cfa level 1 (book-b).docx

8/10/2019 CFA Level 1 (Book-B).docx

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Financial Statements - Introduction

Introduction Financial reporting is the method a firm uses to convey its financial performance to the market,its investors, and other stakeholders. The objective of financial reporting is to provideinformation on the changes in a firm's performance and financial position that can be used tomake financial and operating decisions. In addition to being a management aide, analysts use thisinformation to forecast the firm's ability to produce future earnings and as a means to assess thefirm's intrinsic value. Other stakeholders such as creditors will use financial statements as a wayto evaluate the economic and competitive strength.

The timing and the methodology used to record revenues and expenses may also impact theanalysis and comparability of financial statements across companies. Accounting statements are

prepared in most cases on the basis of these three basic premises:

1. The company will continue to operate (going-concern assumptions).

2. Revenues are reported as they are earned within the specified accounting period (revenues-recognition principle).

3. Expenses should match generated revenues within the specified accounting period (matching principle).

Basic Accounting Methods:

1. Cash-basis accounting - This method consists of recognizing revenue (income) and expenses

when payments are made (checks issued) or cash is received (deposited in the bank).

2. Accrual accounting - This method consists of recognizing revenue in the accounting periodin which it is earned (revenue is recognized when the company provides a product or service to acustomer, regardless of when the company gets paid). Expenses are recorded when they areincurred instead of when they are paid.

Next: Financial Statement Analysis

Financial Statements - Financial Statement Analysis

A. Financial Statement Analysis The income statement is a statement of earnings that shows managers and investors whether thecompany made money over the period of time being reported. This statement details therevenues of the firm as well as the expenses incurred to achieve them, and transforms this intonet income. The conclusion of the statement is to show the firm's gains or losses for the period.The balance sheet reports the company's financial position at a specific point in time. The

balance sheet is made up of three parts: assets, liabilities and owners' equity. Assets detail the
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firm's economic resources that have been built up through the firm's operations or acquisitions.Liabilities are the current or estimated obligations of the firm. The difference between assets andliabilities is known as net assets or net worth of the firm. The net assets of the firm are alsoknown as owners' equity, which is amount of assets that would remain once all creditors are

paid. According to the accounting equation, owners' equity equals assets minus liabilities

Assets Liabilities = Owners' Equity

The statement of cash flows reconciles the firm's net income to its reports on the company's cashinflows and outflows. It shows how changes in balance sheet accounts and income affect cashand cash equivalents. These cash receipts and payments are categorized as by operating cashflows, investing cash flows and financing cash flowsThe statement of changes in owners' equity reports the sources and amounts of changes inowners' equity over the period of time being reportedLet's consider a practical example to fully understand the impact of Cash versus AccrualAccounting on XYZ Corporation's Income Statement and Balance Sheet.

Cash Basis Accounting Taken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is notdoing well, with a net loss of $43,200, and may not be a good investment opportunity.

Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting

Note: For simplicity the tax effect not considered.

Accrual Basis Accounting Armed with some additional information, let's see what the income statement would look like if


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the accrual-basis accounting method was used.

Additional Information:

A1. June 12, 2005 - The company received a rush order for $80,000 of wood panels. The order

was delivered to the customer five days later. The customer was given 30 days to pay. (With thecash-basis method, sales are not recorded in the income statement and not recorded in accountsreceivables: no cash, no record).

A2. June 13, 2003 - The company received $60,000 worth of wood panels to replenish theirinventory, and $40,000 was related to the rush order. The company paid the invoice in full totake advantage of a 2% early-payment discount. (With the cash-basis method, this is recorded infull on the income statement, and there is no record of inventory on hand).

A3. June 1, 2005 - The company launched an advertising campaign that will run until the end ofAugust. The total cost of the advertising campaign was $15,000 and was paid on June 1, 2005.

Figure 6.2: XYZ Corporation's Restated Financial Statements using Accrual BasisAccounting

Note: tax effect not considered

Adjustments:To obtain the figures in the restated financial statements in figure 6.2 above, the followingadjusting entries were made:


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A1. Product sales and Accounts receivable - Even though the client has not paid this invoice, thecompany still made a sale and delivered the products. As a result, sales for the accounting periodshould increase by $80,000. Account s receivables (reported sales made but awaiting payment)should also increase by $80,000.

Adjusting entries:

A2. June 13, 2003 - Since the entire $60,000 order was paid during the accounting period, thefull amount was included in production costs under the cash-basis method. Only $40,000 of theorder was related to product sales during that accounting period, and the rest was stored asinventory for future product sales.

Adjusting entries:

A3. June 1, 2005 - Marketing expenses included in the income statement totaled $15,000 for athree-month advertising campaign because it was paid in full at initiation (cash-basisaccounting). The reality is that this campaign will last for three months and will generate a

benefit for the company every month. As a result, under accrual-basis accounting, the companyshould record in this accounting period only one-third of the cost. The remainder should beallocated to the next period and recoded as prepaid expenses on the assets side of the balancesheet.

Adjusting entries:

Results:

Under cash-basis accounting, this company was not profitable and its balance sheet would have been weak at best. Under accrual accounting, the financials tell us a very different story.

Accrual accounting requires that revenue is recorded when the firm earns it, and that expensesare taken when the firm incurs them regardless of when the cash is actually received or paid. Ifcash is received first then an unearned revenue or prepaid expense account is set up anddecreased as the revenue and expense is recorded over time. If cash is received after goods aredelivered then the revenue and expense is recorded and a receivables or payables account is setup and decreased as the cash is paid. Most accruals fall into one of four categories:

1. Accrued Revenues : A firm will usually earn revenue before it is actually paid for its goods orservices. Typically the asset account for accounts receivable is increased until the customer


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actually pays for goods that have been invoiced. The company records the revenue when thegoods are delivered and invoiced. The accounts receivable account is decreased when thecustomer pays the invoice in cash.

2. Unearned Revenue : Some firms collect income before goods are provided. Subscriptions are

examples of goods that are prepaid, but the revenue is not recognized until the goods aredelivered. In this situation the firm increases the asset account cash and a liability account forunearned income. Unearned income is decreased as revenue is earned over time.

3. Accrued Expenses : Most firms buy inventories and supplies on account and pay for themafter they have been invoiced. When the goods are delivered and equal amount is recorded in theexpense account and in accounts payable. When the invoice is paid, cash and the accounts

payable account are decreased.

4. Prepaid Expenses : Some companies pay some expenses in advance. A prepaid expanseaccount is increased and the actual expense is not recorded until the actual goods or services are

delivered.

