16.2: Standardizing Financial Statements

16.2.1: Income Statements

Learning Objective

Describe the different methods used for presenting data in a company’s income statement

Key Points

• Income statement displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write offs (e.g., depreciation and amortization of various assets) and taxes.
• The income statement can be prepared in one of two methods: The Single Step income statement and Multi-Step income statement.
• The income statement includes revenue, expenses, COGS, SG&A, depreciation, other revenues and expenses, finance costs, income tax expense, and net income.

Key Term

intangible asset

Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched, or physically measured, and are created through time and effort, and are identifiable as a separate asset.

Income Statement

Income statement (also referred to as profit and loss statement [P&L]), revenue statement, a statement of financial performance, an earnings statement, an operating statement, or statement of operations) is a company’s financial statement. This indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as “Net Profit” or the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.

Income statement

GAAP and IRS accounting can differ.

Two Methods

• The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line.
• The Multi-Step income statement (as the name implies) takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.

Operating Section

• Revenue – cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances. Every time a business sells a product or performs a service, it obtains revenue. This often is referred to as gross revenue or sales revenue.
• Expenses – cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major operations.
• Cost of Goods Sold (COGS)/Cost of Sales – represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandizing). It includes material costs, direct labor, and overhead costs (as in absorption costing), and excludes operating costs (period costs), such as selling, administrative, advertising or R&D, etc.
• Selling, General and Administrative expenses (SG&A or SGA) – consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs such as direct labour.
• Selling expenses – represent expenses needed to sell products (e.g., salaries of sales people, commissions, and travel expenses; advertising; freight; shipping; depreciation of sales store buildings and equipment, etc.).
• General and Administrative (G&A) expenses – represent expenses to manage the business (salaries of officers/executives, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies, etc.).
• Depreciation/Amortization – the charge with respect to fixed assets/intangible assets that have been capitalized on the balance sheet for a specific (accounting) period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.
• Research & Development (R&D) expenses – represent expenses included in research and development.
• Expenses recognized in the income statement should be analyzed either by nature (raw materials, transport costs, staffing costs, depreciation, employee benefit, etc.) or by function (cost of sales, selling, administrative, etc.).

Non-operating Section

• Other revenues or gains – revenues and gains from other than primary business activities (e.g., rent, income from patents).
• Other expenses or losses – expenses or losses not related to primary business operations, (e.g., foreign exchange loss).
• Finance costs – costs of borrowing from various creditors (e.g., interest expenses, bank charges).
• Income tax expense – sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities/tax payable) and the amount of deferred tax liabilities (or assets).
• Irregular items – are reported separately because this way users can better predict future cash flows – irregular items most likely will not recur. These are reported net of taxes.

Bottom Line

Bottom line is the net income that is calculated after subtracting the expenses from revenue. Since this forms the last line of the income statement, it is informally called “bottom line. ” It is important to investors as it represents the profit for the year attributable to the shareholders.

16.2.2: Balance Sheets

Learning Objective

Identify the basics of a balance sheet

Key Points

• Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business’ calendar year.
• The main categories of assets are usually listed first (in order of liquidity) and are followed by the liabilities.
• The difference between the assets and the liabilities is known as “equity”.
• Balance sheets can either be in the report form or the account form.
• A balance sheet is often presented alongside one for a different point in time (typically the previous year) for comparison.
• Guidelines for balance sheets of public business entities are given by the International Accounting Standards Board and numerous country-specific organizations/companies.

Key Terms

asset

Something or someone of any value; any portion of one’s property or effects so considered.

equity

Ownership, especially in terms of net monetary value, of a business.

balance sheet

A summary of a person’s or organization’s assets, liabilities and equity as of a specific date.

Balance sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation or other business organization, such as an LLC or an LLP. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a “snapshot of a company’s financial condition. ” Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business’ calendar year.

A standard company balance sheet has three parts: assets, liabilities, and ownership equity. The main categories of assets are usually listed first, and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as “equity. ” Equity is the net assets or net worth of the capital of the company. According to the accounting equation, net worth must equal assets minus liabilities.

Balance Sheet Example

Types

A balance sheet summarizes an organization or individual’s assets, equity, and liabilities at a specific point in time. We have two forms of balance sheet. They are the report form and the account form. Individuals and small businesses tend to have simple balance sheets. Larger businesses tend to have more complex balance sheets, and these are presented in the organization’s annual report. Large businesses also may prepare balance sheets for segments of their businesses. A balance sheet is often presented alongside one for a different point in time (typically the previous year) for comparison.

Personal Balance Sheet

A personal balance sheet lists current assets, such as cash in checking accounts and savings accounts; long-term assets, such as common stock and real estate; current liabilities, such as loan debt and mortgage debt due; or long-term liabilities, such as mortgage and other loan debt. Securities and real estate values are listed at market value rather than at historical cost or cost basis. Personal net worth is the difference between an individual’s total assets and total liabilities.

U.S. Small Business Balance Sheet

A small business balance sheet lists current assets, such as cash, accounts receivable and inventory; fixed assets, such as land, buildings, and equipment; intangible assets, such as patents; and liabilities, such as accounts payable, accrued expenses, and long-term debt. Contingent liabilities, such as warranties, are noted in the footnotes to the balance sheet. The small business’s equity is the difference between total assets and total liabilities.

Public Business Entities Balance Sheet

Structure

Guidelines for balance sheets of public business entities are given by the International Accounting Standards Board and numerous country-specific organizations/companies.

Balance sheet account names and usage depend on the organization’s country and the type of organization. Government organizations do not generally follow standards established for individuals or businesses.

If applicable to the business, summary values for the following items should be included in the balance sheet: Assets are all the things the business owns, including property, tools, cars, etc.

Assets:

1. Current assets

• Cash and cash equivalents
• Accounts receivable
• Inventories
• Prepaid expenses for future services that will be used within a year

2. Non-current assets (fixed assets)

• Property, plant, and equipment.
• Investment property, such as real estate held for investment purposes.
• Intangible assets.
• Financial assets (excluding investments accounted for using the equity method, accounts receivables, and cash and cash equivalents).
• Investments accounted for using the equity method
• Biological assets, which are living plants or animals. Bearer biological assets are plants or animals which bear agricultural produce for harvest, such as apple trees grown to produce apples and sheep raised to produce wool.

Liabilities:

• Accounts payable.
• Provisions for warranties or court decisions.
• Financial liabilities (excluding provisions and accounts payable), such as promissory notes and corporate bonds.
• Liabilities and assets for current tax.
• Deferred tax liabilities and deferred tax assets.
• Unearned revenue for services paid for by customers but not yet provided.

Equity:

• Issued capital and reserves attributable to equity holders of the parent company (controlling interest).
• Non-controlling interest in equity.

Regarding the items in equity section, the following disclosures are required:

• Numbers of shares authorized, issued and fully paid, and issued but not fully paid.
• Par value of shares.
• Reconciliation of shares outstanding at the beginning and the end of the period/
• Description of rights, preferences, and restrictions of shares.
• Treasury shares, including shares held by subsidiaries and associates.
• Shares reserved for issuance under options and contracts.
• A description of the nature and purpose of each reserve within owners’ equity

16.3: Ratio Analysis Overview

16.3.1: Classification

Ratio analysis consists of calculating financial performance using five basic types of ratios: profitability, liquidity, activity, debt, and market.

Learning Objective

Classify a financial ratio based on what it measures in a company

Key Points

• Ratio analysis consists of the calculation of ratios from financial statements and is a foundation of financial analysis.
• A financial ratio, or accounting ratio, shows the relative magnitude of selected numerical values taken from those financial statements.
• The numbers contained in financial statements need to be put into context so that investors can better understand different aspects of the company’s operations. Ratio analysis is one method an investor can use to gain that understanding.

Key Terms

liquidity

Availability of cash over short term: ability to service short-term debt.

ratio

A number representing a comparison between two things.

ratio analysis

the use of quantitative techniques on values taken from an enterprise’s financial statements

shareholder

One who owns shares of stock.

Classification

Financial statements are generally insufficient to provide information to investors on their own; the numbers contained in those documents need to be put into context so that investors can better understand different aspects of the company’s operations. Ratio analysis is one of three methods an investor can use to gain that understanding.

Business analysis and profitability

Financial ratio analysis allows an observer to put the data provided by a company in context. This allows the observer to gauge the strength of different aspects of the company’s operations.

Financial statement analysis is the process of understanding the risk and profitability of a firm through analysis of reported financial information. Ratio analysis is a foundation for evaluating and pricing credit risk and for doing fundamental company valuation. A financial ratio, or accounting ratio, is derived from a company’s financial statements and is a calculation showing the relative magnitude of selected numerical values taken from those financial statements.

There are various types of financial ratios, grouped by their relevance to different aspects of a company’s business as well as to their interest to different audiences. Financial ratios may be used internally by managers within a firm, by current and potential shareholders and creditors of a firm, and other audiences interested in understanding the strengths and weaknesses of a company, especially compared to the company over time or compared to other companies.

Types of Ratios

Most analysts think of financial ratios as consisting of five basic types:

• Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.
• Liquidity ratios measure the availability of cash to pay debt.
• Activity ratios, also called efficiency ratios, measure the effectiveness of a firm’s use of resources, or assets.
• Debt, or leverage, ratios measure the firm’s ability to repay long-term debt.
• Market ratios are concerned with shareholder audiences. They measure the cost of issuing stock and the relationship between return and the value of an investment in company’s shares.

16.4: Using Financial Ratios for Analysis

16.4.1: Limitations of Financial Statement Analysis

Financial statement analyses can yield a limited view of a company because of accounting, market, and management related limitations of such analyses.

Learning Objective

Describe the limitations associated with using ratio analysis

Key Points

• Ratio analysis is hampered by potential limitations with accounting and the data in the financial statements themselves. This can include errors as well as accounting mismanagement, which involves distorting the raw data used to derive financial ratios.
• Proponents of the stronger forms of the efficient-market hypothesis, technical analysts, and behavioral economists argue that fundamental analysis is limited as a stock valuation tool, all for their own distinct reasons.
• Ratio analysis can also omit important aspects of a firm’s success, such as key intangibles, like brand, relationships, skills and culture. These are primary drivers of success over the longer term even though they are absent from conventional financial statements.
• Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers that may not provide adequate context or be comparable across time or industry.

Key Term

valuation

The process of estimating the market value of a financial asset or liability.

Limitations of Financial Statement Analysis

Ratio analysis using financial statements includes accounting, stock market, and management related limitations. These limits leave analysts with remaining questions about the company.

First of all, ratio analysis is hampered by potential limitations with accounting and the data in the financial statements themselves. This can include errors as well as accounting mismanagement, which involves distorting the raw data used to derive financial ratios. While accounting measures may have more external standards and oversights than many other ways of benchmarking companies, this is still a limit.

Ratio analysis using financial statements as a tool for performing stock valuation can be limited as well. The efficient-market hypothesis (EMH), for example, asserts that financial markets are “informationally efficient. ” In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. While the weak form of this hypothesis argues that there can be a long run benefit to information derived from fundamental analysis, stronger forms argue that fundamental analysis like ratio analysis will not allow for greater financial returns.

In another view on stock markets, technical analysts argue that sentiment is as much if not more of a driver of stock prices than is the fundamental data on a company like its financials. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These audiences also see limits to ratio analysis as a predictor of stock market returns.

At the management and investor level, ratio analysis using financial statements can also leave out a number of important aspects of a firm’s success, such as key intangibles, like brand, relationships, skills, and culture. These are primary drivers of success over the longer term even though they are absent from conventional financial statements.

Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers. Also, changes in the information underlying ratios can hamper comparisons across time and inconsistencies within and across the industry can also complicate comparisons.

16.4.2: Trend Analysis

Trend analysis consists of using ratios to compare company performance on an indicator over time, often to forecast or inform future events.

Learning Objective

Analyze the benefits and challenges of using trend analysis to evaluate a company

Key Points

• Trend analysis is the practice of collecting information and attempting to spot a pattern or trend in the same metric historically, either by examining it in tables or charts. Often this trend analysis is used to predict or inform decisions around future events.
• Trend analysis can be performed in different ways in finance. Fundamental analysis relies on historical financial statement analysis, often in the form of ratio analysis.
• Trend analysis using financial ratios can be complicated by changes to companies and accounting over time. For example, a company may change its business model and begin to operate in a new industry or it may change the end of its financial year or the way it accounts for inventories.

Key Terms

sentiment

A general thought, feeling, or sense.

forecast

An estimation of a future condition.

In addition to using financial ratio analysis to compare one company with others in its peer group, ratio analysis is often used to compare the company’s performance on certain measures over time. Trend analysis is the practice of collecting information and attempting to spot a pattern, or trend, in the information. This often involves comparing the same metric historically, either by examining it in tables or charts. Often this trend analysis is used to forecast or inform decisions around future events, but it can be used to estimate uncertain events in the past .

Trend Analysis

Determining the popularity and demand for specific subject over time through trend analysis.

Trend analysis can be performed in different ways in finance. For example, in technical analysis the direction of prices of a particular company’s public stock is calculated through the study of past market data, primarily price, and volume. Fundamental analysis, on the other hand, relies not on sentiment measures (like technical analysis) but on financial statement analysis, often in the form of ratio analysis. Creditors and company managers also use ratio analysis as a form of trend analysis. For example, they may examine trends in liquidity or profitability over time.

Trend analysis using financial ratios can be complicated by the fact that companies and accounting can change over time. For example, a company may change its business model so that it begins to operate in a new industry or it may change the end of its financial year or the way it accounts for inventories. When examining historical trends in ratios, analysts will often make adjustments to the ratios for these reasons, perhaps performing some ratio analysis in which they segment out business segments that are not consistent over time or they separate recurring from non-recurring items.

16.4.3: Benchmarking

Comparing the financial ratios of a company to those of the top performer in its class is a type of benchmarking.

Learning Objective

Describe how benchmarking can be used to assess the strength of a company

Key Points

• Financial ratios allow for comparisons and, therefore, are intertwined with the process of benchmarking, comparing one’s business to that of relevant others or of the same company at a different point in time processes on a specific indicator or series of indicators.
• Benchmarking can be done in many ways and ratio analysis is only one of these. One benefit of ratio analysis as a component of benchmarking is that many financial ratios are well-established calculations derived from verified data.
• Benchmarking using ratio analysis can be useful to various audiences; for example, investors and managers interested in incorporate quantitative comparisons of a company to peers.

Key Terms

benchmark

A standard by which something is evaluated or measured.

ratio

A number representing a comparison between two things.

Benchmarking

Financial ratios allow for comparisons and, therefore, are intertwined with the process of benchmarking, comparing one’s business to that of others or of the same company at a different point in time. In many cases, benchmarking involves comparisons of one company to the best companies in a comparable peer group or the average in that peer group or industry. In the process of benchmarking, an analyst or manager identifies the best firms in their industry, or in another industry where similar processes exist, and compares the results and processes of those studied to one’s own results and processes on a specific indicator or series of indicators.

Benchmarking Measures Performance

Results are the paramount concern to a transactional leader.

Benchmarking can be done in many ways, and ratio analysis is only one of these. One benefit of ratio analysis as a component of benchmarking is that many financial ratios are well-established calculations derived from verified data. In benchmarking as a whole, benchmarking can be done on a variety of processes, meaning that definitions may change over time within the same organization due to changes in leadership and priorities. The most useful comparisons can be made when metrics definitions are common and consistent between compared units and over time.

Benchmarking using ratio analysis can be useful to various audiences. From an investor perspective, benchmarking can involve comparing a company to peer companies that can be considered alternative investment opportunities from the perspective of an investor. In this process, the investor may compare the focus company to others in the peer group (leaders, averages) on certain financial ratios relevant to those companies and the investor’s investment style. From a management perspective, benchmarking using ratio analysis may be a way for a manager to compare their company to peers using externally recognizable, quantitative data.

16.4.4: Industry Comparisons

While ratio analysis can be quite helpful in comparing companies within an industry, cross-industry comparisons should be done with caution.

Learning Objective

Describe how valuation methodologies are used to compare different companies in different sectors

Key Points

• One of the advantages of ratio analysis is that it allows comparison across companies. However, while ratios can be quite helpful in comparing companies within an industry and even across some similar industries, cross-industry comparisons may not be helpful and should be done with caution.
• An industry represents a classification of companies by economic activity, but “industry” can be too broad or narrow a definition for ratio analysis comparison. When comparing ratios, companies should be comparable in terms of having similar characteristics in the statistics being analyzed.
• Valuation using multiples only reveals patterns in relative values. For multiples to be useful, the statistic involved must bear a logical, meaningful relationship to the market value observed, which is something that can vary across industry.

Key Terms

metric

A measure for something; a means of deriving a quantitative measurement or approximation for otherwise qualitative phenomena.

valuation

The process of estimating the market value of a financial asset or liability.

One of the advantages of ratio analysis is that it allows comparison across companies, an activity which is often called benchmarking. However, while ratios can be quite helpful in comparing companies within an industry and even across some similar industries, comparing ratios of companies across different industries may not be helpful and should be done with caution .

Industry

Comparing ratios of companies within an industry can allow an analyst to make like to like (apples to apples) comparisons. Comparisons across industries may be like to unlike (apples to oranges) comparisons, and thus less useful.

An industry represents a classification of companies by economic activity. At a very broad level, industry is sometimes classified into three sectors: primary or extractive, secondary or manufacturing, and tertiary or services. At a very detailed level are classification systems like the ISIC (International Standard Industrial Classification).

However, in terms of ratio analysis and comparing companies, it is most helpful to consider whether the companies being compared are comparable in the financial metrics being evaluated in the ratios. Different businesses will have different ratios for different reasons. A peer group is a set of companies or assets which are selected as being sufficiently comparable to the company or assets being valued (usually by virtue of being in the same industry or by having similar characteristics in terms of earnings growth and return on investment). From the investor perspective, peers can include companies that are not only direct product competitors but are subject to similar cycles, suppliers, and other external factors.

Valuation using multiples involves estimating the value of an asset by comparing it to the values assessed by the market for similar or comparable assets in the peer group. A valuation multiple is simply an expression of market value of an asset relative to a key statistic that is assumed to relate to that value. To be useful, that statistic – whether earnings, cash flow, or some other measure – must bear a logical relationship to the market value observed; to be seen, in fact, as the driver of that market value. The price to earnings ratio, for example, is a common multiple but can differ across companies that have different capital structures; this could make it difficult to compare this particular ratio across industries.

Additionally, there could be problems with the valuation of an entire industry, making ratio analysis of a company relative to an industry less useful. The use of multiples only reveals patterns in relative values, not absolute values such as those obtained from discounted cash flow valuations. If the peer group as a whole is incorrectly valued (such as may happen during a stock market “bubble”), then the resulting multiples will also be misvalued.

16.4.5: Evaluating Financial Statements

With a few exceptions, the majority of the data used in ratio analysis comes from evaluation of the financial statements.

Learning Objective

Differentiate between recurring and non-recurring items in financial reports

Key Points

• Ratio analysis is a tool for evaluating financial statements but also relies on the numbers in the reported financial statements being put into order to be used for comparison. With a few exceptions, the majority of the data used in ratio analysis comes from the financial statements.
• Prior to the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies.
• In terms of reformulation, earnings might be separated into recurring and non-recurring items. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

Key Terms

valuation

The process of estimating the market value of a financial asset or liability.

earnings management

A euphemism, such as creative accounting, to refer to fraudulent accounting practices that manipulate reporting of income, assets or liabilities with the intent to influence interpretations of the income statements.

Ratio analysis is a tool for evaluating financial statements but also relies on the numbers in the reported financial statements being put into order to be used as ratios for comparison over time or across companies. Financial statements are used as a way to discover the financial position and financial results of a business. With a few exceptions, such as ratios involving stock price, the majority of the data used in ratio analysis comes from the financial statements. Ratios put this financial statement information in context.

Putting Numbers in Order

Evaluating financial statements involves getting the numbers in order and then using these figures to perform ratio analysis.

Prior to the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies. In terms of reformulation, one common reformulation is to divide reported items into recurring or normal items and non-recurring or special items. In this way, earnings could be separated into normal or core earnings and transitory earnings with the idea that normal earnings are more permanent and hence more relevant for prediction and valuation. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

The evaluation of a company’s financial statement analysis is a form of fundamental analysis that is bottoms up. While analysis of a company’s prospects can include a number of factors, including understanding the economic situation or the industry or sentiment about the company or its products, ratio analysis of a company relies on the specific company financials.

16.4.6: Selected Financial Ratios and Analyses

Financial ratios and their analysis provide information on a firm’s profitability and allow comparisons between the firm and its industry.

Learning Objective

Summarize how an interested party would use financial ratios to analyze a company’s financial statement

Key Points

• When using comparative financial statements, the calculation of dollar or percentage changes in the statement items or totals from one period to the next or for the timeframe presented is referred to as horizontal analysis.
• Vertical analysis performed on an income statement is especially helpful in analyzing the relationships between revenue and expense items, such as the percentage of cost of goods sold to sales.
• Financial ratios, which compare one value in relation to another value over a 12 month period, are computed using information from a company’s financial statements. Ratios can identify various financial attributes, such as solvency and liquidity, profitability, and return on equity.
• An example of a financial ratio is the current ratio, used to determine a company’s liquidity, or its ability to meet its short term obligations. When comparing two companies, in theory, the entity with the higher current ratio is more liquid than the other.
• Often a financial ratio, which is a relative magnitude of two selected numerical values taken from a company’s financial statements is used to find out a specific piece of information such as the quality of income.

Key Terms

solvency

The state of having enough funds or liquid assets to pay all of one’s debts; the state of being solvent.

comparative

Comparable; bearing comparison.

trend

an inclination in a particular direction

Analyzing the Financial Statements

Analyzing a company’s financial statements allows interested parties (investors, creditors and company management) to get an overall picture of the financial condition and profitability of a company. There are several ways to analyze a company’s financial statements.

Horizontal vs. Vertical Analysis

Two main methods for analysis are horizontal and vertical analysis. When using comparative financial statements, the calculation of dollar or percentage changes in the statement items or totals over time is horizontal analysis. This analysis detects changes in a company’s performance and highlights trends.

Vertical analysis is usually performed on a single financial statement (i.e., income statement): each item is expressed as a percentage of a significant total. Vertical analysis performed on an income statement is especially helpful in analyzing the relationships between revenue and expense items, such as the percentage of cost of goods sold to sales.

The Balance Sheet

If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

Using Ratios

Financial ratios, which compare one value in relation to another value over a 12 month period, are computed using information from a company’s financial statements. Ratios can identify various financial attributes of a company, such as solvency and liquidity, profitability (quality of income), and return on equity. A company’s financial ratios can also be compared to those of their competitors to determine how the company is performing in relation to the rest of the industry.

Financial ratios may be used by managers within a firm, by current and potential shareholders (owners), and by a firm’s creditors. For example, financial analysts compute financial ratios of public companies to evaluate their strengths and weaknesses and to identify which companies are profitable investments and which are not. Changes in financial ratios can impact a public company’s stock price, depending on the effect the change has on the business. A publicly traded company’s stock price can also be a variable used in the computation of certain ratios, such as the price/earnings ratio.

Examples of Ratios

The following are some examples of financial ratios that are used to analyze a company. For example, the quality of income ratio is computed by dividing cash flow from operating activities (CFOA) by net income:

Quality of income = CFOA / Net income

This ratio indicates the proportion of income that has been realized in cash. As with quality of sales, high levels for this ratio are desirable. The quality of income ratio has a tendency to exceed 100% because depreciation expense decreases net income and cash outflows to replace operating assets (part of cash flow from investing activities) is not subtracted when calculating the numerator.

Capital

Acquisition Ratio = (cash flow from operations – dividends) / cash paid for acquisitions.

The capital acquisition ratio reflects the company’s ability to finance capital expenditures from internal sources. A ratio of less than 1:1 (100 %) indicates that capital acquisitions are draining more cash from the business than they are generating revenues.

Current Ratio = Current Assets/Current

Liabilities

The current ratio is used to determine a company’s liquidity, or its ability to meet its short term obligations. When comparing two companies, in theory, the entity with the higher current ratio is more liquid than the other. However, it is important to note that determination of a company’s solvency is based on various factors and not just the value of the current ratio.

16.5: Liquidity Ratios

16.5.1: Current Ratio

Current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.

Learning Objective

Use a company’s current ratio to evaluate its short-term financial strength

Key Points

• The liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings.
• The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.
• Current ratio = current assets / current liabilities.
• Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses.

Key Terms

working capital management

Decisions relating to working capital and short term financing are referred to as working capital management [19]. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities.

current ratio

current assets divided by current liabilities

Liquidity Ratio

Liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means it is fully covered .

Liquidity

High liquidity means a company has the ability to meet its short-term obligations.

Liquidity ratio may refer to:

• Reserve requirement – a bank regulation that sets the minimum reserves each bank must hold.
• Acid Test – a ratio used to determine the liquidity of a business entity.

The formula is the following:

LR = liquid assets / short-term liabilities

Current Ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm’s current assets to its current liabilities. It is expressed as follows:

Current ratio = current assets / current liabilities

• Current asset is an asset on the balance sheet that can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash, cash equivalents, short-term investments, accounts receivable, inventory, and the portion of prepaid liabilities that will be paid within a year.
• Current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.

The current ratio is an indication of a firm’s market liquidity and ability to meet creditor’s demands. Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company’s current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management. In such a situation, firms should consider investing excess capital into middle and long term objectives.

Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, low values do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio less than one. For example, if inventory turns over much more rapidly than the accounts payable do, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

If all other things were equal, a creditor, who is expecting to be paid in the next 12 months, would consider a high current ratio to be better than a low current ratio. A high current ratio means that the company is more likely to meet its liabilities which fall due in the next 12 months.

16.5.2: Quick Ratio (Acid-Test Ratio)

The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately.

Learning Objective

Calculate a company’s quick ratio

Key Points

• Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.
• Acid Test Ratio = (Current assets – Inventory) / Current liabilities.
• Ideally, the acid test ratio should be 1:1 or higher, however this varies widely by industry. In general, the higher the ratio, the greater the company’s liquidity.

Key Term

Treasury bills

Treasury bills (or T-Bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity.

Quick ratio

In finance, the Acid-test (also known as quick ratio or liquid ratio) measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. A company with a Quick Ratio of less than 1 cannot pay back its current liabilities.

Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company’s balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence. They mature within 3 months, whereas short-term investments are 12 months or less and long-term investments are any investments that mature in excess of 12 months. Another important condition that cash equivalents need to satisfy, is the investment should have insignificant risk of change in value. Thus, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can be.

Cash

Cash is the most liquid asset in a business.

Acid test ratio

Acid test often refers to Cash ratio instead of Quick ratio: Acid Test Ratio = (Current assets – Inventory) / Current liabilities.

Note that Inventory is excluded from the sum of assets in the Quick Ratio, but included in the Current Ratio. Ratios are tests of viability for business entities but do not give a complete picture of the business’ health. A business with large Accounts Receivable that won’t be paid for a long period (say 120 days), and essential business expenses and Accounts Payable that are due immediately, the Quick Ratio may look healthy when the business could actually run out of cash. In contrast, if the business has negotiated fast payment or cash from customers, and long terms from suppliers, it may have a very low Quick Ratio and yet be very healthy.

