in Exhibit 12-12.

Exhibit 12-12

Schedule of Cash Flows from Financing Activities

Capital Stock

Exhibit 12-8 indicates an increase in capital stock of $25,000, from $75,000 to $100,000. According to item 6 in the additional information in Exhibit 12-8, Julian issued capital stock

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in exchange for $25,000 in cash. The increase in cash from this issuance is presented as a cash inflow on the Schedule of Cash Flows from Financing Activities shown in Exhibit 12-12.

Retained Earnings

This account increased during the year by $53,000, from $193,000 to $246,000. Because we know from Exhibit 12-7 that net income was $120,000; however, the company must have declared some dividends.

We can determine the amount of cash dividends for 2017 in the following manner:

Solving for X, we can find the amount of cash dividends paid during the year.

Item 7 in the additional information confirms that this was in fact the amount of dividends paid during the year. The dividends paid appear on the Schedule of Cash Flows from Financing Activities presented in Exhibit 12-12.

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Chapter 12: The Statement of Cash Flows Using the Three Schedules to Prepare a Statement of Cash Flows Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Using the Three Schedules to Prepare a Statement of Cash Flows

All of the information needed to prepare a statement of cash flows is now available in the three schedules, along with the supplemental schedule prepared earlier. From the information gathered in Exhibits 12-9, 12-11, and 12-12, a completed statement of cash flows appears in Exhibit 12-13.

Exhibit 12-13

Completed Statement of Cash Flows for Julian Corp.

What does Julian's statement of cash flows tell us? Cash flow from operations totaled $174,000. Cash used to acquire investments and equipment amounted to $80,000 after $25,000 was received from the sale of a machine. A net amount of $105,000 was used for financing activities. Thus, Julian used more cash than it generated, which is why the cash balance declined.

Module 2

Test Yourself

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Question

1. Why is it necessary to analyze both inventory and accounts payable in trying to determine cash payments to suppliers when the direct method is used?

2. Jackson Company prepays the rent on various office facilities. The beginning balance in Prepaid Rent was $9,600, and the ending balance was $7,300. The income statement reports Rent Expense of $45,900. Under the direct method, what amount would appear for cash paid in rent in the Operating Activities section of the statement of cash flows?

3. Baxter Inc. buys as treasury stock 2,000 shares of its own common stock at $20 per share. How is this transaction reported on the statement of cash flows?

Apply

Fill in the blank for each of the following situations.

Balance Sheet Beginning Ending Income Statement

Cash Inflow (Outflow)

a. Accounts receivable

$2,000 $5,000 Sales on account, $15,000

b. Prepaid insurance

$4,000 $3,000 Insurance expense, $7,000

c. Income taxes payable

$6,000 $9,000 Income tax expense, $20,000

d. Wages payable

$5,000 $3,000 Wages expense, $25,000

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LO 6 - Prepare a statement of cash flows using the indirect method to determine cash flow from operating activities.

Chapter 12: The Statement of Cash Flows: Module 3 Preparing the Statement of Cash Flows using the Indirect Method Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 3 Preparing the Statement of Cash Flows using the Indirect Method

The purpose of the Operating Activities section of the statement changes when the indirect method is used. Instead of reporting cash receipts and cash payments, the objective is to reconcile net income to net cash flow from operating activities. The other two sections of the completed statement in Exhibit 12-13, the Investing and Financing sections, are unchanged.

An approach similar to that used for the direct method can be used to prepare the Operating Activities section of the statement of cash flows under the indirect method.

Net Income Recall that the first line in the Operating Activities section of the statement under the indirect method is net income. That is, we start with the assumptions that all revenues and gains reported on the income statement increase cash flow and that all expenses and losses decrease cash flow. Julian's net income of $120,000, as reported on its income statement in Exhibit 12-7, is reported as the first item in the Operating Activities section of the statement of cash flows shown in Exhibit 12-14.

Exhibit 12-14

IndirectMethod for Reporting Cash Flows from Operating Activities

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Source: The authors are grateful to Jeannie Folk for the development of this work sheet.

Accounts Receivable Recall from the balance sheets in Exhibit 12-8 the net increase in Accounts Receivable of $6,000. Because net income includes sales (as opposed to cash collections), the $6,000 net increase must be deducted to adjust net income to cash from operations, as shown in Exhibit 12-14.

Connect to the Real World 12-2

Walgreens: Reading the Statement of Cash Flows

Did Walgreens Boots Alliance's Accounts Receivable, net, increase or decrease during the most recent year? Why is the change in this account deducted on the statement of cash flows?

Gain on Sale of Machine The gain itself did not generate any cash, but the sale of the machine did. As we found earlier, the cash generated by selling the machine was reported in the Investing Activities section of the statement. The cash proceeds included the gain. Because the gain of $5,000 is included in the net income figure, it must be deducted to determine cash from operations, as shown in Exhibit 12-14. Also note that the gain is included twice in cash inflows if it is not deducted from the net income figure in the Operating Activities section.

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Inventory As the $8,000 net decrease in the Inventory account indicates, Julian liquidated a portion of its stock of inventory during the year. A net decrease in this account indicates that the company sold more products than it purchased during the year. As shown in Exhibit 12- 14, the net decrease of $8,000 is added back to net income.

Accounts Payable According to Exhibit 12-8, Julian owed suppliers $31,000 at the start of the year. By the end of the year, the balance had grown to $38,000. Effectively, the company saved cash by delaying the payment of some of its outstanding accounts payable. The net increase of $7,000 in this account is added back to net income, as shown in Exhibit 12-14.

Salaries and Wages Payable Salaries and Wages Payable decreased during the year by $2,000. The rationale for deducting the $2,000 net decrease in this liability in Exhibit 12-14 follows from what was just said about an increase in Accounts Payable. The payment to employees of $2,000 more than the amount included in expense on the income statement requires an additional deduction under the indirect method.