Look Out!

Debit: An accounting term that refers to an entry thatincreases an expense or asset account, or decreases anincome, liability or net-worth account.

Credit: An accounting term that refers to an entry thatdecreases an expense or asset account, or increases anincome, liability or net-worth account.

Look Out!

Going forward, all statements will use accrual-basisaccounting. Please note that on the exam, candidatesshould assume that all financial statements useaccrual-basis accounting, unless it is specified thatthe cash-basis accounting method is used in thequestion.

Next: Accounting Process

Financial Statements - Accounting Process

Accounting Process
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Accounting systems take the cash and accruals from various transactions and generate financialreports and statements. Information flows through an accounting system in four steps:

1. The first step is to create journal entries and adjusting entries. The general journal is list ofeach transaction, the amount, and the accounts affected in chronological order. At the end of

accounting periods adjustments are made to record accruals not yet made.2. The general ledger show the journal entries sorted by the accounts affected rather than inchronological order. This can be useful for reviewing the activity in a specific account.

3. At the end of the accounting period an initial trial balance is prepared lists the ending balanceof each account on a given date. If needed, adjusting entries are recorded in an adjusted trial

balance.

4. The financial statements are prepared as a final product of the system, based on the totals froman adjusted trial balance.

Security Analysis In conducting security analysis, an analyst cannot solely rely on the financial statements.Financial reporting is affected by the choice of accounting methods, and the estimates thatmanagement uses to determine the value of assets. In order to get a good understanding of theearnings potential of a business, an analyst must understand the accounting process used to

produce the financial statements to better understand the business and the results for the period.Since much of the detail information on management's accruals, adjustments and estimates iscontained in the footnotes to the statements and Management's Discussion and Analysis, it isimperative that the analyst review these sections of the financial statements. Using thisinformation an analyst should determine:

The various accruals, adjustments and assumptions that went into the financialstatements.

The detailed information that underlies the company's accounting system. How well the financial statements reflect the company's true performance. How the data needs to be adjusted for the analyst's own analysis

Because adjustments and assumptions are at the discretion of management, analysts shouldalways be on the lookout for possible financial statement manipulation and any situation thatmight incent management to falsify or misrepresent the actual operations of the firm

Next: Income Statement Basics

Financial Statements - Income Statement Basics

I. Basics Within this basics section, we will define each component of a multi-step income statement, and

prepare a multi-step income statement.
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Multi-Step Income Statement A multi-step income statement is a condensed statement of income as opposed to a single-stepformat, which is the more detailed format. Both single and multi-step formats conform to GAAPstandards. Both yield the same net income figure.

The main difference is how they are formatted, not how figures are calculated.

Figure 6.3: Multi-Step Income Statement

Sales - These are defined as total sales (revenues) during the accounting period.Remember these sales are net of returns, allowances and discounts

Cost of goods sold (COGS) - These are all the direct costs related to the product orrendered service sold and recorded during the accounting period. (Reminder: matching

principle.)

Operating expenses - These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period.This account is most commonly referred to as "SG&A" (sales general and administrative)

and includes expenses such as selling, marketing, administrative salaries, sales salaries,maintenance, administrative office expenses (rent, computers, accounting fees, legalfees), research and development (R&D), depreciation and amortization, etc.

Other revenues & expenses - These are all non-operating expenses such as interestearned on cash or interest paid on loans.


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Income taxes - This account is a provision for income taxes for reporting purposes.

Next: Income Statement Components

Financial Statements - Income Statement Components

Income Statement Format The following figure demonstrates which components are used to calculate a company's netincome, which is the income available to shareholders.

Figure 6.4: How Net Income is Derived on the Income Statement

The Components of Net Income:

Operating income from continuing operations - This comprises all revenues net ofreturns, allowances and discounts, less the cost and expenses related to the generation ofthese revenues. The costs deducted from revenues are typically the COGS and SG&Aexpenses.

Recurring income before interest and taxes from continuing operations - Thiscomponent includes, in addition to operating income from continuing operations, allother income, such as investment income from unconsolidated subsidiaries and/or otherinvestments and gains (or losses) from the sale of assets. To be included in this category,these items must be recurring in nature. This component is generally considered to be the

best predictor of future earning. That said, it does assume that noncash expenses such asdepreciation and amortization are a good indicator of future capital expenditures. Since
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this component does not take into account the capital structure of the company (use ofdebt), it is also used to value similar companies.

Recurring (pre-tax) income from continuing operations - This component takes thecompany's financial structure into consideration as it deducts interest expenses.

Pre-tax earning from continuing operations - This component considers all unusual orinfrequent items. Included in this category are items that are either unusual or infrequentin nature but cannot be both. Examples are an employee-separation cost, plant shutdown,impairments, write-offs, write-downs, integration expenses, etc.

Net income from continuing operations - This component takes into account the impactof taxes from continuing operations.

Non-Recurring Items Discontinued operations, extraordinary items and accounting changes are all reported as separateitems in the income statement. They are all reported net of taxes and below the tax line, and arenot included in income from continuing operations. In some cases, earlier income statements and

balance sheets have to be adjusted to reflect changes.

Income (or expense) from discontinued operations - This component is related to

income (or expense) generated due to the shutdown of one or more divisions oroperations (plants). These events need to be isolated so they do not inflate or deflate thecompany's future earning potential. This type of nonrecurring occurrence also has anonrecurring tax implication and, as a result of the tax implication, should not beincluded in the income tax expense used to calculate net income from continuingoperations. That is why this income (or expense) is always reported net of taxes. Thesame is true for extraordinary items and cumulative effect of accounting changes (see

below).

Extraordinary items - This component relates to items that are both unusual andinfrequent in nature. That means it is a one-time gain or loss that is not expected to occurin the future. An example is environmental remediation.


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Cumulative effect of accounting changes - This item is generally related to changes inaccounting policies or estimations. In most cases, these are non cash-related expenses butcould have an effect on taxes.

Next: Income Statement: Non-recurring Items

Financial Statements - Income Statement: Non-recurringItems

Within this section we will further our discussion on the non-recurring components of netincome, such as unusual or infrequent items, discontinued operations, extraordinary items, and

prior period adjustments.

Unusual or Infrequent Items Included in this category are items that are either unusual or infrequent in nature but cannot be both.