The acid test ratio should be 1:1 or higher, however this varies widely by industry. The higher the ratio, the greater the company’s liquidity will be (better able to meet current obligations using liquid assets).

16.6: Debt-Management Ratios

16.6.1: Times-Interest-Earned Ratio

Times Interest Earned ratio (EBIT or EBITDA divided by total interest payable) measures a company’s ability to honor its debt payments.

Learning Objective

Use a company’s index coverage ratio to evaluate its ability to meet its debt obligations

Key Points

• Times interest earned (TIE) or Interest Coverage ratio is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest payable.
• Interest Charges = Traditionally “charges” refers to interest expense found on the income statement.
• EBIT = Revenue – Operating expenses (OPEX) + Non-operating income.
• EBITDA = Earnings before interest, taxes, depreciation and amortization.
• Times Interest Earned or Interest Coverage is a great tool when measuring a company’s ability to meet its debt obligations.

Key Term

Non-operating income

Non-operating income, in accounting and finance, is gains or losses from sources not related to the typical activities of the business or organization. Non-operating income can include gains or losses from investments, property or asset sales, currency exchange, and other atypical gains or losses.

Times interest earned (TIE), or interest coverage ratio, is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA, divided by the total interest payable.

Times-Interest-Earned = EBIT or EBITDA / Interest charges

Interest

Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.

Times-Interest-Earned = EBIT or EBITDA / Interest charges

• Interest Charges = Traditionally “charges” refers to interest expense found on the income statement.
• EBIT = Earnings Before Interest and Taxes, also called operating profit or operating income. EBIT is a measure of a firm’s profit that excludes interest and income tax expenses. It is the difference between operating revenues and operating expenses. When a firm does not have non-operating income, then operating income is sometimes used as a synonym for EBIT and operating profit.
• EBIT = Revenue – Operating Expenses (OPEX) + Non-operating income.
• Operating income = Revenue – Operating expenses.
• EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization. The EBITDA of a company provides insight on the operational profitability of the business. It shows the profitability of a company regarding its present assets and operations with the products it produces and sells, taking into account possible provisions that need to be done.

If EBITDA is negative, then the business has serious issues. A positive EBITDA, however, does not automatically imply that the business generates cash. EBITDA ignores changes in Working Capital (usually needed when growing a business), capital expenditures (needed to replace assets that have broken down), taxes, and interest.

Times Interest Earned or Interest Coverage is a great tool when measuring a company’s ability to meet its debt obligations. When the interest coverage ratio is smaller than 1, the company is not generating enough cash from its operations EBIT to meet its interest obligations. The Company would then have to either use cash on hand to make up the difference or borrow funds. Typically, it is a warning sign when interest coverage falls below 2.5x.

16.6.2: Total Debt to Total Assets

The debt ratio is expressed as Total debt / Total assets.

Learning Objective

Use a company’s debt ratio to evaluate its financial strength

Key Points

• The debt ratio measures the firm’s ability to repay long-term debt by indicating the percentage of a company’s assets that are provided via debt.
• Debt ratio = Total debt / Total assets.
• The higher the ratio, the greater risk will be associated with the firm’s operation.

Key Terms

goodwill

Goodwill is an accounting concept meaning the value of an asset owned that is intangible but has a quantifiable “prudent value” in a business for example a reputation the firm enjoyed with its clients.

debt to total assets ratio

after tax income divided by liabilities

Example

• For example, a company with 2 million in total assets and 500,000 in total liabilities would have a debt ratio of 25%.

Financial Ratios

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures.

Financial ratios allow for comparisons:

• Between companies
• Between industries
• Between different time periods for one company
• Between a single company and its industry average

Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition, are usually hard to compare.

Debt ratios

Debt

Debt ratio is an index of a business operation.

Debt ratios measure the firm’s ability to repay long-term debt. It is a financial ratio that indicates the percentage of a company’s assets that are provided via debt. It is the ratio of total debt (the sum of current liabilities and long-term liabilities) and total assets (the sum of current assets, fixed assets, and other assets such as ‘goodwill’).

• Debt ratio = Total debt / Total assets

Or alternatively:

• Debt ratio = Total liability / Total assets

The higher the ratio, the greater risk will be associated with the firm’s operation. In addition, high debt to assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the firm’s financial flexibility. Like all financial ratios, a company’s debt ratio should be compared with their industry average or other competing firms.

Total liabilities divided by total assets. The debt/asset ratio shows the proportion of a company’s assets which are financed through debt. If the ratio is less than 0.5, most of the company’s assets are financed through equity. If the ratio is greater than 0.5, most of the company’s assets are financed through debt. Companies with high debt/asset ratios are said to be “highly leveraged,” not highly liquid as stated above. A company with a high debt ratio (highly leveraged) could be in danger if creditors start to demand repayment of debt.

16.7: Profitability Ratios

16.7.1: Basic Earning Power (BEP) Ratio

The Basic Earning Power ratio (BEP) is Earnings Before Interest and Taxes (EBIT) divided by Total Assets.

Learning Objective

Calculate a company’s Basic Earning Power ratio

Key Points

• The higher the BEP ratio, the more effective a company is at generating income from its assets.
• Using EBIT instead of operating income means that the ratio considers all income earned by the company, not just income from operating activity. This gives a more complete picture of how the company makes money.
• BEP is useful for comparing firms with different tax situations and different degrees of financial leverage.

Key Terms

EBIT

Earnings before interest and taxes. A measure of a business’s profitability.

Return on Assets

A measure of a company’s profitability. Calculated by dividing the net income for an accounting period by the average of the total assets the business held during that same period.

BEP Ratio

Another profitability ratio is the Basic Earning Power ratio (BEP). The purpose of BEP is to determine how effectively a firm uses its assets to generate income.

The BEP ratio is simply EBIT divided by total assets . The higher the BEP ratio, the more effective a company is at generating income from its assets.

Basic Earnings Power Ratio

BEP is calculated as the ratio of Earnings Before Interest and Taxes to Total Assets.

This may seem remarkably similar to the return on assets ratio (ROA), which is operating income divided by total assets. EBIT, or earnings before interest and taxes, is a measure of how much money a company makes, but is not necessarily the same as operating income:

EBIT = Revenue – Operating expenses+

Non-operating

income

Operating income = Revenue – Operating expenses

The distinction between EBIT and Operating Income is non-operating income. Since EBIT includes non-operating income (such as dividends paid on the stock a company holds of another), it is a more inclusive way to measure the actual income of a company. However, in most cases, EBIT is relatively close to Operating Income.

The advantage of using EBIT, and thus BEP, is that it allows for more accurate comparisons of companies. BEP disregards different tax situations and degrees of financial leverage while still providing an idea of how good a company is at using its assets to generate income.

BEP, like all profitability ratios, does not provide a complete picture of which company is better or more attractive to investors. Investors should favor a company with a higher BEP over a company with a lower BEP because that means it extracts more value from its assets, but they still need to consider how things like leverage and tax rates affect the company.

16.7.2: Return on Common Equity

Return on equity (ROE) measures how effective a company is at using its equity to generate income and is calculated by dividing net profit by total equity.

Learning Objective

Calculate the Return on Equity (ROE) for a business

Key Points

• ROE is net income divided by total shareholders’ equity.
• ROE is also the product of return on assets (ROA) and financial leverage.
• ROE shows how well a company uses investment funds to generate earnings growth. There is no standard for a good or bad ROE, but a higher ROE is better.

Key Term

equity

Ownership, especially in terms of net monetary value, of a business.

Return on Equity

Return on equity (ROE) is a financial ratio that measures how good a company is at generating profit.

ROE is the ratio of net income to equity. From the fundamental equation of accounting, we know that equity equals net assets minus net liabilities. Equity is the amount of ownership interest in the company, and is commonly referred to as shareholders’ equity, shareholders’ funds, or shareholders’ capital.

In essence, ROE measures how efficient the company is at generating profits from the funds invested in it. A company with a high ROE does a good job of turning the capital invested in it into profit, and a company with a low ROE does a bad job. However, like many of the other ratios, there is no standard way to define a good ROE or a bad ROE. Higher ratios are better, but what counts as “good” varies by company, industry, and economic environment.

ROE can also be broken down into other components for easier use. ROE is the product of the net margin (profit margin), asset turnover, and financial leverage. Also note that the product of net margin and asset turnover is return on assets, so ROE is ROA times financial leverage.

Return on Equity

The return on equity is a ratio of net income to equity. It is a measure of how effective the equity is at generating income.

Breaking ROE into parts allows us to understand how and why it changes over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm’s capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm’s ROE only if the matching return on assets (ROA) of that debt exceeds the interest rate on the debt.

16.7.3: Return on Total Assets

The return on assets ratio (ROA) measures how effectively assets are being used for generating profit.

Learning Objective

Calculate a company’s return on assets

Key Points

• ROA is net income divided by total assets.
• The ROA is the product of two common ratios: profit margin and asset turnover.
• A higher ROA is better, but there is no metric for a good or bad ROA. An ROA depends on the company, the industry and the economic environment.
• ROA is based on the book value of assets, which can be starkly different from the market value of assets.

Key Terms

net income

Gross profit minus operating expenses and taxes.

asset

Something or someone of any value; any portion of one’s property or effects so considered.

Return
on Assets

The return on assets ratio (ROA) is found by dividing net income by total assets. The higher the ratio, the better the company is at using their assets to generate income. ROA was developed by DuPont to show how effectively assets are being used. It is also a measure of how much the company relies on assets to generate profit.

Return on Assets

The return on assets ratio is net income divided by total assets. That can then be broken down into the product of profit margins and asset turnover.

Components of ROA

ROA can be broken down into multiple parts. The ROA is the product of two other common ratios – profit margin and asset turnover. When profit margin and asset turnover are multiplied together, the denominator of profit margin and the numerator of asset turnover cancel each other out, returning us to the original ratio of net income to total assets.

Profit margin is net income divided by sales, measuring the percent of each dollar in sales that is profit for the company. Asset turnover is sales divided by total assets. This ratio measures how much each dollar in asset generates in sales. A higher ratio means that each dollar in assets produces more for the company.

Limits of ROA

ROA does have some drawbacks. First, it gives no indication of how the assets were financed. A company could have a high ROA, but still be in financial straits because all the assets were paid for through leveraging. Second, the total assets are based on the carrying value of the assets, not the market value. If there is a large discrepancy between the carrying and market value of the assets, the ratio could provide misleading numbers. Finally, there is no metric to find a good or bad ROA. Companies that operate in capital intensive industries will tend to have lower ROAs than those who do not. The ROA is entirely contextual to the company, the industry and the economic environment.

16.7.4: Profit Margin

Profit margin measures the amount of profit a company earns from its sales and is calculated by dividing profit (gross or net) by sales.

Learning Objective

Calculate a company’s net and gross profit margin

Key Points

• Profit margin is the profit divided by revenue.
• There are two types of profit margin: gross profit margin and net profit margin.
• A higher profit margin is better for the company, but there may be strategic decisions made to lower the profit margin or to even have it be negative.

Key Terms

gross profit

The difference between net sales and the cost of goods sold.

net profit

The gross revenue minus all expenses.

Profit Margin

Profit margin is one of the most used profitability ratios. Profit margin refers to the amount of profit that a company earns through sales.

The profit margin ratio is broadly the ratio of profit to total sales times 100%. The higher the profit margin, the more profit a company earns on each sale.

Since there are two types of profit (gross and net), there are two types of profit margin calculations. Recall that gross profit is simply the revenue minus the cost of goods sold (COGS). Net profit is the gross profit minus all other expenses. The gross profit margin calculation uses gross profit and the net profit margin calculation uses net profit . The difference between the two is that the gross profit margin shows the relationship between revenue and COGS, while the net profit margin shows the percentage of the money spent by customers that is turned into profit.

Net Profit Margin

The percentage of net profit (gross profit minus all other expenses) earned on a company’s sales.

Gross Profit Margin

The percentage of gross profit earned on the company’s sales.

Companies need to have a positive profit margin in order to earn income, although having a negative profit margin may be advantageous in some instances (e.g. intentionally selling a new product below cost in order to gain market share).

The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses’ operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure. Comparing one business’ arrangements with another has little meaning. A low profit margin indicates a low margin of safety. There is a higher risk that a decline in sales will erase profits and result in a net loss or a negative margin.

16.7.5: Operating Margin

The operating margin is a ratio that determines how much money a company is actually making in profit and equals operating income divided by revenue.

Learning Objective

Calculate a company’s operating margin

Key Points

• The operating margin equals operating income divided by revenue.
• The operating margin shows how much profit a company makes for each dollar in revenue. Since revenues and expenses are considered ‘operating’ in most companies, this is a good way to measure a company’s profitability.
• Although It is a good starting point for analyzing many companies, there are items like interest and taxes that are not included in operating income. Therefore, the operating margin is an imperfect measurement a company’s profitability.

Key Term

operating income

Revenue – operating expenses. (Does not include other expenses such as taxes and depreciation).

Operating Margin

The financial job of a company is to earn a profit, which is different than earning revenue. If a company doesn’t earn a profit, their revenues aren’t helping the company grow. It is not only important to see how much a company has sold, it is important to see how much a company is making.

The operating margin (also called the operating profit margin or return on sales) is a ratio that shines a light on how much money a company is actually making in profit. It is found by dividing operating income by revenue, where operating income is revenue minus operating expenses .

Operating margin formula

The operating margin is found by dividing net operating income by total revenue.

The higher the ratio is, the more profitable the company is from its operations. For example, an operating margin of 0.5 means that for every dollar the company takes in revenue, it earns $0.50 in profit. A company that is not making any money will have an operating margin of 0: it is selling its products or services, but isn’t earning any profit from those sales.

However, the operating margin is not a perfect measurement. It does not include things like capital investment, which is necessary for the future profitability of the company. Furthermore, the operating margin is simply revenue. That means that it does not include things like interest and income tax expenses. Since non-operating incomes and expenses can significantly affect the financial well-being of a company, the operating margin is not the only measurement that investors scrutinize. The operating margin is a useful tool for determining how profitable the operations of a company are, but not necessarily how profitable the company is as a whole.

16.8: Market-Value Ratios

16.8.1: Price/Earnings Ratio

Price to earnings ratio (market price per share / annual earnings per share) is used as a guide to the relative values of companies.

Learning Objective

Calculate a company’s Price to Earnings Ratio

Key Points

• P/E ratio = Market price per share / Annual earnings per share.
• The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies; for example, a higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more expensive than one with a lower P/E ratio.
• Different types of P/E include: trailing P/E or P/E ttm, trailing P/E from continued operations, and forward P/E or P/Ef.

Key Terms

time value of money

The value of money, figuring in a given amount of interest, earned over a given amount of time.

inflation

An increase in the general level of prices or in the cost of living.

Example

• As an example, if stock A is trading at 24 and the earnings per share for the most recent 12 month period is three, then stock A has a P/E ratio of 24/3, or eight.

Price/Earnings Ratio

In stock trading, the price-to-earnings ratio of a share (also called its P/E, or simply “multiple”) is the market price of that share divided by the annual earnings per share (EPS).

The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies; a higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more “expensive” than one with a lower P/E ratio. The P/E ratio can be regarded as being expressed in years. The price is in currency per share, while earnings are in currency per share per year, so the P/E ratio shows the number of years of earnings that would be required to pay back the purchase price, ignoring inflation, earnings growth, and the time value of money.

Price-Earning Ratios as a Predictor of Twenty-Year Returns

The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Note that over the last century, as the P/E ratio has decreased, annualized returns have increased.

P/E ratio = Market price per share / Annual earnings per share

The price per share in the numerator is the market price of a single share of the stock. The earnings per share in the denominator may vary depending on the type of P/E. The types of P/E include the following:

• Trailing P/E or P/E ttm: Here, earning per share is the net income of the company for the most recent 12 month period, divided by the weighted average number of common shares in issue during the period. This is the most common meaning of P/E if no other qualifier is specified. Monthly earnings data for individual companies are not available, and usually fluctuate seasonally, so the previous four quarterly earnings reports are used, and earnings per share are updated quarterly. Note, each company chooses its own financial year so the timing of updates will vary from one to another.
• Trailing P/E from continued operations: Instead of net income, this uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), and accounting changes. Longer-term P/E data, such as Shiller’s, use net earnings.
• Forward P/E, P/Ef, or estimated P/E: Instead of net income, this uses estimated net earnings over the next 12 months. Estimates are typically derived as the mean of those published by a select group of analysts (selection criteria are rarely cited). In times of rapid economic dislocation, such estimates become less relevant as the situation changes (e.g. new economic data is published, and/or the basis of forecasts becomes obsolete) more quickly than analysts adjust their forecasts.

By comparing price and earnings per share for a company, one can analyze the market’s stock valuation of a company and its shares relative to the income the company is actually generating. Stocks with higher (or more certain) forecast earnings growth will usually have a higher P/E, and those expected to have lower (or riskier) earnings growth will usually have a lower P/E. Investors can use the P/E ratio to compare the value of stocks; for example, if one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading. P/E ratio in general is useful for comparing valuation of peer companies in a similar sector or group.

The P/E ratio of a company is a significant focus for management in many companies and industries. Managers have strong incentives to increase stock prices, firstly as part of their fiduciary responsibilities to their companies and shareholders, but also because their performance based remuneration is usually paid in the form of company stock or options on their company’s stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders). The stock price can increase in one of two ways: either through improved earnings, or through an improved multiple that the market assigns to those earnings. In turn, the primary driver for multiples such as the P/E ratio is through higher and more sustained earnings growth rates.

Companies with high P/E ratios but volatile earnings may be tempted to find ways to smooth earnings and diversify risk; this is the theory behind building conglomerates. Conversely, companies with low P/E ratios may be tempted to acquire small high growth businesses in an effort to “rebrand” their portfolio of activities and burnish their image as growth stocks and thus obtain a higher P/E rating.

16.8.2: Market/Book Ratio

The price-to-book ratio is a financial ratio used to compare a company’s current market price to its book value.

Learning Objective

Calculate the different types of price to book ratios for a company

Key Points

• The calculation can be performed in two ways: 1) the company’s market capitalization can be divided by the company’s total book value from its balance sheet, 2) using per-share values, is to divide the company’s current share price by the book value per share.
• A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal.
• Technically, P/B can be calculated either including or excluding intangible assets and goodwill.

Key Term

outstanding shares

Shares outstanding are all the shares of a corporation that have been authorized, issued and purchased by investors and are held by them.

Price/Book Ratio

The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company’s current market price to its book value. The calculation can be performed in two ways, but the result should be the same either way.

In the first way, the company’s market capitalization can be divided by the company’s total book value from its balance sheet.

• Market Capitalization / Total Book Value

The second way, using per-share values, is to divide the company’s current share price by the book value per share (i.e. its book value divided by the number of outstanding shares).

• Share price / Book value per share

As with most ratios, it varies a fair amount by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than, for example, consulting firms. P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued at market values.

A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal (and/or that the market value of the firm’s assets is significantly higher than their accounting value). P/B ratios do not, however, directly provide any information on the ability of the firm to generate profits or cash for shareholders.

This ratio also gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately. For companies in distress, the book value is usually calculated without the intangible assets that would have no resale value. In such cases, P/B should also be calculated on a “diluted” basis, because stock options may well vest on the sale of the company, change of control, or firing of management.

It is also known as the market-to-book ratio and the price-to-equity ratio (which should not be confused with the price-to-earnings ratio), and its inverse is called the book-to-market ratio.

Total Book Value vs Tangible Book Value

Technically, P/B can be calculated either including or excluding intangible assets and goodwill. When intangible assets and goodwill are excluded, the ratio is often specified to be “price to tangible book value” or “price to tangible book”.

16.9: Considering Inflation’s Distortionary Effects

16.9.1: Deflation

Deflation is a decrease in the general price level of goods and services and occurs when the inflation rate falls below 0%.

Learning Objective

Explain how deflation can effect a business

Key Points

• In the IS/LM model (Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly a fall in the aggregate level of demand.
• In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it. This can produce a liquidity trap.
• In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation.
• In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money; specifically the supply of money going down and the supply of goods going up.
• The effects of deflation are: decreasing nominal prices for goods and services, increasing buying power of cash money and all assets denominated in cash terms, possibly decreasing investment and lending if cash holdings are seen as preferable, and benefiting recipients of fixed incomes.

Key Terms

liquidity trap

A liquidity trap is a situation in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.

deflationary spiral

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause.

In economics, deflation is a decrease in the general price level of goods and services. This occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. In turn, this allows one to buy more goods with the same amount of money over time.

Economists generally believe that deflation is a problem in a modern economy because they believe it may lead to a deflationary spiral .

US historical inflation rates

Annual inflation (in blue) and deflation (in green) rates in the United States from 1666 to 2004

In the IS/LM model (Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly with a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Since this idles the productive capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral.

An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply; or by the fiscal authority to increase demand, and to borrow at interest rates which are below those available to private entities.

In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce a liquidity trap. A central bank cannot normally charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic contraction of the money supply, or to adherence to a gold standard or to other external monetary base requirements.

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically: the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

The effects of deflation are thus: decreasing nominal prices for goods and services, increasing buying power of cash money and all assets denominated in cash terms, possibly decreasing investment and lending if cash holdings are seen as preferable (aka hoarding), and benefiting recipients of fixed incomes.

16.9.2: Disinflation

Disinflation is a decrease in the inflation rate; a slowdown in the rate of increase of the general price level of goods, services.

Learning Objective

Describe what causes disinflation

Key Points

• Disinflation occurs when the increase in the “consumer price level” slows down from the previous period when the prices were rising. Disinflation is the reduction in the general price level in the economy but for a very short period of time.
• The causes of disinflation may be a decrease in the growth rate of the money supply. If the central bank of a country enacts tighter monetary policy, the supply of money reduces, and money becomes more upscale and the demand for money remains constant.
• Disinflation may result from a recession. The central bank adopts contractionary monetary policy, goods, and services are more expensive. Even though the demand for commodities fall, the supply still remains unaltered.Thus, the prices would fall over a period of time leading to disinflation.

Key Terms

recession

A period of reduced economic activity.

business cycle

A long-term fluctuation in economic activity between growth and recession.

Disinflation is a decrease in the rate of inflation–a slowdown in the rate of increase of the general price level of goods and services in a nation’s gross domestic product over time. Disinflation occurs when the increase in the “consumer price level” slows down from the previous period when the prices were rising. Disinflation is the reduction in the general price level in the economy but for a very short period of time. Disinflation takes place only when an economy is suffering from recession.

Disinflation

Disinflation is a decrease in the rate of inflation as illustrated in the yellow region of this graph.

If the inflation rate is not very high to start with, disinflation can lead to deflation–decreases in the general price level of goods and services. For example if the annual inflation rate for the month of January is 5% and it is 4% in the month of February, the prices disinflated by 1% but are still increasing at a 4% annual rate. Again, if the current rate is 1% and it is -2% for the following month, prices disinflated by 3% (i.e., 1%-[-2]%) and are decreasing at a 2% annual rate.

The causes of disinflation are either a decrease in the growth rate of the money supply, or a business cycle contraction (recession). If the central bank of a country enacts tighter monetary policy, (i.e., the government start selling its securities) this reduces the supply of money in an economy. This contraction of the monetary policy is known as a “quantitative tightening technique. ” When the government sell its securities in the market, the supply of money reduces, and money becomes more upscale and the demand for money remains constant. During a recession, competition among businesses for customers becomes more intense, and so retailers are no longer able to pass on higher prices to their customers. The main reason is that when the central bank adopts contractionary monetary policy, its becomes expensive to annex money, which leads to the fall in the demand for goods and services in the economy. Even though the demand for commodities fall, the supply of commodities still remains unaltered. Thus the prices fall over a period of time leading to disinflation.

When the growth rate of unemployment is below the natural rate of growth, this leads to an increase in the rate of inflation; whereas, when the growth rate of unemployment is above the natural rate of growth it leads to a decrease in the rate of inflation also known as disinflation. This happens when people are jobless, and they have a very small portion of money to spend, which indirectly implies reduction in the supply of money in an economy.

16.9.3: Impact of Inflation on Financial Statement Analysis

General price level changes creates distortions in financial statements. Inflation accounting is used in countries with high inflation.

Learning Objective

Discuss how inflation can impact a company’s financial statements

Key Points

• Many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.
• Since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive.
• Reported profits may exceed the earnings that could be distributed to shareholders without impairing the company’s ongoing operations.
• Future earnings are not easily projected from historical earnings. Future capital needs are difficult to forecast and may lead to increased leverage, which increases the risk to the business.
• The asset values for inventory, equipment and plant do not reflect their economic value to the business.

Key Terms

Financial Accounting Standards Board

private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public’s interest

hyperinflation

In economics, this occurs when a country experiences very high, accelerating, and perceptibly “unstoppable” rates of inflation. In such a condition, the general price level within an economy rapidly increases as the currency quickly loses real value.

historical cost basis

Under this type of accounting, assets and liabilities are recorded at their values when first acquired. They are not then generally restated for changes in values. Costs recorded in the Income Statement are based on the historical cost of items sold or used, rather than their replacement costs.

Inflation’s Impact on Financial Statements

In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices. Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s .

Hyperinflation Graph

German Hyperinflation Data

General price level changes in financial reporting creates distortions in financial statements such as:

• Many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.
• Since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive. Hence, adding cash of $10,000 held on December 31, 2002, with $10,000 representing the cost of land acquired in 1955 (when the price level was significantly lower) is a dubious operation because of the significantly different amount of purchasing power represented by the two identical numbers.
• Reported profits may exceed the earnings that could be distributed to shareholders without impairing the company’s ongoing operations.
• The asset values for inventory, equipment and plant do not reflect their economic value to the business.
• Future earnings are not easily projected from historical earnings.
• The impact of price changes on monetary assets and liabilities is not clear.
• Future capital needs are difficult to forecast and may lead to increased leverage, which increases the risk to the business.
• When real economic performance is distorted, these distortions lead to social and political consequenses that damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior).

Inflation accounting, a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation, is a solution to these problems. This type of accounting is used in countries experiencing high inflation or hyperinflation. For example, in countries such as these the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index.

16.10: The DuPont Equation, ROE, ROA, and Growth

16.10.1: Assessing Internal Growth and Sustainability

Sustainable– as opposed to internal– growth gives a company a better idea of its growth rate while keeping in line with financial policy.

Learning Objective

Calculate a company’s internal growth and sustainability ratios

Key Points

• The internal growth rate is a formula for calculating the maximum growth rate a firm can achieve without resorting to external financing.
• Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy.
• Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy.

