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ACTG 2011 NOTES

CHAPTER 8: CAPITAL ASSETS - PROPERTY, PLANT, EQUIPMENT, INTANGIBLES, AND GOODWILL


Introduction - What are Capital Assets?
- Resources that contribute to earning revenue over more than one period; help an entity produce,
supply, support or make available goods or services it offers to its customers; are not bought and sold in
the ordinary course of business; essential to any entity
- Property, Plant, Equipment (PPE): tangible assets used to produce or supply goods or services
to customers, rented to customers, or used for administrative purposes; land, building, vehicles,
etc.; can have very long lives or relatively short lives
- Capital Intensive Business: company that has a large proportion of PPE in its assets
- Intangible Assets: capital assets without physical substance; patents, copyrights, trademarks,
etc.; life length can vary
- Goodwill: an intangible asset, arises when one business acquires another and pays more than
the fair value of the net identifiable assets purchased
- Leasing Capital Assets: do not have to be owned to be classified as assets on the balance sheet
- Disparities: accounting sometimes has difficulty with certain types of capital assets, intangibles in
particular; inconsistencies exist with software, employees, leased capital, brand names ,etc.
Measuring Capital Assets & Limitations to Historical Cost Accounting
-Most companies follow IFRS, use historical cost to account for capital assets, but have the option to use
fair value; all costs incurred to acquire an asset and prepare it for use are capitalized
- Purpose of recording at historical cost is to match cost of capital assets to revenue earned over
the life of the asset; difficult to understand how it can be used for future predictions
- Three Alternatives to Historical Cost Accounting
- Fair Value: price that would be received to sell an asset in an orderly transaction between
market participants; less objective, less reliable than historical cost, amount is an estimate, is
not supported by a transaction; obtaining a reasonable fair value estimate difficult, many used
and new capital assets are not bought sold very often, no ready market price; today's fair value
says nothing about what asset could be sold for in the future
- Replacement Cost: amount that would have to be spent to replace a capital asset; can be cost
of a new identical item, or the cost of an equivalent one if the existing asset is no longer
available; information on timing and amounts involved in replacement would be very useful for
pre-directing cash flows; less objective than historical cost, no transaction supporting the
amount; obtaining replacement costs can be difficult for some assets, especially if they do not
exist anymore; today's replacement cost says nothing about cost of the item when actually
replaced
- Value-In-Use: net present value of cash flow the asset will generate or save over its life (entity-
specific value under IFRS); relevant for many purposes (investors trying to determine value of
business); severe practical limitations, individual assets rarely generate cash on their own,
estimating future cash flows of a group of assets can require many assumptions, making
estimate imprecise and possibly unreliable
- Historical Cost: has uses, but not for future-oriented decision; used to evaluate historical
performance, calculate return on investment, calculate stewardship
What is Cost?
- When capital asset acquired, always recorded at cost, the fair value on the date the asset is acquired
- Should include all costs incurred to purchase; costs that can be included are the purchase price,
architectural design, engineering fees, non-refundable taxes, delivery costs, transportation insurance
costs, duties, testing and preparation charges, installation costs, legal costs, any and all costs related to
getting; employee costs to ready the asset for use should be capitalized; costs not necessary or related
to the acquisition should NOT be capitalized
- Interest: capitalized until asset is ready for use, expensed afterwards; capitalizing interest most
common when entity is building an asset itself
- Need for judgement when deciding which costs should be capitalized and which should be expensed;
managers may thus influence their choices by self-interest whenever ambiguity exists; if tax
minimization is entity's main objective, may expense as much and as many costs of acquiring asset as it
reasonably can; if entity prefers to maximize current income, will capitalize as much as it can to defer
expensing costs
- Repairs/Maintenance: expenditures enabling asset to do what it is designed to do; should be expensed
when incurred; increases expenses and reduces income by the full amount of the expenditure in the
period in which it is incurred; expenditure on existing capital assets are more likely to be repairs than
betterments
- Betterment: only capitalized if the expenditure meets the definition of an asset (future benefit,
probable, controlled, result of a past transaction, measurable); makes existing asset better; cost is
depreciated over the remaining life of the asset
- Basket Purchases
- Entity may sometimes purchase a bundle of assets at a single price; prices of individual assets
will not be known
- Difficulties when it comes to allocating the total cost among the assets in the bundle; purchase
price must be allocated in proportion to the market values of each of the assets; hard to know
what the market values of the different components, managers have flexibility to make
allocation to suit their reporting objectives, as long as amount assigned to each is reasonable
(within two valuation estimates)

Ex/ Land and building purchased in a bundle for $25,000,000. 40% land, 60% building

Dr. Land (asset +) 10,000,000


Dr. Building (asset +) 15,000,000
Cr. Cash (asset -) 25,000,000
To record basket purchase of land and building
Depreciation
- Capital assets get used up when helping to earn revenue; cost must somehow be matched to revenues
they help earn; expensing cost of capital asset conceptually same as expensing cost of inventory when it
is sold or salaries when work done; matching principle application
- Depreciation (IFRS): process of allocating the cost of property, plant, equipment to expense
- Physical Use: effects that the passage of time, wear and tear, exposure to elements have on
the capital asset's ability to help earn revenue
- Obsolescence: advances in technology, shifts in business environment; less to contribute to
money-making activities of the business than newer equipment would
- Amortization (IFRS): process of allocating the cost of intangible assets to expense; patents, copyrights
- Depletion (IFRS): process of allocating the cost of natural resources to expense; mines, oil, gas
- Residual Value: amount that would be received today from selling the asset if it was at the end of its
useful life
- Manager's Judgement: get the discretion to choose a reasonable useful life, a reasonable residual
value, and an appropriate, systematic way to depreciate cost; stakeholders must recognize that there
are different treatments possible
- Not Amortizing
- Land: not usually depreciated; does not wear out or become obsolete
- Mines: the exception to the "land does not depreciate" rule; cost of land is expensed
as the land is mined; land is used up as resources are removed
- Intangible assets not amortized when no factor limiting their useful lives; goodwill not
amortized either
- Depreciation & Market Values
- Allocates cost of a capital asset to expense
- Carrying amount of asset (cost less depreciation to date) is not an estimate of market values
- Depreciation Methods

Dr. Depreciation Expense (expense +, owner's equity +) $$$


Cr. Accumulated Depreciation (contra-asset +) $$$
To record depreciation expense, increase in accumulated depreciation account for the year

- Straight-Line Depreciation: depreciation expense is same in each period; assumed the


contribution to revenue generation by the capital asset is the same each period, probably not
realistic; annual depreciation expense will likely change as estimates of the asset's useful life
and residual value change, but these changes have no direct economic impact on the entity,
may affect outcome of contracts based on net income and other financial statement measures
- Depreciable Amount: amount of capital asset that will be depreciated

Depreciation Expense = (Cost - Estimated Residual Value) / Estimated Useful Life


= Depreciable Amount / Estimated Useful Life
- Accelerated Depreciation: allocate more of the cost of a capital asset to expense in the early
years of its life and less in the later years; used when asset's revenue-generating ability is
greater in the early part of its life; appropriate for assets sensitive to obsolescence, assets that
lose efficiency and/or effectiveness over time
- Declining-Balance: applies depreciation rate to the carrying amount of the asset at the
beginning of the period to calculate the depreciation expense; amount remaining at the
last year of the useful life is depreciated, irrespective of the rate

Depreciation Expense = (Cost - Accumulated Depreciation, Period Start) * Rate


= Carrying Amount, Period Start * Rate

- Effects: since depreciation expense is greater in the early life of the asset, net income
is lower; net income will be higher in later years, however; if an entity is growing and
continually purchasing and replacing capital assets, depreciation expense almost always
lower than declining balance; if entity not growing, declining balance eventually
produces lower depreciation expenses
- Usage-Based Depreciation: used if asset's consumption can be associated with its use, not to
the passage of time or obsolescence
- Units of Production: manager must be able to estimate the number of units that the
asset will produce over its life; depreciation expense is the portion of units produced in
the year to total estimated units to be produced over its useful life; assumption is made
that the asset's actual lifetime production will equal the production estimated by the
manager, rarely true in practice

Depreciation Expense = (Number Units Produced in Period / Estimated Number of Units)


* (Cost - Estimated Residual Value)

- Widely-used in Canada by companies in natural resource industries; possible to


estimate amount of resource available, estimated amount is basis for
depreciating costs
- Complications: difficult to make reasonable estimate of the capacity of many assets,
estimate crucial for finding depreciation expense; usage-based depreciation is not
appropriate for many assets, no obvious unit of measurement applicable
- Advantages: results in good matching, good link between amount of depreciation and
asset consumption
- Comparison: the three methods can produce very different numbers for some fundamental
figures, including net income, net capital assets and total assets, yet the underlying economic
position of the company stays the same; whether or not the choice of how to depreciate
matters depends on who is using the financial statements, how, and for what purpose
- Stock Price: unaffected by changing depreciation methods to report higher income
- Contracts: those depending on financial statement numbers would be affected
- Manager Bonuses: if based on net income, might prefer units-of-production because
bonus would be higher in first year
- Loan: managers reluctant to use declining balance because of the loss it produces in
first year; lenders may be less willing to invest in an entity that comes off as unprofitable
- Tax: no method is appropriate; Income Tax Act specifies how depreciation must be
calculated
- Depreciation - An Arbitrary Allocation: no depreciation method justified over all others, impossible to
know how capital asset contributes to revenue earned; difficult to estimate useful life, residual value
with any precision; as long as estimate reasonable under circumstances, it is acceptable; managers have
significant room in choosing depreciation methods, useful lives and residual totals; manager's decisions
influenced by knowledge of how assets used, methods used by other firms in industry, information
needs of stakeholders, own interests
- Depreciation Issues to be Mindful of
- Many different, acceptable methods of depreciating capital assets, little restriction; no method
is the best for all situations
- Difficult to estimate useful life or residual value of an asset, so will be variation in manager's
choices; estimates depend on how asset used and cared for, can be difficult to determine from
financial statement information
- Managers can make choices that serve their reporting objectives
- Depreciation is irrespective of cash flow
- Manager's choices can have economic consequences
- Componentization of Assets (Required by IFRS)
- When PPE is made up of parts or components, different useful lives or depreciation methods
appropriate; required each component be accounted for separately; when asset purchased for a
single price, management has to decide how to allocate the cost among the components,
management has flexibility to achieve reporting objectives
- ASPE: technically, requires componentization, but has not been practiced in Canada
Valuing Capital Assets at Fair Value
- IFRS provides option of valuing PPE at fair value if measurable reliably, some companies may want to
do this; intangibles can be valued at fair value if active market exists, tend to be unique so very unusual
to be revalued; IFRS requires revaluations done often enough so difference between carrying amount
and fair value is not significant
- Gross Method: records asset at its revalued amount; eliminates accumulated depreciation
- Proportional Method: ratio of accumulated depreciation to gross carrying amount of the asset must be
the same before and after the revaluation; carrying amount must equal market value
- Balancing Accounting Equation: fair value higher than previous carrying amount; adjustment needed to
keep accounting equation in balance; affects the "other comprehensive income" account in the
statement of comprehensive income, "accumulated other comprehensive income - revaluation surplus"
in equity section of balance sheet
- Comprehensive Income: change in equity during a period from transactions and economic
events that involve non-owners
- Fair Value Decreased: decrease in value reported as a loss on the income statement, NOT in
the other comprehensive income section; losses recognized in calculation of net income
- Investment Properties: land and buildings held to earn rent or for capital appreciation; excluding land
and building used to produce or supply goods or services, administrative purposes, or held for sale as
part of the normal business activities of a company; if fair value approach used, changes reported in
calculation of NET INCOME
- Biological Assets: living animal or plant; grows, reproduces, produces; required by IFRS to be valued at
the end of each reporting period at fair value less costs to sell; change in fair value included in NET
INCOME calculations
- ASPE: does not allow valuation of capital assets at their fair value
- Implications of Valuing at Fair Value
- Fair-valuing makes income (or comprehensive income) more volatile; changes in value
recognized even if asset is not sold
- May be difficult to find precise fair value; flexibility to management to manage earnings
- Fair values may provide more relevant information for stakeholders; assets valued at current
values instead of historical costs
- Financial Statement Disclosure (Required by IFRS)
- Required to disclose measurement basis for determining the carrying amount (cost or fair
value); depreciation method, useful lives of each major category of capital assets; gross carrying
amount, accumulated depreciation at the beginning and end of the period; reconciliation of the
carrying amount at the start and end of the period; depreciation expense
Natural Resources
- Spend a lot of money and time finding resources to extract and sell; IFRS not yet clear on which costs
incurred developing resource should be capitalized
- Failures: companies must bear failures in order to be successful in the future; unknown whether the
cost of failures should be capitalized and depleted, even though they have not been useful beyond
helping companies find more profitable extraction sites
- Unknown when costs should start being capitalized; costs expensed as incurred until the starting time
Intangible Assets
- Capital assets with no physical qualities; cannot be seen, touched or felt; often crucial to the success of
an entity; patents, copyrights, trademarks, franchise rights, brand names, customer lists, software,
licences; movies, human resources, goodwill; can be fair value or historical cost, fair value only possible
if there is an active market for the intangible
- Accounting (IFRS) done similarly to accounting for PPE, but with a few differences
- Amortized over useful lives, but some considered to have indefinite lives, do not have to be
amortized; management have reasonable discretion over which items they believe have finite
and indefinite useful lives
- Conditions for Intangible Asset: must be separately identifiable (be able to sell or license it); must have
future benefits; future benefits must be controlled by entity; cost must be reliably measurable; can be
recognized if it represents a contractual/legal right
- If criteria not met; costs involved must be expensed when incurred
- Internally Generated Intangibles: entities investing a lot of resources in creation of knowledge assets,
intellectual capital; extremely valuable, but costs associated with them must be expensed as incurred;
are definitely assets in essence
- IFRS's recognition criteria states an asset must create probable future benefits; very uncertain
if there will be future benefit to expenditures of internal knowledge; measurability another
problem, relation between expenditure and future benefit often unclear
- Effects: economic costs incurred to earn revenue are not expensed in period benefits are
earned; net income as a measure of performance is weakened; gross margin, profit margin,
return on assets, return on equity are distorted, latter two would be higher if knowledge assets
were capitalized
- Missing Assets: can be recognized by comparing the book value of the equity of a company
(amount in equity section) to the value of its equity (share price on stock market times the
number of shares outstanding)
- Purchased Intangibles: usually recorded as cost; classified as asset; amortized over useful life, or
treated as an intangible with an indefinite life
- Goodwill
- Arises when one company purchases all or a majority of the shares of another company, pays
more for it than the fair value of the assets and liabilities of the purchased company; amount
paid over and above the fair value of the purchased entity's identifiable assets & liabilities on
the date of purchase