Depreciation Expense Depreciation is a noncash expense. Because it was deducted to arrive at net income, we must add back $40,000, the amount of depreciation, to find cash from operations. The same holds true for amortization of intangible assets and depletion of natural resources.

Prepaid Insurance This account decreased by $6,000, according to Exhibit 12-8. A decrease in this account indicates that Julian deducted more on the income statement for the insurance expense of the period than it paid in cash for new policies. That is, the cash outlay for insurance protection was not as large as the amount of expense reported on the income statement. Thus, the net decrease in the account is added back to net income in Exhibit 12-14.

Income Taxes Payable Exhibit 12-8 reports a net increase of $3,000 in Income Taxes Payable. The net increase of $3,000 in this liability is added back to net income in Exhibit 12-14 because the payments to the government were $3,000 less than the amount included on the income statement.

Loss on Retirement of Bonds The $3,000 loss from retiring bonds was reported on the income statement as a deduction. There are two parts to the explanation for adding back the loss to net income to eliminate its effect in the Operating Activities section of the statement. First, any cash outflow from retiring bonds is properly classified as a financing activity, not an operating activity. Second, the amount of the cash outflow is $63,000, not $3,000. To summarize, to convert net income to a cash basis, the loss is added back in the Operating Activities section to eliminate its effect.

Summary of Adjustments to Net Income under the Indirect Method Following is a list of the most common adjustments to net income when the indirect method is used to prepare the Operating Activities section of the statement of cash flows:

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Additions to Net Income Deductions from Net IncomeAdditions to Net Income Deductions from Net Income

Decrease in accounts receivable Increase in accounts receivable

Decrease in inventory Increase in inventory

Decrease in prepayments Increase in prepayments

Increase in accounts payable Decrease in accounts payable

Increase in accrued liabilities Decrease in accrued liabilities

Losses on sales of long-term assets Gains on sales of long-term assets

Losses on retirements of bonds Gains on retirements of bonds

Depreciation, amortization, and depletion

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Study Tip

Notice in this list how changes in current assets and current liabilities are treated on the statement. For example, because accounts receivable and accounts payable are on opposite sides of the balance sheet, increases in each of them are handled in opposite ways. But an increase in one and a decrease in the other are treated the same way.

Chapter 12: The Statement of Cash Flows Comparison of the Indirect and Direct Methods Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Comparison of the Indirect and Direct Methods

The amount of cash provided by operating activities is the same under the direct and indirect methods. The FASB has expressed a strong preference for the direct method but allows companies to use the indirect method.

If a company uses the indirect method, it must separately disclose two important cash payments: income taxes paid and interest paid. Thus, if Julian uses the indirect method, it reports the following at the bottom of the statement of cash flows or in a note to the financial statements:

Advocates of the direct method believe that the information provided with this approach is valuable in evaluating a company's operating efficiency. For example, use of the direct method allows the analyst to follow any trends in cash receipts from customers and compare them with cash payments to suppliers. Someone without a technical background in accounting can easily tell where cash came from and where it went during the period.

Advocates of the indirect method argue two major points: (1) The direct method reveals too much to competitors by telling them the amount of cash receipts and cash payments from operations. (2) The indirect method focuses attention on the differences between income on an accrual basis and a cash basis. In fact, this reconciliation of net income and cash provided by operating activities is considered to be important enough that if a company uses the direct method, it must present a separate schedule to reconcile net income to net cash from operating activities. This schedule, in effect, is the same as the Operating Activities section for the indirect method.

Module 3

Test Yourself

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Question

1. What is your evaluation of the following statements? Depreciation is responsible for providing some of the highest amounts of cash for capital- intensive businesses. This is obvious by examining the Operating Activities section of the statement of cash flows. Other than the net income of the period, depreciation is often the largest amount reported in this section of the statement.

2. Assume that a company uses the indirect method to prepare the Operating Activities section of the statement of cash flows. Why would a decrease in accounts receivable during the period be added back to net income?

3. A company reports a net loss for the year. Is it possible that cash could increase during the year? Explain your answer.

4. Why do accounting standards require a company to separately disclose income taxes paid and interest paid if it uses the indirect method in the Operating Activities section of the statement of cash flows?

Apply

1. Assume that a company uses the indirect method to prepare the Operating Activities section of the statement of cash flows. For each of the following items, indicate whether it would be added to net income (A), be deducted from net income (D), or not be reported in this section of the statement under the indirect method (NR).

a. Decrease in accounts payable

b. Increase in accounts receivable

c. Decrease in prepaid insurance

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d. Purchase of new factory equipment

e. Depreciation expense

f. Gain on retirement of bonds

2. Assume that a company uses the indirect method to prepare the Operating Activities section of the statement of cash flows. For each of the following items, indicate whether it would be added to (A) or deducted from (D) net income to arrive at net cash provided by operating activities.

a. Decrease in accounts receivable

b. Increase in prepaid rent

c. Decrease in inventory

d. Increase in accounts payable

e. Decrease in income taxes payable

f. Depreciation expense

g. Loss on sale of equipment

3. Duke sold a delivery truck for $9,000. Its original cost was $25,000, and the book value at the time of the sale was $11,000. Explain how the transaction to record the sale appears on a statement of cash flows prepared using the indirect method.

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LO 7 - Use cash flow information to help analyze a company.

Chapter 12: The Statement of Cash Flows: Module 4 Cash Flow Analysis Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Module 4 Cash Flow Analysis The statement of cash flows is a critical disclosure to a company's investors and creditors. Many investors focus on cash flow from operations rather than net income as their key statistic. Similarly, many bankers are as concerned with cash flow from operations as they are with net income because they care about a company's ability to pay its bills. Accrual accounting can mask cash flow problems. For example, a company with smooth earnings could be building up accounts receivable and inventory. This may not become evident until the company is in deep trouble.