Key Terms

sustainable growth rate

the optimal growth from a financial perspective assuming a given strategy with clear defined financial frame conditions/ limitations

retention ratio

retained earnings divided by net income

retention

The act of retaining; something retained

Example

• A company’s net income is 750,000 and its total shareholder equity is 5,000,000. Its earnings retention rate is 80%. What is its sustainable growth rate? Sustainable Growth Rate = (750,000/5,000,000) x (1-0.80). Sustainable Growth Rate = 3%

Internal Growth and Sustainability

The true benefit of a high return on equity arises when retained earnings are reinvested into the company’s operations. Such reinvestment should, in turn, lead to a high rate of growth for the company. The internal growth rate is a formula for calculating maximum growth rate that a firm can achieve without resorting to external financing. It’s essentially the growth that a firm can supply by reinvesting its earnings. This can be described as (retained earnings)/(total assets), or conceptually as the total amount of internal capital available compared to the current size of the organization.

We find the internal growth rate by dividing net income by the amount of total assets (or finding return on assets) and subtracting the rate of earnings retention. However, growth is not necessarily favorable. Expansion may strain managers’ capacity to monitor and handle the company’s operations. Therefore, a more commonly used measure is the sustainable growth rate.

Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy, such as target debt to equity ratio, target dividend payout ratio, target profit margin, or target ratio of total assets to net sales.

We find the sustainable growth rate by dividing net income by shareholder equity (or finding return on equity) and subtracting the rate of earnings retention. While the internal growth rate assumes no financing, the sustainable growth rate assumes you will make some use of outside financing that will be consistent with whatever financial policy being followed. In fact, in order to achieve a higher growth rate, the company would have to invest more equity capital, increase its financial leverage, or increase the target profit margin.

Optimal Growth Rate

Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy. The concept of optimal growth rate was originally studied by Martin Handschuh, Hannes Lösch, and Björn Heyden. Their study was based on assessments on the performance of more than 3,500 stock-listed companies with an initial revenue of greater than 250 million Euro globally, across industries, over a period of 12 years from 1997 to 2009.

Revenue Growth and Profitability

ROA, ROS and ROE tend to rise with revenue growth to a certain extent.

Due to the span of time included in the study, the authors considered their findings to be, for the most part, independent of specific economic cycles. The study found that return on assets, return on sales and return on equity do in fact rise with increasing revenue growth of between 10% to 25%, and then fall with further increasing revenue growth rates. Furthermore, the authors attributed this profitability increase to the following facts:

1. Companies with substantial profitability have the opportunity to invest more in additional growth, and
2. Substantial growth may be a driver for additional profitability, whether by attracting high performing young professionals, providing motivation for current employees, attracting better business partners, or simply leading to more self-confidence.

However, according to the study, growth rates beyond the “profitability maximum” rate could bring about circumstances that reduce overall profitability because of the efforts necessary to handle additional growth (i.e., integrating new staff, controlling quality, etc).

16.10.2: Dividend Payments and Earnings Retention

The dividend payout and retention ratios offer insight into how much of a firm’s profit is distributed to shareholders versus retained.

Learning Objective

Calculate a company’s dividend payout and retention ratios

Key Points

• Many corporations retain a portion of their earnings and pay the remainder as a dividend.
• Dividends are usually paid in the form of cash, store credits, or shares in the company.
• Cash dividends are a form of investment income and are usually taxable to the recipient in the year that they are paid.
• Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends.
• Retained earnings can be expressed in the retention ratio.

Key Term

stock split

To issue a higher number of new shares to replace old shares. This effectively increases the number of shares outstanding without changing the market capitalization of the company.

Dividend Payments and Earnings Retention

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. On the other hand, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or accumulated deficit. Retained earnings and losses are cumulative from year to year with losses offsetting earnings. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. Retained earnings are shown in the shareholder equity section in the company’s balance sheet–the same as its issued share capital.

Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a “special dividend” to distinguish it from the fixed schedule dividends. Dividends are usually paid in the form of cash, store credits (common among retail consumers’ cooperatives), or shares in the company (either newly created shares or existing shares bought in the market). Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

Cash dividends (most common) are those paid out in currency, usually via electronic funds transfer or a printed paper check. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is $0.50 per share, the holder of the stock will be paid $50. Dividends paid are not classified as an expense but rather a deduction of retained earnings. Dividends paid do not show up on an income statement but do appear on the balance sheet.

Example Balance Sheet

Retained earnings can be found on the balance sheet, under the owners’ (or shareholders’) equity section.

Stock dividends are those paid out in the form of additional stock shares of the issuing corporation or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, a 5% stock dividend will yield five extra shares). If the payment involves the issue of new shares, it is similar to a stock split in that it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held.

Dividend Payout and Retention Ratios

Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends:

The part of the earnings not paid to investors is left for investment to provide for future earnings growth. These retained earnings can be expressed in the retention ratio. Retention ratio can be found by subtracting the dividend payout ratio from one, or by dividing retained earnings by net income.

Dividend Payout Ratio

The dividend payout ratio is equal to dividend payments divided by net income for the same period.

16.10.3: Relationships between ROA, ROE, and Growth

Return on assets is a component of return on equity, both of which can be used to calculate a company’s rate of growth.

Learning Objective

Discuss the different uses of the Return on Assets and Return on Assets ratios

Key Points

• Return on equity measures the rate of return on the shareholders’ equity of common stockholders.
• Return on assets shows how profitable a company’s assets are in generating revenue.
• In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.
• Capital intensity is the term for the amount of fixed or real capital present in relation to other factors of production. Rising capital intensity pushes up the productivity of labor.

Key Terms

return on common stockholders’ equity

a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage

quantitatively

With respect to quantity rather than quality.

Example

• A company has net income of 500,000. It has total assets valued at 3,000,000. Its retention rate is 80%, and its shareholder equity is equal to $1,500,000. What is the company’s ROA and internal growth rate? What is the company’s ROE and sustainable growth rate? ROA = 500,000/3,000,000 = 17% Internal growth rate = 17% x 80% = 13% ROE = 17% x (3,000,000/1,500,000) = 34% Sustainable growth rate = 34% x 80% = 27.2%

Return On Assets Versus Return On Equity

In review, return on equity measures the rate of return on the ownership interest (shareholders’ equity) of common stockholders. Therefore, it shows how well a company uses investment funds to generate earnings growth. Return on assets shows how profitable a company’s assets are in generating revenue. Return on assets is equal to net income divided by total assets.

Return On Assets

Return on assets is equal to net income divided by total assets.

This percentage shows what the company can do with what it has (i.e., how many dollars of earnings they derive from each dollar of assets they control). This is in contrast to return on equity, which measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. Return on assets is, however, a vital component of return on equity, being an indicator of how profitable a company is before leverage is considered. In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.

ROA, ROE, and Growth

In terms of growth rates, we use the value known as return on assets to determine a company’s internal growth rate. This is the maximum growth rate a firm can achieve without resorting to external financing. We use the value for return on equity, however, in determining a company’s sustainable growth rate, which is the maximum growth rate a firm can achieve without issuing new equity or changing its debt-to-equity ratio.

Capital Intensity and Growth

Return on assets gives us an indication of the capital intensity of the company. “Capital intensity” is the term for the amount of fixed or real capital present in relation to other factors of production, especially labor. The underlying concept here is how much output can be procured from a given input (assets!). The formula for capital intensity is below:

The use of tools and machinery makes labor more effective, so rising capital intensity pushes up the productivity of labor. While companies that require large initial investments will generally have lower return on assets, it is possible that increased productivity will provide a higher growth rate for the company. Capital intensity can be stated quantitatively as the ratio of the total money value of capital equipment to the total potential output. However, when we adjust capital intensity for real market situations, such as the discounting of future cash flows, we find that it is not independent of the distribution of income. In other words, changes in the retention or dividend payout ratios can lead to changes in measured capital intensity.

16.10.4: The DuPont Equation

The DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage.

Learning Objective

Explain why splitting the return on equity calculation into its component parts may be helpful to an analyst

Key Points

• By splitting ROE into three parts, companies can more easily understand changes in their returns on equity over time.
• As profit margin increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.
• As asset turnover increases, a company will generate more sales per asset owned, resulting in a higher overall return on equity.
• Increased financial leverage will also lead to an increase in return on equity, since using more debt financing brings on higher interest payments, which are tax deductible.

Key Term

competitive advantage

something that places a company or a person above the competition

Example

• A company has sales of 1,000,000. It has a net income of 400,000. Total assets have a value of 5,000,000, and shareholder equity has a value of 10,000,000. Using DuPont analysis, what is the company’s return on equity? Profit Margin = 400,000/1,000,000 = 40%. Asset Turnover = 1,000,000/5,000,000 = 20%. Financial Leverage = 5,000,000/10,000,000 = 50%. Multiplying these three results, we find that the Return on Equity = 4%.

The DuPont Equation

DuPont Model

A flow chart representation of the DuPont Model.

The DuPont equation is an expression which breaks return on equity down into three parts. The name comes from the DuPont Corporation, which created and implemented this formula into their business operations in the 1920s. This formula is known by many other names, including DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit model.

The DuPont Equation

In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage.

Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage. By splitting ROE (return on equity) into three parts, companies can more easily understand changes in their ROE over time.

Components of the DuPont Equation: Profit Margin

Profit margin is a measure of profitability. It is an indicator of a company’s pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.

Components of the DuPont Equation: Asset Turnover

Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate sales revenue or sales income for the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity.

Components of the DuPont Equation: Financial Leverage

Financial leverage refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that the company utilizes. As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s capital structure leads to a higher return on equity.

The DuPont Equation in Relation to Industries

The DuPont equation is less useful for some industries, that do not use certain concepts or for which the concepts are less meaningful. On the other hand, some industries may rely on a single factor of the DuPont equation more than others. Thus, the equation allows analysts to determine which of the factors is dominant in relation to a company’s return on equity. For example, certain types of high turnover industries, such as retail stores, may have very low profit margins on sales and relatively low financial leverage. In industries such as these, the measure of asset turnover is much more important.

High margin industries, on the other hand, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin. For high end fashion and other luxury brands, increasing sales without sacrificing margin may be critical. Finally, some industries, such as those in the financial sector, chiefly rely on high leverage to generate an acceptable return on equity. While a high level of leverage could be seen as too risky from some perspectives, DuPont analysis enables third parties to compare that leverage with other financial elements that can determine a company’s return on equity.

16.10.5: ROE and Potential Limitations

Return on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed.

Learning Objective

Calculate a company’s return on equity

Key Points

• Return on equity is an indication of how well a company uses investment funds to generate earnings growth.
• Returns on equity between 15% and 20% are generally considered to be acceptable.
• Return on equity is equal to net income (after preferred stock dividends but before common stock dividends) divided by total shareholder equity (excluding preferred shares).
• Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity.

Key Term

fundamental analysis

An analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets.

Example

• A small business’ net income after taxes is $10,000. The total shareholder equity in the business is $50,000. What is the return on equity? ROE = 10,000/50,000 ROE = 20%

Return On Equity

Return on equity (ROE) measures the rate of return on the ownership interest or shareholders’ equity of the common stock owners. It is a measure of a company’s efficiency at generating profits using the shareholders’ stake of equity in the business. In other words, return on equity is an indication of how well a company uses investment funds to generate earnings growth. It is also commonly used as a target for executive compensation, since ratios such as ROE tend to give management an incentive to perform better. Returns on equity between 15% and 20% are generally considered to be acceptable.

The Formula

Return on equity is equal to net income, after preferred stock dividends but before common stock dividends, divided by total shareholder equity and excluding preferred shares.

Return On Equity

ROE is equal to after-tax net income divided by total shareholder equity.

Expressed as a percentage, return on equity is best used to compare companies in the same industry. The decomposition of return on equity into its various factors presents various ratios useful to companies in fundamental analysis.

ROE Broken Down

This is an expression of return on equity decomposed into its various factors.

The practice of decomposing return on equity is sometimes referred to as the “DuPont System. “

Potential Limitations of ROE

Just because a high return on equity is calculated does not mean that a company will see immediate benefits. Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity. Earnings per share is the amount of earnings per each outstanding share of a company’s stock. EPS is equal to profit divided by the weighted average of common shares.

Earnings Per Share

EPS is equal to profit divided by the weighted average of common shares.

The true benefit of a high return on equity comes from a company’s earnings being reinvested into the business or distributed as a dividend. In fact, return on equity is presumably irrelevant if earnings are not reinvested or distributed.

16.11: Asset-Management Ratios

16.11.1: Fixed Assets Turnover Ratio

Fixed-asset turnover is the ratio of sales to value of fixed assets, indicating how well the business uses fixed assets to generate sales.

Learning Objective

Calculate the fixed-asset turnover ratio for a business

Key Points

• Fixed asset turnover = Net sales / Average net fixed assets.
• The higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.
• Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash.

Key Term

IAS

International Financial Reporting Standards (IFRS) are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.

Fixed Assets

Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. This can be compared with current assets, such as cash or bank accounts, which are described as liquid assets. In most cases, only tangible assets are referred to as fixed.

Moreover, a fixed/non-current asset also can be defined as an asset not directly sold to a firm’s consumers/end-users. As an example, a baking firm’s current assets would be its inventory (in this case, flour, yeast, etc.), the value of sales owed to the firm via credit (i.e., debtors or accounts receivable), cash held in the bank, etc. Its non-current assets would be the oven used to bake bread, motor vehicles used to transport deliveries, cash registers used to handle cash payments, etc. Each aforementioned non-current asset is not sold directly to consumers.

These are items of value that the organization has bought and will use for an extended period of time; fixed assets normally include items, such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and machinery. These often receive favorable tax treatment (depreciation allowance) over short-term assets. According to International Accounting Standard (IAS) 16, Fixed Assets are assets which have future economic benefit that is probable to flow into the entity and which have a cost that can be measured reliably.

The primary objective of a business entity is to make a profit and increase the wealth of its owners. In the attainment of this objective, it is required that the management will exercise due care and diligence in applying the basic accounting concept of “Matching Concept.” Matching concept is simply matching the expenses of a period against the revenues of the same period.

The use of assets in the generation of revenue is usually more than a year–that is long term. It is, therefore, obligatory that in order to accurately determine the net income or profit for a period depreciation, it is charged on the total value of asset that contributed to the revenue for the period in consideration and charge against the same revenue of the same period. This is essential in the prudent reporting of the net revenue for the entity in the period.

Fixed-asset Turnover

Fixed-asset turnover is the ratio of sales (on the profit and loss account) to the value of fixed assets (on the balance sheet). It indicates how well the business is using its fixed assets to generate sales.

Turn Tables

Turn tables should help you remember turnover. Fixed-asset turnover indicates how well the business is using its fixed assets to generate sales.

Fixed asset turnover = Net sales / Average net fixed assets

Generally speaking, the higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.

16.11.2: Total Assets Turnover Ratio

Total asset turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue.

Learning Objective

Calculate the total assets turnover ratio for a business

Key Points

• Total assets turnover = Net sales revenue / Average total assets.
• Net sales are operating revenues earned by a company for selling its products or rendering its services.
• Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset.
• Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.

Key Term

profit margins

Profit margin, net margin, net profit margin or net profit ratio all refer to a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue.

Example

• Examples of intangible assets are goodwill, copyrights, trademarks, patents, computer programs, and financial assets, including such items as accounts receivable, bonds and stocks.

Total assets turnover

This is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company.

Assets

Asset turnover measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company.

Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. Companies in the retail industry tend to have a very high turnover ratio due mainly to cut-throat and competitive pricing.

Total assets turnover = Net sales revenue / Average total assets

• “Sales” is the value of “Net Sales” or “Sales” from the company’s income statement”.
• Average Total Assets” is the average of the values of “Total assets” from the company’s balance sheet in the beginning and the end of the fiscal period. It is calculated by adding up the assets at the beginning of the period and the assets at the end of the period, then dividing that number by two.

Net sales

• In bookkeeping, accounting, and finance, Net sales are operating revenues earned by a company for selling its products or rendering its services. Also referred to as revenue, they are reported directly on the income statement as Sales or Net sales.
• In financial ratios that use income statement sales values, “sales” refers to net sales, not gross sales. Sales are the unique transactions that occur in professional selling or during marketing initiatives.

Total assets

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value, and that is held to have positive economic value, is considered an asset. Simply stated, assets represent value of ownership that can be converted into cash (although cash itself is also considered an asset).

The balance sheet of a firm records the monetary value of the assets owned by the firm. It is money and other valuables belonging to an individual or business.

Two major asset classes are tangible assets and intangible assets.

• Tangible assets contain various subclasses, including current assets and fixed assets. Current assets include inventory, while fixed assets include such items as buildings and equipment.
• Intangible assets are non-physical resources and rights that have a value to the firm because they give the firm some kind of advantage in the market place.

16.11.3: Days Sales Outstanding

Days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period.

Learning Objective

Calculate the days sales outstanding ratio for a business

Key Points

• Days sales outstanding is a financial ratio that illustrates how well a company’s accounts receivables are being managed.
• DSO ratio = accounts receivable / average sales per day, or DSO ratio = accounts receivable / (annual sales / 365 days).
• Generally speaking, higher DSO ratio can indicate a customer base with credit problems and/or a company that is deficient in its collections activity. A low ratio may indicate the firm’s credit policy is too rigorous, which may be hampering sales.

Key Terms

days in inventory

the average value of inventory divided by the average cost of goods sold per day

average collection period

365 divided by the receivables turnover ratio

outstanding check

a check that has been written but has not yet been deposited in the receiver’s bank account

business cycle

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years.

Days Sales Outstanding

In accountancy, days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period. It is a financial ratio that illustrates how well a company’s accounts receivables are being managed. The days sales outstanding figure is an index of the relationship between outstanding receivables and credit account sales achieved over a given period.

Typically, days sales outstanding is calculated monthly. The days sales outstanding analysis provides general information about the number of days on average that customers take to pay invoices. Generally speaking, though, higher DSO ratio can indicate a customer base with credit problems and/or a company that is deficient in its collections activity. A low ratio may indicate the firm’s credit policy is too rigorous, which may be hampering sales.

Days sales outstanding is considered an important tool in measuring liquidity. Days sales outstanding tends to increase as a company becomes less risk averse. Higher days sales outstanding can also be an indication of inadequate analysis of applicants for open account credit terms. An increase in DSO can result in cash flow problems, and may result in a decision to increase the creditor company’s bad debt reserve.

A DSO ratio can be expressed as:

• DSO ratio = accounts receivable / average sales per day, or
• DSO ratio = accounts receivable / (annual sales / 365 days)

For purposes of this ratio, a year is considered to have 365 days.

Days sales outstanding can vary from month to month and over the course of a year with a company’s seasonal business cycle. Of interest, when analyzing the performance of a company, is the trend in DSO. If DSO is getting longer, customers are taking longer to pay their bills, which may be a warning that customers are dissatisfied with the company’s product or service, or that sales are being made to customers that are less credit worthy or that sales people have to offer longer payment terms in order to generate sales. Many financial reports will state Receivables Turnover defined as Net Credit Account Sales / Trade Receivables; divide this value into the time period in days to get DSO.

However, days sales outstanding is not the most accurate indication of the efficiency of accounts receivable department. Changes in sales volume influence the outcome of the days sales outstanding calculation. For example, even if the overdue balance stays the same, an increase of sales can result in a lower DSO. A better way to measure the performance of credit and collection function is by looking at the total overdue balance in proportion of the total accounts receivable balance (total AR = Current + Overdue), which is sometimes calculated using the days’ delinquent sales outstanding (DDSO) formula.

16.11.4: Inventory Turnover Ratio

Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year.

Learning Objective

Calculate inventory turnover and average days to sell inventory for a business

Key Points

• Inventory turnover = Cost of goods sold/Average inventory.
• Average days to sell the inventory = 365 days /Inventory turnover ratio.
• A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
• Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.

Key Term

holding cost

In business management, holding cost is money spent to keep and maintain a stock of goods in storage.

Inventory Turnover

In accounting, the Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year. The equation for inventory turnover equals the cost of goods sold divided by the average inventory. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.

Inventory Turnover Equation

• The formula for inventory turnover:

Inventory turnover = Cost of goods sold/Average inventory

• The formula for average inventory:

Average inventory = (Beginning inventory + Ending inventory)/2

• The average days to sell the inventory is calculated as follows:

Average days to sell the inventory = 365 days / Inventory turnover ratio

Application in Business

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages.

Inventory

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.

Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low. This often can result in stock shortages.

Some compilers of industry data (e.g., Dun & Bradstreet) use sales as the numerator instead of cost of sales. Cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. Cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded. Sales are generally recorded at market value (i.e., the value at which the marketplace paid for the good or service provided by the firm). In the event that the firm had an exceptional year and the market paid a premium for the firm’s goods and services, then the numerator may be an inaccurate measure. However, cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms “cost of sales” and “cost of goods sold” are synonymous.

An item whose inventory is sold (turns over) once a year has a higher holding cost than one that turns over twice, or three times, or more in that time. Stock turnover also indicates the briskness of the business. The purpose of increasing inventory turns is to reduce inventory for three reasons.

• Increasing inventory turns reduces holding cost. The organization spends less money on rent, utilities, insurance, theft, and other costs of maintaining a stock of good to be sold.
• Reducing holding cost increases net income and profitability as long as the revenue from selling the item remains constant.
• Items that turn over more quickly increase responsiveness to changes in customer requirements while allowing the replacement of obsolete items. This is a major concern in fashion industries.

When making comparison between firms, it’s important to take note of the industry, or the comparison will be distorted. Making comparison between a supermarket and a car dealer, will not be appropriate, as a supermarket sells fast moving goods, such as sweets, chocolates, soft drinks, so the stock turnover will be higher. However, a car dealer will have a low turnover due to the item being a slow moving item. As such, only intra-industry comparison will be appropriate.

16.12: Other Distortions

16.12.1: Extraordinary Gains and Losses

Extra gains or losses are nonrecurring, onetime, unusual, non-operating gains or losses that are recorded by a business during the period.

Learning Objective

Define what makes a gain or loss extraordinary

Key Points

• Extra gains or losses are nonrecurring, onetime, unusual, non-operating gains or losses that are recorded by a business during the period.
• No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. (IAS 1.87) The amount of each of these gains or losses, net of the income tax effect, is reported separately in the income statement.
• Examples of extraordinary items are casualty losses, losses from expropriation of assets by a foreign government, gain on life insurance, gain or loss on the early extinguishment of debt, gain on troubled debt restructuring, and write-off of an intangible asset.

Key Terms

extraordinary items

unusual (abnormal) and infrequent things that impact the company

non-operating

Non-operating in accounting and finance is not related to the typical activities of the business or organization.

Extraordinary Gains and Losses

Extraordinary items are both unusual (abnormal) and infrequent, for example, unexpected natural disaster, expropriation, prohibitions under new regulations. It is notable that a natural disaster might not qualify depending on location (e.g., frost damage would not qualify in Canada but would in the tropics).

Extra gains or losses are the result of unforeseen and atypical events. They are nonrecurring, onetime, unusual, non-operating gains, or losses that are recorded by a business during the period.

No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. (IAS 1.87) The amount of each of these gains or losses, net of the income tax effect, is reported separately in the income statement. Net income is reported before and after these gains and losses. As a result, extraordinary gains or losses don’t skew the company’s regular earnings. These gains and losses should not be recorded very often but, in fact, many businesses record them every other year or so, causing much consternation to investors. In addition to evaluating the regular stream of sales and expenses that produce operating profit, investors also have to factor into their profit performance analysis the perturbations of these irregular gains and losses reported by a business.

Income statement in accordance with IFRS

This income statement is a very brief example prepared in accordance with IFRS; no extraordinary items are presented.

Examples of extraordinary items are casualty losses, losses from expropriation of assets by a foreign government, gain on life insurance, gain or loss on the early extinguishment of debt, gain on troubled debt restructuring, and write-off of an intangible asset. Write down and write off of receivables and inventory are not extraordinary, because they relate to normal business operational activities.They would be considered extraordinary, however, if they resulted from an Act of God (e.g., casualty loss arising from an earthquake) or governmental expropriation.

16.12.2: Discrepancies

Accounting discrepancies are unintentional mistakes in the delivery of financial statements.

Learning Objective

Recognize the various reasons a discrepancy may occur, and how to prevent them

Key Points

• Mistakes happen. Being aware of common pitfalls is the best way to avoid accounting discrepancies, though.
• Discrepancies shouldn’t be confused with irregularities, which are generally assumed to be intentional mistakes to misrepresent data.
• Data errors, software issues, late payments, and shrinkage may all contribute to potential discrepancies in the tracking of organizational finances.
• Preventing discrepancies is best, but if a mistake occurs, it is best to address it as soon as possible (as opposed to waiting for an audit to catch it).

Key Terms

accounting irregularity

An intentional misrepresentation of accounting data.

discrepancies

Accidental misrepresentations of accounting data.

Nobody’s perfect, including accountants. From time to time, discrepancies will arise on financial statements, for a wide variety of reasons. Accounting errors that are not intentional are described as discrepancies (as opposed to an accounting irregularity, which is distinguished from a discrepancy by an intention to defraud). Accounting requires meticulous eye for detail and a strong sense of accuracy and accountability, and financial professionals and internal stakeholders must be careful of errors which could be mistaken for intentional fraud.

Common Discrepancies

Data Errors

All accounting relies heavily on input data from various sources, including accurate inventory counts, revenue reports, sales figures, asset valuations, and a wide variety of other relevant aspects of income statements, balance sheets, and statements of cash flows. Any error from input data points will thus be reflected in the final financial statements, for public companies these are released externally. Catching these errors through careful confirmation of all receipts and cash flows is a central responsibility of both management and the accounting and finance teams.

Late Payments

If a large client is late in providing capital for a service or product provided, this can impact the accuracy of a financial release. Accounts receivable, by their nature, are timed payments with specific deadlines. If an accountant assumes a receivable will be timely, they may potentially create a discrepancy. As a result, all reporting should be done on what actually is, rather than what’s expected to be.

Shrinkage

Particularly relevant for retail outlets is the concept of shrinkage. Shrinkage is the lost inventory/sales that occurs over an operational period. This can be due to petty theft, mismanaged inventory, perishable goods going unrecorded, and a wide variety of other factors. Ensuring that inventory is carefully managed and shrinkage is built into any current financial calculations is important to maintain accuracy and avoid discrepancy.

Bank Reconciliation

While rarely an issue in the long term, bank transfer and capital movements sometimes take time. Taking into account bank reconciliation when viewing the amount shown in a current account and the amount that should be shown is an occasionally cause of temporary discrepancy.

Technology

Modern accounting is largely a software endeavor. Utilizing complex software incurs the potential for complex, hard to catch errors. Having a strong IT team, and accountants familiar with the world of software coding are important assets in modern financial reporting. 

Addressing Discrepancies

While perhaps common sense, amending a discrepancy as soon as it is identified is important. Waiting to be audited is not a good tactic, as this will likely result in fees or penalties for inaccurate reporting. Double and triple checking financial statements inputs before building them into public releases is particularly important for this field of work.

16.13: Next Steps in Financial Statement Analysis

16.13.1: Interpreting Ratios and Other Sources of Company Information

Financial statement analysis uses comparisons and relationships of data to enhance the utility or practical value of accounting information.