Examples of unusual or infrequent items:o Gains (or losses) as a result of the disposition of a company's business segment

including: Plant shutdown costs Lease-breaking fees Employee-separation costs

o Gains (or losses) as a result of the disposition of a company's assets or

investments (including investments in subsidiary segments) including: Plant shut-down costs Lease-breaking fees

o Gains (or losses) as a result of a lawsuito Losses of operations due to an earthquakeo Impairments, write-offs, write-downs and restructuring costso Integration expenses related to the acquisition of a business

Look Out!

Accounting treatment is usually displayed as pre-tax .That means that they are displayed on the incomestatement after income from continuing operationsgross of tax implication.

Extraordinary Items Events that are both unusual and infrequent in nature are qualified as extraordinary expenses.
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Example of extraordinary items:o Losses from expropriation of assetso Gain (or losses) from early retirement of debt

Look Out!

Accounting treatment is usually displayed net of tax.That means that they are displayed on the incomestatement after income from continuing operationsnet of its tax implication.

Discontinued Operations Sometimes management decides to dispose of certain business operations but either has not yetdone so or did it in the current year after it had generated income or losses. To be accounted for

as a discontinued operation, the business must be physically and operationally distinct from therest of the firm. Basic definitions:

Measurement date - The date when the company develops a formal plan for disposing. Phaseout period - Time between the measurement date and the actual disposal date

The income or loss from discontinued operations is reported separately, and past incomestatements must be restated, separating the income or loss from discontinued operations.On the measurement date, the company will accrue any estimated loss during the phaseout

period and estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is completed (same rule applies to the sale of a portion of a

business segment).

Look Out!

Important: Accounting treatment of income andlosses from discontinued operations are reported netof tax after net income from continuing operations.

Accounting Changes Accounting changes occur for two reasons:

1. As a result of a change in an accounting principle2. As a result of a change in an accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFOinventory accounting method to another method such FIFO or average cost basis.


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The most common form of a change in accounting estimates is a change in depreciation methodfor new assets or change in depreciable lives/salvage values, which is considered a change inaccounting estimates and not a change in accounting principle. Note that past income does notneed to be restated from the LIFO inventory accounting method to another method such FIFO oraverage cost basis.

In general, prior years' financial statements do not need to be restated unless it is a change in:

Inventory accounting methods (LIFO to FIFO) Change to or from full-cost method (This is used in oil & gas exploration. The

successful-efforts method capitalizes only the costs associated with successful activitieswhile the full-cost method capitalizes all the costs associated with all activities.)

Change from or to percentage-of-completion method (look at revenue- recognitionmethods)

All changes just prior to a company's IPO

Prior Period Adjustments These adjustments are related to accounting errors. These errors are typically NOT reported inthe income statement but are reported in retained earnings. (These can be found in changes inretained earnings.) These errors are disclosed as footnotes explaining the nature of the error andits effect on net income.

Next: Balance Sheet Basics

Financial Statements - Balance Sheet Basics

I. Basics Within this section we'll define each asset and liability category on the balance sheet, and prepare aclassified balance sheet

Balance Sheet Categories The balance sheet provides information on what the company owns (its assets), what it owes (itsliabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specificdate.

Total Assets = Total Liabilities + Shareholders' Equity

Assets are economic resources that are expected to produce economic benefits for their owner. Liabilities are obligations the company has to outside parties. Liabilities represent others' rights

to the company's money or services. Examples include bank loans , debts to suppliers anddebts to employees.
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Shareholders' equity is the value of a business to its owners after all of its obligations have beenmet. This net worth belongs to the owners. Shareholders' equity generally reflects the amountof capital the owners have invested, plus any profits generated that were subsequentlyreinvested in the company.

Look Out!

Components of Total Assets on the balance sheet are listedin order of liquidity and maturity.

Balance Sheet Presentation Formats Although there are no required reporting balance sheet designs there are two customary formats that

are used, the account format and the report format. The two formats follow the accounting equation bysubtotaling assets and showing that they equal the combination of liabilities and shareholder's equity.However, the report format presents the categories in one vertical column, while the report formatplaces assets in one column on the left hand side and places liabilities and shareholder's equity on theright. Both formats can be collapsed further into a classified balance sheet that subtotals and shows onlysimilar categories such as current assets, noncurrent assets, current liabilities, noncurrent liabilities, etc.

Next: Balance Sheet Components - Assets

Financial Statements - Balance Sheet Components - Assets

Total Assets Total assets on the balance sheet are composed of:

1. Current Assets - These are assets that may be converted into cash, sold or consumed within a year orless. These usually include:

Cash - This is what the company has in cash in the bank. Cash is reported at its market value atthe reporting date in the respective currency in which the financials are prepared. (Differentcash denominations are converted at the market conversion rate.

Marketable securities (short-term investments) - These can be both equity and/or debtsecurities for which a ready market exist. Furthermore, management expects to sell these
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investments within one year's time. These short-term investments are reported at their marketvalue.

Accounts receivable - This represents the money that is owed to the company for the goods andservices it has provided to customers on credit. Every business has customers that will not payfor the products or services the company has provided. Management must estimate whichcustomers are unlikely to pay and create an account called allowance for doubtfulaccounts .Variations in this account will impact the reported sales on the income statement.Accounts receivable reported on the balance sheet are net of their realizable value (reducedbyallowance for doubtful accounts).

Notes receivable - This account is similar in nature to accounts receivable but it is supported bymore formal agreements such as a "promissory notes" (usually a short term-loan that carriesinterest). Furthermore, the maturity of notes receivable is generally longer than accountsreceivable but less than a year. Notes receivable is reported at its net realizable value (what willbe collected).

Inventory - This represents raw materials and items that are available for sale or are in theprocess of being made ready for sale. These items can be valued individually by several differentmeans - at cost or current market value - and collectively by FIFO (first in, first out), LIFO (last in,first out) or average-cost method. Inventory is valued at the lower of the cost or market price topreclude overstating earnings and assets.

Prepaid expenses - These are payments that have been made for services that the companyexpects to receive in the near future. Typical prepaid expenses include rent, insurancepremiums and taxes. These expenses are valued at their original cost (historical cost).

2. Long-term assets - These are assets that may not be converted into cash, sold or consumed within ayear or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidatedbalance sheet. However, all items that are not included in current assets are long-term Assets. These

are:

Investments - These are investments that management does not expect to sell within the year.These investments can include bonds, common stock, long-term notes, investments in tangiblefixed assets not currently used in operations (such as land held for speculation) and investmentsset aside in special funds, such as sinking funds, pension funds and plan-expansion funds. Theselong-term investments are reported at their historical cost or market value on the balancesheet.
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Fixed assets - These are durable physical properties used in operations that have a useful lifelonger than one year. This includes:

o Machinery and equipment - This category represents the total machinery, equipment

and furniture used in the company's operations. These assets are reported at theirhistorical cost less accumulated depreciation.o Buildings (plants) - These are buildings that the company uses for its operations. These

assets are depreciated and are reported at historical cost less accumulated depreciation . o Land - The land owned by the company on which the company's buildings or plants are

sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP Other assets - This is a special classification for unusual items that cannot be included in one of

the other asset categories. Examples include deferred charges (long-term prepaid expenses),non-current receivables and advances to subsidiaries.