The statement of cash flows provides investors, analysts, bankers, and other users with a valuable starting point as they attempt to evaluate a company's financial health. They pay particular attention to the relationships among various items on the statement, as well as to other financial statement items. In fact, many large banks have their own cash flow models, which typically involve a rearrangement of the items on the statement of cash flows to suit their needs. We now consider two examples of how various groups use cash flow information.

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Chapter 12: The Statement of Cash Flows Creditors and Cash Flow Adequacy Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Creditors and Cash Flow Adequacy

Bankers and other creditors are especially concerned with a company's ability to meet its principal and interest obligations. Cash flow adequacy is a measure intended to help in this regard. It gauges the cash that a company has available to meet future debt obligations after paying taxes and interest costs and making capital expenditures. Because capital expenditures on new plant and equipment are a necessity for most companies, analysts are concerned with the cash available to repay debt after the company has replaced and updated its existing base of long-term assets.

How could you use the information in an annual report to measure a company's cash flow adequacy? First, whether a company uses the direct or indirect method to report cash flow from operating activities, this number represents cash flow after interest and taxes are paid. The numerator of the ratio is determined by deducting capital expenditures, as they appear in the Investing Activities section of the statement, from cash flow from operating activities. A disclosure required by the SEC provides the information needed to calculate the denominator of the ratio. This regulatory body requires companies to report the annual amount of long-term debt maturing over each of the next five years.

Making Business Decisions

Nordstrom

Analyzing Cash Flow Adequacy

Managers, investors, and creditors are all interested in a company's cash flows. Use the following models to help you in your role as a banker to decide whether to lend money to Nordstrom, Inc.

A.The Ratio Analysis Model

1. Formulate the Question

Did Nordstrom generate enough cash this year from its operations to pay for its capital expenditures and meet its maturing debt obligations?

2. Gather the Information from the Financial Statements

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To calculate a company's cash flow adequacy, it is essential to know the amounts of three items:

Net cash from operating activities: From the statement of cash flows

Capital expenditures: From the statement of cash flows

Average debt maturing over the next five years: From the note disclosures

3. Calculate the Ratio

4. Compare the Ratio with Other Ratios

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Ratios are of no use in a vacuum. It is necessary to compare them with prior years and with competitors.

5. Interpret the Ratios

Nordstrom's cash flow adequacy ratios in 2015 is very similar to its competitor, Dillard's. Nordstrom's ratio increased from the prior year, while Dillard's ratio decreased. Nordstrom's 2015 ratio of 5.5 is an indication the company generated enough cash from operations to not only make necessary capital expenditures but also to cover its average annual debt maturing over the next five years.

B.The Business Decision Model

1. Formulate the Question

If you were a banker, would you loan money to Nordstrom, Inc.?

2. Gather Information from the Financial Statements and Other Sources

This information will come from a variety of sources, not limited to but including:

The balance sheet provides information about liquidity, the income statement regarding profitability, and the statement of cash flows on inflows and outflows of cash.

The outlook for the retail apparel industry, including consumer trends, the competitive landscape, labor issues, and other factors.

The outlook for the economy in general.

Alternative uses for the money.

3. Analyze the Information Gathered

Compare Nordstrom's cash flow adequacy ratio in (A) above with Dillard's as well as with industry averages.

Look at trends over time in the cash flow adequacy ratios.

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Look at trends in cash provided by operations over time as an indication of the ability to generate enough cash to make necessary capital expenditures and meet debt obligations.

Review projections for the economy and the industry.

4. Make the Decision

Taking into account all of the various sources of information, decide either to

Loan money to Nordstrom, Inc., or

Find an alternative use for the money

5. Monitor Your Decision

If you decide to make the loan, you will need to monitor it periodically. During the time the loan is outstanding, you will want to assess the company's continuing ability to generate cash from operations as well as other factors you considered before making the loan.

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Chapter 12: The Statement of Cash Flows Stockholders and Cash Flow per Share Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Stockholders and Cash Flow per Share

One measure of the relative worth of an investment in a company is the ratio of the stock's market price per share to the company's earnings per share (that is, the price/earnings ratio). Many stockholders and analysts are even more interested in the price of the stock in relation to the company's cash flow per share. Cash flow for purposes of this ratio is normally limited to cash flow from operating activities. These groups have used this ratio to evaluate investments—even though the accounting profession has expressly forbidden the reporting of cash flow per share information in the financial statements. The accounting profession's belief is that this type of information is not an acceptable alternative to earnings per share as an indicator of company performance.

Module 4

Test Yourself

Question

Explain where to find the information needed to determine a company's cash flow adequacy.

Apply

A company generated $1,500,000 from its operating activities and spent $900,000 on additions to its plant and equipment during the year. The total amount of debt that matures in the next five years is $750,000. Compute the cash flow adequacy ratio for the year.

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LO 8 - Use a work sheet to prepare a statement of cash flows using the indirect method to determine cash flow from operating activities.

Chapter Review

Module 5 Appendix: A Work Sheet Approach to Preparing the Statement of Cash Flows

The chapter illustrated a systematic approach to help in analyzing the transactions of the period. We now consider the use of a work sheet as an alternative tool to organize the information needed to prepare the statement of cash flows. We will use the information given in the chapter for Julian Corp. (Refer to Exhibits 12-7 and 12-8 for the income statement and comparative balance sheets, respectively.) Although it is possible to use a work sheet to prepare the statement when the Operating Activities section is prepared under the direct method, we illustrate the use of a work sheet using the more popular indirect method.

A work sheet for Julian Corp. is presented in Exhibit 12-15. The following steps were taken to prepare the work sheet:

Step 1:

The balances in each account at the end and the beginning of the period are entered in the first two columns of the work sheet. For Julian, these balances can be found in its comparative balance sheets in Exhibit 12-8. Note that the contra-asset account, accumulated depreciation, as well as the liability and stockholders' equity accounts are shown in parentheses on the work sheet. Because the work sheet lists all balance sheet accounts, the total of the asset balances must equal the total of the liability and stockholders' equity balances; thus, the totals at the bottom for these first two columns equal $0.