Goodwill = Purchase Price - Fair Value of Identifiable Assets & Liabilities Purchased

- Identifiable Assets & Liabilities: tangible, intangible assets and liabilities that can be specifically
identified; include cash, inventory, land, buildings, patents, copyrights, research & development
- Assumed extra amount paid for something of value; often attributed to things such as
management ability, location , synergies, customer loyalty, reputation, benefits associated with
the elimination of a competitor; all things should lead to higher profits, very difficult to
specifically identify and measure
- Internally-Generated Goodwill: things like management ability, location, customer loyalty
exist before the company is sold, but are not recorded on the balance sheet; too difficult to
determine if there are future benefits associated with expenditures that give rise to goodwill, so
amounts expensed as incurred
- Amortization: goodwill is not amortized, according to IFRS; management must estimate fair
value of goodwill each year to determine if it is impaired; if fair value less than carrying amount,
goodwill must be written down, write-down amount expensed in yearly income statement;
despite IFRS guidelines for estimating fair value, management has considerable leeway in
deciding timing and amount of any write-down
Sale of Capital Assets
- When entity sells asset not usually sold in the ordinary course of its business for an amount that is
different from its carrying amount, gain or loss occurs; gain when sold for more than carrying amount,
loss when sold for less than the carrying amount
- When depreciable asset sold, cost of asset and its accumulated depreciation must both be removed
from the books; any changes affecting the carrying amount of an asset will change the amount of gain or
loss reported, assuming the selling price is constant
- Managerial Discretion: manager's decision to sell an asset may be affected by amount of any
gain or loss; if entity requires higher net income to meet requirements of loan, manager may be
unwilling to sell capital asset at a loss, may sell one to generate a gain

Ex/ Equipment for $1,200,000; Residual $200,000; Useful Life 10 Years; Carrying Amount
$500,000; sold 1/4 of the way though the year; Straight-Line Basis

Depreciation expense of $25,000 needed for current year...

Dr. Depreciation Expense (expense +, shareholder's equity - ) 25,000


Cr. Accumulated Depreciation (contra-asset +) 25,000
To record the part-year depreciation expense for equipment sold during 2018
([($1,200,000 - $200,000) / 10] * 0.25)

On day of sale, accumulated depreciation is $725,000; carrying amount is $475,000...

Dr. Cash (asset +) 400,000


Dr. Accumulated Depreciation (contra-asset -) 725,000
Dr. Loss on Sale of Equipment (net income -, shareholder's equity -) 75,000
Cr. Equipment (asset -) 1,200,000

Impairment of Capital Assets


- Carrying amount of a capital asset is greater than its future benefits; should be written down, which
reduces the carrying amount of the capital asset, reduces income; under IFRS, capital asset impaired if
recoverable amount is less than its carrying amount
- Recoverable Amount: greater of the "fair value less cost to sell" and "value-in-use" (present
value of asset's future cash flows)

Write-down = Carrying Amount - Recoverable Amount

- IFRS states write-downs of capital assets can be reversed if the recoverable amount increases in a later
period, excluding write-downs of goodwill
- Longer-Term Perspective: inventory uses the lower of "cost" or "net realizable value" rule, compared at
the end of each period, written down if NRV less than cost; but for capital assets, cash flows over entire
life are considered; short-term reduction in net cash flows or fair value not enough to trigger write-
down of capital asset

Ex/ Building at cost $12,000,000; Accumulated Depreciation $5,000,000; Value-In-Use


$5,000,000; Fair Value Appraisal $2,500,000
Value-In-Use > Fair Value, so use Value-In-Use as the recoverable amount; recoverable amount
less than carrying amount, so must write down the building

Dr. Loss Due to Impairment of Building


(net income -, shareholder's equity -) 2,000,000
Cr. Accumulated Depreciation (contra-asset +) 2,000,000
To write down building to its recoverable amount

- Accumulated Depreciation: where the write-down is credited to; decrease the carrying amount of the
asset; cash is not affected by the journal entry, despite the potential for future cash flow losses
- Managerial Discretion: lot of judgement needed in deciding timing and amount of write-down; future
cash flows, present value of future cash flows, fair value are highly uncertain; manager's will time write-
downs of capital assets to accomplish reporting objectives
- Big Bath: assets written down, resulting in large expenses now, paving way for higher earnings
in future because less carrying amount of assets to depreciate; must be justifiable, but
management can usually make a reasonable justification if company not performing well
- ASPE: capital asset impaired if undiscounted net cash flow asset is expected to generate over
remaining life, including residual value, is less than carrying amount; carrying amount of asset is
compared with fair value; when fair value less than carrying amount, asset is written down to fair value;
does not allow write-downs to be reversed
Does the Way Capital Assets are Accounted for Affect the Cash Flow Statement?
- Accounting choices do not affect the actual amount of cash entering/leaving an entity, but can affect
how cash flows are classified
- When expenditure is capitalized, appears as an investing activity in the cash flow statement; if that
expenditure was expensed instead, it would have been included in cash from operations
- Capitalization: outlay classified as investing activity; amortization expense added back to net income in
the calculation of CFO using the indirect method
- Expense: in the calculation of CFO, amortization expense is added back to net income; does not appear
explicitly in the cash flow statements
- Managerial Discretion: even though statement of cash flows is designed to neutralize the effects of
accounting choices by managers; managers can influence it by deciding which outlays will be capitalized
and which will be expensed; impairs comparability between similar companies
- Why Accounting Choice?: allows managers to present information in ways that are useful to
stakeholders, but provides them the means to achieve their own reporting objectives; stakeholders
should recognize opportunity for abuse and use accounting information cautiously; accounting very
important role in communicating information about an entity; essential that managers and any external
accountants behave ethically; if stakeholders cannot use accounting information with confidence, costs
of doing business will increase and economic performance will decline
Financial Statement Analysis Issues
- Limits: when analyzing historical cost information, there are limits to the insights one can gain;
usefulness of historical cost information about capital assets is questionable; extensive choice about
how to account for capital assets, how it is done significantly affects numbers in the financial
statements; expenses, net income, assets, retained earnings, any ratios will be greatly affected by what
costs get capitalized, depreciation method used, estimates of useful life and residual value, existence of
unrecorded assets, and the impairment of capital assets
- Return on Assets: used to measure performance and operating efficiency of an entity; measure of how
efficiently an entity used its assets to generate profit; can improve ROA by lowering asset base or
increasing profits;

Return on Assets (ROA) = (Net Income + After-Tax Interest Expense) / Average Total Costs

Tax Rate = Tax Expense / (Net Income + Income Tax Expense)

- Problems: ratio will be affected by management's accounting choices, when assets purchased;
assets purchased at different times will have different costs, so comparing ROA of different
firms must be done with caution
- Fixed- Asset Turnover Ratio: used to examine efficiency of use of PPE; measures number of dollars of
sales generated by each dollar invested in PPE; higher ratio implies more efficient use of assets

Fixed-Asset Turnover Ratio: Revenue / Average PPE

- Ratio must be analyzed carefully, may be other characteristics of the industry or company that
influences the fixed-asset turnover ratio; care also must be exercised comparing ratios of
different industries; one can reasonably expect a lower ratio for companies in more capital
extensive industries

CHAPTER 9: LIABILITIES
Introduction: What are Liabilities?
- Liabilities: obligations to provide cash, goods, or services to customers, suppliers, employees,
governments, lenders and anyone else an entity "owes something to"; some obligations are not even
recorded on the balance sheet; all companies will have some extent of liabilities because not all
purchases are for cash
- Current Liabilities: debt to be settled within a year
- Long-Term Liabilities: debt shall last longer than one year
- Liquidity: whether an entity has adequate resources to meet claims; assessed using information about
liabilities, are claims on entity's cash and other resources
- Solvency: whether an entity will be able to meet its obligations as they come due; assessed using
information about liabilities, are non-negotiable, must be paid; an entity unable to meet obliations likely
to face legal or economical consequences
-IFRS Criteria: obligations arising from past transactions or economic events; require sacrificing
economic resources to settle
- Valued at present-value; timing and amount of cash flows known or can be estimated; possible to
identify appropriate discount rates, but not all liabilities are discounted to present-value (discounting of
current liabilities is immaterial)
Current Liabilities
- Obligations that shall be satisfied in one year or one operating cycle; important for assessing short-
term liquidity of a firm; not usually discounted to their present-value
- Bank & Other Current Loans
- Demand Loans: reported as current liabilities if amount must be repaid within the next year or
operating cycle; lender can ask for repayment at any time; loans remain on books for long time
- Line of Credit: allows entity to borrow up to a specified maximum amount whenever it requires
the money; only classified as a liability if money is actually borrowed
- Accounts Payable
- Amounts owed to suppliers for goods and services, include anything entity uses in its
operations; measuring amount not difficult, payable triggered by invoice from supplier
- Collections on Behalf of Third Parties
- Usually not disclosed separately, would be included in accounts payable
- Most entities act as tax collectors for various government taxation authorities
- Firms adding Harmonized Sales Tax (HST) to the purchase price
- Employers withholding amounts from employees' pay for transfer payments
- Employers withholding amounts for items (shares of benefits, pension plan
contributions, charitable donations, etc.)
- Money withheld does not belong to entity; liability reflects obligation to send amounts to
appropriate institutions

Dr. Cash (assets +) $$$


Cr. Revenue (revenue +, shareholder's equity +) $$$
Cr. HST Payable (liabilities +) $$$
To record the sale of merchandise and collection of HST

Dr. HST Payable (liabilities -) $$$


Cr. Cash (assets -) $$$
To record remittance of HST to the government

- Money withheld from employees' pay also does not belong to the employer

Dr. Wages Expense (expenses +, shareholder's equity -) $$$


Cr. Income Taxes Payable - Employee (liabilities +) $$$
Cr. CPP Payable (liabilities +) $$$
Cr. EI payable (liabilities +) $$$
Cr. Union Dues Payable (liabilities +) $$$
Cr. Cash (assets -) $$$
To record wages and employee withholdings
Dr. Income Taxes Payable - Employee (liabilities -) $$$
Dr. CPP Payable (liabilities -) $$$
Dr. EI Payable (liabilities -) $$$
Dr. Union Dues Payable (liabilities -) $$$
Cr. Cash (assets -) $$$
To record remittance of payroll withholdings

- Income Taxes Payable


- Canadian businesses pay tax on income to both federal and provincial governments; pay
instalments based on estimated amount of tax they will owe for the year
- Corporation pays taxes on its income and must file a tax return within six months of its fiscal
year-end
- Unincorporated business's income included in the proprietor or partner's tax return
- Amount of income taxes owed is accrued; amount accrued is the difference between
estimated amount of income tax for the year and the amount already paid
- Dividends Payable
- Obligation to pay corporation's shareholders a dividend that has been declared; amount of
dividend is classified as a liability until it is paid
- Accrued Liabilities & Provisions
- Recorded with an adjusting journal entry when entity incurs an expense with no external event
- Provision: similar to an accrued liability, but more uncertainty about the timing and amount of
the liability; warranty liabilities, liabilities for affinity programs, liabilities to redeem coupons
- Reversed when management removes a provision from the financial statements that it
believes will not be incurred
- Require management to estimate amount of the expense and the associated liability; accrued
liabilities can be estimated fairly accurately; provisions more difficult to estimate, potential for
significant errors
- Non-current and current components
- Accounting Estimates: integral to accounting, provides useful information to stakeholders; estimates
are indeed imprecise, affect financial statement numbers; actual amounts uncertain, so difficult-to-
estimate accruals are attractive for earnings management; management can use warranty costs and
coupon usage to manage earnings in a similar way as hidden reserves
- Unearned Revenue
- Entity receives cash in advance of providing goods or services; obligation to provide those
goods or services; cash in hand, revenue not yet recognized, liability for amount required

Dr. Cash (assets +) $$$


Cr. Unearned Revenue - Gift Card (liabilities +) $$$
To record the sale of a gift card
Dr. Unearned Revenue - Gift Card (liabilities -) $$$
Cr. Revenue (revenue +, shareholder's equity +) $$$
To record the use of a gift card

- Disclosure
- IFRS: disclosure requirements for current liabilities general, wide variation in classification and
detail provided by public companies; must be segregated by main class; detailed disclosure on
provisions also required; most entities separate current and non-current liabilities, IFRS allows
entities to order by liquidity, without the current vs. non-current classification
Bonds & Other Forms of Long-Term Debt
- Debt: amounts borrowed and owed by an entity; non-current (long-term) or current; long-term debt is
often used to finance business operations
- Collateral: protection for lenders should the borrower not repay the loan; lenders get the collateral or
the proceeds from the sale; can be anything from inventory to land
- Variable Rate Loan: interest rate varies with market conditions
- Fixed-Rate Loan: interest rate does not change
- Debt Instruments:
- Bond: formal borrowing arrangement in which a borrower agrees to make periodic interest
payments to lenders as well as repay the principal at a specified time in the future
- Debenture: bond with no collateral provided to the lenders
- Mortgage: loan that provides the borrower's property as collateral
- Note Payable: formal obligation signed by the borrower, promising to repay a debt
- Financing by Debt: liabilities that have to be repaid; interest is tax-deductible, means actual cost of
borrowing is lower than the interest rate stated on the loan; debt holders do not have a say in the firm's
management; riskier for the issuing entity because interest and principal payments have to be made as
specified regardless of how the entity is doing; less risky for investors because debt investors must be
fully repaid before equity investors get anything if an entity goes bankrupt; less costly way to finance an
entity because less risky for investors; higher risk investors face, higher return they expect
- Characteristics of Bonds
- Face Value: amount the bondholder will receive when the bond matures
- Maturity Date: date on which borrower has agreed to pay back the principal (face value)
- Coupon Rate: percentage of face value the issuer pays to investors each period
- Proceeds; amount the issuer receives from sale of the bond; not necessarily the face value
- Effective Interest Rate: real or market rate of interest required by investors to invest in
the bond; if coupon rate different from effective interest rate, bond's selling price must
allow investors to earn the effective interest rate; if coupon rate lower than effective
interest rate, bond sold at discount and proceeds less than face value; if coupon rate
greater than effective interest rate, bond sold at premium, proceeds greater than face
value; if coupon rate and effective interest rate same, proceeds equal face value
- Additional Features of Bonds: cause a change in the interest rate; if feature beneficial to
investors, issuing entity should be able to offer a lower interest rate, vice-versa
- Callable Bond: bond issuer has option to repurchase bond from investors at a time
other than maturity date; attractive to issuer because if interest rates fall, issuer can call
bond and make another issue at a lower interest rate; not attractive to investors as
they lose an investment paying a higher-than -market rate of interest
- Convertible Bond: may be exchanged by investor for other securities of the issuing
entity, such as common stock
- Retractable Bond: investors have the option of cashing in the bond before the maturity
date, under certain conditions
- Bond Restrictions: on issuer's activities; intended to reduce investor's risk, reduce cost of
borrowing; many stated in relation to accounting ratios; violations can have significant economic
consequences, so managers take steps (both accounting and operating decisions) to avoid them
- Pricing of Bonds
- Bonds and other long-term debts are priced according to recent value tools; price of bond is
equal to present value of the cash flows that will be paid to the investor, discounted at the
effective interest rate; effective interest rate determined by market forces, depends on risk;
riskier the bond, higher the rate

Ex/ Face Value = $5,000,000


Coupon Rate = 0.05
Maturity = 5 Years, on September 30th, 2022 (Issued October 1st, 2017)
Individual Interest Payment = $5,000,000 * 0.05 = $250,000
Effective Interest Rate = 6% (Important!)

