Corporate financial accounting, Summaries of Financial Accounting

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M. Loughran,

Corporate financial accounting

Ch. 1 – Basics to Financial Accounting Accounting – system to provide information for decision making GAAP – procedures / policies set by authorities to help prepare financial statements Managerial (internal) – helps improve profitability / efficiency Financial (external) – for people outside the business: should we invest / loan to this business? Assets = Liabilities + Equity Basic types of accounts Assets – resources owned by a business Rights / claims to assets:

1. Rights of creditors Liabilities – obligations they must pay; rights of the creditors Bought on account → creates Account Payable (Sold on account → creates Account Receivable, which is an asset)
2. Rights of stockholders / owners Equity – owner’s claims to assets a. Paid- in capital – invested by owners / stockholders b. Retained earnings – profits retained & not given to stockholders as dividends i. Revenue – generated based on sales or services ii. Expenses – costs of generating revenue iii. Dividends* – reduce retained earnings; distribute assets to stockholders. *Not all companies pay these. Stockholder’s vs. owner’s equity: S. E. – rights of owners for a corporation (because they have stock) O. E. – rights of owners for a proprietorship / LLC / partnership Expanded accounting equation: Assets = Liabilities + Capital Stock + Beginning Retained Earnings + End Retained Earnings Retained Earnings = Net Income – Dividends Net Income = Revenue – Expenses Stockholder’s equity equation: Beginning stockholder’s equity + capital stock + net income – dividends = ending stockholder’s equity Financial Statements (in order of preparation) 1) Income statement – summary of revenues & expenses for a period of time a. Net income – excess revenue (revenue > expenses) b. Net Loss – expenses > revenue

• Expenses are listed largest to smallest 2) Retained earnings statement (or statement of stockholder’s equity) – change in retained earnings for a period of time

Ch. 2 – Journalizing T- accounts – Debits on left, credits on right DEAD – Debit {Expenses, Assets, Dividends} COLR – Credit {(Owner’s) equity, Liabilities, Revenue} Journalizing – recording a transaction in the journal.

• At least 1 debit & 1 credit (think double- entry accounting)
• Total debits = total credits
• Must affect at least two or more accounts Ledger – group of accounts for a business Trial Balance – verifies that debits = credits Errors affecting trial balance: If the difference between columns is

1. 10, 100, 1000 – addition error
2. Divisible by 2 – may have double- counted a journal entry as 2 debits or 2 credits
3. Divisible by 9 – it is either one of the following: a. Transposition : mix- up (ex. $54 2 vs $452) b. Slide : ($5420 vs. $54.20 vs. $542.00)
4. None of the above – retrace the ledger. Did you omit a debit or credit? Errors not affecting trial balance:
5. Usually because of an abnormal account balance (ex. A credit balance in Supplies is impossible; you cannot have negative supplies)
6. Incorrect account used (ex. using Supplies vs. Office Equipment)

Ch. 3 – Adjustments Accrual basis accounting – revenues / expenses reported in income statement in the period they are earned in Cash basis accounting – not allowed under GAAP

• revenues / expenses are reported in income statement in the period when cash is received or paid (small businesses can use this instead of accrual basis because they have few receivables) Net income for cash basis accounting = cash receipts – cash payments Adjustments occur before financial statements are prepared to bring accounts up to date Why are adjustments needed?
• Some expenses aren’t recorded daily (uses of supplies)
• Some elements evolve into revenues/expenses over time & are incurred that way
• Some revenues/expenses unrecorded (Ex. Wages not paid ‘til next accounting period, but earned in current period)
• Always involves assets / liabilities (balance) and revenue / expenses (income) Types of Adjustments Deferrals – Future expenses / revenues paid or received in cash before revenue / expense is recognized in books Accruals – Paid or received cash after revenue / expense recognized in books (revenue / expense recorded in current period but not yet paid) Types of accounts requiring adjustments:

1. Prepaid expenses : advanced payment of future expense. (paying in advance for an expense, like insurance rent etc). Recorded as an asset. Becomes an expense over time.
2. Unearned revenue : recorded as a liability when cash is received (you haven’t earned it yet).
3. Accrued rev enue: revenue you have earned but have not recorded. Cash has not been received. Ex: A service has been provided, but not billed (getting paid soon), or accrued rent on property you rented out.
4. Accrued expense : unrecorded; incurred, but not paid. Ex: Taxes, interest on notes payable. Done for period it was incurred in. No original entry. PREPAID EXPENSE: essentially getting rid of prepaid expense with adjustment Original: (paying for expenses) Prepaid expense x (asset) Cash x Adjustment: Expense x Prepaid expense x