Step 2:

The additional information listed at the bottom of Exhibit 12-8 is used to record the various investing and financing activities on the work sheet. (The item numbers that follow correspond to the superscript numbers on the work sheet in Exhibit 12-15.)

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Long-term investments were purchased for $30,000. Because this transaction required the use of cash, it is entered in parentheses in the Investing column and in the Changes column as an addition to the Long-Term Investments account.

Land was acquired by issuing a $50,000 note payable. This transaction is entered on two lines on the work sheet. First, $50,000 is added to the Changes column for Land and as a corresponding deduction in the Noncash column (the last column on the work sheet). Likewise, $50,000 is added to the Changes column for Notes Payable and to the Noncash column.

Item 3 in the additional information indicates the acquisition of equipment for $75,000. This amount appears on the work sheet as an addition to Property and Equipment in the Changes column and as a deduction (cash outflow) in the Investing column.

A machine with an original cost of $35,000 and a book value of $20,000 was sold for $25,000, resulting in four entries on the work sheet. First, the amount of cash received, $25,000, is entered as an addition in the Investing column on the line for property and equipment. On the same line, the cost of the machine, $35,000, is entered as a deduction in the Changes column. The difference between the cost of the machine, $35,000, and its book value, $20,000, is its accumulated depreciation of $15,000. This amount is shown as a deduction from this account in the Changes column. Because the gain of $5,000 is included in net income, it is deducted in the Operating column (on the Retained Earnings line).

Bonds with a face value of $60,000 were retired by paying $63,000 in cash, resulting in the entry of three amounts on the work sheet. The face value of the bonds, $60,000, is entered as a reduction of Bonds Payable in the Changes column. The amount paid to retire the bonds, $63,000, is entered on the same line in the Financing column. The loss of $3,000 is added in the Operating column because it was a deduction to arrive at net income.

Capital stock was issued for $25,000. This amount is entered on the Capital Stock line under the Changes column (as an increase in the account) and under the Financing column as an inflow.

Dividends of $67,000 were paid. This amount is entered as a reduction in Retained Earnings in the Changes column and as a cash outflow in the Financing column.

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Step 3:

Because the indirect method is being used, net income of $120,000 for the period is entered as an addition to Retained Earnings in the Operating column of the work sheet [entry (8)]. The amount is also entered as an increase (in parentheses) in the Changes column.

Step 4:

Any noncash revenues or expenses are entered on the work sheet on the appropriate lines. For Julian, depreciation expense of $40,000 is added (in parentheses) to Accumulated Depreciation in the Changes column and in the Operating column. This entry is identified on the work sheet as entry (9).

Step 5:

Each of the changes in the noncash current asset and current liability accounts is entered in the Changes column and in the Operating column. These entries are identified on the work sheet as entries (10) through (15).

Step 6:

Totals are determined for the Operating, Investing, and Financing columns and entered at the bottom of the work sheet. The total for the final column, Noncash Activities, of $0, is also entered.

Step 7:

The net cash inflow (outflow) for the period is determined by adding the totals of the Operating, Investing, and Financing columns. For Julian, the net cash outflow is $11,000, shown as entry (16) at the bottom of the statement. This same amount is then transferred to the line for Cash in the Changes column. Finally, the total of the Changes column at this point should net to $0.

Exhibit 12-15

Julian Corp. Statement of Cash Flows Work Sheet

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Source: The authors are grateful to Jeannie Folk for the development of this work sheet.

Module 5

Test Yourself

Question

Assume the format illustrated in Exhibit 12-15 for a statement of cash flows work sheet. Why will the Changes column of the work sheet total to 0?

Apply

Assume that a company uses a work sheet as illustrated in Exhibit 12-15 to prepare its statement of cash flows and that it uses the indirect method

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in the Operating Activities section of the statement. For each of the following changes in balance sheet accounts, indicate in one of the three columns whether it is an addition (A) or a deduction (D). Assume that the change in (b) and (f) includes a corresponding change in cash.

Type of Activity

Balance Sheet Change Operating Investing Financing

a. Accounts receivable increased

b. Land increased

c. Inventory decreased

d. Accounts payable decreased

e. Income taxes payable increased

f. Capital stock increased

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Chapter Review

Ratio Review

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Chapter A: International Financial Reporting Standards Appendix Contents Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

A International Financial Reporting Standards

Appendix Introduction

Ford and Daimler

Why Do Accounting Standards Differ?

Benefits from a Single Set of Standards

Who Is Responsible for Developing Global Accounting Standards?

Major Differences Between U.S. GAAP and IFRS

Format and Terminology Differences

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Chapter A: International Financial Reporting Standards Appendix Introduction Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Appendix Introduction

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Chapter A: International Financial Reporting Standards Ford and Daimler Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Ford and Daimler You have $1,000 to invest and are trying to decide between the common shares of two car makers: Ford Motor Company in the United States and Daimler AG in Germany. As part of your analysis, you read the notes to the financial statements for each company and realize that the accounting standards used by these two companies might not necessarily be the same. Not surprisingly, Ford's statements are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) as determined by the Financial Accounting Standards Board (FASB). On the other hand, Daimler follows a set of international accounting standards that we will describe later in this appendix. When you compare the net income of these companies, can you be assured that you are comparing “apples to apples”? Or could it be that differences in accounting standards are responsible for some of the differences in the earnings of these companies?

The objective of this appendix is to give you an appreciation for the differences in accounting standards around the world and an understanding of efforts to develop a unified set of standards that all companies would use. Regardless of your career path, these issues will be important to your future in business. With the rapid development of global business, your need to understand the movement toward a unified set of accounting standards will only increase in importance.

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LO 1 - Explain why accounting standards currently differ among countries around the world.