Learning Objective

Explain how a company would use one of the four financial statement analysis methods to interpret their data

Key Points

• In financial statement analysis, comparisons and relationships can be shown in the following ways: vertical analysis, horizontal analysis, trend percentages, and ratios.
• The vertical method is used on a single financial statement, such as an income statement, and involves each item being expressed as a percentage of a significant total.
• The horizontal method is comparative, and shows the same company’s financial statements for one or two successive periods in side-by-side columns. The side-by-side display reveals changes in a company’s performance and highlights trends.
• Trend percentages make comparisons to a selected base year or period. Trend percentages are useful for comparing financial statements over several years, because they disclose changes and trends occurring through time.
• Ratios are expressions of logical relationships between items in the financial statements from a single period. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g.balance sheet and income statement).

Key Terms

trend

an inclination in a particular direction

ratio

A number representing a comparison between two things.

analysis

a process of dismantling or separating an object of inquiry into its constituent elements in order to study the nature, function, or meaning of the object

Financial Statement Analysis

Financial statement analysis, also known as financial analysis, is the process of understanding the risk and profitability of a company through the analysis of that company’s reported financial information. This information includes annual and quarterly reports, such as income statements, balance sheets, and statements of cash flows.

All financial analysis relies on comparing or relating data in a way that enhances the utility or practical value of the information. For example, when analyzing a particular company, it is helpful to know that they had a net income of $100,000 for the year, but it is even more helpful to know that, in a previous year, they only had $25,000 in net income. As more information is added, such as the total amount of sales, the number of assets, and the cost of goods sold, the initial information becomes increasingly valuable, and a more complete picture of a company’s financial activity can be derived.

In financial statement analysis, comparisons and relationships can be shown in the following ways:

• Absolute increases and decreases for an item from one period to the next
• Percentage increases and decreases for an item from one period to the next
• Percentages of single items to an aggregate total
• Trend percentages
• Ratios

Methods for Financial Statement Analysis

There are four methods for making these types of comparisons: vertical analysis, horizontal analysis, ratios, and trend percentages.

The vertical method is used on a single financial statement, such as an income statement. In a vertical analysis, each item is expressed as a percentage of a significant total. This type of analysis is especially helpful in analyzing income statement data .

The horizontal method is a comparative, and presents the same company’s financial statements for one or two successive periods in side-by-side columns. This comparative display shows dollar changes or percentage changes in the statement items or totals across given periods of time. Horizontal analysis detects changes in a company’s performance and highlights various other trends.

The trend percentages method is the same as horizontal analysis, except that in the former, comparisons are made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years, because they reveal changes and trends occurring over time.

Ratios are expressions of logical relationships between items in financial statements from a single period. It is possible to calculate a number of ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g.balance sheet and income statement). The only limiting factor in choosing ratios is that the items used to construct a ratio must have a logical relationship to one another.

Analyzing the Income Statement

In vertical analysis each item is expressed as a percentage of a significant total.

15.2: Pension Accounting

15.2.1: Overview of Pension Accounting

Learning Objective

Summarize how a company reports their pension plan on their financials statements

Key Points

• The two most common are the defined benefit and the defined contribution plan.
• The employer (sponsor) reports pension expense on the income statement, and a pension liability which is the sum of two accounts, accrued/prepaid pension cost and additional liability, and an intangible asset-deferred pension cost (if required).
• In a defined contribution plan (such as a 401k), while the company makes contributions or matching contributions, it does not promise the future benefit to the employee.

Key Terms

pension

A regularly paid gratuity paid regularly as benefit due to a person in consideration of past services; notably to one retired from service, on account of retirement age, disability, or similar cause; especially, a regular stipend paid by a government to retired public officers, disabled soldiers; sometimes passed on to the heirs, or even specifically for them, as to the families of soldiers killed in service.

contribution

An amount of money given toward something.

Components of a Pension Plan

A pension is a contract for a fixed sum to be paid regularly to a person, typically following retirement from service.

Types of Pension Plans

While there are various pension plans in use today, the two most common are the defined benefit and the defined contribution plan.

With a defined benefit plan, an employee knows the terms of the benefit to be received upon retirement. So, the company must invest in a fund in order to meet its obligations to the employee. In this type of plan the company bears the investment risk.

In a defined contribution plan (such as a 401k), while the company makes contributions or matching contributions, it does not promise the future benefit to the employee. In such a plan, the employee bears the investment risk.

A 401k is a defined contribution plan

In a defined contribution plan the employees bear all the risk.

Pension Plan Accounting

Due to the nature of pension plans, accounting for them is rather complicated. The first complication is that pension benefits are payable to retirees in the far future, so it is hard to estimate the amount of future payments.

The second complication comes from the application of accrual accounting. Since, the actual cash flows are not counted each year; this means the annual pension expense is based on rules that attempt to capture changing assumptions about the future.

The last complication comes from the rules that require companies to prevent over/under stating the pension funds. This smoothing out of the account disguises the true position of the plan.

The employer (sponsor) reports pension expense on the income statement, and a pension liability which is the sum of two accounts, accrued/prepaid pension cost and additional liability, and an intangible asset-deferred pension cost (if required).

The employer is also required to maintain memo accounts for unrecognized prior service costs and unrecognized gains and losses.

How a Pension Plan Is Presented in the Financials

In addition to reporting the pension expense on the income statement companies should disclose the following information about the pension plan:

• Plan description (including benefit formula, employee groups covered, funding policy. and types of assets held)
• The amounts for the components of pension expense for the period
• A reconciliation schedule relating the funding status of the plan

15.3: Lease Accounting

15.3.1: Overview of Lease Accounting

There are two types of leases: capital leases and operating leases and each has a different accounting methodology.

Learning Objective

Summarize how a company would account for a lease

Key Points

• A lease allows a company to get a major piece of equipment with no large expenditure of cash.
• A capital lease is a form of debt-equity financing in which the lease acts like loan.
• An operating lease lets a company obtain equipment with virtually no upfront capital outlay and with the lease payments treated as a deductible cost of business.

Key Terms

monetary

Of, pertaining to, or consisting of money.

capital lease

a financial arrangement where the borrower uses an asset and pays regular installments plus interest

lessor

The owner of property that is leased.

expenditure

An amount expended; an expense; an outlay.

What is a Lease

A lease is a contract calling for the lessee (user) to pay the lessor (owner) for use of an asset for a specified period.

Why Do Some Companies Lease

For many companies the decision is monetary. A lease allows a company to get a major piece of equipment with no large expenditure of cash. In addition, some companies who are in the financial position to buy equipment still prefer to lease because they would not benefit from the depreciation on the equipment.

Equipment Lease

An equipment lease allows a company to get a piece of equipment without a large expenditure.

Types of Leases

There are two types of leases capital leases and operating leases.

Capital equipment is financed either with debt or equity. A capital lease is a form of debt-equity financing in which the lease acts like loan. To that end, a capital lease must be recorded as liability on the company’s balance sheet, it is important to note that the IRS treats capital leases as a liability.

On the other hand, an operating lease lets a company obtain equipment with virtually no upfront capital outlay and with the lease payments treated as a deductible cost of business.

Accounting for the Lease-Leasee

Under an operating lease, the lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable. If an operating lease has scheduled changes in rent, normally the rent must be registered as an expense on a straight-line basis over its life, with a deferred liability or asset reported on the balance sheet for the difference between expense and cash outlay.

Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset’s economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.

Note: For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.

Accounting for the Lease-Lessor

Under an operating lease, the lessor records rent revenue (credit) and a corresponding debit to either cash/rent receivable. The asset remains on the lessor’s books as an owned asset. The lessor records depreciation expense over the life of the asset. Under a capital lease, the lessor credits owned assets and debits a lease-receivable account for the present value of the rents. The rents are an asset, which is broken out between current and long-term, the latter being the present value of rents due more than 12 months in the future. With each payment, cash is debited, the receivable is credited, and unearned (interest) income is credited.

Other Lease Items

• Leasehold Improvements: Improvements made by the lessee. These are permanently affixed to the property and revert to the lessor at the termination of the lease. The value of the leasehold improvements should be capitalized and depreciated over the lesser of the lease life or the leasehold improvements life. If the life of the leasehold improvement extends past the life of the initial term of the lease and into an option period, normally that option period must be considered part of the life of the lease.
• Lease Bonus: Prepayment for future expenses. Classified as an asset; amortized using the straight-line method over the life of the lease.
• Security Deposits: Nonrefundable security deposits:deferred by the lessor as unearned revenue; capitalized by the lessee as a prepaid rent expense until the lessor considers the deposit earned. Refundable security deposits: treated as a receivable by the lessee; treated as a liability by the lessor until the deposit is refunded to the lessee.

15.4: Making Changes and Correcting Errors

15.4.1: Overview of Statement Changes and Errors

Despite best efforts, occasionally an error is made on the financial statement and must be corrected.

Learning Objective

Explain why a previously issued financial statement would have an error and how to correct it

Key Points

• These errors are most usually caused by mathematical mistakes, mistakes in applying generally accepted accounting principles, or through the oversight of facts existing when the financial statements were prepared.
• In order to properly correct an error, it is necessary to retrospectively restate the prior period financial statements.
• A counterbalancing error occurs when an an error is made that cancels out another error.
• It makes no difference whether the books are closed or still open; a correcting journal entry is necessary.

Key Terms

offset

Anything that acts as counterbalance; a compensating equivalent.

cumulative

Incorporating all data up to the present

retrospectively

In a retrospective manner.

Changes and Errors on the Financial Statements

Despite best efforts, occasionally an error is made on the financial statement. Most often, the error is in the recognition, measurement, presentation, or disclosure of an item in financial statements. These errors are usually caused by mathematical mistakes, mistakes in applying generally accepted accounting principles, or the oversight of facts existing when the financial statements were prepared.

Please note: an error correction is the correction of an error in previously issued financial statement; it is not an accounting change.

How to Correct an Error

In order to properly correct an error, it is necessary to retrospectively restate the prior period financial statements. In order to restate the financials the company must:

• Reflect the cumulative effect of the error on periods prior to those presented in the carrying amounts of assets and liabilities as of the beginning of the first period presented; and
• Make an offsetting adjustment to the opening balance of retained earnings for that period; and
• Adjust the financial statements for each prior period presented, to reflect the error correction.

If the financial statements are only presented for a single period, then reflect the adjustment in the opening balance of retained earnings.

Counterbalancing vs. Non-counterbalancing Errors

A counterbalancing error has occurred when an error is made that cancels out another error. An example of a counterbalancing error is expenses charged to year X that should have been charged to year Y. The result is year X has an overstated expense and an understated profit and year Y has an expense understated and the profit overstated. Yet when retained earning for year Z is correct, because the two previous errors cancelled each other out. While the effects of the error are corrected over a period of two years, the yearly net income figures for year X and year Y were still misstated.

Accounting for a counterbalancing error is made by determining if the books for the current year are closed or not. If the current year books are closed-no entry is necessary if the error has already counterbalanced. If the error has not counterbalanced then an entry must be made to retained earnings.

If the books are not closed for the current year, the company is in the second year, and the error hasn’t already counterbalanced then it is necessary to correct the current period and adjusted beginning retained earnings. If the error has not counterbalanced, an entry is necessary to adjusted beginning retained earnings and correct the current period.

Keep in mind the financial statements need to be re-run no matter what.

Non-counterbalancing errors are those that will not be automatically offset in the next accounting period. It makes no difference whether the books are closed or still open, a correcting journal entry is necessary.

The Balance Sheet

If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

15.5: Additional Notes on Disclosures

15.5.1: Mechanics of a Disclosure

Disclosures provide additional information about the specific data on the company’s financial statements.

Learning Objective

Summarize why a company would have a disclosure on the financial statement

Key Points

• All relevant information must be disclosed. “Relevant” means any context that may impact a financial statement’s reliability.
• The disclosures can be required by generally accepted accounting principles or voluntary per management decisions.
• Types of disclosures include, accounting changes, accounting errors, asset retirement, insurance contract modifications, and noteworthy events.

Key Terms

contingent

An event which may or may not happen; that which is unforeseen, undetermined, or dependent on something future; a contingency.

disclosure

The act of revealing something.

Purpose of Disclosures

While a company’s financial statements contain all the relevant financial data about the company, that data is often in need of further explanation. That is where the disclosures on the financial statement come into play.

A financial statement disclosure will communicate relevant information not captured in the statement itself to a company’s stakeholders. The disclosures can be required by generally accepted accounting principles or voluntary per management decisions.

What Is Disclosed: Materiality and Impact

All relevant information must be disclosed. “Relevant” means any context that may impact a financial statement’s reliability. This may include information about accounting methods, dependencies, or changes in amounts or estimates.

Types of Financial Disclosures

Accounting Changes

If a company makes a significant change to their accounting policies, such as a change in inventory valuation, depreciation methods, or application of GAAP, they must disclose it. Such disclosures alert the financial statement’s users as to why the company’s financial information may suddenly look different.

Accounting Errors

Accounting errors can result for a variety of reasons including transposition, mathematical computation, and incorrect application of GAAP or failing to revalue assets using fair market value. When an error is discovered, it must be corrected. This often means correcting prior period financial statements. This information must be noted in the disclosure. Keep in mind, significant accounting errors can result in financial audits and possible bankruptcy by the company.

Asset Retirement

Companies retire assets once the asset provides no future benefits to the company. The procedure for retiring an asset requires the company to obtain both a fair market value and salvage value for the asset. Usually, the difference between the sale price and the asset’s salvage value results in a net loss. The net loss is then included on the company’s income statement, which is then explained via a disclosure.

Insurance Contract Modifications

Insurance contract modifications affect a company’s balance sheet. Since companies use the balance sheet to determine the total economic value added by their company’s operations. A financial disclosure is necessary to explain why the insurance contract was modified and what current or future implications may occur. Examples of insurance contracts include the business owner’s life insurance policy or the general liability insurance for business operations.

Other items

Other items requiring disclosure are noteworthy events and transactions. These events are infrequent but made a significant impact on the current financial period.

Credit Cards Represent Debt

Notes to financial statements can include information on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g., to indicate a lawsuit).

Notes to financial statements can include information on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g., to indicate a lawsuit).

Methods of Making a Disclosure

Disclosures may be simple statements regarding the change or provide a lengthy explanation for the reason to change the company’s accounting policies and procedures.

Voluntary disclosure in accounting is the provision of information by a company’s management beyond requirements, such as generally accepted accounting principles and Securities and Exchange Commission rules, where the information is believed to be relevant to the decision making of users of the company’s annual reports.

Voluntary disclosure benefits investors, companies, and the economy; for example, it helps investors make better capital allocation decisions and lowers firms’ cost of capital, the latter of which also benefits the general economy. Chau and Gray (2002) also found support for the theory that voluntary disclosure helps reduce conflicts of interest in widely held firms. Firms, however, balance the benefits of voluntary disclosure against the costs, which may include the cost of procuring the information to be disclosed, and decreased competitive advantage.

Structure of Disclosures

Disclosures can span several pages at the end of the financial statements.

14.2: Calculating Cash Flows

14.2.1: Preparation of the Statement of Cash Flows: Direct Method

Learning Objective

Explain the direct method for preparing the statement of cash flows

Key Points

• In order to identify the inflows and outflows for operating activities, you need to analyze the components of the income statement.
• Under the direct method, adjustments are made to the “expense accounts” themselves.
• The direct method of preparing a cash flow statement results in a more easily understood report, as compared with the indirect method.
• The most common example of an operating expense that does not affect cash is a depreciation expense.

Key Term

asset

Something or someone of any value; any portion of one’s property or effects so considered

Example

• The following is an example of using the direct method for calculating cash flows. For example, in order to find out the cash inflow from a customer we need to know the sales revenue, but the sales revenue is also affected by the accounts receivable account. So, if the sales revenue is 300, and the accounts receivable increases by 20, then the cash received from customers would be 280. In order to determine the cash paid to suppliers, you need to look at both the inventory and the accounts payable account, and then determine their effect on the cost of goods sold. For example, if the cost of goods sold was 220, and inventory increased by seven, and the accounts payable decreased by fifteen, the cash paid to suppliers would be 242. You add seven because the inventory increased, and you add fifteen because the accounts payable decreased, which means more money was paid.The cash paid for interest is determined by the bond interest expense and discount on the bonds payable. For example, if the interest expense is ten dollars, and the unamortized discount decreases by three dollars, then the cash paid for interest is seven dollars.

Calculating Cash Flows

Cash flows refer to inflows and outflows of cash from activities reported on an income statement. In short, they are elements of net income. Cash outflows occur when operational assets are acquired, and cash inflows occur when assets are sold. The resale of assets is normally reported as an investing activity unless it involves the purchase and sale of inventory, in which case it is reported as an operating activity. There are two different methods that can be used to report the cash flows of operating activities: the direct method and the indirect method .

Calculating Cash Flows

The two methods to calculate cash flows are the direct method and the indirect method

The Direct Method

For items that normally appear on the income statement, cash flows from operating activities display the net amount of cash that was received or disbursed during a given period of time. The direct method for calculating this flow involves deducting from cash sales only those operating expenses that consumed cash. In this method, each item on an income statement is converted directly to a cash basis, and each cash effect is directly reported. To employ this direct method, use the following equation:

• add net sales
• add ending accounts receivable
• subtract beginning accounts receivable
• add ending assets (prepaid rent, inventory, et al)
• subtract beginning assets (prepaid rent, inventory, et al)
• subtract ending payables (tax, interest, salaries, accounts payable, et al. )
• add ending payables (tax, interest, salaries, accounts payable, et al. )

Once the cash inflows and outflows from operating activities are calculated, they are added together in the “Operating Activities” section of the cash flow statement to obtain the net cash flow for a company’s operating activities.

Indirect Method

In the indirect (addback) method for calculating cash flows, the accrual basis net income is established first. This net income is then indirectly adjusted for items that affected the reported net income but did not involve cash. The indirect method adjusts net income (rather than adjusting individual items in the income statement) for the following phenomena: changes in current assets (other than cash), changes in current liabilities, and items that were included in net income but did not affect cash.

14.2.2: Preparation of the Statement of Cash Flows: Indirect Method

Learning Objective

Explain how to use the indirect method to calculate cash flow

Key Points

• The indirect method adjusts net income (rather than adjusting individual items in the income statement).
• The most common example of an operating expense that does not affect cash is depreciation expense.
• Depreciation expense must be added back to net income.

Key Terms

income statement

A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.

accrual

A charge incurred in one accounting period that has not been paid by the end of it.

indirect method

a way to construct the cash flow statement using net-income as a starting point, and makeing adjustments for all transactions for non-cash items, then adjusting from all cash-based transactions

Example

• Consider a firm reporting revenues of $125,000.During the reporting period, the firm’s accounts receivables increased by $36,000. Therefore, cash collected from these revenues was $89,000. Operating expenses reported during the period were $85,000, but accounts payable increased during the period by $5,000. Therefore, cash operating expenses were only $80,000.The net cash flow from operating activities, before taxes, would be:Cash flow from revenue: $89,000Cash flow from expenses: $(80,000)Net cash flow: $9,000The indirect method would find these cash flows as follows.Revenue: $125,000Expenses: $(85,000)Net Income: $40,000The adjustments for cash flow would then be made to this amount of net income. $36,000 would be subtracted due to the increase in accounts receivable, and $5,000 would be added due to the increase in accounts payable. This leaves us with the amount of $9,000 for net cash flow.

Calculating Cash Flows

There are two different methods that can be used to report the cash flows of operating activities. There is the direct method and the indirect method.

Calculating cash flow

The indirect method adjusts net income (rather than adjusting individual items in the income statement).

Indirect Method

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for:

1. changes in current assets (other than cash) and current liabilities, and
2. items that were included in net income but did not affect cash.

The indirect method uses net income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions. The following rules can be followed to calculate cash flows from operating activities:

• Decrease in non-cash current assets are added to net income;
• Increase in non-cash current asset are subtracted from net income;
• Increase in current liabilities are added to net income;
• Decrease in current liabilities are subtracted from net income;
• Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period);
• Revenues with no cash inflows are subtracted from net income;
• Non operating losses are added back to net income;
• Non operating gains are subtracted from net income.

Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expenses must be added back to net income. So, depreciation expense is shown (or captioned) on the statement of cash flows. Also, in the indirect method cash paid for taxes and cash paid for interest must be disclosed.

Direct Method Versus Indirect Method

Consider a firm reporting revenues of $125,000. During the reporting period, the firm’s accounts receivables increased by $36,000. Therefore, cash collected from these revenues was $89,000. Operating expenses reported during the period were $85,000, but accounts payable increased during the period by $5,000. Therefore, cash operating expenses were only $80,000. The net cash flow from operating activities, before taxes, would be:

Cash flow from revenue: 89,000

Cash flow from expenses: (80,000)

Net cash flow: 9,000

The indirect method would find these cash flows as follows.

Revenue: 125,000

Expenses: (85,000)

Net Income: 40,000

The adjustments for cash flow would then be made to this amount of net income. $36,000 would be subtracted due to the increase in accounts receivable, and $5,000 would be added due to the increase in accounts payable. This leaves us with the amount of $9,000 for net income.

13.2: Revenue Recognition

13.2.1: The Importance of Timing: Revenue and Expense Recognition

Learning Objective

Explain how the timing of expense and revenue recognition affects the financial statements

Key Points

• According to the principle of revenue recognition, revenues are recognized in the period earned (buyer and seller have entered into an agreement to transfer assets) and if they are realized or realizable (cash payment has been received or collection of payment is reasonably assured).
• The matching principle, part of accrual accounting, requires that expenses be recognized when obligations are (1) incurred (usually when goods are transferred or services rendered), and (2) that they offset recognized revenues, which were generated from those expenses.
• As long as the timing of the recognition of revenue and expense falls within the same accounting period, the revenues and expenses are matched and reported on the income statement.

Key Terms

matching principle

An accounting principle related to revenue and expense recognition in accrual accounting.

accrual accounting

refers to the concept of recognizing and reporting revenues when earned and expenses when incurred, regardless of the effect on cash.

incur

To render somebody liable or subject to.

Revenues and Matching Expenses

According to the principle of revenue recognition, revenues are recognized in the period when it is earned (buyer and seller have entered into an agreement to transfer assets) and realized or realizable (cash payment has been received or collection of payment is reasonably assured).

For example, if a company enters into a new trading relationship with a buyer, and it enters into an agreement to sell the buyer some of its goods. The company delivers the products but does not receive payment until 30 days after the delivery. While the company had an agreement with the buyer and followed through on its end of the contract, since there was no pre-existing relationship with the buyer prior to the sale, a conservative accountant might not recognize the revenue from that sale until the company receives payment 30 days later.

Expense Recognition

The assets produced and sold or services rendered to generate revenue also generate related expenses. Accounting standards require that companies using the accrual basis of accounting and match all expenses with their related revenues for the period, so that the income statement shows the revenues earned and expenses incurred in the correct accounting period.

A Sample Income Statement

Expenses are listed on a company’s income statement.

The matching principle, part of the accrual accounting method, requires that expenses be recognized when obligations are (1) incurred (usually when goods are transferred, such as when they are sold or services rendered) and (2) the revenues that were generated from those expenses (based on cause and effect) are recognized.

For example, a company makes toy soldiers and acquires wood to make its goods. It acquires the wood on January 1^st and pays for it on January 15th. The wood is used to make 100 toy soldiers, all of which are sold on February 15. While the costs associated with the wood were incurred and paid for during January, the expense would not be recognized until February 15^th when the soldiers that the wood was used for were sold.

If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period they expired (e.g., when they have been used up or consumed, spoiled, dated, related to the production of substandard goods, or the services are not in demand). Examples of costs that are expensed immediately or when used up include administrative costs, R&D, and prepaid service contracts over multiple accounting periods.

The Effect of Timing on Revenues & Expenses

Often, a business will spend cash on producing their goods before it is sold or will receive cash for good sit has not yet delivered. Without the matching principle and the recognition rules, a business would be forced to record revenues and expenses when it received or paid cash. This could distort a business’s income statement and make it look like they were doing much better or much worse than is actually the case. By tying revenues and expenses to the completion of sales and other money generating tasks, the income statement will better reflect what happened in terms of what revenue and expense generating activities during the accounting period.

13.2.2: Current Guidelines for Revenue Recognition

Learning Objective

Explain how the revenue recognition principle affects how a transaction is recorded

Key Points

• Under accrual accounting, revenues are recognized when they are realized (payment collected) or realizable (the seller has reasonable assurance that payment on goods will be collected) and when they are earned (usually occurs when goods are transferred or services rendered).
• For companies that don’t follow accrual accounting and use the cash-basis instead, revenue is only recognized when cash is received.
• Revenue recognition is a part of the accrual accounting concept that determines when revenues are recognized in the accounting period.
• The matching principle, along with revenue recognition, aims to match revenues and expenses in the correct accounting period. It allows a better evaluation of the income statement, which shows the revenues and expenses for an accounting period or how much was spent to earn the period’s revenue.

Key Terms

intangible asset

Any valuable property of a business that does not appear on the balance sheet, including intellectual property, customer lists, and goodwill.

fixed asset

Asset or property which cannot easily be converted into cash, such as land, buildings, and machinery.

Revenue Recognition Concepts

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized if they are realized or realizable (the seller has collected payment or has reasonable assurance that payment on goods will be collected). Revenues must also be earned (usually occurs when goods are transferred or services rendered), regardless of when cash is received. For companies that don’t follow accrual accounting and use the cash-basis instead, revenue is only recognized when cash is received .

Presentation of Revenue Trends over Time

Guidelines for revenue recognition will affect how and when revenue is reported on the income statement.

Transactions that Recognize Revenue

Transactions that result in the recognition of revenue include:

• Sales of inventory, which are typically recognized on the date of sale or date of delivery, depending on the shipping terms of the sale
• Sales of assets other than inventory, typically recognized at point of sale.
• Sales of services rendered, recognized when services are completed and billed.
• Revenue from the use of the company’s assets such as interest earned for money loaned out, rent for using fixed assets, and royalties for using intangible assets, such as a licensed trademark. Revenue is recognized due to the passage of time or as assets are used.

The Matching Principle

The matching principle’s main goal is to match revenues and expenses in the correct accounting period. The principle allows a better evaluation of the income statement, which shows the revenues and expenses for an accounting period or how much was spent to earn the period’s revenue. By following the matching principle, businesses reduce confusion from a mismatch in timing between when costs (expenses) are incurred and when revenue is recognized and realized.

13.2.3: Recognition of Revenue at Point of Sale or Delivery

Learning Objective

Explain how the delivery date affects revenue recognition

Key Points

• The accrual journal entry to record the sale involves a debit to the accounts receivable account and a credit to sales revenue; if the sale is for cash, debit cash instead. The revenue earned will be reported as part of sales revenue in the income statement for the current accounting period.
• When transfer of ownership of goods sold is not immediate and delivery of the goods is required, the shipping terms of the sale dictate when revenue is recognized. Shipping terms are typically “FOB Destination” and “FOB Shipping Point”.
• If a company cannot reasonably estimate the amount of future returns and/or has extremely high rates of returns on sales, they should recognize revenues only when the right of return expires.