First, use present value annuity formula to calculate present value for interest payments

PV Annuityn,r = (1 / r) * [1 - (1 / (1 + r)n)] * Amount to be Paid Periodically


PV Annuity5,0.06 = (1 / 0.06) * [1 - (1 / (1 + 0.06)5)] * $250,000
PV Annuity5,0.06 = $1,053,091

Then, use present value formula to calculate present value of principal

PVn,r = 1 / [(1 + r)n] * Amount to be Paid


PV5,0.06 = 1 / [(1 + 0.06)5] * $5,000,000
PV5,0.06 = $3,736,291

Proceeds from bond are the sum of these two present value calculations

Proceeds = $1,053,091 + $3,736,291 = $4,789,382 (Bond sells at a discount)

If effective interest rate lower than coupon rate, proceeds would be higher than face
value. If effective interest rate the same as the coupon rate, proceeds equal face value.
- Accounting for Bonds
- When Effective Interest Rate = Coupon Rate, Bonds Sold at Face Value

Dr. Cash (asset +) $$$


Cr. Long-Term Debt - Bonds (liability +) $$$
To record the issue of bonds

Dr. Interest Expense (expense +, shareholder's equity +) $$$


Cr. Cash (asset -) $$$
To record the interest expense

Dr. Long-Term Debt - Bonds (liability -) $$$


Cr. Cash (asset -) $$$
To record derecognition of the bonds

- When Effective Interest Rate > Coupon Rate, Bonds Sold at Discount

Dr. Cash (asset +) $$$


Dr. Bond Discount (contra-liability +) $$$
Cr. Long-Term Debt - Bonds (liability +) $$$
To record the issue of bonds at a discount

- Carrying Value: face value of the bonds less bond discount; net present value of bonds
discounted using the effective interest rate
- Discount Amortization: can be thought of as interest investors must receive to earn the
effective interest rate; compensation for the low coupon rate; is amortized over the life
of the bonds, included as part of the interest expense each year
- Straight-Line Method: same as straight-line amortization for capital assets; can
be chosen by companies following ASPE; allocates an equal amount of premium
or discount to each period; divide initial amount of premium or discount by
number of periods until maturity; interest expense for each period is the same
- Effective Interest Rate Method (IFRS REQUIRED): annual interest expense
calculated as amount of liability outstanding at the beginning of the period
(carrying amount) multiplied by the effective interest rate; amount of discount
amortized in a period is difference between interest expense (calculated using
effective interest rate) and amount of interest paid (based on coupon rate)

Dr. Interest Expense (expense +, shareholder's equity -) $$$


Cr. Bond Discount (contra-liability -) $$$
Cr. Cash (asset -) $$$
To record interest expense
- When Effective Interest Rate < Coupon Rate, Bonds Sold at Premium
- Premium: bonds sold to investors for more than face value; difference between
proceeds and face value of bonds

Dr. Cash (asset +) $$$


Cr. Bond Premium (contra-liability +) $$$
Cr. Long-Term Debt - Bonds (liability +) $$$
To record issue of bonds at a premium

- Bond premium account carries a credit balance


- Amortization: decreases the interest expense instead of increasing it; premium still
amortized over the life of the bonds using the straight-line or effective interest method

Dr. Interest Expense (expense +, shareholder's equity -) $$$


Dr. Bond Premium (contra-liability -) $$$
Cr. Cash (asset -) $$$

Dr. Long-Term Debt - Bonds (liability -) $$$


Cr. Cash (asset -) $$$
To record derecognition of the bonds

- Some Perspective on Technical Complexity: details of how premiums and discounts are
amortized is less important than understanding how price of bonds is determined, why
premiums and discounts arise, and what impact premiums and discounts have on the interest
expense; you are learning this so that you can understand what the numbers in financial
statements mean so you can use them intelligently and effectively
- Accruing Interest on Long-Term Debt
- Must record an accrued expense/accrued liability adjusting entry

Dr. Interest Expense (expense +, shareholder's equity -) $$$


Cr. Interest Payable (liability +) $$$
To record an adjustment on the amount of interest expense

Dr. Interest Expense (expense +, shareholder's equity -) $$$


Dr. Interest Payable (liability +) $$$
Cr. Cash (asset -) $$$
To record the interest expense for the period of time, the reduction in the interest payable
liability that was accrued, and the cash payment to investors

- Early Retirement of Debt


- Can be done easily if debt includes an option for issuer to redeem it; entity can also repurchase
its debt in the open market, if it is publically traded
- Requires removing any unamortized discount or premium from the books; remaining
unamortized premium/discount included in income statement when debt is returned
- Gain arises if cost of retiring debt is less than its carrying amount
- Loss arises if cost of retiring debt greater than its carrying amount

Dr. Long-Term Debt - Bonds (liability -) $$$


Dr. Loss on Bond Redemption
(income statement +, shareholder's equity -) $$$
Cr. Bond Discount (contra-liability -) $$$
Cr. Cash (asset -) $$$
To record the early retirement of bonds, assuming that interest expense was recorded
before the bonds were retired

- Similar approach if there was an unamortized premium; if no unamortized


discount/premium, gain/loss would be the difference between the face value of the
bonds and the amounts paid to retire them
- Disclosure
- Stakeholders need more information than what is provided in the balance sheet, in order to
estimate future cash flows, funding requirements and earnings, and to evaluate the
management and stewardship of an entity
- Principal Repayments: important for assessing future cash flows, cash requirements and
financing needs
- Letter of Credit: guarantee from a bank that a customer will pay amounts owed to a seller
- Unsecured: no specific collateral for the arrangement
- Restricted Cash: money on deposit that is not available for general purposes
- Private companies may provide less information because stakeholders do not require, or have
access to, the information in other ways
- Fair Value of Debt
- IFRS: bonds and other forms of long-term debt valued at present value of the cash payments to
investors, discounted using the effective interest rate on the date the bond is issued
- Changes in the interest rate over the life of a bond causes the market value of a bond to
change; if interest rates increase, market value decreases, vice-versa
- Financial statements do not reflect real economic gains and losses on long-term debt
- Disclosure of market value of debt must be made in the notes to the financial statements
- Mortgages
- Loan for which the borrower provides real property (land, buildings, equipment) as security
- If borrower cannot make loan payments, lender can have real property sold and can collect the
proceeds to satisfy the loan
- Blended Payments: borrower agrees to make equal period payments over the mortgage term ;
payments made up of principal and interest; payments stay the same but the amount of
principal and interest changes; amount of principal paid each period increases, amount of
interest decreases, over time
Ex/ $5,000,000; 5-year mortgage
Interest Rate = 5% per year
Annual Payments

First, calculate annual payment...

Mortgage Payment = Amount Borrowed / Present Value of an Annuity


Mortgage Payment = Amount Borrowed / {(1 / r) * [1 - (1 / (1 + r)n)]}
Mortgage Payment = $5,000,000 / {(1 / 0.05) * [1 - (1 / (1 + 0.05)5)]}
Mortgage Payment = $1,154,873.99

Payment has to be broken into interest and principal...

Interest Payment = Beginning Mortgage Balance * Interest Rate


Year One = ($5,000,000)(0.05) = $250,000
Year Two = ($4,095,126)(0.05) = $204,756
Year Three = ($3,145,008)(0.05) = $157,250

Principal Payment = Annual Payment - Interest Payment


Year One = $1,154,874 - $250,000 = $904,873
Year Two = $1,154,874 - $204,756 = $950,118
Year Three = $1,154,874 - $157,250 = $ 997,624

Prepare the appropriate journal entries to record the mortgage...

Dr. Cash (asset +) $$$


Cr. Mortgage (liability +) $$$
To record the mortgage

Dr. Interest Expense (expense +) $$$


Dr. Mortgage (liability -) $$$
Cr. Cash (asset -) $$$
To record the mortgage payment

Leases
- Lease: one entity (lessee) agrees to pay another entity (lessor) a fee for use of an asset
- Lessee: entity that leases an asset from its owner; has certain rights and obligations, as defined
in the lease agreement
- Lessor: entity that leases assets it owns to other entities; owns the asset
- Benefits to Leasing
- Entity does not have to obtain separate financing for the purchase; important when already
much debt existent, lenders reluctant
- Allows for financing 100% cost of asset; lenders often only lend a portion of a purchase amount
- Provides flexibility to lessees; perhaps some protection from technological obsolescence,
depending on contract terms
- Attractive for entities that do not need certain assets continuously; allows entity to use an
asset without the cost of owning assets that are idle for significant amounts of time
- Off-Balance-Sheet Financing: entity incurs an obligation without reporting a liability on its balance
sheet; allowed before accounting standards for leasing introduced, rules only required a lessee to
record a lease or rent expense when payment to lessor was paid or payable; allows entity to incur
liability without balance sheet consequences, making it seem like the firm has less debt and is less risky
- As practice became more common, rules established requiring leased assets and associated
liabilities to be reported on lessee's balance sheet if the lease resulted in the transfer of risks
and rewards of ownership to lessee; lease accounted for similarly to a purchase, if criteria met
- Types of Leases:
- Capital/Financing Leases: transfers risks and rewards of ownership to the lessee; leased asset
and liability recorded on lessee's balance sheet at present value of the lease payments; lease is
depreciated over its useful life (or term of lease if shorter); lessor treats lease as a sale,
removing the asset from its books, reporting receivable equal to the present value
- Must be likely the lessee will get ownership of the asset by the end of the lease
- Bargain Purchase Option: lessor will sell item to the lessee at the end of the
lease term for a significantly lower price
- Lease term must be long enough that the lessee receives most of the economic
benefits of the asset
- Present value of the lease payments must be equal to most of the fair value of the
leased asset
- Operating Leases: risks and rewards of ownership are not transferred to the lessee, retained by
lessor; lessee does not record leased assets or an associated liability; lessee recognizes an
expense when payment to lessor paid or payable; lessor recognizes revenue from lease when
payments received or receivable; lessee has off-balance-sheet financing

Ex/ Four Year Lease on Computers


$80,000 Paid Annual
Firm can purchase computers for $1 each at the end of the lease
Firm responsible for maintaining, repairing, insuring

Criteria (If any met, is a Capital Lease):


- Firm likely to gain title of computers at the end of the lease; low price, so would
purchase if could still be used
- Useful life of the item is unknown; four years is pretty long time to hold onto
computers (obsolescence); firm will therefore derive most of the economic benefits
- Present value of the lease payments is over 95% of the purchase price of the
computers, very close to the fair value of the equipment
PV = $80,000 * (1 / 0.10) * [1 - (1 / 1.104)] = $253,589
$253,589 / $265,000 = 95% + ... Assuming 10% Discount Rate

Dr. Assets Under Capital Lease (asset +) $253,589


Cr. Lease Liability (liability +) $253,589
To record the acquisition of computers under a capital lease

- Depreciation: if the term of the capital lease is shorter than the useful life of the asset,
lessee is not likely to take title of asset at the end of the lease, asset should be
depreciated over the term of the lease
- Straight-Line: over estimated five-year life; annual depreciation expense
$50,718, assuming no residual value

Dr. Depreciation Expense


(expenses +, shareholder's equity -) $50,718
Cr. Accumulated Depreciation
(contra-asset +) $50,718
To record the depreciation of leased computers

- Interest Expense: calculate by multiplying liability outstanding at beginning of the year


by the interest rate; rate has to be assumed usually; interest rate will affect the financial
statement numbers, managers have some flexibility in choosing the rate

Expense = Liability Outstanding * Interest Rate


Expense = $253,589 * 0.10
Expense = $25,359

Dr. Interest Expense


(expenses +, shareholder's equity -) $25,359
Dr. Lease Liability (liability -) $54,641
Cr. Cash (asset -) $80,000
To record the lease payment for one year