Chapter A: International Financial Reporting Standards Why Do Accounting Standards Differ? Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Why Do Accounting Standards Differ? No single explanation can be given for the divergence of accounting standards. However, the following are among the most important reasons why they differ:

1.Legal System

The two primary legal systems used around the world are the common law system and the code law system. The common law system has its roots in the United Kingdom and, because of historical ties, is also the system used in the United States. In common law countries, there are generally fewer statutes written into the laws and thus more reliance on interpretation by the courts. In code law countries, such as Germany, there are more detailed rules written into the statutes. But what does this difference have to do with accounting standards? Because less detailed laws are written into the statutes of common law countries such as the United States, nongovernmental bodies such as the Financial Accounting Standards Board (FASB) have developed more detailed rules. In contrast, the accounting standards in Germany are much briefer.

2.Taxation

Countries differ in terms of how similar or different the rules are for determining accounting income and taxable income. For example, in the United States significant differences exist between the two because the computation of accounting income is based on the rules of the FASB whereas taxable income is based on the rules as set forth by the Internal Revenue Service. In many other countries, including Japan and much of Europe, fewer differences exist between the amount of income reported to stockholders and that reported to the taxing authorities.

3.Financing

Corporations in the United States receive most of their financing from two sources: creditors and stockholders. Because stockholders and creditors such as bondholders and banks are not privy to the internal records of the corporation, accountability to the public is of paramount importance. In some other countries, more of the financing may come from families, banks, and even the government. In these cases, there has been less need to develop detailed rules for disclosure.

4.Inflation

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In some countries, notably those in Latin America and South America, inflation has been much more rampant than in other parts of the world. Because of the instability of the measuring unit that is the currency in those countries, companies have been required to adjust their financial statements to take into account the effects of inflation. At one time, the FASB developed rules for companies in the United States to use to adjust for inflation. As inflation has subsided in this country, U.S. companies no longer present financial information adjusted for the effects of inflation.

5.Relationships Between Countries

Countries that have strong political and economic ties often share similar accounting practices. For example, the roots of accounting systems in Canada and Australia, two former British colonies, can be traced to those found in the United Kingdom.

6.State of Economic Development

At any one time, all countries around the world are at different stages in the development of their economies. For example, the free-market systems used in the United Kingdom and in the United States have been in place for many years. Complex business arrangements such as leases and pension plans necessitate relatively detailed accounting rules to deal with them. In contrast, the economies in some countries, such as those that made up the former Soviet Union, are just beginning to develop and thus so are the accounting standards in those countries.

We have now seen that accounting standards differ around the world for a variety of reasons, some of which are interrelated. For example, the legal system in the United States, coupled with a highly advanced economy, has resulted in a lengthy and complex set of accounting standards. Although the Securities and Exchange Commission has ultimate authority to set accounting standards, it has delegated much of the responsibility to the non- governmental FASB. As a private-sector, independent body, the FASB gathers information from a variety of sources, including the multi-billion-dollar corporations that dominate business in this country. The influence of these companies in setting accounting standards is considerable. In some of the less-developed countries of the world, especially those in which the forces of capitalism are less prevalent, accounting standards have developed at a much slower pace.

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LO 2 - Explain the benefits from a single set of accounting standards.

Chapter A: International Financial Reporting Standards Benefits from a Single Set of Standards Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Benefits from a Single Set of Standards Consider the case of General Mills. According to the company's web site, it sells its products in more than 100 countries on six continents and its international business accounted for almost 30 percent of total sales in fiscal 2015. It operates a joint venture with Nestlé, a Swiss company, called Cereal Partners Worldwide. Like a vast majority of publicly traded U.S. corporations, General Mills truly is a global company. So what would be some of the advantages to General Mills and its stockholders if a single set of accounting standards were used around the world?

1.Save on Accounting Costs

The development of accounting systems, their maintenance, and the eventual preparation of financial statements are major costs to most businesses, especially those with significant international operations. For example, the financial statements of General Mills's foreign subsidiaries must be consolidated with those of the parent corporation. The income from the company's joint venture with Nestlé must be accounted for prior to presenting the company's net income. Both of these tasks are that much more costly to General Mills if accounting principles differ in those other countries. A single set of worldwide accounting standards would save companies considerable money in accounting fees.

2.Make It Easier to Acquire Foreign Companies

According to General Mills's web site, in fiscal 2012 the company acquired a controlling interest in French-based Yoplait. Certainly, General Mills took a close look at the financial statements of this French company prior to acquiring it. But what if those statements were prepared using different standards than those used in the United States? A single set of standards would make it much easier to decide whether to acquire a foreign company.

3.Make It Easier to Access Foreign Capital Markets

Assume that a U.S. company wants to borrow money from a bank in Japan. With the current differences in accounting standards between the two countries, the Japanese bank might require the U.S. borrower to present financial statements prepared in accordance with Japanese standards. Or conversely, consider the case of a Japanese company that wants to list its stock on a stock exchange in the United States. It might need to adjust its financial statements so that they were in conformity with U.S. accounting practices. Both the U.S.

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company looking to borrow money abroad and the Japanese company wanting to access the U.S. capital markets could save considerable time and money if a single set of standards were used universally.

4.Facilitate Comparisons

Recall the dilemma presented at the beginning of this appendix: you are deciding whether to invest in Ford Motor Company in this country or Daimler AG in Germany. Just as it would be easier for one corporation to evaluate alternative investments if those companies all used the same accounting rules, so would it be easier for analysts and individual investors to compare companies if a single set of standards were used by all of them.

To a large extent, corporations are the primary beneficiaries of a unified set of accounting standards. They save accounting costs and can more easily make acquisition decisions and access foreign capital markets. Thus, stockholders, as the owners of corporations, have a vested interest in the development of common standards. However, not all companies and their stockholders are convinced that unified standards are in their best interests. For example, the argument has been made that U.S. corporations may find themselves more susceptible to lawsuits in a principles-based system that relies on fewer detailed rules. Considerable costs will be incurred in training accountants under a new set of standards. Ultimately, it will be the responsibility of the Securities and Exchange Commission in this country to decide if the advantages outweigh the disadvantages.