Key Terms

FOB

Stands for “Free on Board” or “Freight on Board”; specifies which party (buyer or seller) pays for shipment and loading costs, and/or where responsibility for the goods is transferred.

accrual

A charge incurred in one accounting period that has not been paid by the end of it.

Recognizing Revenue at Point of Sale or Delivery

Goods sold, especially retail goods, typically earn and recognize revenue at point of sale, which can also be the date of delivery if the buyer takes immediate ownership of the merchandise purchased. Since most sales are made using credit rather than cash, the revenue on the sale is still recognized if collection of payment is reasonably assured. The accrual journal entry to record the sale involves a debit to the accounts receivable account and a credit to the sales revenue account; if the sale is for cash, the cash account would be debited instead. The revenue earned will be reported as part of sales revenue in the income statement for the current accounting period .

Street Market in India with Goods for Sale

A street market seller recognizes revenue when he relinquishes his merchandise to a buyer and receives payment for the item sold.

Terms of Delivery

When the transfer of ownership of goods sold is not immediate and delivery of the goods is required, the shipping terms of the sale dictate when revenue is recognized. Shipping terms are typically “FOB Destination” and “FOB Shipping Point”. For goods shipped under FOB destination, ownership passes to the buyer when the goods arrive at the buyer’s receiving dock; at this point, the seller has completed the sales transaction and revenue has been earned and is recorded. If the shipping terms are FOB shipping point, ownership passes to the buyer when the goods leave the seller’s shipping dock, thus the sale of the goods is complete and the seller can recognize the earned revenue.

Revenue Recognition & Right of Return

If a company cannot reasonably estimate the amount of future returns and/or has extremely high rates of returns on sales, they should recognize revenues only when the right of return expires. Those companies that can estimate the number of future returns and have a relatively small return rate can recognize revenues at the point of sale, but must deduct estimated future returns.

13.2.4: Recognition of Revenue Prior to Delivery

Learning Objective

Distinguish between the percentage of completion method and the completion of production method of revenue recognition

Key Points

• For most goods that have been sold and are undelivered, the sales transaction is not complete and revenue on the sale has not been earned. In this case, an accrual entry for revenue on the sale is not made.
• The cash method of accounting recognizes revenue and expenses when cash is exchanged. For a seller using the cash method, if cash is received prior to the delivery of goods, the cash is recorded as earnings.
• Under the percentage-of-completion method, if a long-term contract specifies the price and payment options with transfer of ownership and details the buyer’s and seller’s expectations, then revenues, costs, and gross profit can be recognized each period based upon the progress of construction.
• The completion of production method allows recognizing revenues even if no sale was made. This applies to natural resources where there is a ready market for these products with reasonably assured prices, units are interchangeable, and selling and distributing costs are not significant.

Key Terms

accrual

A charge incurred in one accounting period that has not been paid by the end of it.

conservatism

A risk-averse attitude or approach; for accounting purposes, it relates to disclosing expenses and losses incurred immediately and delaying the recognition of revenues and gains until realized.

Definition of Revenue Recognition

The accounting principle regarding revenue recognition states that revenues are recognized when they are earned (transfer of value between buyer and seller has occurred) and realized or realizable (collection is reasonably assured). A transfer of value takes place between a buyer and seller when the buyer receives goods in accordance to a sales order approved by the buyer and seller and the seller receives payment or a promise to pay from the buyer for the goods purchased. Revenue must be realizable. In order words, for sales where cash was not received, the seller should be confident that the buyer will pay according to the terms of the sale .

Goods in Inventory

Depending on the shipping terms of the sale, a seller may not recognize revenue on goods sold that are pending delivery.

Methods that Recognize Revenue Prior to Delivery or Sale

• Percentage-of-completion method: if a long-term contract clearly specifies the price and payment options with transfer of ownership — the buyer is expected to pay the whole amount and the seller is expected to complete the project — then revenues, expenses, and gross profit can be recognized each period based upon the progress of construction (that is, percentage of completion). For example, if during the year, 25% of the building was completed, the builder can recognize 25% of the expected total profit on the contract. Percentage of completion is preferred over the completed contract method. However, expected loss should be recognized fully and immediately due to the conservatism constraint. All revenues, expenses, losses, and gains resulting from the percentage completed will be reported on the income statement.
• Completion of production method: This method allows recognizing revenues even if no sale was made. This applies to agricultural products and minerals because there is a ready market for these products with reasonably assured prices, the units are interchangeable, and selling and distributing does not involve significant costs. All expected revenues and costs of production related to the units produced will be reported on the income statement.

13.2.5: Recognition of Revenue After Delivery

Learning Objective

Differentiate between the installment sales method, the cost recover method and the deposit method to account for recognizing revenue after the delivery of goods

Key Points

• When a sale of goods carries a high uncertainty on collectibility, a company must defer the recognition of revenue until after delivery.
• The installment sales method recognizes income after a sale or delivery is made; the revenue recognized is a proportion or the product of the percentage of revenue earned and cash collected.
• The cost recovery method is used when there is an extremely high probability of uncollectable payments. Under this method, no revenue is recognized until cash collections exceed the seller’s cost of the merchandise sold.
• The deposit method is used when a company receives cash before transfer of ownership occurs. Revenue is not recognized when cash is received, because the risks and rewards of ownership have not transferred to the buyer. Only as the transfer of value takes place is revenue recognized.

Key Terms

liability

An obligation, debt or responsibility owed to someone.

deferral

An account where the asset or liability recording cash paid or received is not realized until a future date (accounting period)

Recognizing Revenue after Delivery of Goods

When a sale of goods transaction carries a high degree of uncertainty regarding collectibility, a company must defer the recognition of revenue. In this situation, revenue is not recognized at point of sale or delivery. There are three methods that recognize revenue after delivery has taken place: .

Service Delivery

Delivery of goods or service may not be enough to allow for a business to recognize revenue on a sale if there is doubt that the customer will pay what it owes.

The installment sales method recognizes income after a sale or delivery is made; the revenue recognized is a proportion or the product of the percentage of revenue earned and cash collected. The unearned income is deferred (recorded as a liability) and then recognized to income when cash is collected. For example, if a company collected 45% of a product’s sale price, it can recognize 45% of total revenue on that product. The installment sales method is typically used to account for sales of consumer durables, retail land sales, and retirement property.

The cost recovery method is used when there is an extremely high probability of uncollectable payments. Under this method, no revenue is recognized until cash collections exceed the seller’s cost of the merchandise sold. For example, if a company sold a machine worth $10,000 for $15,000, it can start recognizing revenue when the buyer has made payments in excess of $10,000. In other words, each dollar collected greater than $10,000 goes towards the seller’s anticipated revenue on the sale of $5,000.

The deposit method is used when a company receives cash before transfer of ownership occurs. Revenue is not recognized when cash is received because the risks and rewards of ownership have not transferred to the buyer. The seller records the cash deposit as a deferred revenue, which is reported as a liability on the balance sheet until the revenue is earned. For example, sales of magazine subscriptions utilize the deposit method to recognize revenue. A deferral is recorded when a seller receives a subscriber’s payment on the subscription; cash is debited and deferred magazine subscriptions (a liability account) is credited. As the delivery of the magazines take place, a portion of revenue is recognized, and the deferred liability account is reduced for the amount of the revenue.

13.2.6: Differences Between Accrual-Basis and Cash-Basis Accounting

Learning Objective

Differentiate between accrual and cash basis accounting

Key Points

• Accrual accounting does not consider cash when recording revenue; in most cases, goods must be transferred to the buyer in order to recognize earnings on the sale. An accrual journal entry is made to record the revenue on the transferred goods as long as collection of payment is expected.
• In accrual accounting, expenses incurred in the same period that revenues are earned are also accrued for with a journal entry. Same as revenues, the recording of the expense is unrelated to the payment of cash.
• For a seller using the cash method, revenue on the sale is not recognized until payment is collected and expenses are not recorded until cash is paid.
• The cash model is only acceptable for smaller businesses for which a majority of transactions occur in cash and the use of credit is minimal.

Key Terms

liability

An obligation, debt or responsibility owed to someone.

accrue

To increase, to augment; to come to by way of increase; to arise or spring as a growth or result; to be added as increase, profit, or damage, especially as the produce of money lent.

Definition of Accrual Accounting

Under the accrual accounting method, the receipt of cash is not considered when recording revenue; however, in most cases, goods must be transferred to the buyer in order to recognize earnings on the sale. An accrual journal entry is made to record the revenue on the transferred goods even if payment has not been made. If goods are sold and remain undelivered, the sales transaction is not complete and revenue on the sale has not been earned. In this case, an accrual entry for revenue on the sale is not made until the goods are delivered or are in transit. Expenses incurred in the same period in which revenues are earned are also accrued for with a journal entry. Just like revenues, the recording of the expense is unrelated to the payment of cash. An expense account is debited and a cash or liability account is credited.

Definition of Cash-Basis Accounting

The cash method of accounting recognizes revenue and expenses when cash is exchanged. For a seller using the cash method, revenue on the sale is not recognized until payment is collected. Just like revenues, expenses are recognized and recorded when cash is paid. The Financial Accounting Standards Board (FASB), which dictates accounting standards for most companies—especially publicly traded companies—discourages businesses from using the cash model because revenues and expenses are not properly matched. The cash model is acceptable for smaller businesses for which a majority of transactions occur in cash and the use of credit is minimal. For example, a landscape gardener with clients that pay by cash or check could use the cash method to account for her business’ transactions .

A cashier at a hotel in Thailand

The cash-basis method, unlike the accrual method, relies on the receipt and payment of cash to recognize revenues and expenses.

13.3: Expense Recognition

13.3.1: Expense Recognition

Expense recognition is an essential element in accounting because it helps define how profitable a business is in an accounting period.

Learning Objective

Calculate the ending balance of an income statement account and discuss how the proper recognition of expenses affects a company’s income

Key Points

• Expenses are outflows of cash or other assets from a person or company to another entity.
• Expenses can either take the form of a decrease in a business’ cash or assets, or an increase in its liabilities. It is important to note that cash or property distributions to a business owner do not count as expenses.
• The accounting method the business uses determines when an expense is recognized.
• If the business uses cash basis accounting, an expense is recognized when the business pays for a good or service.
• Under the accrual system, an expense is recognized once it is incurred.

Key Terms

accrual basis accounting

A method of accounting where income is not recorded until earned and expenses are not recorded until incurred.

cash-basis accounting

A method of accounting where income is recorded when cash is received and expenses are recorded when cash is paid.

expense

In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue

Recognition of Expenses

Expenses are outflows of cash or other valuable assets from a person or company to another entity. This outflow of cash is generally one side of a trade for products or services that have equal or better current or future value to the buyer than to the seller. Technically, an expense is an event in which an asset is used up or a liability is incurred. In terms of the accounting equation, expenses reduce owners’ equity.

A Sample Income Statement

Expenses are listed on a company’s income statement.

The International Accounting Standards Board defines expenses as follows: “Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. “

An important issue in accounting is when to recognize expenditures. When a business recognizes an expenditure, it records the amount in its financial records. The expenditure offsets the income the business earned and is used to calculate the business’s profit.

This makes the timing of expenses and revenues very important. By shifting the timing of when expenses are recognized, a company can artificially make its business appear more profitable. Therefore, the accounting standards institute has established clear guidelines to minimize any subjective judgment regarding when to recognize expenses. Thus, the accounting method the business uses depends on when an expense is recognized.

Cash Basis Accounting

If the business uses cash basis accounting, an expenditure is recognized when the business pays for a good or service. Generally, cash basis accounting is reserved for tax accounting, not for financial reports.

Accrual Basis Accounting

Most financial reporting in the US is based on accrual basis accounting. Under the accrual system, an expense is not recognized until it is incurred. This means it is unimportant with regard to recognition when a business pays cash to settle an expense.

13.3.2: Current Guidelines for Expense Recognition

For an expense to be recognized under the matching principle, it must be both incurred and offset against recognized revenues.

Learning Objective

Explain how accrual accounting uses the matching principle for expense recognition

Key Points

• An expense is incurred when the underlying good is delivered or service is performed.
• If the cost can be tied to a revenue generating activity, it will not be recognized as an expense until the associated good or service is sold.
• If a company generates goods or services that it cannot sell, the costs associated with producing those items become expenses when the items become used up or consumed.
• If a cost is not directly tied to any revenue generating activity, it is recognized as soon as it is incurred.

Key Terms

consigned good

a good sent to another person where the seller still retains ownership until ownership is transferred or the good is sold

matching principle

An accounting principle related to revenue and expense recognition in accrual accounting.

Since most businesses operate using accrual basis accounting, expense recognition is guided by the matching principle. For an expense to be recognized, the obligation must be both incurred and offset against recognized revenues.

Revenues and Expenses

This graph shows the growth of the revenues, expenses, and net assets of the Wikimedia Foundation from june 2003 to june 2006.

Incurred

An expense is incurred when the underlying good is delivered or service is performed. For example, assume a company enters into a contract with a supplier for the delivery of 1,000 units of raw material that will be used to produce the goods it sells. Two weeks later, the raw material is delivered to the company’s warehouse. Two weeks after that, the company pays the outstanding obligation. Under the matching principle, the expense related to the raw material is not incurred until delivery.

Offset Against Recognized Revenues

Generally, an expense being incurred is insufficient for it to be recognized. If the cost can be tied to a revenue generating activity, it will not be recognized as an expense until the associated good or service is sold.

Using the same example from above, the delivery of the raw material is insufficient to cause the cost of those goods to be recognized as an expense. The raw material will be used to make items that will be sold to the public. When the items that used the raw materials are sold, then the costs related to the raw material are recognized.

No Cause and Effect

The matching principle assumes that every expense is directly tied to a revenue generating event, such as a production of a good or service. This is not always the case. When these expenses are recognized depends on what goods or services are related to the cost in question.

If a company generates goods or services that it cannot sell, the costs associated with producing those items become expenses when the items become used up or consumed. So if a business produced substandard goods that it could not sell or the good becomes spoiled, the production costs would be expensed as soon as it became clear that the item could not be sold.

If a cost is not directly tied to any revenue generating activity, it is recognized as soon as it is incurred. Examples of such costs include general administration and research and development.

13.3.3: Differences Between Accrued and Deferred Expenses

Accrued and deferred expenses represent the two possibilities that can occur due to timing differences under the matching principle.

Learning Objective

Explain the difference between accrued expenses and deferred expenses

Key Points

• An accrued expense is a liability that represents an expense that has been recognized but not yet paid.
• A deferred expense is an asset that represents a prepayment of future expenses that have not yet been incurred.
• Oftentimes an expense is not recognized at the same time it is paid. This difference requires a business to record either an asset or liability on its balance sheet to reflect this difference in timing.

Key Terms

matching principle

Expenses should be matched with revenues.

deferred expense

A deferred expense or prepayment, prepaid expense, is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period.

accrued expense

Accrued expense is a liability with an uncertain timing or amount, the reason being no invoice has been received yet.

accrued revenue

income recognized before cash is received

Expenses

Accrued expenses and deferred expenses are two examples of mismatches between when expenses are recognized under the matching principle and when those expenses are actually paid. Both are represented on the company’s balance sheet .

Balance Sheet

Accrued and deferred expenses are both listed on a company’s balance sheet.

Accrued Expense

An accrued expense is a liability that represents an expense that has been recognized but not yet paid. Not every transaction requires an immediate exchange of cash for goods and services. Sometimes, especially when there is a prolonged history of ongoing transactions between two parties, formal invoicing and payment requirements can occur after the expense associated with the transaction has been recognized.

For example, assume a reseller receives goods from a supplier that it is able to immediately resell. However, the billing for those goods does not require payment for another month. Since the supplier delivered the goods and the reseller already generated revenues from the sale of those goods, it must recognize the associated expense. So the associated expense must be listed as a liability to be paid at some point in the future.

Deferred Expense

A deferred expense is an asset that represents a prepayment of future expenses that have not yet been incurred. Deferred expense is generally associated with service contracts that require payment in advance.

For example, assume a company enters into a legal services contract that requires an upfront payment of $12,000 for a year of services. The service has not yet been delivered, so the business cannot recognize the expense yet. So the business will record a $12,000 deferred expense asset. The provider then delivers on his service each month, requiring the business to recognize the associated expense. As a result, the business must recognize $1000 in expenses each month and decrease the value of the deferred expense asset by that amount.

13.4: Additional Income Statement Considerations

13.4.1: Impact of the Operating Cycle on the Income Statement

The accrual method ensures proper reporting on the income statement because the operating cycle doesn’t coincide with the accounting cycle.

Learning Objective

Differentiate between the accounting cycle and the operating cycle

Key Points

• A company’s income statement shows profit (or loss) for a given period of time.
• A company’s operating cycle is the length of time necessary to convert inventory into a sale, plus the length of time to receive payment from receivables, plus the length of time to pay the accounts payable.
• The length of the operating cycle varies depending on how long inventory, receivable, and payable remain outstanding.
• The accounting cycle is a series of steps performed during the accounting period (some throughout the period, some only at the end of the period) for the purpose of creating financial statements.
• The accounting cycle is often different from the operating cycle.

Key Terms

income statement

A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.

profitability

The capacity to make a profit.

operating cycle

The average time between purchasing or acquiring inventory and receiving cash proceeds from its sale.

Income Statement

The income statement is one component of the financial statements for a company. It can also be referred to as an earnings statement, profit and loss statement, or operating statement . The income statement reports the profitability of a business organization for a stated period, such as a month or a year. These time periods are usually of equal length so that statement users can make valid comparisons of a company’s performance from period to period. Profitability is measured by comparing the revenues earned with the expenses incurred to produce the revenue.

The company’s income statement

The income statement shows a company’s profit or loss.

An example of revenue is cash received from the sale of products or services. Expenses are the costs involved in producing revenue, such as cash spent to purchase materials or pay bills or employees. If the revenues for a period exceed the expenses for the same period, net income results (Net income = Revenues – Expenses). If expenses exceed revenues for the period, then the result is a net loss.

Accounting Cycle vs. Operating Cycle

Information enters the income statement via the accounting cycle. The accounting cycle is a series of steps performed during the accounting period (some throughout the period, some only at the end of the period) for the purpose of creating the financial statements. This includes analyzing items to determine if they are a business transaction, as well as classifying and recording the transactions as journal entries in the proper journal. After that, the items are posted from the journals to the general ledger, which is used to prepare the financial statements. Companies choose the length of their accounting cycle by how long it takes to carry out the required accounting—not when the individual business transactions take place.

Often, companies have a separate operating cycle for their business. The operating cycle reflects the length of time it takes a company to convert its inventory purchase to sales revenue. A typical operating cycle includes the length of time to convert inventory into a sale, length of time to receive payment from receivables, and length of time to pay the accounts payable.

The length of the operating cycle varies depending on how long inventory, receivable, and payable remain outstanding and may occur several times in one period. It is very rare that the accounting cycle and operating cycle coincide with each other. That is why each business transaction during the operating cycle is analyzed to determine which accounting cycle to record it in. When companies fail to follow this procedure, the current accounting cycle records do not accurately reflect the business transactions in each of the operating cycles. In that case, the financial statements, including the income statement, will not be accurate.

Accrual Basis of Accounting

To allow for the fluctuations in the operating cycle, many companies choose to use the accrual basis of accounting. In accrual accounting, companies recognize revenues when the company makes a sale or performs a service, regardless of when the company receives the cash. However, the matching principle necessitates the preparation of adjusting entries. Adjusting entries are journal entries made at the end of an accounting period, or at any time financial statements are to be prepared, to bring about a proper matching of revenues and expenses.

The matching principle requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. The matching principle is one of the underlying principles of accounting. This matching of expenses and revenues is necessary for the income statement to present an accurate picture of the profitability of a business.

13.4.2: Reporting Irregular Items

Irregular items are reported separately from the income statement proper so that users can better predict future cash flows. 

Learning Objective

Differentiate among discontinued operations, extraordinary items, and changes in accounting principles

Key Points

• Irregular items are shown separately from the income statement proper because they are unlikely to recur. This helps the reader more accurately predict future cash flows
• There are three types of irregular items: discontinued operations, extraordinary items, and changes in accounting principles.
• Discontinued operations, the most common category of irregular items, are a component of an enterprise that either has been disposed of or is classified as “held for sale.”
• Extraordinary items are unexpected, abnormal, and infrequent occurrences—for example, sudden natural disaster or new regulations.
• Changes in accounting principles are when a company adopts a new accounting method that has an impact on the book value of the affected assets or liabilities.

Key Term

irregular item

An unusual occurrence reported separately from the standard income statement because it is unlikely to recur.

Irregular items, which are by definition unlikely to recur, are reported separately from the income statement proper so that users can better predict future cash flows. Irregular items are reported net of taxes.

Discontinued Operations

Discontinued operations are the most common type of irregular items and must be shown separately. A discontinued operation is a component of an enterprise that either has been disposed of or is classified as “held for sale,” and:

• represents a separate major line of business or geographical area of operations; and
• is part of a single, co-ordinated plan to dispose of this separate major line of business or geographical area of operations; or
• is a subsidiary acquired exclusively with a view to resale.

Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Any gain or loss from sale of assets should be recognized in the statement of comprehensive income.

Extraordinary Items

Extraordinary items are unexpected, abnormal, and infrequent—for example, sudden natural disaster, expropriation, or new prohibitions due to changes in regulations.

Changes in Accounting Principles

The effect of changes in accounting principles is the difference between the book value of the affected assets (or liabilities) under the old policy (i.e. principle) vs. what the book value would have been had the new principle been applied. An example, if a company switched from using a weighted-average method to using a LIFO method of valuating inventories, both values for the same time period should be calculated and compared. These changes should be applied retrospectively and shown as adjustments to the beginning balance of affected components in Equity. All comparative financial statements should be restated.

13.4.3: Special Reporting

Irregular items require special reporting procedures, and include discontinued operations, extraordinary items, and the reporting of the resultant EPS.

Learning Objective

Summarize how a company reports extraordinary items, discontinued operations, intraperiod tax allocations, retained earnings and earnings per share.

Key Points

• Discontinued operation pertains to the elimination of a significant portion of a firm’s business, such as the sale of a division.
• Extraordinary items are both unusual (abnormal) and infrequent — for example, unexpected natural disasters, expropriation, and prohibitions under new regulations.
• If a company reports any irregular items on its income statement, then it must report earnings per share for the irregular items.
• With intraperiod tax allocation, the specific item (or items) that generated the income tax expense are shown on the income statement with the applicable tax applied.

Key Terms

income statement

Displays the revenues recognized for a specific period and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the reporting period.

retained earnings

Retained earnings are the portion of net income that is retained by the corporation rather than distributed to its owners as dividends.

dilute

To cause the value of individual shares to decrease by increasing the total number of shares.

Special Reporting Issues

Special, or irregular, items appear on single step or multi-step income statements, and require special reporting procedures. They are reported separately, and net of taxes, so that stakeholders can better predict future cash flows. Two examples of irregular items are discontinued operations and extraordinary expenses.

Discontinued operation is the most common type of irregular item. It pertains to the elimination of a significant portion of a firm’s business, such as the sale of a division. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations.

Extraordinary items are both unusual (abnormal) and infrequent — for example, unexpected natural disasters, expropriation, and prohibitions under new regulations. If an item is unique, but does not fit the criteria of being unusual and infrequent, it must remain in the main section of the income statement. No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP.

Other special reporting issues include Earnings per Share, Retained Earnings and Intraperiod Tax Allocation.

Earnings per Share: If a company reports any irregular items on its income statement, then it must report earnings per share for those items. The earnings per share can appear on the income statement or in the notes to the income statement. Earnings per share measures the dollars earned by each share of common stock. Earnings per share are calculated as net income, with preferred dividends/weighted number of shares outstanding. There are two forms of earnings per share that are reported: basic and diluted. For basic earnings per share, the weighted average of shares outstanding includes only actual stocks outstanding. In diluted, the weighted average of shares outstanding is calculated as if all stock options, warrants, convertible bonds and other securities that could be transformed into shares are transformed. Diluted earnings per share are considered a more reliable way to measure earnings per share.

Retained Earnings: The statement of retained earnings explains the changes in a company’s retained earnings over the reporting period. It is required by the U.S. Generally Accepted Accounting Principles (U.S. GAAP) whenever comparative balance sheets and income statements are presented. It may appear in the balance sheet, in a combined income and changes in retained earnings statement, or as a separate schedule. In essence, the statement of retained earnings uses information from the income statement and provides information to the balance sheet. The statement breaks down changes in the owners’ interest in the organization, and also in the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses from operations, dividends paid, the issue or redemption of stock, and any other items charged or credited to retained earnings.

Intraperiod Tax Allocation: With intraperiod tax allocation, the specific item (or items) that generated the income tax expense are shown on the income statement with the applicable tax amount applied. Income tax is allocated to income from continuing operations before tax, discontinued operations and extraordinary items.

13.5: Reporting and Analyzing the Income Statement

13.5.1: Preparation of the Income Statement

An income statement includes detail on operating and non-operating activities.

Learning Objective

Explain the difference between the operating and non-operating section of the income statement

Key Points

• Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major operations fall under the revenue category of the income statement.
• Cash outflows or other using up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major operations appear under the expenses section of the income statement.
• Discontinued operations is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.
• Certain items must be disclosed separately in the notes, if material, including write-downs of inventories to net realizable value or of property, and restructuring of the activities of an entity and reversal of any provisions for the costs of restructuring; and more.

Key Terms

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

expense

In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue

disclosure

The act of revealing something.

Income Statement

An income statement is a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as net profit or the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

Operating section

Revenue

Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities constitute the entity’s ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances. Every time a business sells a product or performs a service, it obtains revenue. This often is referred to as gross revenue or sales revenue.

A Sample Income Statement

Expenses are listed on a company’s income statement.

Expenses

Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities constitute the entity’s ongoing major operations.

• Cost of Goods Sold (COGS)/Cost of Sales represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandising). It includes material costs, direct labor, and overhead costs (as in absorption costing), and excludes operating costs (period costs), such as selling, administrative, advertising or R&D, etc.
• Selling, General, and Administrative expenses (SG&A or SGA) consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs, such as direct labor. Selling expenses represent expenses needed to sell products (e.g., salaries of sales people, commissions and travel expenses, advertising, freight, shipping, depreciation of sales store buildings and equipment, etc.). General and Administrative (G&A) expenses represent expenses to manage the business (salaries of officers/executives, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies, etc.).
• Depreciation / Amortization is the charge with respect to fixed assets/intangible assets that have been capitalized on the balance sheet for a specific (accounting) period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.
• Research & Development (R&D) expenses represent expenses included in research and development.

Non-operating Section

• Other revenues or gains include those from other than primary business activities (e.g., rent, income from patents). They also includes unusual gains that are either unusual or infrequent, but not both (e.g., gains from the sale of securities or gain from disposal of fixed assets)
• Other expenses or losses not related to primary business operations (e.g., foreign exchange loss).
• Finance costs are costs of borrowing from various creditors (e.g., interest expenses, bank charges).
• Income tax expense is the sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities/ tax payable) and the amount of deferred tax liabilities (or assets).

