Doran Chapter One.pdf

8/11/2019 Doran Chapter One.pdf

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Financial ReportingStandards


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Financial ReportingStandards

A Decision-Making Perspective

for Non-Accountants

David T. Doran


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Financial Reporting Standards A Decision-Making Perspective for Non-AccountantsCopyright Business Expert Press, 2012.All rights reserved. No part of this publication may be reproduced,stored in a retrieval system, or transmitted in any form or by anymeanselectronic, mechanical, photocopy, recording, or any otherexcept for brief quotations, not to exceed 400 words, without the priorpermission of the publisher.

First published in 2012 by

Business Expert Press, LLC222 East 46th Street, New York, NY 10017www.businessexpertpress.com

ISBN-13: 978-1-6064-9387-8 (paperback)

ISBN-13: 978-1-60649-388-5 (e-book)

DOI 10.4128/9781606493885

A publication in the Business Expert Press Financial Accounting andAuditing collection

Collection ISSN: 2151-2795 (print)Collection ISSN: 2151-2817 (electronic)

Cover design by Jonathan Pennell

Interior design by Exeter Premedia Services Private Ltd.,Chennai, India

First edition: 2012

10 9 8 7 6 5 4 3 2 1

Printed in the United States of America.


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To my lovely, patient and understanding wife Mary Anne,and our three children Patrick, Caley, and Matthew.


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Abstract

Accounting is the score keeping system in the game of businessyoucant do well in any game if you dont understand how the score is kept.Tis book is intended to bene t practicing managers, MBA students, andnonaccounting business majors. United States nancial reporting stand-ards are compared and contrasted with international nancial reportingstandards where appropriate. Te book emphasizes how managementschoice of accounting methods and their required estimates in reportingtransactions and events impact nancial statements, both immediately

and in the future. Unlike typical accounting books, journal entries are notused to illustrate topical coverage.

Tis unique book exclusively provides a users decision-making per-spective by using the accounting equation format to directly illustrate

nancial statement effects of transactions and events. Most of the topicsaddressed in this book are typically studied by accounting majors in thetwo course intermediate accounting sequence, but the text also includesdiscussion of consolidationsa topic generally covered in the advancedaccounting course. Intermediate accounting textbooks alone typicallyexceed well over 1,500 pages. By exclusively applying a users perspective,and limiting topical content to areas relevant for decision making, thisbook allows nonaccountants to acquire the requisite underlying knowl-edge in a concise, easy to understand text.

Keywords

Financial Statements, GAAP, Cash Flow vs. Earnings, Accounting

Equation Format, Accounting Method Choice, Accounting Estimates,Off-Balance-Sheet Financing, Economic Consequences of Accounting,Earnings Management, Substance Over Form, IFRS.


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Contents

Chapter 1 Overview of Financial Accounting ...................................1

Chapter 2 Cash, Receivables, and Revenue Recognition .................27

Chapter 3 Inventory and Cost of Goods Sold .................................57

Chapter 4 Operational Assets .........................................................89

Chapter 5 Liabilities: Current, Contingent, and Long- erm Debt ..................................................125

Chapter 6 Leases ..........................................................................163

Chapter 7 Financial Instruments: InvestmentSecurities and Derivatives ............................................179

Chapter 8 Accounting for PostretirementBene ts and Income axes ...........................................223

Chapter 9 Stockholders Equity and Earnings Per Share ...............261

Chapter 10 Statement of Cash Flows ..............................................297

Index .................................................................................................319


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CHAPTER 1

Overview of FinancialAccounting

Introduction

Te objective of accounting is to provide information useful for usersdecision making. wo primary areas of accounting are nancial accountingand managerial accounting.1 Financial accounting is intended to provideinformation to external users in meeting their decision making needsand is the exclusive topic of this text. Unlike managers, external usersare not involved in the day-to-day decision making within the rm, butneed information in making decisions. Te two key external user groups

with the greatest nancial interest targeted to bene t from nancialaccounting information are current and potential creditors and investors.Since this text assumes the corporate form of business throughout, inves-tors are stockholders. Creditors need to decide whether or not to lendmoney to the corporation and if so what interest rate should be chargedto compensate for the level of risk. Stockholders need information toaccommodate buy, hold, or sell decisions. Management has a vested inter-est in understanding nancial accounting information because it impactsthe corporations stock price, and the corporations ability to obtain loans

and the related borrowing rates.

1 Managerial accounting is intended to help internal users (management) in mak-ing decisions. Since management is in the best position to determine what speci cinformation optimally suits their particular decision making needs, there are no rulesor guidelines regarding what information is provided for managerial accounting pur-poses. As such, the study of managerial accounting involves examination of commonconventions and practices, for example, cost-volume-pro t analysis, budgeting andvariance analysis, differential analysis, etc.


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2 FINANCIAL REPORTING STANDARDS

Both creditors and stockholders provide resources to the corpo-

ration in order to receive future cash ows; creditors in the form ofprincipal and interest payments and stockholders in the form of divi-dends and proceeds from sale of the stock. Since the corporation hasnumerous creditors and stockholders, it cannot conceivably provideinformation to each on an individual user basis. Terefore, nancialaccounting information is intended to be useful in assessing the futurecash ows of the rm. Tree things are important regarding the rmsfuture cash ows for valuation purposes, their amounts, timing, anduncertainty. Considering each individually, the greater the amounts,the sooner they occur, and the lesser their uncertainty, the more valu-able is the debt or stock investment. By meeting the information needsof investors and creditors, nancial accounting information is useful inmeeting the decision making needs of other external user groups. Forexample, customers look to nancial accounting information in orderto assess a rms ability to continue providing goods and services in thefuture; and employees are interested in nancial accounting informa-tion as it relates to the rms ability to pay them salaries and wages in

the future.Te nancial statements (including disclosure notes) are the primary

product of nancial accounting and the information provided therein isthe exclusive topic of this book. Te three primary nancial statementsinclude a balance sheet, an income statement, and a statement of cash

ows. Most rms also provide a statement of stockholders equity. Tenancial statements of Behrend Corp. are illustrated in Exhibits 1.21.5.