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LO 3 - Describe the role of the International Accounting Standards Board in setting accounting standards and be familiar with the time frame for the convergence of U.S. GAAP and IFRS standards.

Chapter A: International Financial Reporting Standards Who Is Responsible for Developing Global Accounting Standards? Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Who Is Responsible for Developing Global Accounting Standards? The IFRS Foundation and the International Accounting Standards Board(IASB) state as their mission:

to develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world

The International Accounting Standards Committee was established in 1973 to develop worldwide standards and was replaced in 2001 by the IASB. With headquarters in London, the IASB not only issues new accounting standards (called International Financial Reporting Standards or IFRS), but it also works with national accounting groups such as the FASB towards convergence of standards.

According to the IASB, more than 100 countries now require the use of IFRS by public companies. In fact use of IFRS is now mandatory in all member states of the economic and political organization known as the European Union. Outside Europe, other countries have formally announced their convergence plans. For example, China has substantially reached convergence with IFRS. Beginning in 2011, all Canadian listed companies were required to use IFRS. Companies in Mexico began using IFRS in 2012. Interestingly, Japan had still not made a decision as of mid 2016 about mandatory adoption.

Where does this leave the United States? In 2002, the IASB and the FASB formalized their commitment to the union of U.S. and international standards with the Norwalk agreement. Since that time, the two groups have continued their efforts in this regard. For example, in October 2009, the FASB and the IASB reaffirmed their commitment to achieving convergence and since then have continued to work on a number of joint projects.

In 2007, the SEC dropped its long-standing rule that required foreign companies that filed financial statements with it to adjust those statements to conform with U.S. GAAP. The only stipulation is that the statements must follow the standards of the IASB. However, since then the SEC has delayed any final decision on convergence. In the meantime, the FASB and the IASB continue their efforts to eliminate differences between U.S. and international standards.

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Throughout this book, we have focused our attention on the fundamental concepts underlying financial reporting and the standards that have been developed in this country to support those concepts. Many of the differences between U.S. GAAP and IFRS deal with complex issues beyond the scope of this book. In the next section, we consider the major differences between the two sets of rules, emphasizing those topics that have been discussed in each of the chapters.

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LO 4 - Describe the most significant differences between U.S. GAAP and IFRS.

Chapter A: International Financial Reporting Standards Major Differences Between U.S. GAAP and IFRS Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Major Differences Between U.S. GAAP and IFRS

Chapter 1:Accounting as a Form of Communication

By July 1, 2009, when the codification of accounting standards took effect, the FASB had issued 168 standards, in addition to various interpretations and other documents that comprise what is considered to be U.S. GAAP. In contrast, during a very similar time period, the IASB and its predecessor body had released only about 50 standards. Additionally, FASB statements are generally much more detailed than those of the IASB. Because there are significantly more standards in the United States and they are more detailed, standard setting in the United States has often been characterized as rule based, whereas the approach used by the international body is said to be more principle based. Because less-detailed guidance is usually provided in international standards, it stands to reason that more disclosures are warranted. Thus, it is common to see significantly more disclosures in notes to the financial statements of companies that follow IFRS than for those companies following U.S. GAAP. These differences are summarized as follows:

U.S. GAAP IFRS

Type of standards Rule based Principle based

Number of standards More Fewer

Level of detail in standards

More detailed Less detailed

Level of disclosure required

Less More

Chapter 2:Financial Statements and the Annual Report

As another indication of the cooperation between the FASB and the IASB, in September 2010, the two groups released a joint statement titled “Conceptual Framework for Financial Reporting.” With this statement, both the objectives of financial reporting and the qualitative characteristics that make accounting information useful are the same for the two groups.

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These concepts are discussed in detail in Chapter 2. Both U.S. GAAP and IFRS require a complete set of financial statements to include a balance sheet, a statement of stockholders' equity, an income statement, and a statement of cash flows.

Chapter 3:Processing Accounting Information

How accounting information is processed is largely a function of the technology available to implement an accounting system rather than the result of any specific accounting standards in a particular country. The technology available in less-developed countries may influence the development of accounting systems in those countries. The double-entry system devised in 15th-century Italy is still used almost universally today.

Chapter 4:Income Measurement and Accrual Accounting

The accrual accounting system is used almost universally and is the basis for financial statements prepared using both U.S. GAAP and IFRS. In 2014, the FASB and the IASB issued a joint revenue recognition standard. To date, this is one of the most important joint efforts of the two groups, resulting in convergence in the way companies recognize revenue for a variety of complex situations.

Chapter 5:Inventories and Cost of Goods Sold

The LIFO inventory method is popular in the United States, to some extent due to the fact that it allows companies to minimize income taxes during a period of rising prices. Recall from Chapter 5 that the LIFO conformity rule requires that a company that wants to use the LIFO method for reporting cost of goods sold on its tax return must also use LIFO on its books. Many countries do not allow LIFO for either tax or financial reporting purposes. In fact, the IASB strictly prohibits the use of LIFO by companies that follow its standards. There has been considerable discussion in the United States about the repeal of LIFO for tax purposes. If this were to happen, it is likely that its use for financial reporting purposes would be eliminated as well, which would then remove one of the most significant differences between U.S. and international accounting standards.

Both U.S. GAAP and IFRS require use of the lower-of-cost-or-market rule to value inventories. However, the two sets of standards differ in two respects. First, U.S. GAAP define market value as replacement cost, subject to a maximum and minimum amount. In contrast, IFRS uses net realizable value as the measure of the market value of inventory, and no upper or lower limits are imposed. Second, under U.S. GAAP, if inventory is written down to a new, lower market value, this amount becomes the basis for that inventory. Future write-downs of the inventory use this new amount to compare with market value. However, under IFRS, write-downs of inventory can be reversed in later periods. That is, a gain is recognized when the value of the inventory goes back up.