Irregular Items

Discontinued operations is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.Disclosures

Certain items must be disclosed separately in the notes (or the statement of comprehensive income), if material, including:

• Write-downs of inventories to net realizable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs
• Restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring
• Disposals of items of property, plant, and equipment
• Disposals of investments
• Discontinued operations
• Litigation settlements
• Other reversals of provisions

Earnings Per Share

Because of its importance, earnings per share (EPS) are required to be disclosed on the face of the income statement. A company that reports any of the irregular items must also report EPS for these items either in the statement or in the notes. There are two forms of EPS reported:

Basic:In this case “weighted average of shares outstanding” includes only actual stocks outstanding.

Diluted: In this case, “weighted average of shares outstanding” is calculated as if all stock options, warrants, convertible bonds, and other securities that could be transformed into shares are transformed. This increases the number of shares and so EPS decreases. Diluted EPS is considered to be a more reliable way to measure EPS.

13.5.2: Income Statement Analyses

The income statement indicates how the revenue is transformed into net income and can provide many insights to a company’s performance.

Learning Objective

Explain how the different formulas are used on the income statement to show a company’s performance

Key Points

• Net income is an entity’s income minus expenses for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period. It has also been defined as the net increase in stockholder’s equity that results from a company’s operations.
• In stock trading, the P/E ratio (price-to-earnings ratio) of a share (also called its “P/E,” or simply “multiple”) is the market price of that share divided by the annual Earnings per Share (EPS). The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies.
• The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share.
• The operating ratio is a financial term defined as a company’s operating expenses as a percentage of revenue. This financial ratio is most commonly used for industries that require a large percentage of revenues to maintain operations, such as railroads.
• Times interest earned (TIE) or interest coverage ratio is a measure of a company’s ability to honor its debt payments.

Key Terms

ratio

A number representing a comparison between two things.

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

net income

Gross profit minus operating expenses and taxes.

The Income Statement

Income statement (also referred to as profit and loss statement (P&L), revenue statement, statement of financial performance, earnings statement, operating statement or statement of operations) is a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as Net Profit or the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported .

A Sample Income Statement

Expenses are listed on a company’s income statement.

The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.

Basic Equations

Revenues – Expenses = Net Income

• In business, net income also referred to as the bottom line, net profit, or net earnings is an entity’s income minus expenses for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period. It has also been defined as the net increase in stockholder’s equity that results from a company’s operations.

Earnings per Share = (Net Income –

Preferred

Dividends) / Shares of Stock Outstanding

• Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s stock.

Price to Earnings Ratio = Market Value of Stock / Earnings per Share

• In stock trading, the P/E ratio (price-to-earnings ratio) of a share (also called its “P/E,” or simply “multiple”) is the market price of that share divided by the annual Earnings per Share (EPS). The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies. A higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more “expensive” than one with a lower P/E ratio. The P/E ratio can be regarded as being expressed in years. The price is in currency per share, while earnings are in currency per share per year, so the P/E ratio shows the number of years of earnings which would be required to pay back the purchase price, ignoring inflation, earnings growth and the time value of money.

Dividend Yield = (Dividends per Share / Market Value of Stock) x 100

• The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage.
• Dividend yield is used to calculate the earnings on investment (shares) considering only the returns in the form of total dividends declared by the company during the year.

Operating Expense Ratio = Operating Expense / Net Sales

• The operating ratio is a financial term defined as a company’s operating expenses as a percentage of revenue. This financial ratio is most commonly used for industries that require a large percentage of revenues to maintain operations, such as railroads. In railroading, an operating ratio of 80 or lower is considered desirable.
• The operating ratio can be used to determine the efficiency of a company’s management by comparing operating expenses to net sales. It is calculated by dividing the operating expenses by the net sales. The smaller the ratio, the greater the organization’s ability to generate profit should revenues decrease. The ratio does not factor in expansion or debt repayment.

Times Interest Earned = Net Income / Annual Interest Expense

• Times interest earned (TIE) or interest coverage ratio is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest payable.

12.2: Stock Transactions

12.2.1: Issuing Stock

Learning Objective

Differentiate between common and preferred stock

Key Points

• Issued shares are the sum of outstanding shares and treasury stock, or stock reacquired by the company. Most public companies issue two major types of shares: common and preferred.
• Common shareholders may possess “voting” shares and have the ability to influence company decisions through their vote. Owning common stock tends to be riskier than owning preferred stock.
• Preferred stock is considered a hybrid financial instrument because the shares have properties of both equity and debt.
• When reporting common or preferred stock in stockholder’s equity, the value of shares is divided between the stock’s par, or stated, value, and the amount in excess of par is recorded to additional paid in capital.

Key Terms

creditor

A person to whom a debt is owed.

capital

Money and wealth. The means to acquire goods and services, especially in a non-barter system.

authorized stock

shares created by the company

liquidation

The selling of the assets of a business as part of the process of dissolving it.

Issuing Company Stock

The process of issuing stock– or shares– of a publicly traded company involves several steps. The amount of issued stock is dependent on the authorized capital of a company, or the maximum number of shares authorized by a company’s corporate documents to issue to shareholders. A portion of authorized capital tends to remain unissued, but the number can be changed by shareholder approval. When shares are issued, they are transferred to a subscriber, an action referred to as an allotment. After the allotment, a subscriber becomes a shareholder. Issued shares are the sum of outstanding shares and treasury stock, or stock reacquired by the company. Most public companies issue two major types of shares: common and preferred.

General Motors Common Stock Certificate

Public companies issue common stock to raise business capital.

Common Stock

Shares of common stock are primarily issued in the United States. Common shareholders may possess “voting” shares and have the ability to influence company decisions through their vote. Owning common stock tends to be riskier than owning preferred stock; yet over time, common shares on average perform better than preferred shares or bonds. The greater amount of risk is due to the fact that shares receive dividends only after preferred shareholders are paid and, in the event of a business liquidation, common stock shareholders are paid last, after creditors and preferred shareholders.

Preferred Stock

Preferred stock is considered a hybrid financial instrument because the shares have properties of both equity and debt. Preferred shares tend to pay dividends to shareholders, which can accumulate from one period to the next, and have priority over common shareholders when dividends are paid or assets liquidated. Similar to bonds, preferred shares are rated by credit-rating companies and are also callable by the company. Some other features associated with preferred stock include convertibility to common stock, non-voting rights, and the potential of shares to be either cumulative or non-cumulative of company dividends.

Stock Issuance and Stockholder’s Equity

Both common and preferred stock issued are reported in the stockholder’s equity section of the balance sheet. Each share type is reported at market value at the time the shares are purchased by investors, which is also the point in time when shares become outstanding. This value is divided between the stock’s par, or stated value and additional paid in capital.

12.2.2: Employee Stock Compensation

Learning Objective

Explain how employee stock options work and how a company would record their issue

Key Points

• Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stock’s market price rises higher than the option’s exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price.
• An ESO has features that are unlike exchange-traded options, such as a non-standardized exercise price and quantity of shares, a vesting period for the employee, and the required realization of performance goals.
• An option’s fair value at the grant date should be estimated using an option pricing model, such as the Black–Scholes model or a binomial model. A periodic compensation expense is reported on the income statement and also in additional paid in capital account in the stockholder’s equity section.

Key Terms

exercise price

The fixed price at which the owner of an option can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity.

remuneration

A payment for work done; wages, salary, emolument.

vesting period

A period of time an investor or other person holding a right to something must wait until they are capable of fully exercising their rights and until those rights may not be taken away.

Example

• A company offers stock options due in three years. The stock options have a total value of $150,000, and is for 50,000 shares of stock at a purchase price of $10. The stock’s par value is $1. The journal entry to expense the options each period would be: Compensation Expense $50,000 Additional Paid-In Capital, Stock Options $50,000. This expense would be repeated for each period during the option plan. When the options are exercised, the firm will receive cash of $500,000 (50,000 shares at $10). Paid-In capital will have to be reduced by the amount credited over the three year period. Common stock will increase by $50,000 (50,000 shares at $1 par value). And paid-in capital in excess of par must be credited to balance out the transaction. The journal entry would be:Cash $500,000 Additional Paid-In Capital, Stock Options $150,000 Common Stock $50,000 Additional Paid-In Capital, Excess of Par $600,000

Definition of Employee Stock Options

An employee stock option (ESO) is a call (buy) option on the common stock of a company, granted by the company to an employee as part of the employee’s remuneration package. The objective is to give employees an incentive to behave in ways that will boost the company’s stock price. ESOs are mostly offered to management as part of their executive compensation package. They may also be offered to non-executive level staff, especially by businesses that are not yet profitable and have few other means of compensation. Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stock’s market price rises higher than the option’s exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price .

General Foods Common Stock Certificate

Publicly traded companies may offer stock options to their employees as part of their compensation.

Features of ESOs

ESOs have several different features that distinguish them from exchange-traded call options:

• There is no standardized exercise price and it is usually the current price of the company stock at the time of issue. Sometimes a formula is used, such as the average price for the next 60 days after the grant date. An employee may have stock options that can be exercised at different times of the year and for different exercise prices.
• The quantity of shares offered by ESOs is also non-standardized and can vary.
• A vesting period usually needs to be met before options can be sold or transferred (e.g., 20% of the options vest each year for five years).
• Performance or profit goals may need to be met before an employee exercises her options.
• Expiration date is usually a maximum of 10 years from date of issue.
• ESOs are generally not transferable and must either be exercised or allowed to expire worthless on expiration day. This should encourage the holder to sell her options early if it is profitable to do so, since there’s substantial risk that ESOs, almost 50%, reach their expiration date with a worthless value.
• Since ESOs are considered a private contract between an employer and his employee, issues such as corporate credit risk, the arrangement of the clearing, and settlement of the transactions should be addressed. An employee may have limited recourse if the company can’t deliver the stock upon the exercise of the option.
• ESOs tend to have tax advantages not available to their exchange-traded counterparts.

Accounting and Valuation of ESOs

Employee stock options have to be expensed under US GAAP in the US. As of 2006, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agree that an option’s fair value at the grant date should be estimated using an option pricing model. The majority of public and private companies apply the Black–Scholes model. However, through September 2006, over 350 companies have publicly disclosed the use of a binomial model in Securities and Exchange Commission (SEC) filings. Three criteria must be met when selecting a valuation model:

1. The model is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R;
2. is based on established financial economic theory and generally applied in the field;
3. and reflects all substantive characteristics of the instrument (i.e. assumptions on volatility, interest rate, dividend yield, etc.).

A periodic compensation expense is recorded for the value of the option divided by the employee’s vesting period. The compensation expense is debited and reported on the income statement. It is also credited to an additional paid-in capital account in the equity section of the balance sheet.

12.2.3: Repurchasing Stock

Learning Objective

Explain why a company would repurchase their stock and how they would record it on their financial statements

Key Points

• Shares kept for the purpose of re-issuance are referred to as treasury stock.
• Buying back shares reduces the number of shares a company has outstanding without altering earnings. This can improve a company’s price/earnings ratio and earnings per share.
• In an inefficient market that has underpriced a company’s stock, a repurchase of shares can benefit current shareholders by providing support to the stock price. If the stock is overpriced, the opposite is true.
• On the balance sheet, treasury stock is listed under shareholders’ equity as a negative number. The accounts may be called “Treasury stock” or “equity reduction”.

Key Terms

Earnings Per Share

The amount of earnings per each outstanding share of a company’s stock.

price earnings ratio

The market price of that share divided by the annual earnings per share.

treasury stock

A treasury or “reacquired” stock is one which is bought back by the issuing company, reducing the amount of outstanding stock on the open market (“open market” including insiders’ holdings).

Reasons to Repurchase Stock

The reasons to repurchase stock can vary from company to company. Reasons can include: (1) to cancel and retire the stock; (2) to reissue the stock later at a higher price; (3) to reduce the number of shares outstanding and increase earnings per share (EPS); or (4) to issue the stock to employees. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance. If the intent of stock reacquisition is cancellation and retirement, the treasury shares exist only until they are retired and cancelled by a formal reduction of corporate capital. For accounting purposes, treasury shares are included in calculations to determine legal capital, but are excluded from calculations for EPS amounts.

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Wall Street circa 1910

Public companies sometimes repurchase their own stock. The reacquired stock is referred to as treasury stock.

Benefits to Repurchasing Stock

Stock repurchases are often used as a tax-efficient method to put cash into shareholders’ hands, rather than paying dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Another motive for stock repurchase is to protect the company against a takeover threat.

In an efficient market, the net effect of a stock repurchase does not change the value of each share. For example, if the market fairly prices a company’s shares at $50 a share, and the company buys back 100 shares for $5,000, it now has $5,000 less cash but there are also 100 fewer shares outstanding. So, the net effect of the repurchase would be zero. Buying back shares can improve a company’s price earnings ratio due to the reduced number of shares (and unchanged earnings). It can improve EPS due to the fewer number of shares outstanding as well as unchanged earnings. In an inefficient market that has underpriced a company’s stock, a repurchase of shares can benefit current shareholders by providing support to the stock price. If the stock is overpriced, the opposite is true.

Accounting for Repurchased Shares

On the balance sheet, treasury stock is listed under shareholders’ equity as a negative number. The accounts may be called “Treasury stock” or “equity reduction”.

One way of accounting for treasury stock is with the cost method. In this method, the paid-in capital account is reduced in the balance sheet when the treasury stock is bought. When the treasury stock is sold back on the open market, the paid-in capital is either debited or credited if it is sold for more or less than the initial cost respectively.

Another common way for accounting for treasury stock is the par value method. In the par value method, when the stock is purchased back from the market, the books will reflect the action as a retirement of the shares. Therefore, common stock is debited and treasury stock is credited. However, when the treasury stock is resold back to the market, the entry in the books will be the same as the cost method.

In either method, any transaction involving treasury stock cannot increase the amount of retained earnings. If the treasury stock is sold for more than cost, then the paid-in capital treasury stock is the account that is increased, not retained earnings. In auditing financial statements, it is a common practice to check for this error to detect possible attempts to “cook the books. “

Example

Consider a company that repurchases 15,000 shares of its $1 par value stock for $25 per share. In this transaction:

• Treasury stock is debited $375,000
• Cash is credited $375,000

The firm then resells 7,500 shares of treasury stock for $28. In this transaction:

• Cash is debited $210,000
• Treasure Stock is credited $187,500
• Additional Paid-In Capital is credited $22,500

If the remaining 7,500 shares of stock are resold for less than the original $25 purchase price, and if the adjustment to treasury stock minus the proceeds from the sale is more than the balance of additional paid-in capital, an adjustment to retained earnings must be made. Consider the shares are sold for $21. The accounting for the transaction would be:

• Cash is debited $157,500 
• Additional Paid-In Capital is debited $22,500
• Retained Earnings debited $7,500 
• Treasury Stock is credited $187,500

12.2.4: Treasury Stock

Learning Objective

Distinguish between the cost method and the par value method of recording treasury stock

Key Points

• Treasury stock can be accounted for using the cost or par value methods.
• Using the cost method, a treasury stock account is debited in the equity section of the balance sheet for the stock purchase price and cash is credited.
• When using the par value method, the company’s reacquisition of its own stock is treated as a retirement of the shares reacquired; treasury stock is debited for the par value of the stock and paid-in capital is debited or credited by the difference between the par value and repurchase price.

Key Terms

paid-in capital

refers to capital contributed to a corporation by investors through purchase of stock from the corporation (primary market) (not through purchase of stock in the open market from other stockholders (secondary market)

preemptive right

The right of shareholders to maintain a constant percentage of a company’s shares by receiving a proportionate fraction of any new shares issued, thus preempting any dilution

Treasury Stock

Definition of Treasury Stock

Treasury stock is the corporation’s own capital stock it has issued and then reacquired. Because this stock has not been canceled, it is legally available for reissuance and cannot be classified as unissued stock. When a corporation has additional authorized shares of stock that are to be issued after the date of original issue, in most states the preemptive right requires offering these additional shares first to existing stockholders on a pro rata basis. However, firms may reissue treasury stock without violating the preemptive right provisions of state laws; that is, treasury stock does not have to be offered to current stockholders on a pro rata basis. Treasury stock can be accounted for using the cost or par value methods.

Gerber Products Common Stock Certificate

Companies that issue common stock and reacquire it in the future, reclassify it as treasury stock.

Cost Method

Using the cost method, a treasury stock account is increased (debited) in the equity section of the balance sheet for the stock purchase price and cash is reduced (credited). The treasury stock amount is subtracted from the other stockholders’ equity amount, therefore it is considered a contra account. When the treasury stock is sold back on the open market, the treasury stock account is reduced (credited) for the original cost and the difference between original cost and sales price is debited or credited to a treasury stock paid in capital account, which is also disclosed in the equity section of the balance sheet. Cash is debited for the proceeds of the sale.

Par Value Method

When using the par value method, the company’s reacquisition of its own stock is treated as a retirement of the shares reacquired. On the purchase date, treasury stock is increased (debited) for the par value of stock reacquired and paid in capital is reduced (debited) or increased (credited) by the amount of the purchase price in excess of par. Cash is also credited for the purchase price. When the stock is resold, treasury stock is credited for the par value of the stock sold. Differences between the sales price and repurchase price are debited or credited to paid in capital, along with a debit to cash for proceeds from the sale.

12.3: Rules and Rights of Common and Preferred Stock

12.3.1: Claim to Income

In the cases of bankruptcy and dividend distribution, preferred stock shareholders will receive assets before common stock shareholders.

Learning Objective

Describe the rights preferred stock has to a company’s income

Key Points

• Common stock and preferred stock are both forms of equity ownership but carry different rights and claims to income.
• Preferred stock shareholders will have claim to assets over common stock shareholders in the case of company liquidation.
• Preferred stock also has first right to dividends.

Key Terms

Common stock

Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the line when it comes to dividends and receiving compensation in the case of bankruptcy.

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Preferred and common stock have varying claims to income which will change from one equity issuer to another. In general, preferred stock will be given some preference in assets to common assets in the case of company liquidation, but both will fall behind bondholders when asset distribution takes place. In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors (including employees), and preferred stock holders are paid. As such, these investors often receive nothing after a bankruptcy. Preferred stock also has the first right to receive dividends. In general, common stock shareholders will not receive dividends until it is paid out to preferred shareholders. Access to dividends and other rights vary from firm to firm.

1903 stock certificate of the Baltimore and Ohio Railroad

Preferred and common stock both carry rights of ownership, but represent different classes of equity ownership.

Preferred stock may or may not have a fixed liquidation value (or par value) associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued. Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par (or liquidation) value, unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.

Both types of stock can have a claim to income in the form of capital appreciation as well. As company value increases based on market determinants, the value of equity held in this company also will increase. This translates to a return on investment to shareholders. This will be different to common stock shareholders and preferred stock shareholders because of the different prices and rewards based on holding these different kinds of shares. In turn, should market forces decrease, the value of equity held will decrease as well, reflecting a loss on investment and, therefore, a decrease on the value of any claims to income for shareholders.

12.3.2: Voting Right

Common stock generally carries voting rights, while preferred stock does not; however, this will vary from company to company.

Learning Objective

Summarize the voting rights associated with common and preferred stock

Key Points

• Common stock shareholders can generally vote on issues, such as members of the board of directors, stock splits, and the establishment of corporate objectives and policy.
• While having superior rights to dividends and assets over common stock, generally preferred stock does not carry voting rights.
• Many of the voting rights of a shareholder can be exercised at annual general body meetings of companies. An annual general meeting is a meeting that official bodies, and associations involving the general public, are often required by law to hold.

Key Terms

Voting rights

Rights which are generally associated with common stock shareholders in regards to business entity matters ( such as electing the board of directors or establishing corporate policy)

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Common stock

Common stock is a form of equity and type of security. Common stock shareholders are at the bottom of the line when it comes to dividends and receiving compensation in the case of bankruptcy.

Voting Rights

Common stock can also be referred to as a “voting share. ” Common stock usually carries with it the right to vote on business entity matters, such as electing the board of directors, establishing corporate objectives and policy, and stock splits. However, common stock can be broken into voting and non-voting classes. While having superior rights to dividends and assets over common stock, generally preferred stock does not carry voting rights.

The matters that a stockholder gets to vote on vary from company to company. In many cases, the shareholder will be able to vote for members of a company board of directors and, in general, each share gets a vote as opposed to each shareholder. Therefore, a single investor who owns 300 shares will have more say in a voting matter than a single shareholder that owns 30.

Exercising Voting Rights

Many of the voting rights of a shareholder can be exercised at annual general body meetings of companies. An annual general meeting is a meeting that official bodies and associations involving the general public (including companies with shareholders) are often required by law (or the constitution, charter, by-laws, etc., governing the body) to hold. An AGM is held every year to elect the board of directors and inform their members of previous and future activities. It is an opportunity for the shareholders and partners to receive copies of the company’s accounts, as well as reviewing fiscal information for the past year and asking any questions regarding the directions the business will take in the future. Shareholders also have the option to mail their votes in if they cannot attend the shareholder meetings. In 2007, the Securities and Exchange Commission voted to require all public companies to make their annual meeting materials available online. Shareholders with the right to vote will have numerous options in how to make their voice heard with regards to voting matters should they choose to.

Shareholder Meeting

This scene from “The Office” humorously illustrates a shareholder meeting, where the shareholder can exercise their right to vote on company issues or question company directors.

12.3.3: Provisions of Preferred Stock

Preferred shares have numerous rights which can be attached to them, such as cumulative dividends, convertibility, and participation.

Learning Objective

Describe in detail the different types of provisions for preferred stock

Key Points

• If a preferred share has cumulative dividends, then it contains the provision that should a company fail to pay out dividends at any time at the stated rate, then the issuer will have to make up for it as time goes on.
• Convertible preferred stock can be exchanged for a predetermined number of company common stock shares.
• Often times companies will keep the right to call or buy back preferred shares at a predetermined price.
• Participating preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals.
• Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index.

Key Terms

Callable shares

Shares which can be bought back by the issuer at a predetermined price.

Convertible preferred stock

Convertible preferred stock can be exchanged for a predetermined number of company common stock shares.

Cumulative Dividends

Condition where owners of certain shares will receive accumulated dividends in the case a company cannot pay out dividends at the stated rate at the stated time.

Preferred stock may be entitled to numerous rights, depending on what is designated by the issuer. One of these rights may be the right to cumulative dividends. Preferred stock shareholders already have rights to dividends before common stock shareholders, but cumulative preferred shares contain the provision that should a company fail to pay out dividends at any time at the stated rate, then the issuer will have to make up for it as time goes on.

Historical dividend information for Franklin Automobile Company

Dividends are one of the privileges of stock ownership, and preferred shares get more rights to them than common shares do.

Convertible preferred stock can be exchanged for a predetermined number of company common stock shares. Generally, this can occur at the discretion of the investor, and he or she may pick any time to do so and, therefore, take advantage of fluctuations in the price of common stock. Once converted, the common stock cannot be converted back to preferred status.

Often times companies will keep the right to call or buy back preferred shares at a predetermined price. These shares are callable shares.

There is a class of preferred shares known as “participating preferred stock. ” These preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals. Investors who purchased these stocks receive their regular dividend regardless of company performance (assuming the company does well enough to make its annual dividend payments). If the company achieves predetermined sales, earnings, or profitability goals, the investors receive an additional dividend.

Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value, or as a fixed amount. Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index or floating rate. An example of this would be tying the dividend rate to LIBOR.

12.3.4: Purchasing New Shares

New shares can be purchased on exchanges and current shareholders will usually have preemptive rights to newly issued shares.

Learning Objective

Discuss the process and implication of purchasing new shares by a shareholder that already holds shares in a company

Key Points

• New share purchase is an important indicator of current shareholder belief in the health of the company and long term prospects for growth.
• Current Shareholders will often have preemptive rights that give them the right to purchase newly issued company shares before they go on sale to the general public.
• New shares can be purchased on exchanges, which offer a platform for the financial marketplace.

Key Terms

Stock Exchange

A form of exchange that provides services for stock brokers and traders to trade stocks, bonds and other securities.

Preemption

The right of a shareholder to purchase newly issued shares of a business entity before they are available to the general public so as to protect individual ownership from dilution.

New share purchases are an important action by share shareholders, since it requires a further investment in a business entity and is a reflection of a shareholder’s decision to maintain an ownership position in a company, or a potential investor’s belief that purchasing equity in a company will be an investment that grows in value.

Current shareholders may have preemptive rights over new shares offered by the company. In practice, the most common form of preemption right is the right of existing shareholders to acquire new shares issued by a company in a rights issue, a usually but not always public offering. In this context, the pre-emptive right is also called “subscription right” or “subscription privilege. ” This is the right, but not the obligation, of existing shareholders to buy the new shares before they are offered to the public. In this way, existing shareholders can maintain their proportional ownership of the company, preventing stock dilution.

New shares may be purchased over the same exchange mechanisms that previous stock was acquired. A stock exchange is a form of exchange which provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events, including the payment of income and dividends. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets are driven by various factors that, as in all free markets, affect the price of stocks.

Exchanges

New shares can be traded on exchanges such as the Nasdaq, but will usually be offered to current shareholders before being put on sale to the general public.

12.3.5: Preferred Stock Rules and Rights

Preferred stock can include rights such as preemption, convertibility, callability, and dividend and liquidation preference.

Learning Objective

List the rights that preferred stock generally has

Key Points

• Preferred stock generally does not carry voting rights, but this may vary from company to company.
• Preferred stock can gain cumulative dividends, convertibility to common stock, and callability.
• The rights that come with ownership of preferred stock are detailed in a “Certificate of Designation”.

Key Terms

liquidation

liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and property of the company redistributed

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a “Certificate of Designation. “

VOC stock

Preferred stock is a security ( a little more modern that this stock from the VOC or Dutch East India Company) that carries certain rights which designate it from common stock or debt.

Preferred stock is a special class of shares that may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock: Preference in dividends preference in assets, in the event of liquidation, convertibility to common stock, callability, and at the option of the corporation. Some preferred shares have special voting rights to approve extraordinary events (such as the issuance of new shares or approval of the acquisition of a company) or to elect directors, but, once again, most preferred shares have no voting rights associated with them. Some preferred shares gain voting rights when the preferred dividends are in arrears for a substantial time.

Preferred stock may or may not have a fixed liquidation value (or par value) associated with it. This represents the amount of capital which was contributed to the corporation when the shares were first issued. Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par (or liquidation) value, unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value, or as a fixed amount. Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index. Preferred stock may also have rights to cumulative dividends.

12.3.6: Comparing Common Stock, Preferred Stock, and Debt

Common stock, preferred stock, and debt are all securities that a company may offer; each of these securities carries different rights.

Learning Objective

Differentiate between the rights of common shareholders, preferred shareholders, and bond holders

Key Points

• Common stock and preferred stock fall behind debt holders as creditors that would receive assets in the case of company liquidation.
• Common stock and preferred stock are both types of equity ownership. They receive rights of ownership in the company, such as voting and dividends.
• Debt holders often receive a bond for lending and while this does not give the ownership rights of being a stockholder, it does create a superior claim to a company’s assets in the case of liquidation.

Key Terms

Common stock

Common stock is a form of corporate equity ownership, a type of security.

bond

A bond is an instrument of indebtness of the bond issuers toward the bond holders.