IF OPERATING LEASE, entries only required when payment made or payable

Dr. Lease Expense


(expenses +, shareholder's equity -) $80,000
Cr. Cash (asset -) $80,000
To record the annual payment for computers leased under an operating lease
- Financial Statement Effects: with capital lease, total assets and liabilities higher than under an
operating lease, expenses potentially different; ratios affected: with capital lease, total assets
greater, ROA lower; with operating lease, firm's debt-to-equity ratio lower since fewer liabilities
- Disclosure: IFRS gives no quantitative guidelines for the classification process, but has heavy
regulations once the type of lease is determined
- Operating Leases: firm should disclose minimum lease payments in the next five years
and beyond
- Capital Leases: entity should disclose amount of assets it has under capital leases,
accumulated depreciation, information about capital lease liabilities
- ASPE: has quantitative guideline to help managers classify leases
- Capital Lease: more than 75% of useful life or with present value more than 90% of fair value
- Interpreted as rules by managers; less judgment when classifying a lease, unintentional
- Private company may choose not to follow ASPE; if stakeholder's do not need it, can avoid the
expenditures and complexities of lease accounting
Pensions & Other Post-Retirement Benefits
- Pension: income provided after retirement by employers, government, through Pension Plans, and
through personal savings in registered retirement savings plans (RRSPs); benefits also come in the form
of extended medical, dental, vision, and prescription coverage; negotiated between an employer and its
employees
- Underfunding: benefits promised exceed the value of the assets in the plans; there are not
enough assets to meet the current obligations to employees
-Employees earn benefits while working, receive after they retire; benefits are part of employees'
compensation, cost expensed over employee's working career; matching becomes an issue
- Defined-Contribution Pension Plan: employer makes contributions to the plan as specified in the
pension agreement with the employees; employees often make additional contributions; benefits
depend on amount contributed by both and the performance of the investments in the plan; employee
bears risk because amount received depends on performance of the pension fund

Dr. Pension Expense (expense +, shareholder's equity -) $$$


Cr. Cash (asset -) $$$
Cr. Pension Liability (liability +) $$$
To record contribution to the employee defined-contribution pension plan

- Defined-Benefit Pension Plan: employer promises to provide employees with specified benefits in each
year they are retired; employers bear the risk because they promise specified benefits to employees,
regardless of how investments perform, must pay regardless of how much money is in the plan
- Determining How Much to Fund: calculation straightforward, assumptions difficult;
assumptions will be based on events that occur over many years; must assume the following for
each employee...
- Number of years employee would live after retirement
- Appropriate discount rate to be used in Present Value of an Annuity Formula
- Number of years employees will work for the employer
- Number of employees who will qualify for benefits
- Number of employees who will die before they retire
- Age at which employees will retire
- Salary employees will earn in the year(s) on which the pension is based
- Number of years employees will live after retirement
- Return the money in the pension fund will yearn (higher the expected return, less
needed in the pension fund
- Post-Retirement Benefits: accounting done similarly, is similarly complex; companies not required to
fund non-pension post-retirement benefits, most pay as they occur; obligations significant, will likely
grow as number of retired employees grows
- Importance: benefits represent very significant obligations to an entity; may affect solvency;
stakeholders want to assess impact benefits have on entity's ability to survive, compete, and be
profitable; employees and retired employees have interest in information since it affects the quality of
their lives after retirement; provides information about cash flow requirements
- Judgement: since many assumptions are made, managers exercise considerable judgement
Contingencies
- Contingent Liabilities: a possible obligation whose existence has to be confirmed by a future event
beyond the control of the entity; an obligation with uncertainties about the probability that payment
will be made or about the amount of payment (does not meet definition of a provision, however); not
recognized in financial statements, disclosed in the notes, unless probability of having to pay is remote;
if recognized, it is recorded as a provision
- Contingent Assets: an asset whose existence is uncertain; are not recognized in financial statements,
disclosed in the notes if realization is probable ("more likely than not" according to IFRS); if realization of
asset virtually certain, asset recognized in financial statements, no longer referred to as a contingent
asset
- Judgement: considerable judgement required, necessary to estimate probability of a contingency being
realized and its amount
Commitments
- Commitment: contractual agreement to enter in a future transaction; not reported as liability (IFRS)
- Executory Contracts: when neither party to a contract has performed its part of the bargain; liability to
pay, asset representing good or service to be received are both not recorded
- Alternative Methods to IFRS
- Record asset, liability associated with contract (maybe only when not possible for either side to
cancel contract); no effects of this method, increases assets and liabilities
- IFRS Judgement: though recognition of executory contracts not allowed, information about
significant commitments can be important to stakeholders, should be disclosed; managers must
exercise their judgement when deciding if an executory contract is significant enough to
disclose; disclosure is helpful for predicting future cash requirements and financing needs
Events After the Reporting Period/Subsequent Events
- Subsequent Event: event after the reporting period; economic event that occurs after an entity's year-
end but before financial statements are released to stakeholders
- Events that Provide Information About Circumstances that Existed at Year-End
- Financial statements adjusted to reflect the new information, allows managers to make better
estimates; no information about these adjustments disclosed in notes, instead used to revise
statement numbers
- Events that Happened After the End of the Period
- Only disclosed in the notes, financial statements unaffected;
- Judgement: IFRS says the events that should be disclosed are those that will have a material
effect on the entity; managers have flexibility in deciding what is material
- Public Companies: most relevant situations would be disclosed via media
- Private Companies: disclosure would be a lot more likely to be news to stakeholders
- Subsequent events useful for forecasting future earnings or cash flows
- Debt & Taxes: entities allowed to deduct interest when calculating taxable income; actual cost of
borrowing money less than amount paid to lender; taxpayers pay for a portion of the cost of borrowing
- Taxable Income: measure of income, defined by Income Tax Act, used to calculate amount of
tax an entity must pay
- After-Tax Cost of Borrowing: interest rate an entity pays after taking into consideration the
savings that come from being able to deduct interest in the calculation of taxable income

After-Tax Cost of Borrowing = Stated Interest Rate * (1 - Tax Rate)

Financial Statement Analysis Issues


- Liabilities analysis provides important information about financial situation and prospects, financial
management, and an entity's liquidity
- Debt-to-Equity Ratio
- Measure of amount of debt relative to equity an entity uses for financing; indicates entity's risk
and ability to carry more debt; more debt makes entity riskier, interest and principal payments
on debt must be made regardless of how well the entity is doing
- Advantages: debt not bad way to finance entity; less costly than equity and interest is tax-
deductible
-Disadvantage: debt becomes riskier for lenders as amount of it increases, likelihood of non-
payment increases; debt becomes costlier for borrowers, lenders paid higher interest rates as
compensation for accepting more risk
- Capital Structure: amount of debt and equity the entity has; describes how entity is financed;
firm should have a balance between debt and equity, mix depends on nature of company

Debt-to-Equity Ratio = Total Liabilities / Total Shareholder's Equity

- Analysis: ratio represents how many dollars of liabilities a firm has for every dollar of equity;
cannot be analyzed without a context; entities with highly reliable cash flows can carry more
debt, can be confident that cash flows will be able to make interest and principal payments
- Interest Coverage Ratio: measures an entity's ability to meet fixed financing charges; indicates how
easily an entity can meet its interest payments from its current income; earnings and cash flows can be
volatile, coverage ratios can change dramatically from period to period

Interest Coverage Ratio = (Net Income + Interest Expense + Income Tax Expense) /
Interest Expense

- Analysis: larger the ratio, better able entity is to meet interest payments; must remember that
this ratio does not include other financing charges
The Impact of Off-Balance-Sheet Liabilities
- Significant effect on measures of capital structure and risk; misleading conclusions drawn if they are
not considered
- Extensive use of operating leases will cause liabilities and the debt-to-equity ratio to be understated
- Can impair comparability if companies use different approaches to acquiring assets (purchase vs. lease)
- Risk not affected by including off-balance-sheet items in debt-to-equity ratio, but risk management is

CHAPTER 10: OWNER'S EQUITY


Introduction
- Firms finance assets either through debt or equity; liabilities emerge from assets financed by debt;
equity builds from assets financed by the owners

Assets = Liabilities + Owner's Equity

- Owners can have either direct or indirect investment


- Direct Investment: purchasing an ownership interest from an entity in exchange for cash or
other assets
- Indirect Investment: an entity reinvestments the profits it earns into its own activities;
alternative to distributing them to owners as dividends or distributions
- The residual interest of owners; what is left after assets have been used to satisfy the creditors

Owner's Equity = Assets - Liabilities

Corporations, Partnerships & Proprietorships


- Corporation: separate legal and taxable entity; owners are shareholders; limited liability, shareholders
not liable for corporation's obligations and losses beyond the amount of their investment; shareholders
may sometimes agree to waive the limited liability protection of a corporation
- Shareholders' Equity Section
- Share Capital: money and other assets from the sale of shares by the corporation
directly to shareholders; direct investments; must separate direct and indirect
investment because shareholders need to know whether money distributed to them
from profits or just returning the money collected from them
- Dividends: from profits, shares success with shareholders; from direct
investments, returns money that shareholders have invested
- Ponzi Schemes: investments using investors' money to provide returns to the
investor
- Contributed Surplus: captures equity transactions not included in other categories
- Retained Earnings: accumulated earnings not distributed to shareholders; indirect
investment by shareholders
- Accumulated Other Comprehensive Income: accumulated amounts reported as other
comprehensive income in the statement of comprehensive income; DOES NOT EXIST
UNDER ASPE
- Proprietorships: not incorporated; do not pay income taxes; income included in the personal tax return
of the proprietor; unlimited legal liability, personally liable for any obligations a proprietorship unable to
make; accounting not very different from that of a corporation; no legal requirement to use IFRS or ASPE
- Equity Section: structured differently from that of a corporation
- Retained Earnings: include direct and indirect investments, the two are not separated
- Partnership: not incorporated; do not pay income taxes; income divided between each partner, who
record it on their individual tax returns; unlimited legal liability, personally liable for any obligations a
partnership unable to make
- Limited Partnerships: limited liability protection to some partners; must have at least one
general partner; useful when some investors not actively involved, not prepared to accept risk
associated with unlimited liability; tax benefits encourage limited partnerships
- Limited Partners: same limited liability protection as if the entity was a corporation;
are not personally liable for debts and obligations of the partnership; cannot be involved
in management of partnership, or risk losing limited liability
- General Partners: do not have limited liability; liable for all debts and obligations of
partnership
- Limited Liability Partnerships (LLPs): partners not personally liable for claims against firm
arising from negligence or other forms of malpractice by other partners; assets of partnership at
risk, not personal assets of an innocent partner
- Accounting not very different from corporations; no legal requirements to use IFRS or ASPE;
publically-traded partnership units do in fact use IFRS though
- Equity Section: structured differently from that of a corporation; equity account kept for each
partner, showing capital contributed, portion of earnings that is attributable to, distributions to
each partner
- Partner's Capital: details about changes provided in the Statement of Partner's Capital
- Retained Earnings: include direct and indirect investments, the two are not separated
- Not-for-Profit Organization (NFPO): economic entity; objective to provide services, not to make a
profit; do not have owners or ownership shares to be traded or sold; net income earned is reinvested in
the organization, so net income is actually referred to as the "excess of revenues over expenses";
income statement referred to as the "statement of operations"
- Charities: revenues come from donations, contributions, grants; money spent providing
services to people in need
- No owners, so no owners' or shareholders' equity section; different NFPOs have different
terms for what is known as "equity" under for-profit organizations
- Accounting for NFPOs: somewhat specialized; net assets are resources obtained by university
from sources other than creditors, classified in the following way
- Invested in Capital Assets: amount invested in capital assets, less amount financed by
long-term debt and capital contributions
- Internally Restricted: funds whose use has been restricted, in case it can be used
towards the objective of the NFPO
- Endowments: donations to the NFPO; only income generated from endowed funds can
be used, not the principal donated
- Unrestricted: resources that can be used in whatever way the NFPO wishes
Characteristics of Equity
- No promises; shareholder not entitled to dividends or any other type of payments; return of principal
is not even guaranteed; rights of shareholders come after those of creditors; latter must be paid what
they are owed, in a bankrupt situation, before the former get anything
- Issuing equity less risky to an entity because the corporation is not committed to any payments at any
time; more flexibility to manage
- Drawbacks: new shareholders have a voice in the corporation, diluting the power of existing
shareholders; dividends non-deductible for tax purposes because they are not a cost of business,
increases cost of equity relative to debt (interest payments are still expensed)
- Articles of Incorporation: define terms of reference of a new corporation; changes to such terms must
be approved by shareholders; define types and characteristics of the shares the corporation can issue
- Authorized Capital Stock: maximum number of each type of share that can be issued
- Issued Shares: number of shares that have been distributed to shareholders
- Outstanding Shares: number of shares currently in the hands of shareholders; can be different
from the number of issued shares because shares can be repurchased by a corporation and held
for resale
- Corporation/Company Acts: federal or provincial laws governing companies incorporated in particular
jurisdictions; give shareholders rights and privileges regardless of the size of their investments; regulate
voting rights for the Board of Directors (BOD), attendance to an annual general meeting for questions
and answers, the appointment of auditors, changes in the articles of incorporation
- Canada Business corporations Act: federal legislation governing federally incorporated
companies
- Common & Preferred Shares
- Common Shares: residual ownership in an entity
- Common shareholders entitled to whatever earnings and assets left after obligations
to creditors and preferred shareholders are satisfied
- No associated specified dividend; no obligation to pay a dividend at any time, BOD can
eliminate/reduce dividends if it wants
- Public companies avoid dividend cuts because it suggests the company is in
financial trouble; causes market price of shares to decline
- More than one class of common shares; different voting rights and different dividends
- Par Value: value assigned to each common share in the articles of incorporation; rare in
Canada; selling price of share is split between common shares account (credited for par value)
and contributed surplus (credited for rest)
- No Par Value Shares: shares without a par value; more common in Canada because
Canada Business Corporations Act and various other jurisdictional acts do not allow par
value shares
- Alternative Payments: equity does not have to be paid for using cash, investors can exchange
property or expertise; challenge is determining amount that should be recorded for the
property received and the shares issued; easier when market values of shares and property
available, if not available, estimates/appraisals required, which may allow managers to exercise
judgement
- Preferred Shares: shares with rights that must be satisfied before those of common shareholders;
dividends must be paid before any paid to common shareholders; investment recovered before
common shareholders get anything; often have specified dividend payment, but do not have the power
to take action against the company if dividend not paid (dividends not guaranteed)
- Cumulative Stock: unpaid dividends accrued forward to following fiscal periods; missed
dividends must be paid before common shareholders can receive any dividends; reduces risk
that preferred shareholders will not receive their dividends
- Convertible Stock: shareholders can exchange preferred shares for a specified number of
common shares for each preferred share that is converted
- Redeemable Stock: issue can repurchase preferred shares from shareholders if it chooses,
according to specified terms
- Retractable Stock: shareholders can require issuer to purchase preferred shares from them if
they choose, according to specified terms
- Participating Stock: amount of the preferred share dividend increases above stated amount if
certain conditions met; amount often tied to dividend paid on the common shares
- Advantages: investors can expect periodic payments; taxed at a lower rate than interest
- Disadvantages: cannot be deducted for income tax purposes
- Treasury Stock: shares that were sold to investors, but repurchased and not retired (as is
expected); no voting rights; cannot receive dividends; available for resale by corporations
- Hybrid Securities: includes preferred shares; category of securities with characteristics of both
debt and equity; must be classified according to economic nature under IFRS, depends on if
security has a mandatory payment associated with it, if it has to be repaid and converted by
contract or by choice of the security holder
- Share Repurchases: corporation buys own common shares from shareholders