Tese nancial statements are intended to be useful to external usersin assessing the amounts, timing, and uncertainty of Behrends futurecash ows. Tese users compare Behrend Corp. with other corporationsand over time in making their decisions. Tis is why the informationprovided in the nancial statements needs to comply with certain rulesand guidelinesso that it is comparable across rms and within the rmover time. Te rules and guidelines that the nancial statement informa-tion must comply with are referred to as generally accepted account-ing principles (GAAP). GAAP information must be both relevant


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OVERVIEW OF FINANCIAL ACCOUNTING 3

(make a difference)and provide faithful representation2 (actually

represent what is supposed to be represented) in order to be useful fordecision making. An important part of the nancial reporting processis the audit opinion, where independent Certi ed Public Accountantsattest to the fairness of the information provided in the nancial state-ments in conformity with GAAP.

Te organization with legal authority to establish GAAP for publiclytraded rms in the United States is the Securities and Exchange Com-mission (SEC). Te SEC has primarily delegated the responsibility forsetting U.S. GAAP to nongovernmental organizations. Te currentprivate sector organization with the responsibility to determine U.S.GAAP is the Financial Accounting Standards Board (FASB).3 AlthoughU.S. rms comply with FASB GAAP, most non-U.S. corporationsreport nancial statements based upon a similar but not identical setof GAAP that is formulated by the International Accounting StandardsBoard (IASB). Tis IASB set of GAAP is commonly referred to as Inter-national Financial Reporting Standards (IFRS).4 At the time of writingthis text, the SEC has indicated it may in the future require U.S. rms

to comply with IFRS. Financial accounting topics are addressed in

2 Previously, the two primary qualities considered necessary for information to beuseful for decision making were relevance and reliability. In a September 2010revision, the FASB changed the primary quality of reliability to faithful represen-tation. In doing so, the FASB pronouncement regarding the two primary qualitiesinformation must have to be useful for decision making is now consistent with thoseidenti ed by the IASB relevance and faithful representation. Both of these organiza-tions are discussed below.3 Te FASB replaced the Accounting Principles Board that presided from 1959 to1973. Te original private sector organization that formulated U.S. GAAP was theCommittee on Accounting Procedure that was formed in 1939. Pronouncements ofthese predecessor bodies that have not been superseded by the FASB remain partof U.S. GAAP. U.S. GAAP is contained in the Accounting Standards Codi cation ASC. Te FASBs website is at www.fasb.org.4 Te IASB was formed in 2000 and was preceded by the International AccountingStandards Committee IASC. Pronouncements of the IASC that have not beensuperseded by the IASB remain as part of IFRS.


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this text primarily from a U.S. GAAP perspective, but highlight signi -

cant differences between GAAP and IFRS when appropriate.

Financial Statements

Te balance sheet depicts a corporations nancial position at apoint intime. All the other nancial statements are for aperiod of time and explainchanges that occur in certain balance sheet items during the period. It isimportant to note that these change statements are for the same periodof time, beginning and ending at the comparative balance sheet dates. ForBehrend Corp. the change statements are consistently for the year ended12/31/12. Te ending balance sheet of the previous period is the currentperiods beginning balance sheet. Comparing Behrends year-end 12/31/12balance sheet (Exhibit 1.5) with its beginning balance sheet at 12/31/11(Exhibit 1.1) indicates that cash has decreased by $80,000 during the year.Tis change in cash is illustrated in detail in the statement of cash ows forthe period 2012 (see Exhibit 1.4). Likewise, changes in retained earningsand other components of stockholders equity that occurred during 2012

are depicted in the income statement and the statement of stockholdersequity (see Exhibits 1.2 and 1.3). Te FASB has de ned the basic elementscontained in the nancial statements. Tese elements are next discussed asthey relate to the particular nancial statement.

Balance Sheet

Te balance sheet presents a corporations nancial position at a pointin time by reporting its assets (things of worth) versus its liabilities plusstockholders equity (claims to the assets). Te balance sheet account-ing equation is expressed as: ASSE S = LIABILI IES + OWNERSEQUI Y (A = L + OE). Te nancial statements result from the accumu-lation, classi cation, and summarization of numerous individual transac-tions and events. Each transaction or event that impacts the nancialstatements is termed to be recognized. Te accounting equation isalways in balance. As discussed later, each transaction or event recognizesits dual (at a minimum) effects, which in turn maintains the equality ofthe accounting equation. Tis is referred to as double entry accounting.


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E x h i b i t 1 . 1 .

B e h r e n

d C o r p .

B a l a n c e

S h e e t a t 1

2 / 3 1 / 2 0 1 1

A s s e t s :

L i a b i l i t i e s :

C u r r e n t A s s e t s :

C u r r e n t L i a b i l i t i e s :

C a s h a n d C a s h E q u i v a l e n t s

$ 1 5 0 , 0

0 0

A c c o u n t s P a y a b l e

$ 1 0 0 , 0

0 0

A c c o u n t s R e c e i v a b l e ( n e t )

1 4 0 , 0 0 0

D e b t C u r r e n t l y D u e

1 0 0 , 0 0 0

I n v e n t o r y

2 5 0 , 0 0 0

$ 5 4 0 , 0

0 0

S a l a r i e s & W a g e s P a y a b l e

5 0 , 0

0 0

I n t e r e s t P a y a b l e

2 5 , 0

0 0

$ 2 7 5 , 0

0 0

L o n g - T e r m A s s e t s :

L o n g - T e r m L i a b i l i t i e s :

P P & E ( n e t )

4 0 0 , 0 0 0

L o n g - T e r m D e b t

4 0 0 , 0 0 0

T o t a l L i a b i l i t i e s

$ 6 7 5 , 0

0 0

S t o c k h o l d e r s E q u i t y :

P a i d I n C a p i t a l

$ 1 0 0 , 0

0 0

R e t a i n e d E a r n i n g s

1 6 5 , 0 0 0

2 6 5 , 0 0 0

T o t a l A s s e t s

$ 9 4 0 , 0

0 0

T o t a l L i a b i l i t i e s & S t o c k h o l d e r s E q u i t y

$ 9 4 0 , 0

0 0


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Exhibit 1.2. Behrend Corp. Income Statement for the Year Ended12/31/2012 Net Sales Revenue $1,900,000