Ch. 5 – Merchandising Business Merchandising vs. Service

• Merchandising uses Cost of Goods Sold (“COGS,” an expense) and Gross Profit (profit before deducting operating expenses)
• When something is sold, Merchandising Businesses refer to them as Sales
• When something is sold for Service Businesses, refer to them as Fees Earned Merchandise Inventory (MI) – merchandise on hand (current asset) o Includes freight costs, purchase returns & allowances, purchase discounts o Increases by purchases, decreases by COGS with each sale General & Subsidiary Ledgers
• Sub ledger – large number of small accounts w common characteristics, grouped into one
• Each sub ledger is represented by a controlling account in the general ledger o Accounts Receivable (A/R) sub ledger (“customer’s ledger”) – details receivables from customers, controlling account is A/R o Accounts Payable (A/P) sub ledger (“creditors ledger”) – details payables to creditors, controlling account is A/P o Inventory sub ledger (“inventory ledger”), controlling account is Inventory Multi- step Income Statement Equations Sales – COGS = Gross Profit Gross Profit – Operating Expenses = Operating Income / Loss Operating Income – Non-- operating Expenses = Net Income / Loss Inventory Equations (*Remember the cost of BI for any period = cost of EI for the previous period) Cost of Beginning Inventory + Net Cost of Purchases = Cost of Goods Available for Sale Initially (BI + NP = COGA) – what you started with, + what you added to your inventory Cost of Ending Inventory + Cost of Goods Sold = Cost of Goods Available for Sale Initially (EI + COGS = COGA) – what you ended with, + what you sold = yr original Periodic vs. Perpetual Inventory Systems Periodic – doesn’t track sale of individual goods; you take the physical count of inventory on hand at the end of the period
• Purchases of MI increase purchases
• EI determined by physical count
• Use formulas to determine COGS Perpetual – amount of inventory purchased, available for sale, and sold is always updated

• Lets company know how much inventory is on hand or sold at any time
• Used by large / medium sized companies because it’s up- to- date & accurate; can restock accordingly
• Continuous record of MI & COGS
• Physical count done at the end of each pd. to verify MI balance
• Shrinkage – difference between what should be EI and actual EI Journal Entries Purchasing MI: MI x A / P x (ALWAYS assume they buy on credit) Returning MI: A / P x MI x Making payments: A / P x Cash x Purchase return – return goods for credit or cash Purchase allowance – may keep merchandise; seller grants an allowance (deduction) from the price Purchase discount – incentive to pay back cash early
• Customers paying cash early shortens operating cycle
• Purchaser also saves money
• “2/10, n/30” – 2% discount available for 10 days; net is due 30 days after purchase ( = credit period)
• Sometimes it’ll be “n/eom,” which means pay by end of month purchase was made in
• “1/10 eom” = 1% discount if paid within first 10 days of next mo.
• Example: A company must pay back $3000, with terms 2/10, n/30. o They borrow $2940 to pay off loan on the 10 th^ day ▪ $2940 = $3000 – ($3000 x 2%), where $3,000*2% is the discount ▪ The annual interest rate for the loan is 6%; they take 20 days (‘til the end of the original credit period) to pay off the loan. ▪ $2940 x 6% x 20/360 = $9.80 (interest on the loan they must pay) discount of 2% $ interest on loan - $9. $ saved from disc = $50. Conclusion: It’s smart to borrow money to pay off purchase if interest rates still result in savings

Ch. 8 Receivables Receivables – all yr claims to other ppl’s money Account Receivable – most common receivable; current asset; collected within a short period— 30 - 60 days usually. Notes Receivable – formal, longer credit pd (60+ days). if expected to be collected within a yr, is a current asset. “Trade Receivables” – receivables from sales transactions Other Receivables – Interest Receivable, Tax Receivable, receivables from officers / employees; reported separately on bal sht; if collection beyond 1 yr, called Investments & are noncurrent assets Uncollectible Receivables – customers may not pay accounts → “uncollectible” Factoring – shift risk of receivables by selling them Factor – the buyer Bad Debts Expense – operating expense recorded from uncollectible receivables Clues a receivable may be uncollectible:

1. Overdue
2. No reply to collection attempts
3. Customer files for bankruptcy
4. Customer closes its business
5. Company cannot locate customer When to record BDE:
6. Direct Write-off method – when account actually worthless

• Used by sml companies + companies w few receivables

2. Allowance method – estimate at period’s end which ones are worthless

• Required by GAAP for large companies Direct write-off method – used by companies that mostly use cash or have few receivables → BDE is small Writing off after deemed uncollectible BDE x A/R – Bad Boy x **Can collect A/R’s that have already been written off Reversing entry A/R – Bad Boy x BDE x (cancelled)