Chapter 6:Cash and Internal Control

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The Sarbanes-Oxley Act of 2002 (SOX) placed strict reporting requirements on companies that want to list their securities on U.S. stock exchanges. The initial costs to comply with the act and the annual requirements to maintain an effective system of internal control have been substantial for these companies. No such reporting requirements exist for companies that report using IFRS. Were convergence to be achieved, it remains uncertain whether any additional requirements would be added to international standards similar to those now imposed in this country under SOX.

Chapter 7:Receivables and Investments

No significant differences exist in the accounting for receivables in this country and internationally. U.S. GAAP and IFRS both require that investments be carried at fair value rather than historical cost, although there are minor differences in the rules for application of fair value accounting.

Chapter 8:Operating Assets: Property, Plant, and Equipment, and Intangibles

While the accounting for operating assets is similar under IFRS and U.S. GAAP standards, there are several important differences.

The same depreciation methods are available for long-term assets under both sets of standards, but the estimates of residual values and the depreciable lives of assets may be assessed differently. Under IFRS, estimates of the life of assets and the residual value of assets must be reviewed at least annually, and if the estimates have changed, then the company should treat the change as a change in estimate. U.S. GAAP require companies to assess the estimate of residual value and life only when circumstances have changed and the accountant believes a change in estimate is necessary. Also, the treatment of interest to be capitalized on self-constructed assets varies between IFRS and U.S. GAAP. U.S. GAAP require that a company must capitalize interest on such assets, while IFRS permits capitalization but does not require it.

There are also differences in the reporting for particular operating assets. Both IFRS and U.S. GAAP require companies to report an amount for goodwill and record a write-down of the goodwill if the asset has been “impaired.” However, the methods of evaluating impairment differ between the two sets of standards. The treatment of research and development (R&D) costs also differs. U.S. GAAP require all internally generated research and development costs to be treated as an expense. IFRS requires research costs to be recognized as an expense but does allow certain development costs to be accounted for as an asset.

Perhaps the most significant difference in the accounting for operating assets concerns the use of fair values. Generally, both sets of standards require operating assets to be carried at their historical cost. However, IFRS allows companies to revalue the assets at fair value (either up or down from historical cost) if reliable measures are available. U.S. GAAP do not

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allow companies to revalue to fair value except in cases where an impairment of an asset has occurred and the asset must be written down to a lower value.

Chapter 9:Current Liabilities, Contingencies, and the Time Value of Money

You may be surprised to learn that U.S. GAAP do not require companies to present a balance sheet with classifications for current and long-term liabilities, or any other classifications. Many companies do, however, present a classified balance sheet in order to present information that balance sheet readers consider to be important. In contrast to U.S. GAAP, IFRS does require companies to present current and noncurrent classifications of assets and liabilities.

The IFRS and U.S. GAAP standards differ significantly on what we have referred to as contingencies in Chapter 9. For reporting in the United States, liabilities for which the outcome is dependent upon a future event must be recorded if the unfavorable outcome is probable and the amount can be reasonably estimated. If the outcome is at least reasonably possible, then the liability should be disclosed, usually in the notes to the financial statements. For IFRS, the term contingent liabilities is used only for items that are not recorded on the financial statements. The liabilities that are considered probable and are recorded are referred to as provisions. Also, the two sets of standards differ somewhat on what should be considered as “probable.”

Finally, the standards differ on the reporting of liabilities where a range of values is available as a possible outcome. U.S. GAAP require that a company report the low end of the range if the outcome is probable and disclose the upper end of the range in the notes. IFRS, however, requires companies to record the midpoint of the range as a provision if the unfavorable outcome is probable.

Chapter 10:Long-Term Liabilities

There are two issues in Chapter 10 that illustrate the attempts of the rule-making bodies to make the U.S. and international standards more aligned. The FASB has issued a revised standard on leasing. When that standard is implemented, there will still be differences between U.S. and international standards but the differences will be reduced. Most importantly, the FASB has adopted the terminology of the international standards. Leases will no longer be classified as operating or capital leases. They will be classified as operating or finance leases, as in the international standards.

Also, both sets of standards address the topics of deferred taxes. While there are still some important technical differences, there is no longer a difference in whether deferred taxes are classified as current or long-term. The FASB has adopted the international standard that indicates deferred taxes should be treated as long-term items.

Chapter 11:Stockholders' Equity

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In general, the accounting for stockholders' equity is the same for IFRS and U.S. GAAP. The most significant difference concerns financial instruments that have both debt and equity characteristics (a convertible bond is one example). IFRS requires the portion of the instrument that represents debt to be presented in the Liability category and the portion of the instrument that represents equity to be in stockholders' equity. U.S. GAAP do not always require such instruments to be separately reported as debt and equity.

Also, both IFRS and U.S. GAAP require the presentation of comprehensive income amounts in the Stockholders' Equity category. However, the manner of reporting comprehensive income amounts as income on the income statement or statement of comprehensive income varies between the two sets of standards. These variations are beyond the scope of this textbook.

Chapter 12:The Statement of Cash Flows

Both U.S. GAAP and IFRS require the inclusion of a statement of cash flows in a complete set of financial statements. Each set of standards also mandates that activities be classified into three categories: operating, investing, and financing. Some differences in classification exist. For example, interest (either received or paid) and dividends received are always classified as operating activities under U.S. GAAP. IFRS allows flexibility; cash receipts may be classified as either operating or investing activities and cash payments as either operating or financing. Similarly, dividends paid are always classified as financing activities under U.S. GAAP, but they may be classified as either operating or financing activities under IFRS. Recall from Chapter 12 that significant noncash activities may be presented in either a separate schedule on the face of the statement of cash flows or in the notes to the statements. Under IFRS, these noncash activities must be presented in the notes.