Cost of Goods Sold 1,000,000

Gross Prot $900,000

Operating Expenses:

Selling & General Administrative Expenses:

Salary and Wage Expense $610,000

Research and Development Expense 55,000

Depreciation Expense 40,000 705,000

Operating Income: $195,000 Other Revenue, Expense, Gain and Loss:

Interest Expense 45,000

Income From Continuing OperationsBefore Tax

$150,000

Income Tax Expense 30,000

Income From Continuing Operations $120,000

Extraordinary Loss $50,000

Less Tax Benet 10,000 40,000

Net Income $80,000 Earnings Per Share assume 100,000 shares of

stock outstanding:

Income From Continuing Operations $1.20

Extraordinary Loss $.40

Net Income $.80

Exhibit 1.3. Behrend Corp. Statement of Stockholders Equity for the Year Ended 12/31/2012

Paid-incapital

Retainedearnings

Totalstockholders

equityBeginning of Year 12/31/2011 $100,000 $165,000 $265,000

Issued Stock 50,000 50,000

Net Income 2012 80,000 80,000

Dividends

End of Year 12/31/2012 $150,000 $220,000 $370,000


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Assets are de ned as probable future economic bene ts as a result ofpast transactions or events.Liabilities are the opposite of assets and arede ned as probable future economic sacri ces as a result of past transac-tions or events. Tese are the most important de nitions of nancialstatement elements because all other elements are de ned in terms ofassets and liabilities. For example, the remaining balance sheet element isequity , which is de ned as the residual interest in the assets that remains

after deducting its liabilities. A classi ed balance sheet separates cur-rent from long-term assets and liabilities. A current asset is one that

will be realized in cash or used up within the next year or the operatingcyclewhichever is longer. A current liability is one that will be satis edby using current assets. Te operating cycle is the period that begins withthe corporations acquisition of goods held out for sale or the providing ofservices and ends with the collection of cash from customers in the nor-mal course of business. Although there are exceptions, current liabilities

are generally those that will be satis ed within one year or the operating

Exhibit 1.4. Behrend Corp. Statement of Cash Flows for the Year Ended 12/31/2012

Cash Flow from Operating Activities:

Collected from Customers $1,890,000

Paid to Suppliers for Inventory $1,120,000

Paid to Employees for Salaryand Wage 600,000

Paid for Research and Development 55,000

Interest Paid 50,000

Income Tax Paid 20,000 $45,000

Cash Flow from Investing Activities:

Cash Paid for Truck

Cash Flow from Financing Activities:

Stock Issuance $50,000

Payment of Principal on Debt $100,000

Payment of Dividends 25,000

Change in Cash During 2012 $

Cash at 1/01/2012 150,000

Cash at 12/31/2012 $70,000


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E x h i b i t 1 . 5 .

B e h r e n

d C o r p . B

a l a n c e

S h e e t a t 1

2 / 3 1 / 2 0 1 2

A s s e t s :

L i a b i l i t i e s :

C u r r e n t A s s e t s :

C u r r e n t L i a b i l i t i e s :

C a s h a n d C a s h E q u i v a l e n t s

$ 7 0 , 0 0 0

A c c o u n t s P a y a b l e

$ 8 0 , 0 0 0

A c c o u n t s R e c e i v a b l e n e t

1 5 0 , 0 0 0

S a l a r i e s & W a g e s P a y a b l e

6 0 , 0

0 0

I n v e n t o r y

3 5 0 , 0 0 0

$ 5 7 0 , 0

0 0

I n t e r e s t P a y a b l e

2 0 , 0

0 0

$ 1 6 0 , 0

0 0

L o n g - T e r m L i a b i l i t i e s :

L o n g - T e r m A s s e t s :

L o n g - T e r m D e b t

4 0 0 , 0 0 0

P P & E n e t

3 6 0 , 0 0 0

T o t a l L i a b i l i t i e s

$ 5 6 0 , 0

0 0

S t o c k h o l d e r s E q u i t y :

P a i d I n C a p i t a l

$ 1 5 0 , 0

0 0

R e t a i n e d E a r n i n g s

2 2 0 , 0 0 0

3 7 0 , 0 0 0

T o t a l A s s e t s

$ 9 3 0 , 0

0 0

T o t a l L i a b i l i t i e s & S t o c k h o l d e r s E q u i t y

$ 9 3 0 , 0

0 0


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cyclewhichever is longer. Since most businesses have an operating

cycle of less than one year, unless indicated otherwise, this book assumesclassi cation of assets and liabilities as current or long-term based uponthe one-year period.

Te balance sheet is used to gauge a rms debt paying ability. Teterm liquidity is used in two ways. Te liquidity of individual assets isdetermined by their nearness to cashtherefore, cash is deemed to bethe most liquid of all assets. Investments in marketable debt and equitysecurities can be easily and quickly converted to cash and are consideredhighly liquid. Comparing inventory with accounts receivable, inventoryis deemed less liquid because, relative to accounts receivable, it is onestep removed from cash receiptthe sale has not yet occurred. Liquid-ity is also used to describe a rms short-term debt paying ability. Cur-rent assets (CA) must be considered relative to current liabilities (CL) inmaking this liquidity assessment. Frequently used liquidity measures are

working capital, the current ratio, and the quick ratio. Working capital iscalculated as: CA CL. Although working capital provides an importantnumeric measure of a rms short-term debt paying ability, it is diffi cult

to compare the amount of working capital across rms of different size.Ratios provide relative measures that accommodate comparison across

rms. Both the current ratio and the quick ratio use CL as the denomi-nator but their numerators are different. Te current ratio is computedas CA/CL, whereas the quick ratios numerator includes only the mostliquid of current assets, called quick assets. Quick assets (QA) are CAexcluding inventory and prepaid expenses and typically include cash,short-term investments, and accounts receivable. Te quick ratio is com-puted as QA/CL.