Dr. Retained Earnings (equity -) $$$**


Dr. Share Capital (equity -) $$$*
Dr. Contributed Surplus (equity -) $$$**
Cr. Cash (assets -) $$$
To record repurchase of #__ common shares
*Debit to share capital is average price paid per share (share capital / number of shares
outstanding) by investors multiplied by the number of shares repurchased
**Amount paid over average price debited to retained earnings and contributed surplus

- Excess Cash: repurchasing shares is a way of distributing cash to investors without creating a
precedent of paying regular or higher dividends
- Earnings Per Share: net income / average number of common shares outstanding during the
period; increases when share repurchases occur; should increase share price by extension,
assuming that operating activity of entity not affected by the repurchase (ownership divided
among fewer shares)
- Communication: way to tell market that company thinks it is understating its share value
- Exchanges Between Investors: accounting records only updated when firm issues shares or
repurchases shares; daily trades on the stock exchange have no affect on the company's
financial statements; stock price is still important because share price can affect managers'
wealth, job prospects, and because it indicates how the company is seen to be performing
Retained Earnings, Dividends, & Stock Splits
- Retained earnings: accumulated earnings of an entity less all dividends paid to shareholders over the
entire life of the firm; profits that have been reinvested in the entity by shareholders; indirect
investment by shareholders because investors do not decide to make the investment
- Net income/Loss: measure of how owner's wealth has changed over a period
- Dividends: distributes of earnings to shareholders
- Correction of Errors: accounting errors made in a previous period should be corrected
retroactively by adjusting retained earnings; previous years' financial statements restated so
they appear corrected

Ex/ Correcting the Understatement of Land

Dr. Land (assets +) $$$


Cr. Retained Earnings (equity -)* $$$
To correct an error in accounting

*Crediting retained earnings makes up for the previous understatement of assets, which
caused an overstatement of equity

- Retroactive Application of an Accounting Policy: when entity changes accounting policy,


financial statements reinstated as if new accounting policy had always been used
- Share Retirement: when entity repurchases shares from shareholders, pays more than average
price shareholders paid for them
- Managerial Discretion & Retained Earnings: considerable in deciding how to account for many
transactions and economic events; effects of managerial choices accumulate in retained
earnings; over the entire life of the firm, retained earnings unaffected by different accounting
choices, but at any one point in time, it is highly dependent
- Dividends: distributions of corporation's earnings to shareholders; discretionary, must be declared by
BOD; declared on per share basis, every share of a specific class must receive same dividend; once
declared, appears as a liability on the balance sheet until it is paid
- Important Dates:
- Date of Declaration: date when BOD declares a dividend
- Date of Record: registered owner of shares on the date of record receives the
dividend; marks boundary between determining who gets the dividend, if share is sold
near the date of record; if before, dividend goes to new owner; if after, dividend goes to
old owner; no journal entry required
- Date of Payment: date when dividends actually paid
- Cash Dividend: cash payment from corporation to shareholder; most common

Date of Declaration
Dr. Retained Earnings (equity -)* $$$
Cr. Dividend Payable on Common Shares (liability +)** $$$
To record declaration of dividend on common shares

Date of Payment
Dr. Dividend Payable (liability -) $$$
Cr. Cash (asset -)*** $$$
To record payment of common share dividend

*Dividend cannot be paid if there is a deficit in retained earnings


**Dividend Payable reported as a current liability
***If corporation does not have cash, cannot pay cash dividend no matter how much
retained earnings there are

- Property Dividend: paid with property instead of cash; can be any property an entity has, but is
often impractical because entity must have a property type that can be distributed equally;
possible to issue shares of another company owned by the issuing entity; recorded at property's
fair value on date the dividend is declared; gain/loss reported on income statement if fair value
not equal to the market value of the property

Ex/ Property Dividend of Another Firm's Shares

Date of Declaration
Dr. Investment in Other Firm (assets +) $$$
Cr. Gain on Disposal of Investment
(income statement +, equity +) $$$
To record gain on shares being distributed to shareholders as a property
dividend
Dr. Retained Earnings (equity -) $$$
Cr. Property Dividend Payable (liability +) $$$
To record declaration of property dividend

Date of Payment
Dr. Property Dividend Payable (liability -) $$$
Cr. Investment in Other Firm (asset -) $$$
To record payment of property dividend

- Stock Dividend: shareholders receive company shares as the dividend; number received
depends on how many shares shareholder owned on the date of declaration; each shareholder
owns exactly the same proportion of outstanding shares before and after the stock dividend;
market price would fall because nothing has changed besides the number of shares outstanding;
shares can be valued at either market price before issuance, or BOD can assign a value to the
shares on some other criteria

Ex/ Declaration & Distribution of Common Share

Dr. Retained Earnings (equity -) $$$


Cr. Common Shares (equity +) $$$
To record declaration and distribution of a stock dividend

- No effect on assets, liabilities, or income statement; only the equity section of the
balance sheet is affected by a stock dividend
- Stock Splits: divides entity's shares into a larger number of units; each dividend worth a lesser amount;
similar to a big stock dividend; no accounting effect of a stock split, retained earnings and common
shares accounts are unchanged; no journal entry required; any measurement that uses the number of
shares outstanding will change relative to that value
- Reverse Stock Split: reduces number of shares
- Allows shareholders to receive something when entity unable or unwilling to pay a cash
dividend
- Lowers the price of stock into a range that makes it accessible to more investors
- Insight: neither stock splits nor stock dividends has real economic significance; no effect on
assets, liabilities, net income; no change in underlying value of a shareholder's interest in an
entity; no evidence to suggest shareholders are better off
Accumulated Other Comprehensive Income
- Comprehensive Income: created as an all-inclusive measure of performance capturing all transactions
and economic events; includes events excluded from the calculation of net income, that do not involve
owners

Comprehensive Income = Net Income + Other Comprehensive Income


- Net Income: computed as it usually is; revenue less operational expenses
- Other Comprehensive Income: revenues, expenses, gains, losses that are not included in the
calculation of net income
- Gains and losses on certain costs pertaining to pensions and other post-retirement
benefits
- Gains and losses on certain investment securities
- Gains and losses from translation of companies owned that are stated in foreign
currencies
- Gains from writing up property, plant, and equipment using the revaluation method
- Accumulated Other Comprehensive Income/Loss: accumulates OTHER comprehensive incomes
(not comprehensive incomes); amount under other comprehensive income added to this
account when the books are closed; similar to retained earnings accumulated net incomes
throughout the years
Contributed Surplus
- Captures equity transactions that do not fit into the other equity accounts
- Amounts paid for company shares in excess of the par value
- Receipt of donated assets
- Equity component of some hybrid securities
- Repurchase of shares for more than the average per share cost
- Employees' stock-based compensation
Statement of Changes in Equity
- Shows changes in each of an entity's equity accounts, for a given fiscal period
Accounting Changes - Policies & Estimates
- Consistency: important principle; maintains the integrity and usefulness of financial statements; allows
users to understand and interpret statements more easily
- Accounting Changes: possible; IFRS allows only the policy change makes financial statement
information more relevant and reliable, but managers can exercise judgement on this
- New accounting standards implemented by IFRS may warrant a change
- Firm may decide an alternative way of accounting provides better information to stakeholders
- Reporting objectives themselves may change, so that previous accounting policy is not longer
appropriate
- Changes in Accounting Policies
- Accounting Policies: methods an entity selects for financial reporting; revenue recognition
method, inventory cost formula, capitalization policies, etc.
- Retroactive Changes: previous years financial statements restated as if new accounting
method had always been used; retained earnings must be restated to adjust for the difference
between the methods
- Changes in Accounting Estimates
- Accounting Estimates: judgements about uncertain future events that managers must make to
complete accrual accounting financial statements; useful lives and residual values of capital
assets, bad debt expenses, warranty expenses, etc.
- Proactive Changes: change reflected from time of management's decision; do not return to
previous years' financial statements
- Disclosure of Changes: required under IFRS; would clarify to stakeholders changes that are not the
result of operations
Leverage
- Use of debt in an entity's capital structure; can increase returns earned by owners because profits
earned from investing borrowed money, above cost of borrowing, go to the owner; can make borrowing
more risky because borrowed money must be paid regardless of how well or poorly the entity performs;
- Return on Equity (ROE): measure of an entity's profitability and effectiveness in using the assets
provided by the owners to generate net income; can be used to analyze the effect of leverage, because
it shows how much initial investment an owner gets back

Return on Equity = (Net Income - Preferred Dividends) / Average Common Shareholder's Equity

- Makes good news better because using someone else's money to increase equity investors' returns
- Makes bad news worse because equity investors lose some of their initial investment to pay interest
- Return on equity can be increasing while net income is decreasing; the amount of income being earned
as a proportion of the equity investment is increase, regardless of the changes in the actual dollar
amount of net income
- Usefulness of Leverage:
- Allows for more investment or a larger venture
- Allows investors to diversify; can spread money around instead of investing all their money in
one project, reducing risk
- Allows project to continue even if investors do not have enough of their own money
- Interest: increases as more of a project is financed by debt; must be paid to creditor regardless of the
venture's performance; affects net income
- Operating Income: unchanged; important to separate an entity's business performance from
its cost of financing
- Borrowing Limits: borrowing too great a value compared to owner investment can cause bank to
charge a higher interest rate, or not lend, due to increased risk to them
- Tax Implications: must be taken into consideration in such situations
- Debt-to-Equity Ratio: provides insight into the amount of leverage an entity has; is basis for evaluating
the risk the entity is assuming
Employee Stock Options
- Employee Stock option: right to purchase a specified number of shares of the employer's stock at a
specified price lower a specified period of time; represent right to purchase shares, but not shares
themselves
- Exercise Price: price at which employee may purchase the shares; usually the same or greater than the
market price of the shares on the day it is granted, for tax purposes
- Expiry Date: final date an option can be exercised; option will only be exercised if the exercise price is
less than the market price, otherwise they would be buying shares for more than they are worth in the
open market
- Do not cost entity any cash; crucial for a company that is short of cash or is trying to conserve cash for
future growth
- Significant Economic Cost: exercised when exercise price is below the market value, dilutes
value of the shares of other shareholders; wealth of existing shareholders transferred to the
employees exercising the stock option
- Give employees opportunity to make a lot of money if the company is successful; limits on the number
of shares that can be reserved for any person or to employees in total; number of shares issuable in a
year cannot be greater than 10% of the issued and outstanding voting shares
- Vesting Period: time an employee must remain with a company to be entitled to exercise the options
- IFRS requires that value of stock options granted to employees be expensed as part of the
compensation expense; would lower net income significantly
- Stock options have an economic value as long as there is time before the stock option expires;
if did not, employees would not negotiate for them and accept them as compensation; entity
giving the opportunity to purchase stock at below-market prices, which is valuable
Economic Consequences
- Accounting matters because it has economic consequences for an entity and its stakeholders; wealth
of an entity's stakeholders is affected by how much the entity accounts for various transactions and
economic events; decisions and outcomes (bonuses, debt term compliance, entity selling price, taxation,
etc.) can be affected by entity's choices in how it represents its economic circumstances in the financial
statements
- Underlying economic activity is NOT affected by how an entity accounts, but the representation of
economic activity in the financial statements is affected
Financial Statement Analysis Issues
- Price-to-Book (PB) Ratio
- Used to examine a stock's desirability; measure of the stock market's valuation of a company's
equity relative to its book value; indicates if shares are reasonably valued; low PB ratio indicates
stock undervalued, could either mean entity is an attractive investment, or is facing significant
problems; varies with industry, frequency of unrecorded assets

Price-to-Book (PB) Ratio = Market Value of Equity / Book Value of Equity

- Book Value: amount recorded in the accounting records for the assets, liabilities, and equities;
accounting value of accounting elements; carry amount
- Book Value of Equity: balance sheet value of an entity's equity; equal to assets less
liabilities as reported on financial statements; net assets or net worth of the entity; not
a measure of market value due to reasons like historical costing
- Sometimes considered what would be left over for shareholders if a company
shut down its operations, paid all creditors, collected from all debtors, and
liquidated itself; not a realistic interpretation for knowledge-based companies
that have many unrecorded assets
- Market Value of Equity: market price of an entity's shares multiplied by the number of
common shares outstanding; no readily available market price for private companies
- Earnings Per Share (EPS)
- Amount of net income attributable to each individual common share; analysts estimate future
EPS, whether an entity has had a successful period often measured by whether it has met
analyst forecasts; generally reported at the bottom of the income statement
- Basic Earnings Per Share (Basic EPS)

Basic EPS = (Net Income - Preferred Dividends) / Weighted-Average Number of Common


Shares Outstanding During the Period

- Preferred Dividends: deducted because are not available to common shareholders


- Denominator Value: average number of shares outstanding during the period,
considering when changes in the number of shares outstanding occurred in the period
- Diluted Earnings Per Share (Diluted EPS): reported by firms under IFRS; shows effect of dilutive
securities (convertible bonds, convertible preferred shares, stock options, etc.) on EPS if all
securities converted or exchanged for common shares; considered "worst case scenario" of EPS
- Limitations
- No inherent meaning; must be considered in relation to some benchmark (previous
years' EPS, analysts' forecasts, etc.)
- Depends on accounting policies and estimates used in the financial statements
- Possibly affected by changes in the number of shares outstanding during a period
- No indication of entity's ability or willingness to pay dividends
- Very difficult to compare EPS of different entities; different accounting choices affect
EPS; companies with identical assets and operating performance may have different EPS
if they are financed differently (different debt and equity balance)
- ASPE: does not require companies to report EPS
- Dividend Payout Ratio & Dividend Yield
- Dividend Payout Ratio: measures percentage of net income that is paid out in dividends;
affected by accounting choices made by managers