Intangible assets - These are assets that lack physical substance but provide economic rightsand advantages: patents, franchises, copyrights, goodwill , trademarks and organization costs.These assets have a high degree of uncertainty in regard to whether future benefits will berealized. They are reported at historical cost net of accumulated depreciation.

The value of an identifiable intangible asset is based on the rights or privileges conveyed to its ownerover a finite period, and its value is amortized over its useful life. Identifiable intangible assets includepatents, trademarks and copyrights. Intangible assets that are purchased are reported on the balancesheet at historical cost less accumulated amortization.

An unidentifiable intangible asset cannot be purchased separately and may have an infinite life.Intangible assets with infinite lives are not amortized, and are tested for impairment annually, at least.Goodwill is an example of an unidentifiable intangible asset. Goodwill is recorded when one companyacquires another at an amount that exceeds the fair market value of its net identifiable assets. Itrepresents the premium paid for the target company's reputation, brand names, customers, suppliers,human capital, etc. When computing financial ratios, goodwill and the offsetting impairment charges areusually removed from the balance sheet.

Certain intangible assets that are created internally such as research and development costs areexpensed as incurred under U.S. GAAP. Under IFRS, a firm must identify if the R&D cost is in the research

and development stage. Costs are expensed in the research stage and capitalized during thedevelopment stage.

Look Out!

These assets are listed in order of their liquidity andtangibility. Intangible assets are listed last since they have
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high uncertainty and liquidity.

Next: Balance Sheet Components - Liabilities

Financial Statements - Balance Sheet Components -Liabilities

Total Liabilities Liabilities have the same classifications as assets: current and long-term.

3. Current liabilities - These are debts that are due to be paid within one year or the operating cycle,

whichever is longer; further, such obligations will typically involve the use of current assets, the creationof another current liability or the providing of some service.

Usually included in this section are:

Bank indebtedness - This amount is owed to the bank in the short term, such as a bank line ofcredit.

Accounts payable- This amount is owed to suppliers for products and services that aredelivered but not paid for.

Wages payable (salaries), rent , tax and utilities - This amount is payable to employees,landlords, government and others.

Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a

period prior to the related cash payment. This accounting term is usually used as an all-encompassing term that includes customer prepayments, dividends payables and wagespayables, among others.

Notes payable (short-term loans) - This is an amount that the company owes to a creditor, andit usually carries an interest expense.
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Unearned revenues (customer prepayments) - These are payments received by customers forproducts and services the company has not delivered or started to incur any cost for its delivery.

Dividends payable - This occurs as a company declares a dividend but has not of yet paid it outto its owners.

Current portion of long-term debt - The currently maturing portion of the long-term debt isclassified as a current liability. Theoretically, any related premium or discount should also bereclassified as a current liability.

Current portion of capital-lease obligation - This is the portion of a long-term capital lease thatis due within the next year.

Look Out!

Current liabilities above are listed in order of their duedate.

4. Long-term Liabilities - These are obligations that are reasonably expected to be liquidated at somedate beyond one year or one operating cycle. Long-term obligations are reported as the present value ofall future cash payments. Usually included are:

Notes payables - This is an amount the company owes to a creditor, which usually caries aninterest expense.

Long-term debt (bonds payable) - This is long-term debt net of current portion.

Deferred income tax liability - GAAP allows management to use different accounting principlesand/or methods for reporting purposes than it uses for corporate tax filings (IRS). Deferred taxliabilities are taxes due in the future (future cash outflow for taxes payable) on income that has


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already been recognized for the books. In effect, although the company has already recognizedthe income on its books, the IRS lets it pay the taxes later (due to the timing difference). If acompany's tax expense is greater than its tax payable, then the company has created a futuretax liability (the inverse would be accounted for as a deferred tax asset).

Pension fund liability - This is a company's obligation to pay its past and current employees'post-retirement benefits; they are expected to materialize when the employees take theirretirement (defined-benefit plan). Valued by actuaries and represents the estimated presentvalue of future pension expense, compared to the current value of the pension fund. Thepension fund liability represents the additional amount the company will have to contribute tothe current pension fund to meet future obligations.

Long-term capital-lease obligation - This is a written agreement under which a property ownerallows a tenant to use and rent the property for a specified period of. Long-term capital-leaseobligations are net of current portion.

Look Out!

The liabilities above are listed in order of their due date.

Next: Balance Sheet Components - Marketable & Nonmarketable Instruments

Financial Statements - Balance Sheet Components -Marketable & Nonmarketable Instruments

Marketable & Nonmarketable Instruments Financial instruments are found on both sides of the balance sheet. Some are contracts thatrepresent the asset of one company and the liability of another. Financial assets includeinvestment securities like stocks and bonds, derivatives, loans and receivables. Financial

liabilities include derivatives, notes payable and bonds payable. Some financial instruments arereported on the balance sheet at fair value ( marking to market ), while others are reported at present value or at cost. The FASB recently issued SFAS No. 159, "The Fair Value Option forFinancial Assets and Financial Liabilities," which allows any firm the ability to report almost anyfinancial asset or liability at fair value. Marketable investment securities are classified as one ofthe following:
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Held to Maturity Securities: Debt securities that are acquired with the intention ofholding them until maturity. They are reported at cost and adjusted for the payment ofinterest. Unrealized gains or losses are not reported.

Trading Securities: Debt and equity securities that are acquired with the intention totrade them in the near term for a profit. Trading securities are reported on the balance

sheet at fair value. Unrealized gains and losses before the securities are sold are reportedin the income statement. Available for Sale Securities: are debt and equity securities that are not expected to be

held until maturity or sold in the near term. Although like trading securities, available forsale securities are reported on the balance sheet at fair value, unrealized gains and lossesare reported as other income as part of stockholder's equity.

With all three types of financial securities, income in the form of interest and dividends, as wellas realized gains and losses when they are sold, are reported in the income statement.