A common measure of a rms capital structure is the debt-to-equityratio. Te debt-to-equity ratio includes all debt (D) or total liabilities inthe numerator and total stockholders equity (E) in the denominator.Te debt-to-equity ratio is calculated as D/E. Te D/E ratio generallyin uences a rms long-term debt paying ability (solvency). Althougha numeric measure of a rms solvency can be considered its net assets,or stockholders equity A L = OE, the debt-to-equity ratio provides amore comparable measure across rms. Te D/E ratio can be used to


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gauge a rms leverage or degree to which assets are nanced through

debt versus equity. Te degree of leverage can also be used to assess therms nancial exibility. Financial exibility is the rms ability torespond to unexpected needs and opportunities. Generally, the higherthe D/E ratio, the more diffi cult it is for the rm to make interest andprincipal payments on its debt, particularly during bad times, or toquickly borrow funds in order to take advantage of business opportuni-ties when they arise.

Income StatementComprehensive income is de ned as all changes in net assets (equity)during the period except those resulting from contributions by ownersand distributions to owners. Comprehensive income has two compo-nents, net income and other comprehensive income. Te incomestatement5 of Behrend Corp. for the year ended 12/31/2012 is illustratedin Exhibit 1.2. Net income or loss is the difference between the sum totalsof revenues plus gains versus expenses plus losses.Revenues are de ned

as increases in net assets from providing goods or services that consti-tute the rms ongoing central operations.Expenses are decreases in netassets from providing goods or services that constitute the rms ongoingcentral operations. Like revenues and expenses,gains and losses alsorespectively provide increases and decreases in equity, but they result fromnonowner peripheral or incidental transactions rather than ongoingcentral operations.

Net income and net cash ows over the entire life of the rm areequal after excluding cash ows that result from contributions by anddistributions to owners, but on a period by period basis, may differin terms of timing. Revenue and gain may be included in the incomestatement (recognized) concurrent with, before, or after the related netcash in ow occurs. Tis timing issue is likewise the case for incomestatement recognition of expenses and losses relative to the related

5 echnically the correct title should be the Statement of Net Income however,because it is commonly used in practice, the text also refers to such as the IncomeStatement.


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net cash out ow. Tis timing difference is caused by GAAPs require-

ment to apply the accrual basis of accounting. Te accrual basis ofaccounting is based upon two underlying principlesthe revenue(recognition) principle, and the expense recognition principle. Terevenue principle requires that revenue be included in the incomestatement (recognized) in the period earned whether or not the cashis received in that period. Normally, revenue is deemed to be earnedin the period the goods or services are provided to the customer. Teexpense recognition principle attempts to assure that expenses followrevenues in order to provide a meaningful measure of income. Incomeis sometimes termed the change in well-offness that occurs duringthe period. Te expense recognition principle requires that expenses berecognized with revenue of particular periods, whether or not the cashis paid in that period.

When a rm incurs costs that provide probable future economicbene t, they are presented as assets in the balance sheet. When theseeconomic bene ts are realized, the asset must be recognized as expensein the income statement. Te expense recognition principle considers

four different classi cations of costs for purposes of determiningthe period(s) in which the related expense should be recognized. Tesecost classi cations are:

1) directly related to revenue with a cause and effect relationshipexamples include cost of goods sold and sales commissions;

2) directly related to particular income statement time periodsexamples include rent, interest, and sales salaries;

3) systematically and rationally allocated to income statement peri-ods estimated to be bene tedexamples include depreciation andamortization; and

4) immediately recognized as expense due to a high degree of uncer-tainty that future bene t will resultexamples include research anddevelopment or R&D.

Te FASB contends that the accrual basis of accounting provides users with information more useful in assessing the rms future cash ows thana cash basis income statement would provide. It is ironic that income


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reported under GAAP is based uponpast transactions and events, but is

primarily bene cial to creditors and stockholders only to the extent thatit is useful in predicting future income (and cash ows). Te degree to which a rms reported income is useful in predicting its future incomeand cash ow performance is termed the Quality of Earnings. TeFASBs requirement to use the accrual basis is predicated upon their con-tention that reporting income under the accrual basis results in higherquality of earnings than would result if the cash basis of accounting wasapplied. Higher quality earnings should occur with full disclosure andtransparency in the nancial reporting process where managements req-uisite accounting method choices and estimates regarding future eventsare made with neutralitywith freedom from bias. Of all the nancialstatements, many users place primary emphasis on the income statementin making decisions. Terefore, the concept of Quality of Earnings is ofutmost importance and will be revisited in future chapters.

Although the accrual basis is usually considered an income concept,there are directly related implications for assets and liabilities in the bal-ance sheet. As discussed previously, the accrual basis requires revenue to

be recognized in the period earnedwhether or not the cash is receivedin that period, and expenses follow revenues and are recognized in par-ticular periodswhether or not the cash is paid in that period. When theincome statement recognition of revenue or expense precedes the cash

ow, it is termed an accrual. When the cash ow precedes the revenueor expense recognition in the income statement, it is termed a deferral.

Accruals include revenue recognition with related asset recognition, forexample, interest revenue and interest receivable, and expense recogni-tion with related liability recognition, for example, interest expense andinterest payable. Deferrals include increases and decreases in cash with therelated recognition respectively of liabilities, for example, unearned rentrevenue, or recognition of an asset, for example, prepaid rent.

Tose income statement items that are considered more recurring orpermanent in nature are more important to the user than those itemsthat are nonrecurring or temporary in nature. Te income statementfor Behrend Corp. in Exhibit 1.2 is in multiple-step form. Te itemsthat are given prominence by appearing rst are generally deemed to bemore important because they are more permanent in nature. Te rst


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step in the income statement deducts cost of goods sold from sales rev-

enue to present gross pro t of $900,000. Te normal recurring oper-ating costs for selling and general administrative expense are deductedto yield $195,000 for operating income. Next, the more peripheral orincidental other revenues, expenses, gains, and losses category is addedor deducted to determine income from continuing operations beforetax. Tis example assumes only interest expense of $45,000 is reportedin this other category. A tax rate of 20% is assumed which reducesincome from continuing operations to $120,000 after income tax. Tisis commonly referred to as the line for purposes of presenting twopotential below the line items under U.S. GAAP. Te rst is discon-tinued operations followed by extraordinary items. Each is presentedseparately net of tax effect because there is little if any implication con-cerning future cash ows.