Dividend Payout Ratio = Common Annual Cash Dividends Declared / Net Income

- High Percentage: large proportion of earnings paid out, small amount reinvested; if too
high, can be concerning, company may not be able to maintain the dividend if it does
not perform as well
- Low Percentage: suggests existing dividend is safe, company can maintain it even if
earnings drop; room to increase dividend in future
- Per Share Basis:

Per Share Dividend Payout Ratio = Earnings Per Share / Cash Dividends Declared
Per Share
- Dividend Yield: similar information to dividend payout ratio; based on company's share price,
not earnings; changes daily, as share price changes, so is a more current indicator of the
dividend performance of a company

Dividend Yield: Common Annual Cash Dividends Per Share / Current Share Price

- High Yield: higher return to investors; should be cautious when it is too high, because
share price may be falling; company with falling share price may be unable to sustain
dividend, company may have to cut it to conserve cash
- Low Yield: may indicate company is growing, so investors will earn return on the
appreciation of the share value
- Insight: members in public have a lot of interest in performance of public companies, either
directly or indirectly through pension plans and mutual funds; no market price on which to base
reasonable estimate of private firms' market values
- Return on Shareholder's Equity (ROE)
- Measure of return earned by resources invested ONLY BY COMMON SHAREHOLDERS; affected
by how company is financed; more leverage/debt used by company, the more volatile ROE is

Return on Equity (ROE) = (Net Income - Preferred Dividends) / Average Common Shareholder's
Equity

- Preferred Dividends: deducted because only common shareholders are being


considered; preferred dividends are not available to common shareholders
- Denominator: excludes equity contributed by preferred shareholders
- Investors compare ROEs of different entities to analyze different investment alternatives
- Higher Returns: investment more attractive; risk must also be higher, because risk usually
earns larger return; investors must decide if willing to accept additional risk in exchange for
higher return

CHAPTER 11: INVESTMENTS IN OTHER COMPANIES


Introduction
- Consolidated Statements: single set of statements is an aggregation of more than one corporation's
financial information; required under IFRS when one company controls others; provide information
about the entire economic entity, than the individual pieces
- Parent Company: the company whose financial statements are prepared; the company that
controls the other companies
- Subsidiary: company that is compared by the parent company; financial statements are
consolidated into the parent company's financial statements
- Outcomes of Investment: different types of investments are accounted for differently
- Gain control of another company
- Investing corporation can influence decisions of company, but not control them
- Investing corporation may have no more influence than any small investor would
Why do Companies Invest in Other Companies?
- Temporary Surplus of Cash: invest to earn a reasonable return while it is not needed; purchase
debt/equity of other companies; opportunities to earn dividend, interest, capital gains income; common
from seasonal businesses and businesses expecting future expansion/acquisitions
- Strategic Reasons:
- Investing in Competitors: to reduce competition; to expand presence in a market
- Investing in Customers: to provide markets for products
- Investing in Suppliers: to ensure that inputs are available
- Diversification:
- Cyclical Businesses: performance depends on where economy is in the business cycle;
profitable in some years, not in others; companies mitigate effect of business cycle by investing
in different businesses and parts of the world
Accounting for Investments in Other Corporations: Introduction
- Investor Corporation (Investor): corporation with an investment in another corporation
- Investee Corporation (Investee): corporation in which an investor corporation has invested
- Influence: key decider in how an investor accounts for its investments into an investee corporation
- Control: investor controls investee, can make all important decisions; investee being controlled
is called a subsidiary of the investor corporation; financial statements aggregated into a single
set of consolidated financial statements
- Significant Influence: investor does not control investee, can affect important decisions; equity
method of accounting used by investor corporation
- Passive Investment: investor has no more influence over decision making than any small
investor; investment accounted for at cost or fair value, depending on type of investment
Control: Accounting for Subsidiaries
- Control: when investor able to make important decisions of investee; investor able to determine
strategic operating, financing, investing policies on an ongoing basis, without support of other
shareholders; managers of investor can set key policies for investee; investor owns more than 50% of
the votes of the investee (not the same as 50% of common shares)
- Individual subsidiaries and parent company are still separate legal entities; each has own limited legal
liability, must file own tax returns; consolidated group is not a legal entity
- Consolidated Financial Statements: aggregate accounting information of a parent corporation and all
its subsidiaries into a single set of statements; each line reflects assets, liabilities, revenues, expenses,
and cash flows of parent company and all subsidiaries
- Assets & Liabilities: recorded at amount parent paid for them on date subsidiary was
purchased; subsidiary continues to own assets and liabilities, reports them on own balance
sheet so that assets and liabilities are reported in two places
- Different Balances: values may be different between the two balance sheets;
subsidiary's balance sheet reports assets and liabilities at cost when purchased;
consolidated balance sheet reports same assets and liabilities at the cost to them when
the subsidiary was bought
- Fair Value: costs of the assets and liabilities may be the same on both sheets
Ex/ Company A bought 100% of shares of Company B from shareholders for $20,000,000

Company A records investment into Company B as follows...

Dr. Investment in Schuler (asset +) 20,000,000


Cr. Cash (asset -) 20,000,000
To record purchase of 100% of shares of Company B

- No effect on Company B's financial statements; Company A purchased shares from


Company B's shareholders, not from Company B itself
- Company A must identify assets and liabilities purchased, and determine amounts paid
for each; Company A purchased entire company, so purchase price must be allocated to
individual assets and liabilities; fair values of all Company B's identifiable assets and
liabilities must be determined as of the purchase date, are then reported in
consolidated financial statements
- Identifiable Assets & Liabilities: tangible, intangible assets and liabilities that can be
specifically identified and reasonably measured
- Goodwill: amounts paid over fair value of identifiable assets less identifiable liabilities

Goodwill = Purchase Price - Fair Value, Identifiable Net Assets Purchased

- The Consolidated Balance Sheet on the Date the Subsidiary is Purchased


- Company A's Consolidated Balance Sheet Includes:
- Amounts reported on Company A's own balance sheet at date of purchase
- Unconsolidated Balance Sheet for Company A
- Investment in Subsidiaries: only line that includes any information
about parent's subsidiaries
- Required for tax purposes; provided to some stakeholders; not widely
distributed
- Fair value of Company B's assets and liabilities at date of purchase; not included in
Company B's own balance sheet; Company B's retained earnings and common shares
are not shown, not included in consolidated shareholder's equity
- Goodwill from acquisition of Company B; only appears in consolidated balance sheet
- Company A's Consolidated Balance Sheet Does Not Include:
- Investment in Subsidiary Account: replaced by actual assets & liabilities of subsidiary
- Subsidiary's Shareholders' Equity: reflected in parent company's shareholders' equity
- Revenues & Expenses of Subsidiary: only incorporated into the consolidated income statement
after the date of the purchase
- Non-Controlling/Minority Interest
- Even if a parent company does not own 100% of subsidiary's net assets, revenues or expenses,
they still control 100% of them
- IFRS requires that consolidated balance sheet includes 100% of fair value of a
subsidiary's net assets, even if parent owns less than 100% of them; consolidated
balance sheet contains assets and liabilities that are not owned by the parent
- IFRS requires that consolidated income statements include 100% of revenues and
expenses of a subsidiary, even if 100% is not owned; consolidated balance sheet
contains revenues and expenses that are not owned by the parent
- Non-Controlling Interest:
- Consolidated Balance Sheet: reported in equity section; represents net assets of
subsidiary owned by non-parent shareholders of the subsidiary
- Consolidated Income Statement: represents portion of net income of subsidiary that
belongs to non-parent shareholders; net income calculated normally, then allocated
between parent shareholders and non-controlling shareholders; parent's share of net
income goes to retained earnings; non-controlling interest's share closed to non-
controlling interest on balance sheet
- Non-Controlling Interest: only appears in consolidated financial statements because 100% of
subsidiary's net assets, revenues, expenses reported even if parent owns less than 100%; if only
that specific percentage of net assets, revenues, and expenses were reported in the
consolidated financial statements, there would be no need for the non-controlling interest
account
- Are Consolidated Financial Statements Useful?
- Intercompany Transactions: revenues and profits from exchanges between entities in the
corporate group; not included in consolidated financial statements; are not meaningful, can be
misleading, overstate economic activity; included in financial statements of individual
subsidiaries
- Advantages:
- Provide information about a group of corporations under the control of a parent
- Useful to stakeholders who want stewardship information about entire economic
entity, to evaluate performance of corporate group
- Good way to communicate "the big picture" to stakeholders
- Parent company can move resources and assets from one corporation to another
corporation; consolidated statements allow users to see resources available to the
entire corporate group
- Disadvantages
- Obstacles to Decision Making: information about individual corporations are lost;
impossible to determine which companies, lines of business, geographic areas doing
well, which are doing poorly
- Financial Analysts: interests not served, alongside the interests of other sophisticated
stakeholders
- Ratio Analysis: significantly limited by consolidated statements, because they
sometimes aggregate companies over different industries; hard and useless to
compare to specific industry average
- Segment Disclosure: IFRS require public companies provide
information about different business activities, different geographic
areas they operate in; separation of information by types of products
and services, geographic location, major customers; revenue and
balance sheet information provided for each segment, but complete
financial statements are not; can still not be enough to satisfy demands
of some stakeholders (creditors to subsidiaries)
- Irrelevant to Non-Controlling Shareholders: consolidated financial statements intended
for stakeholders of consolidated entity; little useful information provided by the "non-
controlling interest" account; shareholders entitled to receive financial statements of
subsidiaries in which they have invested
- Tax Purposes: consolidated financial statements are irrelevant to tax agencies; each
individual corporation required to file tax returns; each corporation must prepare
financial statements for tax purposes, regardless of ownership
- Insight: managers have significant opportunities to exercise their discretion when accounting
for subsidiaries; management must allocate purchase price to identifiable assets, identifiable
liabilities, and goodwill when new subsidiary is acquired; fair value price allocation is imprecise,
management can attempt to satisfy reporting objectives
- Goodwill: does not have to be amortized; managers worried about net income may
allocate less to depreciable assets and inventory, and more to goodwill, so that there
are fewer depreciation expenses
Significant Influence
- Investor can affect strategic operating, investing, financing decisions of investee corporation, even
without control; 20%-50% of the votes of an investee company, but judgement must be used to decide
whether significant influence exists
- Equity Method of Accounting: similar to consolidation; information appears in financial statements
differently; information about investees subject to significant influence is presented on a single line on
the balance sheet, single line on income statement
- Recording Process
- Investment initially recorded on investor's balance sheet at cost
- Balance sheet amount adjusted each period by investor's share of the investee's net
income, less dividends declared by investee
- Income statement reports investor's share of investee's net income, determined by
multiplying investee's net income by percentage it is owned by investor

Share of Investee's Net Income = Investee's Net Income


* Percentage Owned by Investor

- Amount adjusted for intercompany transactions and other events


- Dividends from Investment: not considered income; timing & amount cannot be manipulated
by a significant investor under the equity method
- Reported Value vs. Market Value: amount in equity investment account changes with investee
earnings and dividends declared, not with changes in investment's fair value; balance sheet
amount DOES NOT reflect market value of the investment
- Income from Investment: when using equity method, this value is not an indication of the
amount of dividends or cash impending from investee; instead is allocation of investor's share of
investee's income; equity investment may not be liquid, cash from investee may not be readily
available
- Equity Investment Account: provides no information about the investee; segment disclosures
do not include information about a significant influence
- Public Investee: financial statements can be examined
- Private Investee: little will be known about its operations
- ASPE: companies can decide to not use consolidation or equity accounting, even if they control
or have significant influence over an investee corporation; consolidation and equity accounting
is costly, and does not provide useful information to stakeholders (usually)
- Subsidiaries: can be recorded either at cost or using the equity method
- Significant Influence: can be recorded at cost (original amount paid), until it is sold
Passive Investments
- Financial Instruments: assets and liabilities that represent contractual rights or obligations of entity to
receive or pay cash or other financial assets
- Passive Investments: investor corporation cannot influence strategic decision making of investee
corporation; investments do not give investor corporation control or significant influence
- Non-Voting Securities: debt, preferred shares, non-voting common shares; without voting
power, not possible to have an influence
- Voting Securities: are passive investments when investor corporation holds relatively small
proportion of investee's shares; IFRS says relatively small is less than 20% of votes, but other
factors need to be taken into count (i.e. whether the investor is represented on the board of
directors)
- IFRS outlines three methods to account for passive investments; IFRS aims to value at fair value
- Amortized Cost: only for certain debt investments, including bonds and other debt
instruments; used when investment is part of management's plan to hold investment to receive
cash flows (interest & principal), not to actively trade it; used when investment has contractual
terms that create interest and principal payments on specific dates; equity investment
accounting cannot be done with amortized cost because equity investments do not have
specified cash flows
- Investments recorded at cost, including costs and fees to complete transaction; carried
at cost during ownership, unless they become impaired; changes in fair value after
acquisition are ignored; gains and losses recognized on income statement when
investment is sold; interest income reported on income statement as investment
income when it is earned
- Discount/Premium: discount/premium must be amortized to investment income over
the period to maturity using the effective interest rate method
- Impairment: investment must be written down to fair value, loss reported in income
statement; when cash flows associated with investment are at increased risk; higher risk
may be indicated by bankruptcy, financial difficulty, failure to make interest and
principal payment; impairment losses can be reversed if the situation improves
- Fair Value Through Other Comprehensive Income (FVTOCI): only for equity investments that
are designated by management when investment acquired; classification cannot be changed
- Reported on balance sheet at fair value; investment initially recorded at cost, including
fees (fair value when investment purchased); changes in fair value reported in other
comprehensive income (OCI) instead of net income; fair value changes reported in OCI
are closed to accumulated OCI (equity account under balance sheet) at the end of the
year; realized gain or loss at the sale of investment is either left in accumulated OCI or
transferred to retained earnings; dividend income from shares reported in net income
of the period it is earned (not OCI)
- No impact on net income, even when gain or loss actually realized; takes away
potential source of variability in net income; shares still reported on balance sheet at
fair value
- Fair Value Through Profit & Loss (FVTPL): for debt and equity investments that are not
classified as amortized cost or FVTOCI
- Reported on balance sheet at fair value; initially recorded at costs, with fees being
expensed immediately (fair value when investment purchased); changes in fair value
reported in net income (profit/loss); realized gains and losses reported in net income;
investment income from dividends and interest reported in net income
- ASPE: requires equity investments that are publicly traded to be valued at fair value on balance
sheet; other investments can be measured at fair value if entity wishes to
- Other Comprehensive Income (OCI): does not exist under ASPE; unrealized gains/losses
included in net income instead of OCI
- Equity Investments: carried at cost less impairment loss
- Debt Investments: carried at amortized cost
- Interest & Dividend Income: included in net income