The following are measured at fair value :

Assets Liabilities Financial assets held for trading Financial assets held for tradingFinancial assets available for sale DerivativesDerivatives Non-derivative instruments hedged by

derivatives Non-derivative instruments hedged byderivatives

The following are measured at cost or amortized cost :

Assets Liabilities Unlisted instruments All other liabilities (accounts payable,

notes payable)Held-to-maturity investmentsLoans and receivables

Next: Shareholders' (Stockholders') Equity Basics

Financial Statements - Shareholders' (Stockholders') EquityBasics

I. Basics

Components of Shareholder's Equity Also known as "equity" and "net worth", the shareholders' equity refers to the shareholders'ownership interest in a company.
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Usually included are:

Preferred stock - This is the investment by preferred stockholders, which have priorityover common shareholders and receive a dividend that has priority over any distribution

made to common shareholders. This is usually recorded at par value.

Additional paid-up capital (contributed capital) - This is capital received frominvestors for stock; it is equal to capital stock plus paid-in capital. It is also called"contributed capital".

Common stock - This is the investment by stockholders, and it is valued at par or stated

value.

Retained earnings - This is the total net income (or loss) less the amount distributed tothe shareholders in the form of a dividend since the company's initiation.

Other items - This is an all-inclusive account that may include valuation allowance andcumulative translation allowance (CTA), among others. Valuation allowance pertains to

noncurrent investments resulting from selective recognition of market value changes.Cumulative translation allowance is used to report the effects of translating foreigncurrency transactions, and accounts for foreign affiliates.

Look Out!

These components are listed in the order of theirliquidation priority.

Figure 6.5: Sample Balance Sheet


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Stockholders' Equity Statement Instead of presenting a detailed stockholders' equity section in the balance sheet and a retainedearnings statement, many companies prepare a stockholders' equity statement.

This statement shows the changes in each type of stockholders' equity account and the totalstockholders' equity during the accounting period. This statement usually includes:

Preferred stock Common stock Issue of par value stock Additional paid-in capital Treasury stock repurchase Cumulative Translation Allowance (CTA) Retained earning

Next: Components of Stockholders' Equity

Financial Statements - Components of Stockholders' Equity

Within this section we'll identify the components that comprise the contributed capital part ofstockholders' equity.
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Contributed Capital Contributed capital is the total legal capital of the corporation (par value of preferred and commonstock) plus the paid-in capital.

Par value - This is a value of preferred and common stock that is arbitral (artificial); it is set bymanagement on a per share basis. This artificial value has no relation or impact on the marketvalue of the shares.

Legal capital of the corporation - This is par value per share multiplied by the total number ofshares issued.

Additional paid-in capital (paid-in capital) - This is the difference between the actual value thecompany sold the shares for and their par value.

Example:Company XYZ issued 15,000 preferred shares to investors for $300,000.Company XYZ issued 30,000 common shares to investors for $600,000.Par value of preferred shares is $7 per share.Par value of common shares is $15 per share.

Ads by saovE oa nAd Options Legal capital :Preferred shares: $105,000(15,000 x $7)Common shares: $450,000(30,000 x $15)Legal capital $555,000

Paid-in capital: Preferred shares: $195,000 ($300,000-$105,000)Common shares: $150,000 ($600,000-$450,000)Paid-in capital $345,000

Legal capital + Paid-in capital = Contributed Capital

Look Out!

If issued common shares have no par value, the amount the
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stock is sold for constitutes common stock. Preferred stockis always sold with a stated par value.

Next: Accounting for Dividends

Financial Statements - Accounting for Dividends

Dividends Dividends are payments to stockholders that can be made regularly (monthly, quarterly orannually) or occasionally.

Companies are not required to issue a dividend to their common stockholders. Companies may have an obligation to issue a dividend to preferred shareholders (see

definition and properties of preferred shareholders). A company's board of directors must approve of a dividend before it can be declared and

issued.

There are two basic dividend forms:

1. Cash dividends - These are cash payments made to stockholders of record. Retainedearnings are reduced when dividends are declared.

2. Stock dividends - These are dividends paid in the form of additional stock of the issuingcompany to shareholders of record in proportion to their current holdings. A stockdividend does not increase the wealth of the recipient nor does it reduce the net assets ofthe firm. It is a permanent capitalization of retained earnings to contributed capital.

Dividend Terminology

Date of Declaration: This is the date the board approved and declared a dividend.

Date of record: This is thedate set by the issuer that determines who is eligible to receivea declared dividend or capital-gains distribution.
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Ex-dividend date: This is the first day of trading when the selling shareholder is entitledto the recently announced dividend payment. Shares purchased as of the ex-dividend datewill not receive the previously declared dividend.

Date of payment : This is the date on which the company will pay the declared dividendto its stockholders of record as of the date of record.

Accounting for a Cash Dividend Let's examine the payment process of a cash dividend. We'll use XYZ company again for thisexample.

XYZ declares a dividend on Jan 1, 2005, for its common shareholders of $400,000 payable toshareholders of record on Feb 1, 2005, and payable on Feb 31, 2005.

Accounting Impact on the Date of Declaration, Jan 1, 2005:Accounting Impact on the Date of Payment, Feb 31, 2005:

Stock Dividends Stock dividends involve the issuance of additional shares of stock to existing shareholders on a

proportional basis. Stock dividends are issued to stockholders of record as of the record date. Thedividends are not paid in cash but are paid as additional shares.

Since a company does not pay out any cash when it declares a stock dividend, the company'scash account (current assets) is not affected. The only account that is affected is the company's

contributed capital (paid-up capital). When a company issues a stock dividend, the company'sretained earnings are reduced by the value of the stock dividend, and the company will increaseits common stock and paid-up capital accounts.

Note that the size of the dividend declared is important. If the company declares a 25% or lessstock dividend (as a percentage of the company's previous total outstanding shares) then thevalue of the stock dividend declared is equal to the market value of the shares issued. (Commonshares are increased to reflect value of dividend.) If the stock dividend is larger than 25%, thecompany will transfer 100% of the par or stated value of the common shares to the common-stock account.

Examples: Stock dividends are best learned by considering an example of a situation where the stockdividend is 25% or less of previously outstanding shares, and where the stock dividend is 25% ormore of the previously outstanding shares.

Situation 1: Twenty-five percent or less of previous outstanding shares XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005,one share for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZshares have a market value of $10 and a par value of $40. The company has 2 million shares


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outstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 20additional shares for a total of 120. Furthermore, the company will issue 400,000 additionalstocks to stockholders. After the dividend is issued, the company will have 20% more sharesoutstanding.