Discontinued operations involve component operations of a businessthat will not be continued in the future. Tere are two elements of this rstbelow the line item: 1) revenues versus expenses from the componentsoperation during the period, and 2) gain or loss on disposal. Although

Behrend has no discontinued operations to report during 2012, it doesreport an extraordinary loss. Te gross amount of the loss is $50,000, but

with a 20% tax rate, results in a tax savings of $10,000, that reduces thereported loss net of tax to $40,000. For an item to be considered extraor-dinary, it must be: 1) infrequent in occurrence, and 2) unusual in nature.

According to U.S. GAAP, very few items should meet both criteria andbe presented as extraordinary. Presentation of extraordinary items differsunder U.S. GAAP and IFRS. Differences between U.S. GAAP and IFRS

will be indicated throughout the text by highlighting. Although IFRS inaccounting for discontinued operations is similar to U.S. GAAP, IFRSdoes not permit separate reporting of extraordinary items in the incomestatement. Behrend reports net income of $80,000 for 2012.

Earnings per share is a standardized measure of earnings performancethat can be compared over time. Te Behrend Corp. example assumes100,000 shares of stock outstanding during the period. Te amounts ofincome from continuing operations, extraordinary loss, and net incomeare each divided by the 100,000 shares resulting in the earnings per shareamounts reported in Exhibit 1.2.


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Comprehensive Income

As mentioned previously, comprehensive income has two components. Inaddition to net income discussed above, it also includes other compre-hensive income (OCI). Te FASB has identi ed four areas where changesin equity from nonowner exchanges elude inclusion in the income state-ment and are instead included in OCI net of tax effects. Each exceptioninvolves the application of fair value accounting with resulting recog-nition of unrealized gain or loss. Tese four areas are: 1) translationof foreign subsidiaries nancial statements into U.S. dollars, 2) certain

hedging activities using derivative securities, 3) funded status of pensionand other postretirement plans, and 4) accounting for certain investmentsin marketable securities. Although OCI items are discussed later in thetext, it is worth noting here that a signi cant difference between belowthe line and OCI items is that OCI items do not affect reported earningsper share.

Presentation of comprehensive income is consistent across U.S. GAAPand IFRS. Comprehensive income must be presented in one of two ways:1) two separate statements (NI and OCI), or 2) one single combinedstatement of comprehensive income.6 In our illustrations, Behrend doesnot report OCI in its nancial statements because we assume none of thefour OCI items occurred during 2012.

Statement of Stockholders Equity

Te statement of stockholders equity is a detailed reconciliation of begin-ning to ending balances in the individual components of stockholders

equity in the balance sheet. Behrends statement of stockholders equityfor the year ended 12/31/2012 is illustrated in Exhibit 1.3. Each income

6 Prior to 2012, U.S. GAAP allowed a third presentation formatincluding OCIin the statement of stockholders equity. Tis was the primary choice by rms priorto 2012. Accounting Trends & Techniques-2010 New York: AICPA p. 425, indicates492 of 500 surveyed rms reported comprehensive income in their nancial state-ments with 408 of them doing so within the statement of stockholders equity. IFRSnever allowed the U.S. GAAP alternative of presenting OCI within the statement ofstockholders equity.


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statement account is closed to the permanent balance sheet account

retained earnings at the end of the period. Net income of the periodincreases retained earnings whereas a net loss would decrease retainedearnings. Te closing process accomplishes two things: 1) the incomestatement accounts are brought to a zero balance to accommodate thenext period, and 2) retained earnings is adjusted to the correct end ofperiod balance. Althoughdistributions to owners (dividends) do notaffect income in any way, dividends of the period do reduce the amountof retained earnings. Unlike net income that is closed to retained earnings,OCI is closed to accumulated other comprehensive income (AOCI),

which is another permanent component of equity. Te 12/31/11 balancesheet (Exhibit 1.1) does not include AOCI, which indicates Behrend hasno unrealized gain or loss from the four items included in OCI underGAAP at the beginning of the year. Since Behrend has no OCI during2012, net income and comprehensive income are one and the same, andno AOCI is reported at 12/31/12. Consistent with dividends,contribu-tions by owners do not affect income. Contributions by owners increasepaid in capital. Te statement of stockholders equity is generally con-

sidered to be of least importance to users.

Statement of Cash Flows

Like the income statement and the statement of stockholders equity, thestatement of cash ows is for a period of timethe year ended 12/31/2012.Te statement of cash ows shows the change in cash that occurred duringthe period in three categories: 1) operating, 2) investing, and 3) nancing.

Users place primary emphasis on the net cash ow from operating activitybecause a rms long-term viability is dependent upon its ability to gener-ate suffi cient positive net cash ow from its ongoing central operations.Ironically, GAAP does not provide an all-inclusive list of cash ows that areclassi ed as operating activities. Instead, GAAP speci cally identi es cash

ows that constitute investing or nancing activities, and any remainingcash ows not speci cally identi ed as investing or nancing are to beclassi ed as operating activities. Tere are two formats used in present-ing operating cash owthe direct method, and the indirect method.Behrend Corp. is using the direct presentation format in Exhibit 1.4.


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Investing activities include cash ow from purchase or sale of PP&E

and securities of other entities, making loans to other entities, and thecollection of principal on those loans. Financing activities include issu-ance and reacquisition of stock, issuance of debt, repayment of debtprincipal, and payment of dividends. Although an all-inclusive list is notprovided for operating activities, its main cash ow components generallyinclude: collections from customers, payments to suppliers, payments toemployees and others for expenses, payments of interest, and receipts ofinterest or dividends from investment securities. Teoretically, dividendsand interest received on investment securities are considered investingactivities, while interest paid on debt is considered a nancing activity.However, since GAAP does not speci cally identify them as such, theyare classi ed as operating activities.