CHAPTER 12: ANALYZING & INTERPRETING FINANCIAL STATEMENTS


Introduction
- Reader of financial statements must soft through clues, analyze & interpret information, exercise
judgement, decide which information is relevant and which should be ignored, use information to make
a conclusion
- Necessary to read between the lines of numbers to get a true understanding of accounting information
- Permanent & Transitory Earnings: help us understand how current earnings can be used to predict
future earnings
Why Analyze & Interpret Financial Statements?
- Analyzing financial statements is done to make decisions; type of analysis depends on type of decision
to be made, types of questions being asked
- Creditor Perspective
- Supplier Creditors: get paid some time after supplying goods or services
- Bank Creditors: provide short-term or permanent loans to working capital
- Long-Term Lenders: notes payable, bonds, debentures, mortgages
- Concerned With:
- Ability to Pay: creditors consider resources entity possesses, reliability, timing, stability
of future cash flows; concerned with ability to make payments as economic
environment changes
- Value of Security: assets an entity can sell to raise cash if it cannot meet its obligations;
creditor wants to know the net realizable value of the assets provided as security, to
judge how much cash it can gather
- Compliance with Covenants: violation can create significant economic consequences
for the borrower; immediate repayment, renegotiation, increased interest rate
- Covenant: restrictions placed by lending agreements on actions and
behaviours of borrower; can limit dividend payment, additional borrowing,
investment, sale of certain assets; require borrowers to maintain specific ratio
- Analysis depends on nature of credit; short-term creditors care for financial situation at the
time the credit is offered, current asset liquidity, turnover rate of current assets; long-term
creditors care to forecast future cash flows, evaluate borrower's ability to generate cash and
earnings
- Equity Investor Perspective
- Value of Entity/Shares: extremely important to equity investors; private companies set
reasonable price through financial statement analysis; public companies analyzed by individual
investors, investment bank analysts, mutual & pension fund managers to derive whether it is
worth investing in
-Future Cash Flows/Earnings: relevant to investors in both private and public companies; help
decide whether company can pay dividends, if it can meet its current liabilities
- Other Perspectives
- Employees & Union Representatives: determine if employer can pay higher wages
- Canada revenue Agency (CRA): determine whether amounts reported in tax returns are
reasonable
- Regulators: evaluate whether regulated company should be given permission to increase prices
- Donors to NFPs: decide whether money is needed; decide whether donated money is being
used efficiently
Know the Entity
- Financial statements are important, but full analysis of an entity requires more sources of information,
including media, brokerage firms, online services
- Potential Questions About an Entity
- What does the entity do- what business or businesses is it in, how does it make money?
- What strategies does the entity use to make money?
- What are the key success factors?
- What is the competitive environment (many or few; easy or hard to enter market)?
- What are entity's competitive advantages?
- What are the managers? What experience do they have? How have they performed before?
- Who are the customers?
- How do economic conditions and changes in the economic environment affect the entity?
- Is the entity regulated? How does regulation affect the way it can conduct business?
- What are the risks faced by the entity?
- What are the economic conditions in the industry?
- How does the entity produce, market, distribute its products?
- What are the key inputs, how are they obtained? What are the supplier market conditions?
- Annual Reports: should look beyond these for information, but can still be useful even beyond the
financial statements and the notes to the financial statements
- Management Discussion & Analysis (MD&A): public companies must provide, not mandatory
for private companies; prepared b entity's managers; managers discuss financial results,
position, future prospects; provides readers with view of entity through eyes of management
- Paradox: management prepare the MD&A; good because management is the best
source of information and insight about the company; bad because management
probably biased in how information is presented; information is not false, but
management focuses more on the good and favourable sides of the entity, its
performance, its prospects; management more likely to create optimistic
interpretations
- Private Companies: do not need to prepare an MD&A; are not required to disclose
financial statements to public, so less information is available
- Stakeholders should analyze all information for credibility and usefulness, can still be biased even if it is
not prepared by managers; some information sources (Internet discussion boards) are difficult to verify
Permanent & Transitory Earnings & Earnings Quality
- Permanent vs. Transitory Earnings
- Net Income: not an absolute or true number; representation of entity's underlying economic
performance; measuring economic performance very complex, so impossible to find a true net
income number; number reported is a function of accounting policies chosen and estimates
made; provides stakeholders with important decision making information, even though it is
difficult to measure
- Future Predictions: necessary to predict future earnings to help make accurate decisions;
financial statements are reports on what has already happened; historical earnings can still be
used as a starting point to predict future earnings
- Permanent Earnings: earnings that are expected to recur in the future; indicator of
future earnings
- Transitory Earnings: earnings that are not expected to recur in the future
- Stakeholders must understand the sources of an entity's earnings, and the reason for changes
in earnings; permanent and transitory earnings should be interpreted differently, financial
statements should allow stakeholders to distinguish between the two
- IFRS: requires disclosure of events when they are significant and necessary for fair
presentation; vague guideline; stakeholders must be cautious, analyzing the nature of the
expenses; restructuring costs, impairments, write-downs, asset write-offs, gains/losses on
disposal of capital assets & long-term investments, litigation settlements could all be disclosed
separately
- Manager Incentive: judge whether transaction or economic event separately disclosed
in the income statement or notes; want to show that bad news is unusual, non-
recurring; want to show that good news is the norm, recurring; transitory events have
less effect on public companies' stock price; manager bonuses can sometimes be based
on earnings before unusual items
- Insight: Interpretation of transactions and other economic events as permanent or transitory not just
an IFRS problem; stakeholders should always be able to distinguish these two types of events;
stakeholders must always be aware of information affecting predictions; commitments, contingencies,
subsequent events, off-balance-sheet financing, environment changes (economy, labour issues,
regulation, competition, etc.) should be considered
- Earnings Quality
- Indicates usefulness of current earnings for predicting future earnings; high if current and
future earnings are highly correlated; low if current and future earnings are not correlated that
much
- Improved when transitory and permanent earnings can be easily separated, ambiguity in
classification does not exist
- Transitory Earnings: when they cannot be identified, lowers the earnings quality
- Permanent Earnings: improve earnings quality
- Effect of Management: accounting policies, estimates, accruals affect the earnings quality;
earnings management, managers move earnings among periods to meet reporting objectives;
accounting choices that distort relationship between current and future earnings lower earnings
quality, impair usefulness of financial statements for predicting earnings and cash flow
- Earnings: two elements for a specific time period: accruals & cash flow; accounting does not
directly affect cash flow

Earnings = Cash from Operations + Accruals

- Cash From Operations: real cash; entity collects, spends specific amount during period;
accounting cannot change this number
- Accruals: non-cash part of earnings; require judgement, managers must estimate amounts,
actual amounts not known; depreciation, bad debt expense, accrued liabilities, provisions, write-
downs of assets, allowances for returns, etc.
- Compensation: if accrual overstated this period, will eventually be understated in a
following period to even things out; if managers make accruals that lower earnings in
one period, earnings will be higher in another period; accrual amounts are only certain
at the end of an entity's life, estimated during an entity's life; managers use uncertainty
of estimates and accruals to shift earnings among periods, lowering earnings quality
- Operating Decisions: timing of actual transactions; defer discretionary expenditures to later
period if entity wants to increase income in a period; deference can be counterproductive, cuts
create short-term increase in net income, but reduce future earnings; relationship between
current and future earnings is weakened from these operating decisions, so earnings quality
reduced
- Discretionary Spending: can evaluate by looking at expenditure in relation to sales;
significant decrease in the ratio could indicate attempt to boost earnings by cutting
discretionary expenses; must remember that ratios can also be legitimate

Ratio of Discretionary Spending = Discretionary Spending / Sales

- Disclosure: most effective way to understand effects of entity's accounting choices on financial
statements; informed stakeholders are better able to assess quality of entity's earnings, create
better forecasts and assessments of quality of information provided by managers; not practical
to disclose every detail, so limitations to comprehensive analyses will always exist
- Future Implications: accounting choices almost always have implications beyond the period in
which the choice is made; transitory items create events in subsequent years that can be viewed
as permanent (i.e. big bath)
Using Ratios to Analyze Accounting Information
- Four analytical themes exist: evaluating performance, liquidity, solvency & leverage, other common
ratios
- No Standards: ratio or financial statement analysis can be done irrespective of any accounting
standards; person can modify or create any ratios appropriate for analysis; important to make sure the
right tool is used
- Dependence: ratios are presented separately, but must be considered in an integrated way; integrated
insights will allow you to be best informed
- Multiple Sources: financial information has to also be integrated with information from other sources;
provides a more complete picture of the entity and its circumstances
- Materiality: small percentage changes in some accountings may be very significant; large percentage
changes in some accounts may be insignificant
- Comparisons: financial statement information should be compared to earlier years' information for the
same entity; financial statement information must be to information for other companies, industry
standards, forecasts, and other benchmarks
- Vertical & Horizontal Analysis
- Eliminate impact of size from financial statement numbers; restate numbers as proportions
- Vertical Analysis (Common Size Financial Statements)
- Express amounts on balance sheet and income statement as percentages of other
elements in same year's statements; balance sheet amounts are stated as a percentage
of total assets; income statement values reported as a percentage of revenue
- Common Size Balance Sheet: each account is a percentage of total assets;
shows asset and liability composition of entity over time

Common Size Balance Sheet Item = Item / Total Assets


- Common Size Income Statement: stakeholders can see what proportion of
sales each expense represents; shows relative importance of different expenses;
allows comparisons over time and with other entities; can explain trends in
accounts and identify problem areas

Common Size Income Statement = Item / Revenue

- Make year-to-year comparisons very convenient; can see how each amount has
changed over time in a much simpler way than with normal financial statements;
financial statement analysis may help identify problems, will not usually explain them
- Can easily compare entities of different sizes from different industries; eliminate
effects of size, present financial statement components on common basis; differences
interpreted carefully, can be from different accounting choices, different economic
performance, different natures of entities
- Horizontal Analysis (Trend Statements)
- Restate financial statements with each account amount as a percentage of a base year
amount; shows change in each account over time; first need to specify a base year

Trend Statement Account = (Current Year Amount / Base Year Amount) * 100%

- Amounts for future years stated as percentage of base year; to see percentage change
from time other than selected base year, calculation must be redone with a different
denominator
- Interpretational Issues:
- When balance in account changes from positive-to-negative or negative-to-
positive, change cannot be interpreted using only the percentage change
relevant to the base year
- If balance in a base year account is zero, cannot calculate a trend number for
following years; very small balances in the base year can lead to huge
percentage changes, which may not be meaningful
- Trend information gives no perspective on materiality; stakeholders can waste
time worrying about things that are not material because they do not have a
reference to the actual number
- Evaluating Performance
- Performance: multi-faceted concept; measured in different ways; different performance
indicators can tell conflicting stories about how an entity is doing
- Accounting Measurements: representations of entity's economic activity are subject to
accounting policies and estimates made by managers; not possible to know the economic reality
of an account; problems do not take away stakeholder need to use accounts to make decisions
- Income Statement: shows entity's economic benefits (revenues) and economic sacrifices
(expenses)
- Net Income/Loss; net economic benefit/sacrifice of owners of the entity over a period
- Ratios: most commonly used tools for analyzing financial statements, examining relationships
between numbers; eliminate effect of size from data
- Gross Margin
- Difference between sales and cost of sales; relevant to companies that sell goods
- Gross Margin Percentage: gross margin stated as a percentage of sales; percentage of
each dollar of sales available to cover other costs and return a profit to entity's owners
- Service Providers: do not have cost of sales or cost of goods sold

Gross Margin Percentage = (Gross Margin / Sales) * 100%


Gross Margin Percentage = (Sales - Cost of Sales / Sales) * 100%

- Improving Gross Margin Percentage


- Increase Price Charged: increasing price will usually decrease sales; some
companies may be willing to accept lower sales for higher margins
- Cost Control & efficiency: entity can obtain inputs it needs at a lower cost, or
use inputs more efficiency, to get a greater gross margin percentage
- Varies dramatically from entity to entity, industry to industry
- Thing/Small Margins: company may yet be performing well; nature of business may be
one that creates small margins; some businesses make a small amount of money on
each transaction, profit a lot through numerous sales
- Profit Margin Ratio
- Bottom-line measure of performance; indicates percentage of each dollar that entity
earns in profit; higher ratio indicates greater profitability, larger proportion of each
dollar of sales is profit

Profit Margin Ratio = (Net Income / Sales) * 100%

- Variations: provide measures of profitability that reflect ongoing operations,


rather than overall profitability
- Operating Profit Margin: income before financing costs (interest),
unusual items, and other non-operating costs; measure of performance
for the actual business activities of the entity
- Return on Investment (ROI)
- An entity can have high gross margin and profit margin, but the amount of assets or
equity required to earn those investments may be indicative of poor performance
- Return on Assets (ROA): return determined using all investment, debt and equity;
measures entity's performance independent of how assets were financed
- After-Tax Interest Expense: added back, ratio is a measure of return
independent of how assets are financed; if interest expense not added back,
ROA affected by level of debt; interest expense increases with amount of debt

ROA = (Net Income + After-Tax Interest Expense) / Average Total Assets


- ROA in its Components

ROA = Asset Turnover Ratio * Profit Margin Ratio * 100%


ROA = (Sales / Average Total Assets)
* (Net Income - Interest Expense * (1 - Tax Rate)) / Sales
* 100%
ROA = [(Net Income + Interest Expense * (1 - Tax Rate))
/ Average Total Assets]
* 100%