Accounting impact on date of declaration:

Accounting impact on date of issuance:

Situation 2: M ore than 25% of previous outstanding shares. XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005,three shares for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZshares have a market value of $10 and a par value of $40. The company has 2 million sharesoutstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 60additional shares for a total of 160. Furthermore, the company will issue 1.2 million additionalstocks to stockholders. After the dividend is issued, the company will have 60% more sharesoutstanding.

Accounting impact on date of declaration:

Accounting impact on date of issuance:

Look Out!

The most common mistake students make in thissection is that they forget to calculate if the stock


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dividend is less than or higher than 25% of the sharesoutstanding and the reporting effect it will have.

Stock Split

Stock splits are events that increase the number of shares outstanding and reduce the par or statedvalue per share of the company's stock. For example, a two-for-one stock split means that thecompany stockholders will receive two shares for every share they currently own. This willdouble the number of shares outstanding and reduce by half the par value per share. Existingshareholders will see their shareholdings double in quantity, but there will be no change in the

proportional ownership represented by the shares (i.e. a shareholder owning 2,000 shares out of100,000 would then own 4,000 shares out of 200,000).

Most importantly, the total par value of shares outstanding is not affected by a stock split (i.e. thenumber of shares times par value per share does not change). Therefore, no journal entry isneeded to account for a stock split. A memorandum notation in the accounting records indicates

the decreased par value and increased number of shares.

Stocks that are trading on the exchange will normally be re-priced in accordance to the stocksplit. For example, if XYZ stock was trading at $90 and the company did a 3-for-1 stock split,the stock would open at $30 a share.

Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) andto make it more affordable for investors to buy regular lots (regular lot = 100 shares).

Next: Accounting for Equities

Financial Statements - Accounting for Equities

Preferred Stock Characteristics Preferred stock (preferred shares) is a hybrid between common stock and bonds. It provides aspecific dividend that is paid before any dividend is paid to common stockholders.

Dividends o Preferred stocks pay to stockholders a predefined dividend that is based on a

specific amount, or is a percentage of the preferred stock's par value.o Like common stock, preferred stocks represent partial ownership in a company.o Preferred stockholders do not usually enjoy any of the voting rights of common

stockholders or any additional net income distributions beyond the stated dividend payout, unless they are participating preferred stockholders.

Superi ority in the Event of L iqui dation o Preferred stockholders have precedence over common stockholders in the event of

liquidation.o Bondholders always have precedence over preferred stockholders from a dividend

and liquidation point of view.
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o Unlike bondholders, preferred stockholders cannot force a company into bankruptcy.

Classification o From an accounting point of view, preferred stock is classified as equity, and the

dividend payments are classified in a similar fashion as common stock dividends.o

Unlike interest paid on bonds, the fixed dividend paid out to preferredstockholders is not deductible from earnings before taxes (EBT) and is not taxdeductible.

Attributes In general, preferred stock can have several attributes; they can be:

o Cumulative - This is preferred stock on which dividends accrue in the event thatthe issuer does not make timely dividend payments. Unpaid preferred dividendsare called "dividends in arrears". Most preferred stocks are cumulative.

o Non-cumulative - This is preferred stock on which dividends do not accrue in theevent that the issuer does not make timely dividend payments.

o Participating - This is preferred stock that, in addition to a regular dividend, paysa dividend when common stock dividends exceed a specified amount.

o Convertible - This is preferred stock that can be converted into a specified

amount of common stock at the holder's option.

o Retractable - This is preferred stock that grants the stockholder the right toredeem the stock at specified future date(s) and price(s).

o Perpetual - These are preferred shares that have no maturity date.

o Callable (Non-perpetual) - These are preferred shares that have a predeterminedmaturity date. At the maturity date, the company will buy back the preferredshares at their par value.

Voting Rights Most preferred stock is non-voting. However, most of these securities also include a


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Without par value:

Next: Revenue Recognition

Financial Statements - Revenue Recognition

I. What is Revenue Recognition?

The Matching Principle The matching principle of GAAP dictates that revenues must be matched with expenses. Thus, incomeand expenses are reported when they are earned and incurred, even if no cash transaction has beenrecorded.

For example, say a company made a sale for $30,000 within an accounting period but has not receivedpayment. Even though the company was not paid, the sale is recorded as revenue. This revenue has tobe matched with the expenses that the company incurred in the accounting period to generate thatrevenue (revenues and expanses must match).

If revenues were not matched with their related expenses, companies would produce financialstatements that provide little information to the readers and themselves. (This is a fundamentalprinciple of accrual-basis accounting)

Revenue-Recognition Principles SFAS 5 specifies that two conditions must be met for revenue recognition to take place:

1. Completion of the Earnings ProcessThis means the company has provided all or virtually all of the goods and services for which it isto be paid. Furthermore, it means the company can measure the total expected cost ofproviding the goods and services, and the company must have no significant remainingobligations to its customers. Both must be true for this condition to be met.

2. Assurance of Payment There must be a quantification of the cash or assets that will be received for realized goods andservices. Furthermore, the company must be able to accurately estimate the reliability ofpayment. Both must be true for this requirement to be met.
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Gross and Net Reporting of Revenue Under gross revenue reporting, sales and the cost of goods sold are reported separately. With netrevenue reporting only the net revenue, calculated by subtracting cost of goods sold from gross sales, isreported. Since the only the net revenue is reported, revenues will be less than under gross revenuereporting.

Under U.S. GAAP, a firm using gross revenue reporting must be the primary party to any contract, takeon both inventory and credit risk, be able to choose its suppliers, and have the ability to set price.

When analyzing the financial statements analysts should be aware of how aggressive or conservative afirm's revenue recognition policies are. A firm's that has a very aggressive revenue recognition policyruns the risk of over stating its revenues and its earnings performance. Analysts should also be aware ofany assumptions or judgments that are made in reporting revenues

Next: Revenue Recognition Methods and Implications

Financial Statements - Revenue Recognition Methods andImplications

Sales-basis M ethod o Under the sales-basis method, revenue is recognized at the time of sale, which is

defined as the moment when the title of the goods or services is transferred to the buyer.

o The sale can be made for cash or credit. This means that, under this method,revenue is not recognized even if cash is received before the transaction iscomplete.

o For example, a monthly magazine publisher that receives $240 a year for anannual subscription will recognize only $20 of revenue every month (assumingthat it delivered the magazine).

o Implication: This is the most accurate form of revenue recognition .