Review of the Accounting Process

Te accounting process is the underlying system that accumulates therequisite information presented in the nancial statements. Using

Behrend Corp. as our example we will review the accounting processunder the accounting equation framework. We start with Behrendsbeginning balance sheet (Exhibit 1.1). Note that total assets ($940,000)are equal to the sum of liabilities ($675,000) and stockholders equity($265,000). Tis 12/31/2011 balance sheet information is transferred toExhibit 1.6 where we next illustrate the impact that various transactionsand events have on the accounting equation.

Summary Entries

Each transaction or event is individually entered into the accountingsystem. Summary entries are used here to illustrate the impact thatnumerous similar individual transactions have on the accounting equa-tion as a whole. For example, transaction b. involves sales to customers onaccount. Tis likely involves thousands of sales transactions throughout2012, each of which needs to be recorded. All of the sales for the entireyear are summarized, and the effects on the accounts analyzed as if there

was only one transaction recorded.


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E x h i b i t 1 . 6 . F i n a n c

i a l S t a t e m e n t E

f f e c t s o

f T r a n s a c t i o n s a n

d E v e n t s U s i n g t h e

A c c o u n t

i n g

E q u a t

i o n

F o r r m a t

C a s

h

S C F

c l a s s

A c c o u n t s

r e c e

i v a b l e

( n e t

)

I n v e n t o r y

P P & E

( n e t

)

=

A c c o u n t s

p a y a

b l e

D e b t

c u r r e n t l y

d u e

S a l a r i e s

& w

a g e s

p a y a

b l e

I n t e r e s t

p a y a

b l e

L o n g

t e r m

d e b t

+

P a i

d i n

c a p i t a

l R e t a i n e

d

e a r n

i n g s

E x p

l a n a -

t i o n o f

c h a n g e

i n

r e t a

i n e d

e a r n

i n g s

B e g i n n i n g

b a l a n c e s

( B a l a n c e

S h e e

t 1 2 / 3 1 / 1 1 )

1 5 0 , 0 0 0

1 4 0 , 0 0 0

2 5 0 , 0 0 0

4 0 0 , 0 0 0

=

1 0 0 , 0 0 0

1 0 0 , 0 0 0

5 0 , 0

0 0

2 5 , 0

0 0

4 0 0 , 0 0 0

1 0 0 , 0 0 0

1 6 5 , 0 0 0

S U M M A R Y E N T R I E S :

a . P u r . I n v .

f r o m s u p p l

i e r s

a l l o n

a c c o u n t

1 , 1 0 0 , 0 0 0

1 , 1 0 0 , 0 0 0

b . S a l e s t o

c u s t o m e r s a l

l

o n a c c o u n

t ,

a n d

1 , 9 0 0 , 0 0 0

1 , 9 0 0 , 0 0 0

R e v e n u e

e a r n e d

R e c o r d

c o s t o f s a l e s

a n d r e d u c e

i n v e n t o r y

< 1 , 0

0 0 , 0

0 0 >

< 1 , 0

0 0 , 0

0 0 >

C o s

t o f g o o

d s

s o l d

c . C o l l e c -

t i o n s

f r o m

c u s t o m e r s

1 , 8 9 0 , 0 0 0

O

< 1 , 8

9 0 , 0

0 0 >

d . P a y m e n

t s

t o i n v e n

t o r y

s u p p

l i e r s

< 1 , 1

2 0 , 0

0 0 >

O

< 1 , 1

2 0 , 0

0 0 >

( C o n t i n u e d )


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E x h i b i t 1 . 6 . F i n a n c

i a l S t a t e m e n t E

f f e c t s o

f T r a n s a c t i o n s a n

d E v e n t s U s i n g t h e

A c c o u n t

i n g

E q u a t

i o n

F o r r m a t

( C o n t i n u e

d )

C a s

h

S C F

c l a s s

A c c o u n t s

r e c e

i v a b l e

( n e t

)

I n v e n t o r y

P P & E

( n e t

)

=

A c c o u n t s

p a y a

b l e

D e b t

c u r r e n t l y

d u e

S a l a r i e s

& w

a g e s

p a y a

b l e

I n t e r e s t

p a y a

b l e

L o n g

t e r m

d e b t

+

P a i

d i n

c a p i t a

l R e t a i n e

d

e a r n

i n g s

E x p

l a n a -

t i o n o f

c h a n g e

i n

r e t a

i n e d

e a r n

i n g s

e . P a y m e n

t

t o e m p l o y e e s

< 6 0 0

, 0 0 0 >

O

< 5 0 , 0 0 0 >

< 5 5 0

, 0 0 0 >

s a l a r y

&

w a g e e x p .

f . P a y

e s t i m a t e

d

i n c o m e

t a x

f o r 2

0 1 2

< 2 0 , 0 0 0 >

O

< 2 0 , 0 0 0 >

I n c o m e

t a x e s

S P E C I F I C E N T R I E S :

g . P u r c h a s e

n e w v e h

i c l e

f o r c a s h

1 / 2 6 / 1 2

< 5 0 , 0 0 0 >

I

5 0 , 0

0 0

h . P a y f o r

m a r

k e t

r e s e a r c h p r o -

j e c t

3 / 1 2 / 1 2

< 5 5 , 0 0 0 >

O

< 5 5 , 0 0 0 >

R & D e x p .

i . P a y a n n u a l

i n t e r e s t o n

d e b t 6 / 3 0 / 1 2

< 5 0 , 0 0 0 >

O

< 2 5 , 0 0 0 >

< 2 5 , 0 0 0 >

I n t e r e s t e x p .

j . P r i n c i p a

l

p a y m e n

t o n

d e b t 6 / 3 0 / 1 2

< 1 0 0

, 0 0 0 >

F

< 1 0 0

, 0 0 0 >


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k . D e c l a r e

a n d p a y

d i v i

d e n d

9 / 3 0 / 1 2

< 2 5 , 0 0 0 >

F

< 2 5 , 0 0 0 >

N o t o n

i n c o m e

s t a t e .

l . M e t e o r

l o s s

t o b u i

l d .