Chapter 13:Financial Statement Analysis

The IASB prohibits the presentation of items on the income statement as extraordinary. Until recently, U.S. GAAP required certain gains and losses to be classified as extraordinary. With a recent change in U.S. GAAP to prohibit any items to be classified as extraordinary, the standards of the two groups are in conformity in this regard.

Both U.S. GAAP and IFRS require separate presentation on the income statement for discontinued operations.

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LO 5 - Understand how differences in format and terminology affect the appearance of financial statements in various countries.

Chapter A: International Financial Reporting Standards Format and Terminology Differences Book Title: Using Financial Accounting Information: The Alternative to Debits and Credits Printed By: ) © 2018 Cengage Learning, Cengage Learning

Format and Terminology Differences Up to this point, the focus has been on the differing accounting standards used in the preparation of financial statements around the world. But what about the format for the statements and the terms used for the various statement items? It should come as no surprise that significant differences exist in how financial statements are presented and the names given to various accounts. For example, consider the partial statement of financial position (balance sheet) for Daimler AG shown in Exhibit A-1. (We show only the first two columns on the statement titled “Consolidated”—the entire statement also displays columns for its divisions: “Industrial Business” and “Daimler Financial Services.”)

Exhibit A-1

Daimler AG's Consolidated Statement of Financial Position

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Source: Daimler AG, Annual Report, 2015.

Note that amounts are stated in millions of euros, the common currency for members of the European Union. Also, a vast majority of the statement items are referenced to notes to the financial statements. As mentioned earlier in this appendix, because IFRS is less rules based, it is common to see more disclosures in notes to the financial statements (recall that Daimler AG uses IFRS in preparing its statements).

One of the most striking differences is the ordering of both the assets and the equity and liabilities on the statement. For example, long-term assets (non-current) are presented first, followed by current assets. Also, note that three common current assets are listed in reverse

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order of liquidity: inventories first, followed by trade receivables and then cash and cash equivalents. Similarly, equity items are presented before liabilities, with current liabilities as the last category on the statement. Essentially, the entire statement of financial position is inverted compared to what is commonly seen in the United States.

Significant differences in terminology are also evident in looking at Daimler AG's statement. For example, consider the Equity section. Share Capital is the name the company uses for what would normally be referred to as Capital Stock by a U.S. company. Capital Reserve is the equivalent of Additional Paid-In Capital. Daimler AG's non-current and current liabilities both contain an item called Provisions for Other Risks. This is what most U.S. companies would refer to as Contingent Liabilities. Financial statement users need to be aware of these differences in format and terminology. However, these differences should not impede the ability to analyze and make effective use of foreign statements.

Test Yourself

Question

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1. What are at least four reasons that accounting standards currently differ between countries?

2. How have accounting standards developed differently in countries that use a common law system as opposed to those using code law?

3. Why might you expect the accounting standards in Australia to be similar to those in the United Kingdom?

4. What are at least three advantages in all companies around the world using the same accounting standards?

5. How would you describe the current role of the IASB in setting accounting standards?

6. How would you evaluate the following statement: “All of the other major industrialized countries of the world have now adopted IFRS and the United States has set a date for adoption by all companies that currently follow FASB standards”?

7. You are considering investing in the airline industry and are looking specifically at buying shares of either Southwest Airlines or British Airways. Would you expect the financial statements of these two companies to be prepared using the same accounting principles? Explain your answer.

8. How does the application of the lower-of-cost-or-market rule differ between U.S. GAAP and IFRS?

9. How would you evaluate the following statement: “Both the tax laws in the United States and IFRS allow the use of LIFO for tax purposes but only if the method is also used for financial reporting purposes”?

10. How are research and development costs accounted for differently under U.S. GAAP and IFRS?

11. Do either or both U.S. GAAP and IFRS allow operating assets to be carried on the balance sheet at fair value?

12. How does the meaning of the term contingent liabilities differ between U.S. GAAP and IFRS?

13. How does the application of the criteria for accounting for leases differ between U.S. GAAP and IFRS?

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14. What differences are there in classification of interest received and interest paid under U.S. GAAP and IFRS?

15. Is there a standard format used in all countries for the statement of financial position? Explain.

Apply

1. Fill in the blanks below with either “more” or “less” to indicate the differences in U.S. GAAP and IFRS:

U.S. GAAP IFRS

Number of standards

Level of detail in standards

Level of disclosure required

2. The cost of Baxter's inventory at the end of the year was $50,000. Due to obsolescence, the cost to replace the inventory was only $40,000. Net realizable value—what the inventory could be sold for—is $42,000. Determine the amount Baxter should report on its year-end balance sheet for inventory assuming the company follows:

a. U.S. GAAP

b. IFRS

3. Maple Corp. owns a building with an original cost of $1,000,000 and accumulated depreciation at the balance sheet date of $200,000. Based on a recent appraisal, the fair value of the building is $850,000.

a. At what amount will the building be reported on the year-end balance sheet if Maple follows U.S. GAAP?

b. Does Maple have a choice in the amount to report for the building if instead it follows IFRS? What are those choices?

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4. During the most recent year, Butler paid $95,000 in interest to its lenders and $80,000 in dividends to its stockholders.

a. In which category of the statement of cash flows (operating, investing, or financing) should each of these amounts be shown if Butler follows U.S. GAAP? If more than one category is acceptable, indicate what the choices are.

b. In which category of the statement of cash flows (operating, investing, or financing) should each of these amounts be shown if Butler follows IFRS? If more than one category is acceptable, indicate what the choices are.

5. Refer to the statement of financial position for Daimler AG as shown in Exhibit A-1.

a. What is the currency used in preparing this statement?

b. Identify at least three differences in the format of the statement compared to what would normally be seen on a statement of financial position for a U.S. company.

c. Refer to the Equity section of the statement. What account titles would normally be used in the United States for the first two items in this section?

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