Percentage-of -completion method o This method is popular with construction and engineering companies, who may

take years to deliver a product to a customer.o With this method, the company responsible for delivering the product wants to be

able to show its shareholders that it is generating revenue and profits even thoughthe project itself is not yet complete.

o A company will use the percentage-of-completion method for revenue recognitionif two conditions are met:

1. There is a long-term legally enforceable contract2. It is possible to estimate the percentage of the project that is complete, its

revenues and its costs.o Under this method, there are two ways revenue recognition can occur:
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1. Using milestones - A milestone can be, for example, a number of storiescompleted, or a number of miles built for a railway.

2. Cost incurred to estimated total cost - Using this method, a constructioncompany would approach revenue recognition by comparing the costincurred to date by the estimated total cost.)

o Implication:This can overstate revenues and gross profits if expenditures arerecognized before they contribute to completed work.

Completed-contr act method o Under this method, revenues and expenses are recorded only at the end of the

contract.o This method must be used if the two basic conditions needed to use the

percentage-of-completion method are not met (there is no long-term legallyenforceable contract and/or it is not possible to estimate the percentage of the

project that is complete, its revenues and its costs.)o Implication: This can understate revenues and gross profit within an accounting

period because the contract is not accounted for until it is completed. Cost-r ecoverabil i ty method

o Under the cost-recoverability method, no profit is recognized until all of theexpenses incurred to complete the project have been recouped.

o For example, a company develops an application for $200,000. In the first year,the company licenses the application to several companies and generates$150,000.

o Under this method, the company recognizes sales of $150,000 and expensesrelated to the development of $150,000 (assuming no other costs were incurred).As a result, nothing would appear in net income until the total cost is offset bysales.

o Implication: This can understate gross profits initially and overstate profits infuture years.

I nstallment method o If customer collections are unreliable, a company should use the installment

method of revenue recognition.o This is primarily used in some real estate transactions where the sale may be

agreed upon but the cash collection is subject to the risk of the buyer's financingfalling through. As a result, gross profit is calculated only in proportion to cashreceived.

o For example, a company sells a development project for $100,000 that cost$50,000. The buyer will pay in equal installments over six months. Once the first

payment is received, the company will record sales of $50,000, expenses of$25,000 and a net profit of $25,000.

o Implication: This can overstate gross profits if the last payment is not received.


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Summary of Revenue Recognition Methods

Method

First Condition: Completionof Earning Progress

Second Condition:Assurance of Payment

Goods/Services Provided

Measurable Cost

Quantification

Reliability

Sales Basis Yes Yes Yes Yes

Percentage of

Completion Incomplete Yes Yes Yes

CompletedContract Incomplete Yes or No Yes/No Yes/No

Cost Recoverabilit y

YesYes withContingency

Yes/No Yes/No

Installment Method Yes Yes Yes No

Next: Revenue Recognition and Accounting Entries

Financial Statements - Revenue Recognition and AccountingEntries

Accounting Entries The best way to identify the appropriate accounting entries is to consider an example:

Construction Company ABC, has just obtained a $50 million contract to build a five-buildingresort in the Bahamas for Meridian Vacations. Company ABC estimates that each building willtake a full year to build. Meridian Vacations has agreed to pay Company ABC according to the
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Total Expected Inflow

This is basically the same formula used in the percentage-of-completion method.

Step 2:

Cost to be declared Since this is the basic assumption of this accounting methodology, the expenses remain the sameas the ones that were estimated.

Results: 1. Annual Income Statement Entries In each year, the revenues, expenses would be entered as seen on the following table.

Note: For simplicity, taxes were not considered.

Figure 6.8: Construction Company ABC's Income Statement (% of Completion Method)

2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABC's Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:


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Cash: It is the total cash Company ABC has on hand at the end of the year, and is definedas the total cash inflow minus the total cash outflow. If the result of this equation werenegative, the company would have to borrow from its line of credit additional funds tocover its total expenses.

Accoun ts Receivable: The total amount billed less the cash received by Meridian.

Net constructi on in progress (asset) and net advance bil li ng (liability): These accounts offset each other and are composed of construction in progress less total

billings.o If the result of this equation were negative, the company would have billed its

client for more than what has delivered. This would have constituted a liability for

the construction company, and would have been reported as net advance billings.o If this equation were positive, then the company would have built more than theclient has paid for it, and the result of the equation would have constituted anasset and would be recorded as net construction in progress.

o In most cases, companies only report net construction in progress or net advance billing on their balance sheet.

Retained earn in gs -The cumulative shares of the total profit to date. This item is notshown on the balance sheet above. It normally appears after shareholders equity.

Formula 6.5

Construction in progress = the cumulative cost incurredsince inception + (cumulative percentage of completion xtotal estimated net profit of the project)

Less

Total billings = cumulative amount billed to the clientsince inception

Look Out! Remember, if the result of the above equation is:Positive (asset) = net construction in progressNegative (liability) = net advance billings

Figure 6.10: Other Items on Company ABC's Balance Sheet (% of Completion Method)


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Completed-Contract Method Under this accounting methodology, revenues and expenses are not recognized until the contractis completed and the title is transferred to the client.

Annual Income Statements In this case, nothing would be reported on the annual income statements until Year 5.

Figure 6.11: Company ABC's Income Statement (Completed Contract Method)

Balance Sheet Statements Under this method, the balance sheet entries are the same as the percentage-of -completionmethod, except for the Net Advance Billing account.

Figure 6.12: Company ABC's Balance Sheet (Completed Contract Method)

Balance Sheet Entries


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Cash and accoun ts receivables stay the same under both the percentage of completionand completed contract methods.

o This is normal because, no matter which method you use, you always know howmush cash you have in the bank, and you how much credit you have extended toyour client.

Net constructi on in progress (asset) / net advance bil l ing - The basic concepts are thesame, except that under this methodology, construction in progress does not include thecumulative effect of gross profits in the formula (i.e. excludes cumulative percentage ofcompletion x total estimated net profit of the project).

Next: Revenue Recognition Effects on Cash Flows and Financial Ratios

Financial Statements - Revenue Recognition Effects on CashFlows and Financial Ratios

Both methods - the percentage-of-completion and completed-contract methods - produce the same net cash flow effect.

Cash Flow Effects

Percentage-of-completed contract methodo Net income (NI) will be higher in the first years and lower in the last year.o Net Income will be less volatile.o Total assets will be greater.o Liabilities will be lower.

Completed contract method o Net income will be nonexistent in the first years and higher in the last year.o Net income will be very volatile.o Total assets will be smaller.o Liabilities will be higher (no recognition of retained earnings).o Stockholders equity will be lower.o Stockholders equity will be more volatile.