1 0 / 1 9 / 1 2

< 5 0 , 0 0 0 >

< 5 0 , 0 0 0 >

E x t r a .

l o s s

b e f . t a x

m . I

s s u e

s t o c

k f o r c a s

h

1 2 / 3 0 / 1 2

5 0 , 0

0 0

F

5 0 , 0

0 0

A D J U S T

I N G E N T R I E S e a c h

d a t e d 1 2 / 3 1 / 1 2 :

n . D e p r e -

c i a t

i o n a n

d

a m o r

t i z a t i o n

f o r y e a r

< 4 0 , 0 0 0 >

< 4 0 , 0 0 0 >

D e p r e c i a t

i o n

e x p .

o . I n t e r e s t o n

d e b t 7 / 0 1 / 1 2

1 2 / 3 1 / 1 2

2 0 , 0

0 0

< 2 0 , 0 0 0 >

I n t e r e s t e x p .

p . W a g e s a n d

s a l a r i e s o w e d

a t 1 2 / 3 1 / 1 2

6 0 , 0

0 0

< 6 0 , 0 0 0 >

S a l a r y

&

w a g e e x p .

e n d i n g b a l -

a n c e s B a

l a n c e

S h e e

t

1 2 / 3 1 / 1 2

7 0 , 0

0 0

1 5 0 , 0 0 0

3 5 0 , 0 0 0

3 6 0 , 0 0 0

=

8 0 , 0 0 0

0

6 0 , 0

0 0

2 0 , 0

0 0

4 0 0 , 0 0 0

+

1 5 0 , 0 0 0

2 2 0 , 0 0 0


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ransaction a.Purchase inventory on account from suppliers for

$1,100,000. Te effects on the accounting equation are that the asset(inventory) and the liability (accounts payable) are both increased by$1,100,000.

ransaction b.Goods (inventory) is provided to customers onaccount for an aggregate selling price of $1,900,000. Also, assume thatBehrends cost of the inventory transferred to customers is $1,000,000.Because the goods are transferred to the customers in 2012, revenueshould be recognized in the 2012 income statement whether or not thecash is received in 2012. In terms of the accounting equation, the assetaccounts receivable is increased $1,900,000 as will be retained earnings

when the income statement account sales revenue is closed. Te expenserecognition principle requires that $1,000,000 cost of goods sold be rec-ognized in 2012 because the expense is directly related to the $1,900,000in sales revenue recognized. Te asset inventory is reduced by $1,000,000,as will be retained earnings when the income statement account cost ofgoods sold is closed.

ransaction c.Cash of $1,890,000 is collected from customers on

account. Tere is no effect on the right side of the accounting equation.Te asset cash is increased while the asset accounts receivable is decreased,each for $1,890,000. Tis cash in ow is classi ed as operating in thestatement of cash ows.

ransaction d.Cash of $1,120,000 is paid to suppliers on accountspayable. Both the asset cash and the liability accounts payable are reducedby $1,120,000. Tis cash out ow is classi ed as operating in the state-ment of cash ows.

ransaction e.Employees are paid monthly in the month fol-lowing the month of service. Tere is a one-month time lag betweenemployees providing services and Behrend paying them for those ser-vices. For example, employees are paid for work performed in Decem-ber 2011 in January 2012, work performed in January 2012 is paid inFebruary 2012, and work performed in December 2012 will notbe paid by Behrend until January 2013. Under the expense recogni-tion principle, this is an example of an expense that is directly relatedto periods of time. Te expense must be recognized in the periodthe employee provides the service, whether or not the cash is paid


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in that period. Behrend pays salaries and wages during 2012 in the

amount of $600,000. A portion of this payment ($50,000) relates toemployee services that were provided in December 2011 (see salariesand wages payable in the 12/31/11 balance sheet Exhibit 1.1), and theremainder ($550,000) is recognized as a 2012 expense because it relatesto services provided by employees from January through November2012. Note that an adjusting entry will be needed to recognize sala-ries and wages expense for December 2012 that will not be paid until

January 2013 (see adjustment p. below). Te effects on the accountingequation are: a reduction in the asset cash for $600,000, the liabilitysalaries and wages payable is decreased by $50,000, and retained earn-ings will be decreased by $550,000 when the income statement accountsalaries and wages expense is closed. Tis cash out ow is classi ed asoperating in the statement of cash ows.

ransaction f.Paid $20,000 in income taxes based upon estimated2012 taxable income of $100,000 and tax rate of 20%. Estimated taxpayments are due periodically during the year. Actual taxable income isequal to the $100,000 estimated, and the actual income tax due for the

year was $20,000.7 Note from the income statement (Exhibit 1.2) thatincome tax expense on the income statement is $30,000. Tis is basedupon the 20% rate applied to income from continuing operations beforetax ($150,000). Behrend experienced an extraordinary loss (event l.)below) of $50,000 before considering its tax bene t of $10,000 ($50,000loss deduction @ 20% = $10,000 tax savings). Tese two net out to thecorrect total tax provision, $20,000. Te effects on the accounting equa-tion are a decrease in cash of $20,000 and an eventual decrease in retainedearnings when the income statement accounts are closed. Tis cash out-

ow is classi ed as operating in the statement of cash ows.

Specic Transactions and Events

ransaction g.Purchased a new delivery truck for $50,000 cash on1/26/12. Te effects on the accounting equation are strictly within

7 Later in the text we discuss differences between GAAP-based income before tax andtaxable income per the return, but until then will assume there are no differences.


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assets with cash decreased and property plant and equipment (PP&E)

increased by $50,000. Tis cash out ow is classi ed as investing in thestatement of cash ows.ransaction h.On 3/12/12 Behrend received the results of a mar-

keting research project and immediately paid the research rm for itsservice, $55,000. Under the expense recognition principle, this is con-sidered R&D and must be immediately recognized as an expense becausethere is a high degree of uncertainty regarding whether or not a futurebene t will result. Te accounting equation is affected by a reduction inthe asset cash, and decrease in retained earnings when the income state-ment accounts are closed. Tis cash out ow is classi ed as operating inthe statement of cash ows.