Preferred Stock

Preferred stock is an equity security that has the properties of both an equity and debt instrument and is higher ranking than common stock.

Equity

Common Stock and Preferred Stock are both methods of purchasing equity in a business entity.

Common stock generally carries voting rights along with it, while preferred shares generally do not.

Preferred shares act like a hybrid security, in between common stock and holding debt. Preferred stock can (depending on the issue) be converted to common stock and have access to accumulated dividends and multiple other rights. Preferred stock also has access to dividends and assets in the case of liquidation before common stock does.

However, both common and preferred stock fall behind debt holders when it comes to claims to assets of a business entity should bankruptcy occur. Common shareholders often do not receive any assets after bankruptcy as a result of this principle. However, common stock shareholders can theoretically use their votes to affect company decision making and direction in a way they believe will help the company avoid liquidation in the first place.

Debt

Debt can be “purchased” from a company in the form of a bond.

A bond from the Dutch East India Company

A bond is a financial security that represents a promise by a company or government to repay a certain amount, with interest, to the bondholder.

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest and/or to repay the principal at a later date, termed the maturity. Therefore, a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas, bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.

12.4: Additional Detail on Preferred Stock

12.4.1: Dividend Preference

A corporation may issue two basic classes or types of capital stock, common and preferred, both of which can receive dividends.

Learning Objective

Explain the difference between common stock and preferred stock dividends

Key Points

• A corporation may issue two basic classes or types of capital stock, common and preferred. If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal rights.
• Common stock is a form of corporate equity ownership. Common stock holders cannot be paid dividends until all preferred stock dividends are paid in full. On the other hand, common shares on average perform better than preferred shares or bonds over time.
• Preferred stock is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (higher ranking) to common stock, but subordinate to bonds in terms of claim.

Key Terms

dividend in arrears

an omitted dividend on cumulative preferred stock

Preferred Stock

Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).

Common stock

Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.

Dividends

A corporation may issue two basic classes or types of capital stock—common and preferred. If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal rights. Common stock is usually the residual equity in the corporation, meaning that all other claims against the corporation rank ahead of the claims of the common stockholder. Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock. Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with different dividend rates or other features.

Companies issue preferred stock in order to avoid the following:

• Using bonds with fixed interest charges that must be paid regardless of the amount of net income.
• Issuing so many additional shares of common stock that earnings per share are less in the current year than in prior years.
• Diluting the common stockholders’ control of the corporation, since preferred stockholders usually have no voting rights.

Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per share.

1903 stock certificate of the Baltimore and Ohio Railroad

Ownership of shares is documented by the issuance of a stock certificate and represents the shareholder’s rights with regards to the business entity.

Details on Common Stock

Common stock is a form of corporate equity ownership, a type of security. The terms “voting share” or “ordinary share” are also used in other parts of the world; common stock is primarily used in the United States. It is called “common” to distinguish it from preferred stock. If both types of stock exist, common stock holders cannot be paid dividends until all preferred stock dividends (including payments in arrears) are paid in full. In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors (including employees), and preferred stock holders are paid. As such, such investors often receive nothing after a bankruptcy. On the other hand, common shares on average perform better than preferred shares over time.

Common stock usually carries with it the right to vote on certain matters, such as electing the board of directors. However, a company can have both a “voting” and “non-voting” class of common stock. Holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company’s board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company should it issue another stock offering. There is no fixed dividend paid out to common stock holders and so their returns are uncertain, contingent on earnings, company reinvestment, and efficiency of the market to value and sell stock. Additional benefits from common stock include earning dividends and capital appreciation.

Details on Preferred Stocks

Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to stock holders’ share of company assets). Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock upon liquidation, and in the payment of dividends. Terms of the preferred stock are stated in a “Certificate of Designation. “

Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds, and because they are junior to all creditors.

12.4.2: Liquidation Preference

The main purpose of a liquidation where the company is insolvent is to satisfy claims in the manner and order prescribed by law.

Learning Objective

Summarize how the liquidation preference determines which claims will be paid if a company becomes insolvent

Key Points

• The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law.
• Before the claims are met, secured creditors are entitled to enforce their claims against the assets of the company to the extent that they are subject to a valid security interest. In most legal systems, only fixed security takes precedence over all claims.
• Claimants with non-monetary claims against the company may be able to enforce their rights against the company. For example, a party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance.
• Most preferred stocks are preferred as to assets in the event of liquidation of the corporation.

Key Terms

creditor

A person to whom a debt is owed.

Preferred Stock

Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.

liquidation

The selling of the assets of a business as part of the process of dissolving it.

Example

• A party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance and compel the liquidator to transfer title to the land to them, upon tender of the purchase price. After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets.

Liquidation Preference

The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law. The liquidator must determine the company’s title to property in its possession. Property which is in the possession of the company, but which was supplied under a valid retention of title clause will generally have to be returned to the supplier. Property which is held by the company on trust for third parties will not form part of the company’s assets available to pay creditors.

Before the claims are met, secured creditors are entitled to enforce their claims against the assets of the company to the extent that they are subject to a valid security interest. In most legal systems, only fixed security takes precedence over all claims. Security by way of floating charge may be postponed to the preferential creditors.

Claimants with non-monetary claims against the company may be able to enforce their rights against the company. For example, a party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance and compel the liquidator to transfer title to the land to them, upon tender of the purchase price. After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets.

Plane Liquidation

Planes are an example of liquidated items when companies “go under. ” They are generally auctioned off to the highest bidder.

Priority of Claims

Generally, the priority of claims on the company’s assets will be determined in the following order:

• Liquidators costs
• Creditors with fixed charge over assets
• Costs incurred by an administrator
• Amounts owed to employees for wages/superannuation (director limit $2,000)
• Payments owed in respect of workers’ injuries
• Amounts owed to employees for leave (director limit $1,500)
• Retrenchment payments owing to employees
• Creditors with floating charge over assets
• Creditors without security over assets
• Shareholders (Liquidating distribution) – Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders. A corporation’s cumulative preferred dividends in arrears at liquidation are payable even if there are not enough accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock may be preferred as to assets, dividends, or both.
• Unclaimed assets will usually vest in the state as bona vacantia.

12.4.3: Accounting for Preferred Stock

All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock.

Learning Objective

Differentiate between preferred to dividends, noncumulative, cumulative and convertible preferred stock

Key Points

• Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend on preferred stock is the amount paid to preferred stockholders as a return for the use of their money.
• Noncumulative preferred stock is preferred stock on which the right to receive a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year.
• Cumulative preferred stock is preferred stock for which the right to receive a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock.
• All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock. The par value, authorized shares, issued shares, and outstanding shares is disclosed for each type of stock.

Key Terms

Common stock

Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).

Preferred Stock

Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock, and that has priority to common stock in liquidation.

cumulative dividend

a payments by the company to shareholders that accumulate if a previous payment was missed

Preferred Stock

Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock. Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with different dividend rates or other features. Companies issue preferred stock to avoid:

1903 stock certificate of the Baltimore and Ohio Railroad

Ownership of shares is documented by the issuance of a stock certificate and represents the shareholder’s rights with regards to the business entity.

1. using bonds with fixed interest charges that must be paid regardless of the amount of net income;
2. issuing so many additional shares of common stock that earnings per share are less in the current year than in prior years; and
3. diluting the common stockholders’ control of the corporation, since preferred stockholders usually have no voting rights.

Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per share.

Types of Preferred Stock

When a corporation issues both preferred and common stock, the preferred stock may be:

• Preferred as to dividends. It may be noncumulative or cumulative.
• Preferred as to assets in the event of liquidation.
• Convertible or nonconvertible.
• Callable.

Preferred as to Dividends

Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend is the amount paid to preferred stockholders as a return for the use of their money.

For no-par preferred stock, the dividend is a specific dollar amount per share per year, such as USD 4.40. For par value preferred stock, the dividend is usually stated as a percentage of the par value, such as 8% of par value; occasionally, it is a specific dollar amount per share. Most preferred stock has a par value.

Usually, stockholders receive dividends on preferred stock quarterly. Such dividends—in full or in part—must be declared by the board of directors before paid. In some states, corporations can declare preferred stock dividends only if they have retained earnings (income that has been retained in the business) at least equal to the dividend declared.

Noncumulative Preferred Stock

Noncumulative preferred stock is preferred stock in which a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year. Because omitted dividends are lost forever, noncumulative preferred stocks are not attractive to investors and are rarely issued.

Cumulative Preferred Stock

Cumulative preferred stock is preferred stock for which the right to receive a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock. For example, assume a company has cumulative, USD 10 par value, 10% preferred stock outstanding of USD 100,000, common stock outstanding of USD 100,000, and retained earnings of USD 30,000. It has paid no dividends for two years. The company would pay the preferred stockholders dividends of USD 20,000 (USD 10,000 per year times two years) before paying any dividends to the common stockholders.

Dividends in arrears are cumulative unpaid dividends, including the quarterly dividends not declared for the current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability until declared by the board of directors. However, since the amount of dividends in arrears may influence the decisions of users of a corporation’s financial statements, firms disclose such dividends in a footnote.

Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders. A corporation’s cumulative preferred dividends in arrears at liquidation are payable even if there are not enough accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock may be preferred as to assets, dividends, or both.

Convertible Preferred Stock

Convertible preferred stock is preferred stock that is convertible into common stock of the issuing corporation. Convertible preferred stock is uncommon, most preferred stock is nonconvertible. Holders of convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common stock of the same corporation.

Preferred Stock and the Balance Sheet

All preferred stock is reported on the balance sheet in the stockholders’ equity section and it appears first before any other stock. The par value, authorized shares, issued shares, and outstanding shares is disclosed for each type of stock.

12.5: Dividend Policy

12.5.1: Impact of Dividend Policy on Clientele

Change in a firm’s dividend policy may cause loss of old clientele and gain of new clientele, based on their different dividend preferences.

Learning Objective

Describe how the clientele effect can influence stock price

Key Points

• The clientele effect is the idea that the type of investors attracted to a particular kind of security will affect the price of the security when policies or circumstances change.
• Current clientele might choose to sell their stock if a firm changes their dividend policy and deviates considerably from the investor’s preferences. Changes in policy can also lead to new clientele, whose preferences align with the firm’s new dividend policy.
• In equilibrium, the changes in clientele sets will not lead to any change in stock price.
• The real world implication of the clientele effect lies in the importance of dividend policy stability, rather than the content of the policy itself.

Key Terms

clientele effect

The theory that changes in a firm’s dividend policy will cause loss of some clientele who will choose to sell their stock, and attract new clientele who will buy stock based on dividend preferences.

clientele

The body or class of people who frequent an establishment or purchase a service, especially when considered as forming a more-or-less homogeneous group of clients in terms of values or habits.

dividend clientele

Sets of investors who are attracted to certain types of dividend policy.

Example

• Suppose Firm A had been in a growth stage and did not offer dividends to its shareholders, but their policy changed to paying low cash dividends. Clientele interested in long term capital gains might be alarmed, interpreting this decision as a sign of slowing growth, which would mean less stock price appreciation in the future. This set of clientele could choose to sell the stock. On the other hand, dividend payments could appeal to investors who are interested in regular additional income from the investment, and they would buy Firm A’s stock.

The Clientele Effect

The clientele effect is the idea that the type of investors attracted to a particular kind of security will affect the price of the security when policies or circumstances change. These investors are known as dividend clientele. For instance, some clientele would prefer a company that doesn’t pay dividends at all, but instead invests their retained earnings toward growing the business. Some would instead prefer the regular income from dividends over capital gains. Of those who prefer dividends over capital gains, there are further subsets of clientele; for example, investors might prefer a stock that pays a high dividend, while another subset might look for a balance between dividend payout and reinvestment in the company.

Clientele Type Example

Retirees are more likely to prefer high dividend payouts over capital gains since this provides them with cash income. Therefore, if a company discontinued paying dividends, the clientele effect may cause retiree shareholders to sell the stock in favor of other income generating investments.

Clientele may choose to sell their stock if a firm changes its dividend policy, and deviates considerably from its preferences. On the other hand, the firm may attract a new clientele group if its new dividend policy appeals to the group’s dividend preferences. These changes in demographics related to a stock’s ownership due to a change of dividend policy are examples of the “clientele effect. “

This theory is related to the dividend irrelevance theory presented by Modigliani and Miller, which states that, under particular assumption, an investor’s required return and the value of the firm are unrelated to the firm’s dividend policy. After all, clientele can just choose to sell off their holdings if they dislike a firm’s policy change, and the firm may simultaneously attract a new subset of clientele who like the policy change. Therefore, stock value is unaffected. This is true as long as the “market” for dividend policy is in equilibrium, where demand for such a policy meets the supply.

The clientele effect’s real world implication is that what matters is not the content of the dividend policy, but rather the stability of the policy. While investors can always choose to sell shares of firms with undesirable dividend policy, and buy shares of firms with attractive dividend policy, there are brokerage costs and tax considerations associated with this. As a result, an investor may stick with a stock that has a sub-optimal dividend policy because the cost of switching investments outweighs the benefit the investor would receive by investing in a stock with a better dividend policy.

Although commonly used in reference to dividend or coupon (interest) rates, the clientele effect can also be used in the context of leverage (debt levels), changes in line of business, taxes, and other management decisions.

12.5.2: Stock Dividends vs. Cash Dividends

Investors’ preference for stock or cash depends on their inclinations toward factors such as liquidity, tax situation, and flexibility.

Learning Objective

Assess whether a particular shareholder would prefer stock or cash dividends

Key Points

• Cash dividends provide steady payments of cash that can be used to reinvest in a company, if the shareholder desires.
• Holders of stock dividends can sell their stock for (hopefully) high capital gains in the future, or they can sell it off immediately to get cash, much like a cash dividend. This flexibility is seen by some as a benefit of stock dividend.
• Cash dividends are immediately taxable as income, while stock dividends are only taxed when they are actually sold by the shareholder.
• If an investor is interested in long-term capital gains, he or she will likely prefer stock dividends. If an investor needs a regular source of income, cash dividends will provide liquidity.
• Firms can choose to issue stock dividends if they would like to direct their earnings toward the development of the firm but would still like to appease stockholders with some form of payment.
• Established firms with little more room to grow do not have pressing needs for all their cash earnings, so they are more likely to give cash dividends.

Key Terms

cash dividend

a payment by the company to shareholders paid out in currency, usually via electronic funds transfer or a printed paper check

stock dividends

Stock or scrip dividends are those paid out in the form of additional stock shares of either the issuing corporation or another corporation.

cash dividends

Cash dividends are those paid out in currency, usually via electronic funds transfer or by paper check.

If a firm decides to parcel out dividends to shareholders, they have a choice in the form of payment: cash or stock. Cash dividends are those paid out in currency, usually via electronic funds transfer or by paper check. This is the most common method of sharing corporate profits with the shareholders of a company. Stock or scrip dividends are those paid out in the form of additional stock shares of either the issuing corporation or another corporation.Cash dividends provide investors with a regular stream of income. Stock dividends, unlike cash dividends, do not provide liquidity to the investors; however, they do ensure capital gains to the stockholders. Therefore, if investors are not interested in a long-term investment, they will prefer regular cash payments over payments of additional stock.

Income from Dividends

When choosing between cash or stock dividends, the trade-off is between liquidity in the short-term or income from capital gains in the long-term.

Costs of taxes can also play a role in choosing between cash or stock dividends. Cash dividends are immediately taxable under most countries’ tax codes as income, while stock dividends are not taxable until sold for capital gains (if stock was the only choice for receiving dividends). This can be seen as a huge benefit of stock dividends, particularly for investors of a high income tax bracket. A further benefit of the stock dividend is its perceived flexibility. Shareholders have the choice of either keeping their shares in hopes of high capital gains, or selling some of the new shares for cash, which is somewhat like receiving a cash dividend.

If the payment of stock dividends involves the issuing of new shares, it increases the total number of shares while lowering the price of each share without changing the market capitalization of the shares held. It has the same effect as a stock split: the total value of the firm is not affected. If the payment involves the issuing of new shares, it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held. As such, receiving stock dividends does not increase a shareholder’s stake in the firm; by contrast, a shareholder receiving cash dividends could use that income to reinvest in the firm and increase their stake.

For the firm, dividend policy directly relates to the capital structure of the firm, so choosing between stock dividends and cash dividends is an important consideration. A firm that is still in its stages of growth will most likely prefer to retain its earnings and put them toward firm development, instead of sending them to their shareholders. The firm could also choose to appease investors with stock dividends, which would still allow it to retain its earnings. Conversely, a firm that is already quite stable with low growth is much more likely to choose payment of dividends in cash. The needs and cash flow of the firm are necessary points of consideration in choosing a dividend policy.

12.5.3: Investor Preferences

The significance of investors’ dividend preferences is a contested topic in finance that has serious implications for dividend policy.

Learning Objective

Identify the criteria that define a company’s dividend policy

Key Points

• Elements of dividend policy include: paying a dividend vs reinvestment in company, high vs low payout, stable vs irregular dividends, and frequency of payment.
• Some are of the opinion that the future gains are more risky than the current dividends, so investors prefer dividend payments over capital gains. Others contend that dividend policy is ultimately irrelevant, since investors are indifferent between selling stock and receiving dividends.
• Assuming dividend relevance, coming up with a dividend policy is challenging for the firms because different investors have different views on present cash dividends and future capital gains.
• Importance of the content and the stability of a dividend policy are subject to much academic debate.

Key Terms

capital gains

Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).

dividend policy

A firm’s decisions on how to distribute (or not distribute) their earnings to their shareholders.

The role of investor preferences for dividends and the value of a firm are pieces of the dividend puzzle, which is the subject of much academic debate. Assuming dividend relevance, coming up with a dividend policy is challenging for the directors and financial manager of a company because different investors have different views on present cash dividends and future capital gains. Investor preferences are first split between choosing dividend payments now, or future capital gains in lieu of dividends. Further elements of the dividend policy also include:1. High versus low payout, 2. Stable versus irregular dividends, and 3. Frequency of payment. Cash dividends provide liquidity, but the bonus share will bring capital gains to the shareholders. The investor’s preference between the current cash dividend and the future capital gain has been viewed in kind.

Many people hold the opinion that the future gains are more risky than the current dividends, as the “Bird-in-the-hand Theory” suggests. This view is supported by both the Walter and Gordon models, which find that investors prefer those firms which pay regular dividends, and such dividends affect the market price of the share. Gordon’s dividend discount model states that shareholders discount the future capital gains at a higher rate than the firm’s earnings, thereby evaluating a higher value of the share. In short, when the retention rate increases, they require a higher discounting rate.

In contrast, others (see Dividend Irrelevance Theory) argue that the investors are indifferent between dividend payments and the future capital gains. Therefore, the content of a firm’s dividend policy has no real effect on the value of the firm.

Investor preferences play an uncertain role in the “dividend puzzle,” which refers to the phenomenon of companies that pay dividends being rewarded by investors with higher valuations, even though according to many economists, it should not matter to investors whether or not a firm pays dividends. There are a number of factors, such as psychology, taxes, and information asymmetries tied into this puzzle, which further complicate the matter.

Stock Market

Different kinds of investors are active in stock market.

12.5.4: Accounting Considerations

Accounting for dividends depends on their payment method (cash or stock).

Learning Objective

Describe the accounting considerations associated with dividends

Key Points

• Cash dividends are payments taken directly from the firm’s income. This is formally accounted for by marking the amount down as a liability for the firm. The amount is transferred into a separate dividends payable account and this is debited on payment day.
• Accounting for stock dividends is essentially a transfer from retained earnings to paid-in capital.
• Unlike cash dividends, stock dividends do not come out of the firm’s income, so the firm is able to both maintain their cash and offer dividends. The firm’s net assets remain the same, as does the wealth of the investor.

Key Terms

paid-in capital

Capital contributed to a corporation by investors through purchase of stock from the corporation.

retained earnings

The portion of net income that is retained by the corporation rather than distributed to its owners as dividends.

declaration date

the day the Board of Directors announces its intention to pay a dividend

Example

• Cash dividend example: Firm A’s Board of Directors declared a dividend on December 1, 2011 of $100,000 payable to shareholders of record on Feb 1, 2012 and payable on Feb 29, 2012. This $100,000 goes down as a liability on the firm’s accounting sheet.

Accounting for dividends depends on their payment method (cash or stock). On the declaration day, the firm’s Board of Directors announces the issuance of stock dividends or payment of cash dividends. Cash dividends are payments taken directly from the firm’s income. This is formally accounted for by marking the amount down as a liability for the firm. The amount is placed in a separate dividends payable account.

The accounting equation for this is simply:

Retained Earnings = Net Income − Dividends

Retained earnings are part of the balance sheet (another basic financial statement) under “stockholders equity (shareholders’ equity). ” It is mostly affected by net income earned during a period of time by the company less any dividends paid to the company’s owners/stockholders. The retained earnings account on the balance sheet is said to represent an “accumulation of earnings” since net profits and losses are added/subtracted from the account from period to period.

On the date of payment, when dividend checks are mailed out to stockholders, the dividends payable account is debited and the firm’s cash account is credited.

Stock dividends are parsed out as additional stocks to shareholders on record. Unlike cash dividends, this does not come out of the firm’s income. The firm is able to both maintain their cash and give dividends to investors. Here, the firm’s net assets remain the same. If a firm authorizes a 15% stock dividend on Dec 1st, distributable on Feb 29, and to stockholders of record on Feb 1, the stock currently has a market value of $15 and a par value of $4. There are 150,000 shares outstanding and the firm will issue 22,500 additional shares. The value of the dividend is (150,000)(15%)(15) = $337,500.

The declaration of this dividend debits retained earnings for this value and credits the stock dividend distributable account for the number of new stock issued (150,000*.15 = 22,500) at par value. We must also consider the difference between market value and par (stated) value and record that as credit for additional paid-in-capital . On the day of issuance, the stock dividends distributable account is debited and stock is credited $90,000.

12.5.5: Signaling

Dividend decisions are frequently seen by investors as revealing information about a firm’s prospects; therefore firms are cautious with these decisions.

Learning Objective

Describe what information a shareholder can obtain from a company issuing dividends

Key Points

• Signaling is the idea that one agent conveys some information about itself to another party through an action. It took root in the idea of asymmetric information; in this case, managers know more than investors, so investors will find “signals” in the managers’ actions to get clues about the firm.
• For instance, when managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Investors will notice this and choose to sell their share of the firm.
• Investors can use this knowledge about signal to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations.
• Firms are aware of this signaling effect, so they will try not to send a negative signal that sends their stock price down.

Key Terms

dividend decision

A decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company’s stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay.

information asymmetry

In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.

signalling

Action taken by one agent to indirectly convey information to another agent.

A dividend decision may have an information signalling effect that firms will consider in formulating their policy. This term is drawn from economics, where signaling is the idea that one agent conveys some information about itself to another party through an action.

Signaling took root in the idea of asymmetric information, which says that in some economic transactions, inequalities in access to information upset the normal market for the exchange of goods and services . An information asymmetry exists if firm managers know more about the firm and its future prospects than the investors.

A company’s dividend decision may signal what management believes is the future prospects of the firm and its stock price.

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm’s future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends.

When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information in actions like the firm’s dividend policy. For instance, when managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (e.g. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers’ behavior to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.

12.6: Cash Dividend Alternatives

12.6.1: Dividend Reinvestments

Dividend reinvestment plans (DRIPs) automatically reinvest cash dividends in the stock.

Learning Objective

Describe a dividend reinvestment plan

Key Points

• DRIPs help shareholders reinvest their dividends in the underlying stock without having to wait for enough money to buy a whole number of shares. It also may allow them to avoid some brokerage fees.
• DRIPs help stabilize stock prices by inherently encouraging long-term investment instead of active-management, which may cause volatility.
• DRIPs are generally associated with programs offered by the company. However, brokerage firms may offer similar reinvestment programs called “synthetic DRIPs”.

Key Term

reinvest

To invest cash again, instead of holding it as cash.

In some instances, a company may offer its shareholders an alternative option to receiving cash dividends. The shareholder chooses to not receive dividends directly as cash; instead, the shareholder’s dividends are directly reinvested in the underlying equity. This is called a dividend reinvestment program or dividend reinvestment plan (DRIP).

The purpose of the DRIP is to allow the shareholder to immediately reinvest his or her dividends in the company. Should the shareholder choose to do this on his or her own, s/he would have to wait until enough cash accumulates to buy a whole number of shares and s/he would also incur brokerage fees .

Charles Schwab

Brokerage firms like Charles Schwab earn money by charging a brokerage fee for executing transactions. Thus, participating in a DRIP helps shareholders avoid some or all of the fees they would occur if they reinvested the dividends themselves.

Participating in a DRIP, however, does not mean that the reinvestment of the dividends is free for the shareholder. Some DRIPs are free of charge for participants, while others do charge fees and/or proportional commissions.

DRIPs have become popular means of investment for a wide variety of investors as DRIPs enable them to take advantage of dollar-cost averaging with income in the form of corporate dividends that the company is paying out. Not only is the investor guaranteed the return of whatever the dividend yield is, but s/he may also earn whatever the stock appreciates to during his or her time of ownership. However, s/he is also subject to whatever the stock may decline to, as well.

There is an advantage to the the company managing the DRIP, too. DRIPS inherently encourage long-term investment in the shares, which helps to mitigate some of the volatility associated with active-trading. DRIPs help to stabilize the stock price.

The name “DRIP” is generally associated with programs run by the dividend-paying company. However, some brokerage firms also offer similar plans where shareholders can choose to have their cash dividends reinvested in stocks for little or no cost. This is called a synthetic DRIP.

12.6.2: Stock Dividends

Stock dividends are when a company gives each shareholder additional stock in lieu of a cash dividend.

Learning Objective

Create a journal entry to record a stock dividend and a stock split

Key Points

• Stock dividends are no different than stock splits in practice. They simply increase the number of shares outstanding, but not the market capitalization or the total value of the shareholders’ assets.
• Stock dividends may be paid from non-outstanding stock or from the stock of another company (e.g. its subsidiary).
• Cash dividends are taxed while stock dividends are not.
• The journal entry to record the stock dividend is a debit to the retained earnings account and credit both common stock and the paid in capital accounts.

Key Terms

stock split

To issue a higher number of new shares to replace old shares. This effectively increases the number of shares outstanding without changing the market capitalization of the company.

stock dividend

a payment to a shareholder paid out in the form of additional stock shares of the issuing corporation, or another corporation (such as its subsidiary corporation)

In lieu of cash, a company may choose to pay its dividend in the form of stock. Instead of each shareholder receiving, say $2 for each share, they may receive an additional share. A stock dividend (also known as a scrip dividend) can be the economic equivalent of a stock split.

When a stock dividend is paid, no shareholder actually increases the values of his or her assets. The total number of shares outstanding increases in proportion to the change in the number of shares held by each shareholder. If a 5% stock dividend is paid, the total number of shares outstanding increases by 5%, and each shareholder will receive 5 additional shares for each 100 held. As a result, each shareholder has the same ownership stake as before the stock dividend.