Impact on Financial Ratio

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Ratio Formula % ofCompletionMethod

ReasonCompletedMethod
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CurrentRatio Current Assets

CurrentLiabilities

Higher Constructionin progressincludesportion ofestimated

profits

Lower

RevenueTurnover

RevenuesAverageReceivables

Higher Revenuesare reported

Lower - Notmeasurableprior tocompletion

Assets toEquity Total Assets

Equity Higher

Retained

earnings arereported

Lower - Notmeasurableprior tocompletion

TotalDebtRatio

Total LiabilitiesTotal Liabilities+ Total Equity

Lower

Liabilitiesare smallerand thedenominatorincludesequity whichis higher

Higher

Next: The Cash Flow Statement

Financial Statements - The Cash Flow Statement

I. Introduction

Components and Relationships Between the Financial Statements It is important to understand that the income statement, balance sheet and cash flow statementare all interrelated.

The income statement is a description of how the assets and liabilities were utilized in the statedaccounting period. The cash flow statement explains cash inflows and outflows, and willultimately reveal the amount of cash the company has on hand; this is reported in the balance
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sheet as well.

We will not explain the components of the balance sheet and the income statement here sincethey were previously reviewed.

Figure 6.13: The Relationship between the Financial Statements

Next: Cash Flow Statement Basics

Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow The statement of cash flow reports the impact of a firm's operating, investing and financialactivities on cash flows over an accounting period. The cash flow statement is designed toconvert the accrual basis of accounting used in the income statement and balance sheet back to acash basis.

The cash flow statement will reveal the following to analysts:

1. How the company obtains and spends cash2. Why there may be differences between net income and cash flows3. If the company generates enough cash from operation to sustain the business4. If the company generates enough cash to pay off existing debts as they mature5. If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows The statement of cash flows is segregated into three sections:
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1. Operating activities2. Investing activities3. Financing activities

1. Cash F low fr om Operating Activiti es (CF O)

CFO is cash flow that arises from normal operations such as revenues and cash operatingexpenses net of taxes.

This includes:

Cash inflow (+)1. Revenue from sale of goods and services2. Interest (from debt instruments of other entities)3. Dividends (from equities of other entities)

Cash outflow (-)1. Payments to suppliers

2.

Payments to employees3. Payments to government4. Payments to lenders5. Payments for other expenses

2. Cash F low fr om I nvesting Activities (CFI ) CFI is cash flow that arises from investment activities such as the acquisition or disposition ofcurrent and fixed assets.

This includes:

Cash inflow (+)1. Sale of property, plant and equipment

2. Sale of debt or equity securities (other entities)3. Collection of principal on loans to other entities

Cash outflow (-)1. Purchase of property, plant and equipment2. Purchase of debt or equity securities (other entities)3. Lending to other entities

3. Cash f low fr om fin ancing activiti es (CFF ) CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction)of additional shares, short-term or long-term debt for the company's operations. This includes:

Cash inflow (+)1. Sale of equity securities2. Issuance of debt securities

Cash outflow (-)1. Dividends to shareholders2. Redemption of long-term debt


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3. Redemption of capital stock

Reporting Noncash Investing and Financing Transactions Information for the preparation of the statement of cash flows is derived from three sources:

1.

Comparative balance sheets2. Current income statements3. Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow becausethey do not require the use of cash.

Examples Include:

Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found asfootnotes to the financial statements.

Next: Cash Flow Computations - Indirect Method

Financial Statements - Cash Flow Computations - IndirectMethod

Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of two ways:

1. The indirect method2. The direct method

The Indirect Method The indirect method is preferred by most firms because is shows a reconciliation from reported netincome to cash provided by operations.

Calculating Cash flow from Operations Here are the steps for calculating the cash flow from operations using the indirect method:

1. Start with net income.2. Add back non-cash expenses.

o (Such as depreciation and amortization)3. Adjust for gains and losses on sales on assets.
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o Add back losseso Subtract out gains

4. Account for changes in all non-cash current assets.5. Account for changes in all current assets and liabilities except notes payable and dividends

payable.

In general, candidates should utilize the following rules:

(Such as depreciation and amortization)

The following example illustrates a typical net cash flow from operating activities:

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Cash Flow from Investment Activities

Cash Flow from investing activities includes purchasing and selling long-term assets and marketablesecurities (other than cash equivalents), as well as making and collecting on loans.

Here's the calculation of the cash flows from investing using the indirect method:
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Cash Flow from Financing Activities Cash Flow from financing activities includes issuing and buying back capital stock, as well as borrowingand repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are alsoincluded in this category, but the repayment of accounts payable or accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect method:

Next: Cash Flow Computations - Direct Method

Financial Statements - Cash Flow Computations - DirectMethod

The Direct Method The direct method is the preferred method under FASB 95 and presents cash flows from activitiesthrough a summary of cash outflows and inflows. However, this is not the method preferred by mostfirms as it requires more information to prepare.

Cash Flow from Operations Under the direct method, (net) cash flows from operating activities are determined by taking cashreceipts from sales, adding interest and dividends, and deducting cash payments for purchases,operating expenses, interest and income taxes. We'll examine each of these components below:
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Cash collections are the principle components of CFO. These are the actual cash received duringthe accounting period from customers. They are defined as:

Formula 6.7 Cash Collections Receipts from Sales

= Sales + Decrease (or - increase) in AccountsReceivable

Cash payment for purchases make up the most important cash outflow component in CFO. Itis the actual cash dispersed for purchases from suppliers during the accounting period. It isdefined as:

Formula 6.8

Ads by saovE oa nAd Options Cash payments for purchases = cost of goodssold + increase (or - decrease) in inventory +decrease (or - increase) in accounts payable

Cash payment for operating expenses is the cash outflow related to selling general andadministrative (SG&A), research and development (R&A) and other liabilities such as wagepayable and accounts payable. It is defined as:

Formula 6.9 Cash payments for operating expenses =

operating expenses + increase (or - decrease) inprepaid expenses + decrease (or - increase) inaccrued liabilities

Cash interest is the interest paid to debt holders in cash. It is defined as:

Formula 6.10 Cash interest = interest expense - increase (or +decrease) interest payable + amortization of

bond premium (or - discount)

Cash payment for income taxes is the actual cash paid in the form of taxes. It is defined as:

Formula 6.11 Cash payments for income taxes
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= income taxes + decrease (or - increase) in incometaxes payable

Look Out!

Note: Cash flow from investing and financing arecomputed the same way it was cal

cfa level 1 (book-b).docx

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