ransaction i.Interest on outstanding debt is payable annually on6/30 at a 10% rate. Interest is calculated as: PRINCIPAL IN ER-ES RA E POR ION OF YEAR. Interest for the one year periodending 6/30/12 is $50,000 ($500,000 10% 12/12), half of whichis for the period 7/1/1112/31/11, and the other half is for the period1/1/126/30/12. Tis is the interest payable liability from the 12/31/11

balance sheet (Exhibit 1.1). Consistent with transaction e. above, this isan expense directly associated with speci c income statement time peri-ods and must be recognized in the period incurred regardless of when thecash is paid. Te effects on the accounting equation are cash is decreased$50,000, interest payable is decreased $25,000, and retained earnings isdecreased by $25,000 after closing the interest expense account. Notethat an adjustment will be needed at 12/31/12 to accrue interest expensefor the period 7/01/1212/31/12. Tis cash out ow is classi ed as oper-ating in the statement of cash ows.

ransaction j. Record the $100,000 debt principal payment madeon 6/30/12. Tis payment reduces cash and eliminates the $100,000 ofdebt currently due liability that appeared on the 12/31/11 balance sheet.Note that the amount of debt principal is reduced to $400,000. Tis cashout ow is classi ed as nancing in the statement of cash ows.

ransaction k.On 9/30/12 Behrend declared and paid a cash divi-dend to shareholders at the rate of $.25/share 100,000 shares = $25,000.Te effects on the accounting equation are cash and retained earnings are


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each decreased by $25,000.Tere is no income statement effect . Tis

cash out ow is classi ed as nancing in the statement of cash ows.Event l.On 10/19/12 a meteor fell from outer space and unfortu-nately destroyed an empty storage building with a book value of $50,000.Te loss was uninsured. Tis hopefully meets the criteria for classi cationas an extraordinary itemboth infrequent in occurrence and unusual innature. Te effects on the accounting equation are a decrease of $50,000in PP&E and an equal reduction in retained earnings to recognize thegross loss. Although the gross loss was $50,000, the associated tax deduc-tion with a 20% tax rate, results in a $10,000 tax bene t that reducesthe extraordinary loss reported in the income statement to $40,000(net of the $10,000 tax bene t). Recall that transaction f. discussed the2012 $20,000 overall tax burdens presentation in the income statement.Te amount of tax burden that would have been incurred if there wereno below the line items is reported as tax expense ($150,000 @ 20% =$30,000), above the line; and the tax bene t resulting from the taxdeductibility of the meteor damage reduces the reported extraordinaryloss, below the line.

ransaction m.Behrend issues an additional 50,000 shares of stockfor $1/share on 12/30/12. Te effects of this transaction on the account-ing equation are an increase in cash of $50,000 and an increase in paid incapital for an equal amount.Tere is no income statement effect . Tiscash in ow is classi ed as nancing in the statement of cash ows.

Adjusting Entries

Adjusting entries are necessary for the nancial statements to be pre-sented under the accrual basis of accounting, which is required underGAAP. Adjusting entries are generally needed in the case of accruals anddeferrals discussed previously, and therefore should affect at least oneincome statement account and at least one balance sheet account.

Adjustment n.Recognize depreciation expense. Te expenserecognition principle requires that when costs are incurred thatbene t multiple periods they be systematically and rationally recog-nized as expense over the estimated periods bene ted. Depreciation is


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an example of such a cost under the accrual basis of accounting. You

may be familiar with the straight line depreciation method. Underthe straight line method periodic depreciation is computed as: (ASSECOS -ES IMA ED RESIDUAL VALUE)/ES IMA ED SERVICELIFE. For purposes of this example assume PP&E has an aggregate costof $600,000, zero estimated residual value, and an average estimatedservice life of 15 years. Assuming Behrend uses the straight line method,annual depreciation is computed as: ($600,000 $0)/15 years = $40,000per year. Te effects of this adjustment on the accounting equation arePP&E (net) is reduced by $40,000 and retained earnings is reducedby $40,000 when the income statement account depreciation expenseis closed. Note that PP&E (net) represents the book value of theassets. Book value is equal to cost minus accumulated depreciation. At12/31/11 Behrend had PP&E with a cost of $600,000 and a book valueof $400,000, which indicates that accumulated depreciation at thebeginning of the year was $200,000.

Adjustment o.Recognize interest expense incurred but not paid onoutstanding debt. Recall from transaction j. that interest cost incurred for

the period 7/1/1212/31/12 must be recognized as expense on the 2012income statement even though it will not be paid until 6/30/13. Inter-est expense for this period is computed as: $400,000 10% 6/12 =$20,000. Te effects of the adjustment on the accounting equation are toincrease the liability account interest payable by $20,000 and to reduceretained earnings by $20,000 when the income statement account inter-est expense is closed. Note that the income statement now includes inter-est expense for the full calendar year 2012 of $45,000, $25,000 for the

rst six months, plus $20,000 for the last six months. Te $20,000 inter-est expense that will be paid on 6/30/13 is presented in the 12/31/12balance sheet as a current liability.

Adjustment p.Recognize salaries and wages expense for employeeservices provided in December 2012 that will be paid in January 2013.

As discussed in transaction e. under the accrual basis salaries and wagesmust be recognized as expense in the period the employee providesthe services, whether or not paid in that period. In order to recognizeexpense for the full calendar year, an adjustment is necessary to rec-ognize the expense for December employee services. Assume that the


33/34


December payroll is $60,000. Te necessary adjustment increases the

liability salaries and wages payable by $60,000 and also reduces retainedearnings by $60,000 when the income statement account salaries and wages expense is closed to retained earnings. Note that this adjust-ment combined with transaction e. provides that the income statementinclude salaries and wages expense for the full year 2012 of $610,000,$550,000 of which was paid in 2012 and the $60,000 accrual that willbe paid in 2013. Note also that the 12/31/12 balance sheet re ects thecurrent liability salaries and wages payable for $60,000.

In summary, we started the accounting process using the beginning ofthe period balance sheet at 12/31/11. Pertinent transactions and adjust-ments recorded during the year using the accounting equation format

were used to develop the change statements for the year ended 12/31/12(income statement, statement of stockholders equity, and statement ofcash ows). After closing, the effects of all changes are re ected in theyear-end balance sheet at 12/31/12. We will continue to use the account-ing equation format to illustrate the effects of particular transactions andevents upon the nancial statements in all future chapters.


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