Paying off A/R Cash x A/R – Bad Boy x Allowance method – estimates BDE at end of each pd; adjusting entry (w/ this method, you can’t actually write off these A/R accounts w/o knowing which exact amts need to be written off, so you can only use the Allowance account to estimate) Estimation BDE x ADA x

• Income statement: BDE matched w related rev
• Bal sht: value of receivables reduced to NRV Net Realizable Value (NRV) = A/R – ADA (what’s actually expected to be collected of the receivables) Write-off – aka confirmed to be uncollectible ADA x A/R – Bad Boy x Reversal – correcting entries can be in an entirely different period A/R – Bad Boy x ADA x Collection of amounts previously written off Cash x A/R – Bad Boy x
• ADA has a credit balance if you overestimate BDE and write off less than you thought you would need to. (Not all estimates are written off)
• ADA has a debit balance if you underestimate BDE and write off more than you thought you would need to. But at the period’s end, you’re adjusting again for new BDE so it’ll always be a credit balance. Estimating Uncollectibles

1. Percent of sales method – uncollectibles estimated as a percentage of sales

• Based on BDE; places more emphasis on the income statement + matching revenues w expenses
• (BDE / Credit Sales) * 100% = Percent of Sales that’s uncollectible
• credit this amt to ADA

2. Analysis of receivables method – “aging the receivables”

Ch. 11 – Stocks, Dividends Stockholders elect board of directors, who establish corporate policy & pick CEOs Double taxation: first federal income taxes, then on dividends given to stockholders Corps often organize in states with laws more favorable to incorporation

• State grants charter or articles of incorporation
• Prepare bylaws for conducting corp’s affairs
• Costs of organizing a corp – “Organizational expenses” Two main sources of Stockholder’s Equity:

1. Paid-in Capital (Contributed Capital)
2. Retained Earnings Paid-In Capital – main source is issuing stock Characteristics of Stock
3. Authorized – total amt of stock they’re allowed to issue
4. Issued – shares issued to stockholders
5. Outstanding – shares remaining in the hands of stockholders Stock certificates – document ownership; includes name of co., name of stockholder, #shares owned Par – dollar amt assigned to each share of stock (not all stock has a par value—“no-par stock”) Stated value – some boards of directors require no-par stock be assigned a value Legal capital – minimum amt of paid-in capital some states require corps to maintain (to protect creditors) Issued – Outstanding = Treasury Stock Major rights of owning stock; vary with stock class

1. Right to vote
2. Right to dividends
3. Right to share in assets upon liquidation of the company Classes of Stock Common stock – default class; all common stock shares have equal rights; smaller chance of receiving dividends than PS owners Preferred stock – preference (first rights) to dividends; dividend rights stated as $ per share or percentage of par. Ex. Preferred $4 stock, $50 par OR preferred 8% stock, $50 par Cumulative preferred stock – right to receive regular dividends that were not declared in prior years In arrears – cumulative stock that hasn’t been paid in prior years; must be paid before common stock divs are paid

Order of who receives assets in a liquidation

1. Creditors
2. Preferred stockholders
3. Common stockholders Issuing Stock

• Often issued at a price that is not par
• Issued at price more than par – issued at premium
• Issued at price less than par – discount (rarely done) Price depends on

1. Financial condition / earnings + div record of corp
2. Investor expectations of the corp’s potential earning power
3. General business / econ conditions + expectations Transfer agent / registrar – a financial institution used to keep track of a corporation’s stockholders Premium on Stock Paid-In Capital in Excess of Par – any excess amount paid over the par Issuance - $50 par issued at $55. Cash 110, Preferred Stock 100,000 (2,000 shares x $50 par) Paid-In Capital in Excess of Par 10,000 (2,000 shares x $5 difference) ** both preferred stock & PIC in excess increase s.e., even when yr selling stock If stock issued for non-cash, assets acquired recorded at fair-market value (or the fair market price of stock issued if FMV cannot be determined) Land 120,000 (market price of stock, bc fmv of land couldn’t be determined) Common Stock 100,000 (10,000 x $10) Paid-In Capital in Excess of Par 20,000 (10,000 x $2) part of the market value of the stock that is in excess of par No-par stock – issue entries are the same even if issuing price varies Issuance Cash 400,000 (10,000 shares x $40 issue price) Common Stock 400, Next issue Cash 36,000 (1,000 shares x $36 issue price) Common Stock 36, Stated value per share – recorded like par Example: no-par common stock assigned stated value of $25, 10,000 shares issued at $

Example: 2m CS - $20 par shares issued. stock div of 5% of CS shares (2m shares * 5% = 100k shares; market price is $31/share) Stock Dividends 3.1m (based on market value; $31100k shares) Stock Dividends Distributable 2m (based on par; $20100k shares) Paid-In Capital in Excess of Par 1.1m Distribution Stock Divs 2m Common Stock 2m **STOCK DIVS DO NOT AFFECT TOTAL S.E. OR AN INDIVIDUAL PROPORTION OF STOCKHOLDER’S EQUITY. The number of shares they own will change, but the proportion of ownership will still be the same (ex. Given 600 shares in divs; ownership was 10% before divs, 10% after divs, but 10.6k shares vs 10k shares) Treasury Stock – stock issued then reacquired Treasury Stock is deducted from Stockholders Equity. Why buy back TS?