- Asset Turnover: measure of how effectively an entity can generate


sales from its asset base; more sales generated, greater the asset
turnover ratio, greater the ROA; entity producing constant sales, but
carrying less inventory than competitors, will have higher asset turnover
ratio, higher ROA
- Profit Margin & Asset Turnover Combinations: objective is to maximize
ROA; management designs strategies to achieve this goal; compensate
for a low profit margin by having a high asset turnover ratio (small profit
on each sale, many sales); compensate low asset turnover ratio by
having a high profit margin (high profit on each sale, few sales)
- Component Structure: can identify sources of entity's performance
problems; low profit margin needs different corrective steps than low
asset turnover ratio; company with lower profit margin may try
strategies where it increases prices; company with lower asset turnover
may look for unproductive assets
- Management Limitations: a company doing well en profit margin or
asset turnover does not have much room for improvement; nature of
industry creates limits on ratios (i.e. those requiring large capital
investments have companies with lower asset turnover ratios)
- Return on Equity (ROE): determines common equity investor's return on investment
- Preferred Dividends: deducted because ROE is a measure of return to common
shareholders; preferred dividends paid to preferred shareholders

ROE = (Net Income - Preferred Dividends)


/ Average Common Shareholder's Equity

- Problems: cannot compare when average shareholder's equity is negative, or


when changes form negative to positive
- Managerial Discretion: accounting choices can affect return on investment measures;
comparisons amount firms may not be valid; may be possible to interpret trends among
different firms; returns related to risk, higher risks are indicative of higher returns;
differences in returns may reflect differences in risk, in addition to different
performance levels
- Earnings Per Share (EPS)
- Amount attributable to each individual share of common stock; predicting future
earnings is important use of financial statements

Basic EPS = (Net Income - Preferred Dividends)


/ Weighted Average of Common Shares Outstanding During Period

- Preferred Dividends: dedicated in numerator because amount is not available to


common shareholders; not deducted in calculation of net income
- Weighted Average, Common Shares: basic EPS affected y number of shares the
company has outstanding and the accounting choices of management; difficult to
compare EPS amounts between different companies
- Fully Diluted Earnings Per Share: shows effect dilutive securities (convertible bonds,
convertible preferred shares, stock options convertible to common stock) have on EPS if
converted or exchanged for common stock; considered worst-case EPS scenario
- ASPE: does not require companies to calculate and present EPS
- Financial Ratios & Market Values: IFRS allows companies to value some capital assets at their
fair value; makes the interpretation of many ratios problematic; impairs comparability, unless all
companies use the same valuation method; if fair value of the compared assets fluctuations
significantly, the ratios also fluctuates; stakeholders must adjust to this additional challenge
- Liquidity
- Availability of cash, near-cash resources; necessary for making payments when they mature
- Lenders & Creditors: asses entity's liquidity to ensure it will be able to pay amounts owed; may
not provide credit if liquidity concerns exist; may attach terms to offered credit, reflecting risk
associated with lending to the entity
- Current Ratio: measure of resources entity has to meet short-term obligations; higher ratio,
more likely entity will be able to meet current obligations; indicates entity has greater
protection in case the entity's cash flow somehow becomes impaired, assumes current assets
can be converted to cash on a timely basis

Current Ratio = Current Assets / Current Liabilities

-Quick Ratio: stricter ratio test than current ratio; excludes less liquid current assets
- Inventory: excluded from calculations; takes quite long time to convert to cash; must
be sold, amount owed by customer collected before cash is realized
- Prepaids: will never be realized in cash

Quick Ratio Acid Test Ratio = Quick Assets / Current Liabilities


- Quick Assets: cash, temporary investments, accounts receivable; other current
assets quickly convertible to cash
- Static Measures: both current and quick ratio reflect existing current resources available to
meet existing obligations; neither say anything about the ability to generate cash flow; liquidity
depends on ability to generate cash flows, cash from operations is crucial; entity with steady,
reliable cash flow does not need to worry about a low current ratio; unpredictable cash flow,
current ratio indicates ability to weather cash flow disturbances in short-term; higher current or
quick ratio means entity has more insurance in case cash flow becomes impaired
- Change in Accounting Environments: can cause liquidity problems; economy-wide change,
entity-specific change, industry-wide change; affects timing and amount of cash flows; suppliers
must still be paid the full agreed-upon amount
- Turnover Ratios: help stakeholder predict cash flows; help identify liquidity problems;
expression in terms of days allows us to judge how well operating cash inflows and outflows
match; large the cash lag, entity must self-finance its receivables and inventory for a longer
period of time; cash lag increases during times of financial distress

Cash Lag = Average Collection Period of Accounts Receivable


+ Average Number of Days Inventory on Hand
- Average Payment Period for Accounts Payable

- Accounts Receivable Turnover: indicates how quickly an entity collects its receivables;
larger, the more quickly receivables are being collected; decrease relative to previous
fiscal years or to industry averages may suggest liquidity issues, entity with less cash to
meet obligations

Accounts Receivable Turnover Ratio = Credit Sales/Average Accounts Receivable

- Average Collection Period: average number of days it takes to collect


receivables; increase relative to fiscal years or to industry norms may suggest
liquidity problems, entity has less cash to meet its dues

Average Collection Period = 365 / Accounts Receivable Turnover Ratio

- Inventory Turnover Ratio: number of times in period entity able to purchase and sell its
inventory stock; high rate shows inventory is liquid, sold more quickly, less cash invested
in inventory; when decreasing relative to previous years or industry benchmarks, may
indicate liquidity problem, inventory may even be obsolete

Inventory Turnover Ratio = Cost of Sales / Average Inventory

- Average Number of Days Inventory on Hand: average number of days it takes


inventory to be sold or used
Average Number of Days Inventory on Hand = 365 / Inventory Turnover

- Accounts Payable Turnover Ratio: depicts how quickly entity pays accounts payable;
focuses on amounts owed to inventory suppliers, but the accounts payable account
usually includes amounts owed to other types of suppliers, problematic; decreasing
amount may indicate cash flow problems, due to need to extend the time taken to pay

Accounts Payable Turnover Ratio = Credit Purchases / Average Accounts Payable

- Purchases: determined using cost of sales, which must be disclosed under IFRS

Purchases = Cost of Sales - Beginning Inventory + Ending Inventory

- Average Payment Period for Accounts Payable: number of days the entity
takes to pay its accounts payable

Average Payment Period = 365 / Accounts Payable Turnover Ratio

- Notes to Financial Statements: provide useful liquidity information that is not reflected in
financial statements themselves
- Executory Contracts: commitments to make cash payments in the future; contract
arrangements for which neither party has performed its side of the arrangement, so no financial
statement effects; affect liquidity, company is committed to spend cash in the future
- Solvency & Leverage
- Solvency: ability to meet long-term obligations; represents financial viability of the company
- Capital Structure: sources of financing; relative proportions of debt and equity; used to assess
solvency; more debt an entity has, more risk there is to long-term solvency
- Debt-to-Equity Ratio: measure of relative amount of debt to equity an entity is using; indicates
riskiness of entity, ability to carry more debt more debt increases risk, entity faces significant
economic and legal consequences if interest and principal payments are not made on time

Debt-to-Equity Ratio = Total Liabilities / Total Shareholders' Equity

Long-Term Debt-to-Equity Ratio = Long-Term Debt / Total Shareholders' Equity

Debt-to-Total Assets Ratio = Total Liabilities/(Total Liabilities+Total Shareholders Equity)


Debt-to-Total Assets Ratio = Total Liabilities / Total Assets

- Misleading Results: can be mislead when you simply use the numbers on the balance
sheet to calculate debt-to-equity; leases, pensions, future income taxes can impair
interpretation; entity with significant operating leases will have an understated debt-to-
equity ratio because liabilities would be understated (operating leases occur off the
balance sheet)
- Debt: interest must be aid regardless of entity's performance; makes entity riskier;
beneficial because less costly than equity, debt holders specified, entitled to payment
before equity investors; interest on debt is tax-deductible; too much debt can lead to an
inability to pay obligations; debt becomes more expensive as relative amount increases,
lenders charge higher interest rates as risk increases; optimal amount of debt depends
on entity and accounting environment
- Cash Flow Reliability: firms with predictable cash flows can take out more
debt; affected by factors like competition, threat of technological change,
sensitivity to economic cycles, predictability of capital expenditures; firm that
can best generate cash from operations is best at meeting obligations; earnings
can be indicative of long-term cash flow, even though they are different in the
short-term
- Interest Coverage Ratio (Accrual Basis): measures ability of entity to meet fixed financing
charges (interest payments); larger, better able entity is to meet interest payments; ignores that
entities have fixed charges other than interest (debt repayment, lease payments on operating
leases, etc.); higher value is assurance to creditors that they will be repaid; acceptability of
coverage ratio depends on entity; shows what has happened, not what is going to happen,
historic trends can indicate future trends, but must be mindful of potential changes

Interest Coverage Ratio = (Net Income+Interest Expense+Tax Expense)/Interest Expense

- Interest Coverage Ratio (Cash Basis): shows number of dollars of cash from operations for each
dollar of interest that had to be paid

Interest Coverage Ratio = Cash From Operations Excluding Interest Paid/Interest Paid
Interest Coverage Ratio = Cash From Operations + Interest Paid / Interest Paid

- Numerator: interest paid is added back to cash from operations in order to exclude it,
because it is deducted in the calculation of cash from operations
- Covenants: accounting ratios set as boundaries of a credit agreement; if account ratio specified
by creditor not maintained, the creditor immediately recollects its investment
- Other Common Ratios
- Price-to-Earnings (P/E) Ratio: indicates how market values an entity's earnings, what market
sees as growth prospects; higher P/E, more market expects earnings to grow, more sensitive its
share price is to changes in earnings; indicates risk associated with future earnings, higher risk,
lower P/E for a given level of earnings, since future cash flows are discounted at a higher rate to
reflect the risk

Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share
- Permanent & Transitory Earnings: different effects on market price of shares, which
has implications on the P/E ratio; P/E must be interpreted carefully
- Market Price of Share vs. Earnings: share price represents present value of cash flows
that will be received by shareholders, future-oriented perspective; earnings are
historically-focused measure; link between earnings and share price is not perfect;
current information immediately reflected in share price, but earnings not affected until
next financial statements prepared
- Loss of Meaning: P/E loses meaningfulness when earnings are very low but positive,
leads to a very large ratio; cannot determine P/E ratio if entity incurs a loss; not possible
to determine P/E ratio of private companies, market prices for shares are unavailable;
ratio varies with different accounting choices for same underlying economic activity,
because earnings are affected by accounting choices of managers
- Dividend Payout Ratio & Dividend Yield: information about dividends received to investors
- Dividend Payout Ratio: shows proportion of earnings paid to common shareholders as
dividends; the remainder is retained by the corporation; dividend payout greater than
1.0 is possible, if cash being dedicated to dividends is greater than net income

Dividend Payout Ratio = Common Dividends Declared / Net Income

- Net Loss: company with net loss can still pay a dividend; if losses are
continuous, firm will eventually run out of the resources necessary to sustain
the dividend; firm must have cash; dividend payout ratio is no longer
meaningful, cannot calculate with a negative denominator value
- Dividend Yield: indicates return dividends investors are receiving from investment;
investors wanting cash flow from investments want to invest in companies that have
reliable annual dividends

Dividend Yield = Common Annual Cash Dividends Per Share/Current Share Price

Some Limitations and Caveats about Financial Statements & Financial Statement Analysis
- Analysis of IFRS-based information constrained by limitations of the information itself; financial
statement and ratio analysis is still a useful tool, but it is important to understand the strengths and
limitations present
- Historical Nature: financial statements used as starting point of an analysis; user must incorporate own
future-oriented information to make meaningful predictions
- Limitations from Change: accounting environment changes; future may be different from past, limiting
usefulness of historical financial statements; industries with rapid and unpredictable change are
especially limited in the uses of their financial statements (technology-intensive industries)
- Managerial Discretion: managers make financial statements; good because managers the one who
know and understand entity best; bad because self-interests can influence accounting choices made;
managers must choose among competing information needs of different stakeholders when creating
statements, because only one set of general purpose financial statements is prepared
- Incomprehensive: financial statements do not reflect all assets, liabilities, economic activity; value
resources and important obligations are often unreported; IFRS allows fair value usage, but cost usually
chosen as the basis of measurement
- Effect of Policy Choices & Estimates: firms can choose from alternative accounting policies; different
policies for similar economic activity can lead to different financial statements, and thus, different
ratios; must carefully read notes on significant accounting policies to recognize whether differences are
caused by real economic activity or accounting policy choices; estimates require managers to use their
professional judgement, affected by assumptions, information, biases, self-interests
- Difficulty of Comparison: common size financial statements and financial ratios allow financial
statement comparisons; sometimes comparisons may not be valid (different estimates and accounting
policies); must be cautious as a user of the financial statements
- Other Information Sources: not possible to analyze entity on financial statements alone; need to
integrate information from many sources to get an overall view of the corporation
- Diagnostic Tool: financial analysis does not necessarily provide explanations for identified issues;
accounting information reflects economic activity; problem areas identified through the economic
activity, but the root of a problem requires one to have a prior understanding of strategies, operations,
and management
Earnings Management
- Managers have choice in deciding how to account for, disclose, present financial statement
information; choices create significant economic consequences for stakeholders
- Choices also can affect lines other than net income, as well as balance sheet accounts; also applies to
how information is disclosed in the notes to the financial statements
- Motivated by economic consequences of accounting information; earnings of public companies
carefully studied by investors and analysts; managers of public companies under pressure to meet
investors' expectations, to maintain stock rice; managers use accounting choices to increase r smooth
earnings
- Compensation, opportunities in job market, job security affected by financial statement results
- Managers can also be motivated by trying to sell company shares for as high a price as possible, to
obtain the best terms for a loan, to avoid debt covenant violations, to get financial help from
government, to lower taxes, or to generally influence outcome of decisions that rely on accounting
information
- Most cases of earnings management occur within the rules; when they do not, considered a fraud;
managerial discretion must still be reasonable, even if it is not right
- Earnings Management Opportunities
- Revenue Recognition: when to recognize revenue; bad debts; returns; discounts
- Inventory: inventory valuation method (FIFO, average cost, specific identification); costs
included in inventory; write-downs of obsolete and damaged inventory
- Capital Assets: which assets are capitalized; depreciation method; useful lives; timing, amount
of write-downs and write-offs
- Liabilities: leases; warranty provisions; pensions; accrued liabilities
- Assets vs. Expenses: capitalization policies
- Other: big baths; income statement classifications as ordinary versus unusual; off-balance-
sheet financing; non-recurring items; disclosure of commitments and contingencies
A Final Thought
- Accounting is about high-level thinking skills, human nature, judgement