1. To reissue shares to officers / employees under bonuses or stock compensation
2. To have additional shares available for use in the acquisition of other companies
3. To increase stock value (fewer shares in the market)
4. To increase EPS (fewer shares outstanding)
5. Rid company of disgruntled investors, maybe to avoid a takeover Cost method used to record purchase / resale of TS
   • TS debited for purchase price (cost) of stock
   • Resold – TS credited for cost
   • Any difference btwn cost & selling price is d/cr. to Paid-In Capital from Sale of TS
   • Paid-In Capital from Sale has normal credit balance
   • If PIC is emptied & you’re selling TS for a loss, debit Retained Earnings instead Example: CS rebought for $45/share, 1000 shares. TS 45, Cash 45, Corp sells 600 shares of TS for $60/share. Cash 36,000 (600 * $60) TS 27,000 (600 * $45) Paid-In Capital from Sale of TS/9,000 (difference) Corp sells 400 shares for $40/share. Cash 16,000 (400$40) Paid-In Capital from Sale of TS 2,000 (difference) TS 18,000 (400$45)

• here, you aren’t comparing TS to par value but what you bought it back for Stock Split – corporation reduces par or stated value of Common Stock & issues a proportionate number of additional shares

• Applies to all common shares
• Objective: to reduce market price per share, attracting investors + broadening stockholders
• NO ENTRY Financial Analysis & Interpretation 11 – EPS EPS = (Net Income – Preferred Dividends) / Average number of Common Shares Outstanding Preferred dividends are subtracted because the numerator is only based on Common Shares.

1. Market > Contract, your bond is less attractive bc investor receives less interest → sold at DISCOUNT
2. Market = Contract, sold at FACE
3. Market < Contract, your bond is more attractive bc investor earns more interest → sold at PREMIUM Price of a bond quoted as a % of the face (par) value Ex. “quoted at 109” → transaction occurred at $1000 x 1.09 (percent) “quoted at 98” → “ ” at $1000 x. Accounting for bonds payable

• May be issued at face, discount, or premium
• When issued not at face, the discount / premium is amortized over the life of the bond. All this means is that you’re getting rid of the discount / premium from your books. It ends up evening out

1. Issued at face: price of 100 (say face = 100k, interest rate 12%) Issuance entry Cash 100k B / P 100k 1 st^ interest payment (every 6 mo. after issuance) 100k * 12% *. Interest Exp 6k Cash 6k Maturity B / P 100k Cash 100k
2. Issued at discount: face – selling price = discount; contract rate = 12% Carrying amt (BV) of bond = B / P – discount (the part that’s unamortized) Issuance Cash 96406 – selling price; this is what investors will pay for a bond w a lower contract than market (12% vs. 13%) Discount on B / P 3594 B / P 100k Semiannual amortization of the discount increases your interest expense & lowers the discount. → this means you’ll ultimately end up with

• an interest expense that approximates what would’ve been paid if your contract rate was the market rate (13%)

• increases carrying amount til it equals face amount at maturity Interest Expense x Discount on B / P x Or, you can combine amortization with semiannual interest payments. Interest Exp x Discount x Cash x (amount of interest payment) 2 methods of amortizing bond discounts
  1. Straight-line – equal amortization per pd (the one this class teaches)
  2. Effective interest rate – required by GAAP
     • Straight-line may be used if results are not significantly different from the 2nd method Straight-line amortization example for premiums / discounts: Term – 5 yrs, total discount – $ Period = term in years * 2 Semiannual amortization of discount = $3594 / (5 yrs * 2) = $359.

3. Issued at premium – investors will pay more for bonds that pay higher interest Cash 103769 B / P 100k Premium on B / P 3769  what they’ll pay for a 12% interest rate vs the market 11% ***Discounts have normal debit, premiums have normal credit Carrying Value (BV) = B / P + premium (unamortized) Semiannual amortization of premium (same as discounts.) Effect: carrying amt decreases til it hits face, interest expense decreases til it approximates interest expense of market (12 coupon vs 11 market)

• Since you’re getting more $, your interest expense is decreased instead of increased. This way, in your books, interest exp will always be approximating that of market price Premium x Interest Exp x (both are decreasing here) Or Interest Exp x Premium x Cash x (combined with interest payments)