In addition, the value of the shares held does not change for each shareholder. As the number of shares outstanding increases, the price per share drops because the market capitalization does not change. Therefore, each shareholder will hold more shares, but each has a lower price so the total value of the shares remains unchanged.

The stock dividend is not, however, exactly the same as a stock split. A stock split is paid by switching out old shares for a greater number of new shares. The company is essentially converting to a new set of shares and asking each shareholder to trade in the old ones.

A stock dividend could be paid from shares not-outstanding. These are the company’s own shares that it holds: they are not circulating in the market, but were issued just the same. The company may have gotten these shares from share repurchases, or simply from them not being sold when issued.

Stock dividends may also be paid from non-outstanding stock or from the stock of another company (e.g. its subsidiary).

The company would record the stock dividend as a debit to the retained earnings account and credit both common stock and the paid in capital accounts.

An advantage of paying stock dividends instead of cash dividends to the shareholder is due to tax considerations. Cash dividends are taxed, while stock dividends are not . Of course, stock dividends don’t actually change the asset value of the shareholders so, in effect, nothing of substance has occurred.

Supreme Court Seal

The Eisner vs. Macomber case was a US Supreme Court Case that helped determine the differences in taxation of cash and stock dividends.

12.6.3: Drawbacks of Repurchasing Shares

Share repurchases often give an advantage to insiders and can be used to manipulate financial metrics.

Learning Objective

Discuss the drawbacks of a share repurchase

Key Points

• Insiders are more likely to know if a firm is undervalued, and are therefore more likely to know whether they should sell their shares in an open-market repurchase.
• Financial ratios that use the number of shares outstanding change when shares are repurchased. Executives and management whose compensation is tied to these metrics have an incentive to manipulate them through share repurchases.
• Share repurchases are often not completed. It is tough to value the effect of a share repurchase announcement because it is unknown whether it will occur in full.

Key Terms

Earnings Per Share

The amount of earnings per each outstanding share of a company’s stock.

insider

A person who has special knowledge about the inner workings of a group, organization, or institution.

There are a number of drawbacks to share repurchases. Both shareholders and the companies that are repurchasing the shares can be negatively affected.

Shares may be repurchased if the management of the company feels that the company’s stock is undervalued in the market. It repurchases the shares with the intention of selling them once the market price of the shares increase to accurately reflect their true value. Not every shareholder, however, has a fair shot at knowing whether the repurchase price is fair. The repurchasing of the shares benefits the non-selling shareholders and extracts value from shareholders who sell. This gives insiders an advantage because they are more likely to know whether they should sell their shares to the company .

Martha Stewart

Martha Stewart was convicted of insider trading, which is not the same as insiders choosing whether to sell their shares in a share repurchase. Insiders are still at an advantage because they will know not to sell during the share repurchase.

Furthermore, share repurchases can be used to manipulate financial metrics. All financial ratios that include the number of shares outstanding (notably earnings per share, or EPS) will be affected by share repurchases. Since compensation may be tied to reaching a high enough EPS number, there is an incentive for executives and management to try to boost EPS by repurchasing shares. Inaccurate EPS numbers are not good for investors because they imply a degree of financial health that may not exist.

From the investor’s standpoint, one drawback of share repurchases is that it’s hard to judge how it will affect the valuation of the company. Companies often announce repurchases and then fail to complete them, but repurchase completion rates increased after companies were forced to retroactively disclose their repurchase activity. It is difficult for shareholders, especially relatively uninformed ones, to judge how the announcement will affect the value of their holdings if there is no guarantee that the full announced repurchase will occur.

12.6.4: Reverse Splits

Reverse splits are when a company reduces the number of shares outstanding by offering a number of new shares for each old one.

Learning Objective

Define a reverse split

Key Points

• In a reverse stock split (also called a stock merge), the company issues a smaller number of new shares. New shares are typically issued in a simple ratio, e.g. 1 new share for 2 old shares, 3 for 4, etc.
• A reverse split boosts the share price, so there is a stigma attached. Some investors have rules against trading shares below a certain value, so a company in financial trouble may issue a reverse split to keep their share price above that threshold.
• A reverse stock split may be used to reduce the number of shareholders. If a company completes reverse split in which 1 new share is issued for every 100 old shares, any investor holding less than 100 shares would simply receive a cash payment.

Key Terms

outstanding shares

Shares outstanding are all the shares of a corporation that have been authorized, issued and purchased by investors and are held by them.

outstanding stock

all the stock of a corporation or financial asset that have been authorized, issued and purchased by investors and are held by them

By owning a share, the shareholder owns a percentage of the company whose share s/he owns. A share, however, does entitle the shareholder to a specific percentage ownership; the amount of the company that the shareholder owns is dependent of the number of shares owned and the number of shares outstanding. If Jim owns 10 shares of Oracle, and there are 1,000 shares outstanding, Jim effectively owns 1% of Oracle. If the number of shares outstanding were to double to 2,000, Jim’s 10 shares would now correspond to a 0.5% ownership stake. In order for Jim’s ownership stake to remain constant, the number of shares he holds must change in proportion to change in outstanding shares: he must own 20 shares if there are 2,000 shares outstanding.

That is the premise behind a reverse stock split. In a reverse stock split (also called a stock merge), the company issues a smaller number of new shares. New shares are typically issued in a simple ratio, e.g. 1 new share for 2 old shares, 3 for 4, etc.

The reduction in the number of issued shares is accompanied by a proportional increase in the share price. A company with a market capitalization of $1,000,000 from 1,000,000 shares trading at $1 chooses to reduce the number of outstanding shares to 500,000 through a reverse split. This leads to a corresponding rise in the stock price to $2.

There is a stigma attached to doing a reverse stock split, so it is not initiated without very good reason and may take a shareholder or board meeting for consent. Many institutional investors and mutual funds, for example, have rules against purchasing a stock whose price is below some minimum. In an extreme case, a company whose share price has dropped so low that it is in danger of being delisted from its stock exchange, might use a reverse stock split to increase its share price. For these reasons, a reverse stock split is often an indication that a company is in financial trouble.

A reverse stock split may be used to reduce the number of shareholders. If a company completes reverse split in which 1 new share is issued for every 100 old shares, any investor holding less than 100 shares would simply receive a cash payment. If the number of shareholders drops, the company may be placed into a different regulatory categories and may be governed by different laws .

SEC

The Securities and Exchange Commission is the department that sets the different regulations regarding stock trading and splitting.

12.6.5: Benefits of Repurchasing Shares

Share repurchases are beneficial when the stock is undervalued, management needs to meet a financial metric, or there is a takeover threat.

Learning Objective

Discuss the benefits of a company repurchasing its shares

Key Points

• If management feels the company is undervalued, they will repurchase the stock, and then resell it once the price of the shares increases to reflect the accurate value of the firm.
• A member of management may have to meet earnings per share (EPS) metrics which can be increased by increasing earnings or lowering the number of outstanding shares. Share repurchases decrease the number of outstanding shares, and thus increase EPS.
• To prevent a firm from acquiring enough of a company’s stock to take it over, the takeover target may buy back shares, often at a price above market value.

Key Terms

Earnings Per Share

EPS. (Net Income – Dividends on Preferred Stock) / Outstanding Shares

hostile takeover

An attempted takeover of a company that is strongly resisted by the target company’s management.

A company may seek to repurchase some of its outstanding shares for a number of reasons. The company may feel that the shares are undervalued, an executive’s compensation may be tied to earnings per share targets, or it may need to prevent a hostile takeover.

For shareholders, the primary benefit is that those who do not sell their shares now have a higher percent ownership of the company’s shares and a higher price per share. Those who do choose to sell have done so at a price they are willing to sell at – unless there was a ‘put’ clause, in which case they had to sell because of the structure of the share, something they would have already known when they bought the shares.

Undervaluation

Repurchasing shares may also be a signal that the manager feels that the company’s shares are undervalued. In this event, it will choose to repurchase shares, and then resell them in the open market once the price increases to accurately reflect the value of the company.

Executive Compensation

In some instances, executive compensation may be tied to meeting certain earnings per share (EPS) metrics. If management needs to boost the EPS of the company to meet the metric, s/he has two choices: raise earnings or reduce the number of shares. If earnings cannot be increased, there are a number of ways to artificially boost earnings (called earnings management), but s/he can also reduce the number of shares by repurchasing shares . Strictly speaking, this is a benefit to the management and executives, not the company or the shareholders. -Thwart.

Marc Benioff

CEOs, like Marc Benioff of Salesforce.com, may have to meet certain financial targets in order to earn his or her bonus. If one of these targets is EPS, they may have an incentive to try to increase EPS artificially.

Hostile Takeovers

A company can take over another firm if it holds enough of the other takeover target’s shares (the buyer of the shares is called the bidder, and the company it is trying to buy is called the takeover target). The bidder is buying the takeover target’s shares in an attempt to purchase enough to own it. Assuming the firm does not want to be taken over this way, the takeover attempt is called hostile. In order to prevent this from happening, the takeover target needs to prevent the bidder from purchasing enough of the shares. To do this, the takeover target will repurchase its own shares from the unfriendly bidder, usually at a price well above market value. Furthermore, it can prevent future takeover attempts. Companies with a lot of cash on their balance sheets are more attractive takeover targets because the cash can be used to pay down the debt incurred to carry out the acquisition. Share repurchases are one way of lowering the amount of cash on the balance sheet.

12.6.6: Stock Splits

A stock split increases the number of shares outstanding without changing the market value of the firm.

Learning Objective

Describe a stock split

Key Points

• A stock split is executed by offering several new shares in exchange for old ones. This may be a 3-for-1 split, for example: each share could be traded in for three new ones.
• A stock split does not change the market capitalization of the firm, it merely changes the number of shares outstanding. Therefore the price per share decreases as the number of shares outstanding increases.
• Each shareholder retains his or her same ownership stake because the number of share s/he holds changes in proportion to the change in the total number of shares outstanding.

Key Term

market capitalization

The total market value of the equity in a publicly traded entity.

A stock split or stock divide increases the number of shares in a public company. Suppose a company has 1,000 shares outstanding. The company may want to increase this number to 2,000 shares without issuing new shares. They would split their stock 2-for-1. That means that every shareholder trades in one old share and gets two new shares in return.

The ownership stake for each shareholder remains constant because the number of shares held changes in proportion to the number of shares outstanding. They own the same percentage of the outstanding shares, though the nominal number of shares increases.

The price of the shares, however, changes. Since the market value of the company remains the same, the price of the new shares adjusts to reflect the new number of outstanding shares. For example, a company that has 100,000 shares outstanding that trade at $6 has a market capitalization of $600,000. After a 3-for-1 stock split the market capitalization of the company remains unchanged at $600,000, but there are not 300,000 shares trading at $2.

Lowering the price per share is attractive to some companies. Berkshire Hathaway Class A shares have never been split, so the price has followed the company’s growth over time . Since the price of a Class A share was over $121,000 on May 2, 2012, smaller investors may have chosen not to invest in Berkshire Hathaway Class A shares because of cash-flow or liquidity concerns. There are, however, Class B shares that trade at a lower value.

Berkshire Hathaway

Berkshire Hathaway has famously never had a stock split, and has never paid a dividend. As a result its Class A shares traded at $121,775.00 as of May 2, 2012, making them the highest-priced shares on the New York Stock Exchange.

12.6.7: Repurchasing Shares

A share repurchase is when a company buys its own stock from public shareholders, thus reducing the number of shares outstanding.

Learning Objective

Describe the different ways a company may repurchase its stock

Key Points

• Since the market capitalization is unchanged and the number of shares outstanding drops, a share repurchase will lead to a corresponding increase in stock price.
• The reduction of the shares outstanding means that even if profits remain the same, the earnings per share increase.
• There are a number of methods for repurchasing shares, the most popular of which is open-market: the company buys back shares at the market dictated price if the price is favorable.

Key Term

Repurchase

To buy back a company’s own shares. The issuing company pays public shareholder for their shares.

An alternative to cash dividends is share repurchases. In a share repurchase, the issuing company purchases its own publicly traded shares, thus reducing the number of shares outstanding. The company then can either retire the shares, or hold them as treasury stock (non-circulating, but available for re-issuance).

When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of the shares outstanding means that even if profits remain the same, the earnings per share increase. Repurchasing shares when a company’s share price is undervalued benefits non-selling shareholders and extracts value from shareholders who sell.

Repurchasing shares will lead to a corresponding increase in price of the shares still outstanding. The market capitalization of the company is unchanged, meaning that a reduction in the number of shares outstanding must be accompanied by an increase in stock price.

There are six primary repurchasing methods:

1. Open Market: The firm buys its stock on the open market from shareholders when the price is favorable. This method is used for almost 75% of all repurchases.
2. Selective Buy-Backs: The firm makes repurchase offers privately to some shareholders.
3. Repurchase Put Rights: Put rights are the right of the seller to purchase at a certain price, set ahead of time. If the company has put rights on its shares, it may use them to repurchase shares at that price.
4. Fixed Price Tender Offer: The firm announces a number of shares it is looking for and a fixed price they are willing to pay. Shareholders decide whether or not to sell their shares to the company.
5. Dutch Auction Self-Tender Repurchase: The company announces a range of prices at which they are willing to repurchase. Shareholder voluntarily state the price at which they individually are willing to sell. The company then constructs the supply-curve, and then announces the purchase price. The company repurchases shares from all shareholders who stated a price at or below that repurchase price .
6. Employee Share Scheme Buy-Back: The company repurchases shares held by or for employees or salaried directors of the company.

12.7: Reporting and Analyzing Equity

12.7.1: Reporting Stockholders’ Equity

Equity (beginning of year) + net income − dividends +/− gain/loss from changes to the number of shares outstanding = Equity (end of year).

Learning Objective

Explain how a company would report changes in stockholder’s equity

Key Points

• The book value of equity will change relative to changes in the firm’s assets (liabilities, depreciation, new issue, and stock repurchase).
• The book value of equity will change as there are changes in the firm’s assets. This includes changes to liabilities, depreciation, new issue, and stock repurchase.
• The market value of shares in the stock market does not correspond to the equity per share calculated in the accounting statements.

Key Term

share repurchase

Stock repurchase (or share buyback) is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company’s outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.

Reporting Stockholders’ Equity

In financial accounting, owner’s equity consists of an entity’s net assets. Net assets are the difference between the total assets of the entity, and all its liabilities. Equity appears on the balance sheet of financial position, one of the four primary financial statements. “”

Balance Sheet

Shareholders’ equity in a balance sheet.

A statement of shareholder’s equity provides investors with information regarding the transactions that affected the stockholder’s equity accounts during the period.

The book value of equity will change in the case of the following events:

• Changes in the firm’s assets relative to its liabilities. For example, a profitable firm may receive more cash for its products than the cost at which it produced the goods, and so in the act of making a profit, it increases its assets.
• Depreciation. For example, equity will decrease when machinery depreciates. Depreciation is registered as a decline in the value of the asset, and as a decrease in shareholders’ equity on the liabilities side of the firm’s balance sheet.
• Issue of new equity in which the firm obtains new capital and increases the total shareholders’ equity.
• Share repurchases, in which a firm gives back money to its investors, reducing its financial assets, and the liability of shareholders’ equity. For practical purposes (except for its tax consequences), share repurchasing is similar to a dividend payment, as both consist of the firm giving money back to investors. Rather than giving money to all shareholders immediately in the form of a dividend payment, a share repurchase reduces the number of shares, thereby increasing the percent of future income and distributions garnered by each remaining share.

The market value of shares in the stock market does not correspond to the equity per share calculated in the accounting statements. Stock valuations, which are often much higher, are based on other considerations related to the business’s operating cash flow, profits, and future prospects. Some factors are derived from the accounting statements.

Equity (beginning of year) + net income − dividends +/− gain/loss from changes to the number of shares outstanding = Equity (end of year).

Dirty Surplus Accounting

Dirty surplus accounting involves the inclusion of other comprehensive income or unusual items in net income, which will consequently flow into retained earnings. These items can skew net income and provide information that could be misleading. A prime example of dirty surplus accounting is the inclusion of unrealized gains or losses on treasury stocks, or securities they are holding for sale.

The main problem with dirty surplus accounting is that unusual items that affect shareholders equity can be easily hidden. Employee stock options are a good example of expenses that may not explicitly show up on the income statement. ESOs can, in actuality, cost shareholders a large sum; therefore, it is important for investors to realize the magnitude of these costs in order to correctly value a firm’s equity.

12.7.2: Earnings per Share

Earnings per share (EPS) is the amount of a company’s earnings per each outstanding share of a company’s stock.

Learning Objective

Explain how a company would calculate their earnings per share

Key Points

• Companies’ income statements must report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income.
• The EPS formula does not include preferred dividends for categories outside of continued operations and net income.
• EPS (basic formula) = Profit / Weighted Average Common shares. EPS (net income formula) = Net income / Average Common shares. EPS (continuing operations formula) = Income from continuing operations / Weighted Average Common shares.
• Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted shares outstanding (i.e. including the impact of stock option grants and convertible bonds).

Key Term

discontinued operations

A discontinued operation is a component of an enterprise that has either been disposed of, or is classified as “held for sale”, and also represents a separate major line of business or geographical area of operations; and is part of a single, co-ordinated plan to dispose of this separate major line of business or geographical area of operations; or is a subsidiary acquired exclusively with a view to resale.

Earnings Per Share

Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s stock. In the United States, the Financial Accounting Standards Board (FASB) requires that companies’ income statements report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income.

The EPS formula does not include preferred dividends for categories outside of continued operations and net income. Earnings per share for continuing operations and net income are more complicated; any preferred dividends are removed from net income before calculating EPS. This is because preferred stock rights have precedence over common stock. If preferred dividends total $100,000, then that money is not available to distribute to each share of common stock.

Earnings Per Share (Basic Formula): “”

Earnings Per Share

Basic formula

Earnings Per Share (Net Income Formula): “”

Earnings Per Share

Net income formula

Earnings Per Share (Continuing Operations Formula): “”

Earnings Per Share

Continuing operations formula

Only preferred dividends actually declared in the current year are subtracted. The exception is when preferred shares are cumulative, in which case annual dividends are deducted regardless of whether they have been declared or not. Dividends in arrears are not relevant when calculating EPS.

Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted outstanding shares (i.e. including the impact of stock option grants and convertible bonds). Diluted EPS indicates a “worst case” scenario, one in which everyone who could have received stock without purchasing it directly for the full market value did so.

To find diluted EPS, basic EPS is first calculated for each of the categories on the income statement. Then each of the dilutive securities are ranked based on their effects, from most dilutive to least dilutive and antidilutive. Then the basic EPS number is diluted one by one by applying each, skipping any instruments that have an antidilutive effect.

Calculations of diluted EPS vary. Morningstar reports diluted EPS “Earnings/Share $” (net income minus preferred stock dividends divided by the weighted average of common stock shares outstanding over the past year). This is adjusted for dilutive shares. Some data sources may simplify this calculation by using the number of shares outstanding at the end of a reporting period.

12.7.3: Dividend Yield Ratio

The dividend-price ratio is a company’s annual dividend payments divided by market capitalization, or dividend per share divided by the price per share.

Learning Objective

Explain how a company would use the dividend yield ratio

Key Points

• Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year. Its reciprocal is the Price/Dividend ratio.
• Preferred share dividend yield is the dividend payments on preferred shares are set out in the prospectus.
• Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to holders of common stock are set by management, usually with regard to the company’s earnings.
• Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield may be evidence that a stock is under priced or that the company has fallen on hard times, and future dividends will not be as high as previous ones.

Key Term

preferred share

Preferred stock (also called “preferred shares,” “preference shares,” or simply “preferreds”) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e., higher ranking) to common stock but subordinate to bonds in terms of claim (or rights to their share of the assets of the company). Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a “Certificate of Designation. “

The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage.

Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year. Its reciprocal is the Price/Dividend ratio.

Preferred share dividend yield is the dividend payments on preferred shares, which are set out in the prospectus. The name of the preferred share will typically include its yield at par. For example, a 6% preferred share. However, the dividend may, under some circumstances, be passed or reduced. The yield is the ratio of the annual dividend to the current market price, which will vary.

Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to holders of common stock are set by management, usually with regard to the company’s earnings. There is no guarantee that future dividends will match past dividends or even be paid at all. The historic yield is calculated using the following formula:

Current dividend yield

Current dividend yield = Most recent Full-Year Dividend / Current Share Price

For example, take a company which paid dividends totaling 1 per share last year and whose shares currently sell for $20. Its dividend yield would be calculated as follows: 1/20 = 0.05 = 5%.

The yield for the S&P 500 is reported this way. U.S. newspaper and Web listings of common stocks apply a somewhat different calculation. They report the latest quarterly dividend multiplied by 4 divided by the current price. Others try to estimate the next year’s dividend and use it to derive a prospective dividend yield. Such a scheme is used for the calculation of the FTSE UK Dividend+ Index. Estimates of future dividend yields are by definition uncertain.

Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield can be considered to be evidence that a stock is under priced or that the company has fallen on hard times and future dividends will not be as high as previous ones. Similarly, a low dividend yield can be considered evidence that the stock is overpriced or that future dividends might be higher. Some investors may find a higher dividend yield attractive, for instance, as an aid to marketing a fund to retail investors, or maybe because they cannot get their hands on the capital, which may be tied up in a trust arrangement. In contrast, some investors may find a higher dividend yield unattractive, perhaps because it increases their tax bill.

12.8: Additional Topics in Stockholders’ Equity

12.8.1: Other Comprehensive Income

Accumulated Other Comprehensive Income (AOCI) is all the changes in equity other than transactions from owners and distributions to owners.

Learning Objective

Summarize the purpose of the comprehensive income section on the financial statement

Key Points

• Other comprehensive income is comprised of several gains and losses that are not disclosed in the income statement and which relate to available for sale securities, foreign currency translation, derivatives, pension plans, and revaluation of assets.
• The AOCI balance is presented as a line item in the stockholder’s equity section of the balance sheet.
• The individual components of AOCI can be presented in a separate statement of comprehensive income or a separate section for comprehensive income within the income statement.

Key Terms

hedge

Contract or arrangement reducing one’s exposure to risk (for example, the risk of price movements or interest rate movements).

IFRS

International Financial Reporting Standards; designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.

Definition of Other Comprehensive Income

Other comprehensive income, disclosed in the stockholder’s equity section, is the total non-owner change in equity for a reporting period or all the changes in equity other than transactions from owners and distributions to owners. Most changes to equity, such as revenues and expenses, appear in the income statement. A few gains and losses are not shown in the income statement since they are not closed to retained earnings. They are disclosed in the shareholder equity section of the balance sheet known as “accumulated other comprehensive income” .

Stakeholders that use financial statements.

Other comprehensive income can be reported in its own statement of comprehensive income or in a separate section within the income statement.

Components of Other Comprehensive Income

Other comprehensive income is comprised of the following items:

• Unrealized gains and losses on available for sale securities (debt and equity)
• Gains and losses on the effective portion of derivatives held as cash flow hedges
• Gains and losses resulting from the translation of the financial statements of foreign subsidiaries from the foreign currency to the reporting currency
• Actuarial gains and losses on recognized defined benefit pension plans (minimum pension liability adjustments)
• Changes in the revaluation surplus account (this account records changes between the market and book value of fixed assets on the balance sheet)

The accumulated other comprehensive income balance is presented as a line item in the stockholder’s equity section of the balance sheet. The individual components of the balance can be presented in a separate statement of comprehensive income or a separate section for comprehensive income within the income statement.

Other Comprehensive Income and IFRS

All items of income and expense recognized in a period must be included in profit or loss unless a standard or an interpretation requires otherwise. Some IFRSs (international financial reporting standards) require or permit that some components be excluded from the income statement and instead be included in other comprehensive income.

12.8.2: Convertible Stock

A convertible security, such as convertible preferred stock, is any security that can be converted into another.

Learning Objective

Explain why a company would offer convertible stocks

Key Points

• Convertible preferred stock has an embedded option that allows the stock to be converted into a specified number of shares of common stock at a predetermined price; usually at a premium over the stock’s market price.
• The conversion feature in convertible stock adds an option of acquiring common shares, which has certain advantages, such as voting rights and unlimited access to company earnings.
• Accounting principles require the reporting of convertible preferred stock in the same manner as non-convertible preferreds. The value of the conversion feature is not reported due to the uncertainty of when the conversion may occur, if at all.

Key Terms

par value

The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

liquidation

The selling of the assets of a business as part of the process of dissolving it.

Definition of Convertible Securities

This refers to any security that can be converted into another security. Convertible securities can include bonds that pay interest or preferred stocks that pay dividends. This type of stock has an embedded option that allows it to be converted into a specified number of shares of common stock at a predetermined price; usually at a premium over the stock’s market price.

The conversion can also be based on the occurrence of certain conditions, such as the stock’s market price appreciating to a predetermined level, or the requirement that the conversion take place by a certain date. The conversion is exercised at the security holder’s discretion. The shareholder can also sell the original security and use the conversion feature as a favorable selling point .

Allied Paper Corp. Common Stock Certificate

A public company’s preferred stock is designated as convertible if it can be exchanged for common stock.

Convertible Preferred Stock

Preferred stock (also called preferred shares) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid. Preferred shares rank higher to common stock during earnings distributions, such as dividends; however, they are subordinate to bonds in terms of their claim to company assets in the event of a business liquidation. Unlike common stock, preferred shares usually have no voting rights. The shares may also be cumulative or non-cumulative. A cumulative preferred stock accumulates unpaid prior period dividends into the future, while a non-cumulative preferred loses rights to any dividends not paid in prior periods. The conversion feature adds an option of acquiring common shares, which has certain advantages, such as voting rights.

Convertible Stock and Stockholder’s Equity

Accounting principles require the reporting of convertible preferred stock in the same manner as non-convertible preferreds. Preferred stock is reported in the stockholder’s equity section as the number of shares outstanding, multiplied by the stock’s market price. The result is divided between the value of the shares that fall under “common stock – par value” and the excess value over par is reported as “common stock – additional paid-in-capital”. The value of the conversion feature is not reported due to the uncertainty of when the conversion may occur, if at all.

12.8.3: Stock Warrants

A stock warrant entitles the holder to buy the underlying stock of the issuer at a fixed exercise price until the expiration date.

Learning Objective

Summarize why a company would issue a stock warrant

Key Points

• Stock warrants, like options, are discretionary and it is not mandatory for the warrant holder to acquire the underlying stock. Warrants are frequently attached to bonds or preferred stock as an added bonus for the buyer.
• Stock warrants have several features that should be evaluated: premium, expiration date, leverage, and restrictions on exercise option.
• No matter the type of warrant, all are reported in the stockholder’s equity section of the balance sheet as a line item under contributed capital. They are valued at their exercise price multiplied by the specified number of shares the warrant provides.

Key Terms

contributed capital

Refers to capital contributed to a corporation by investors through purchase of stock from the corporation (primary market) (not through purchase of stock in the open market from other stockholders (secondary market)). It includes share capital (i.e. capital stock) as well as additional paid-in capital.

exercise price

The fixed price at which the owner of an option can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity.

yield

The current return as a percentage of the price of a stock or bond.

Definition of Stock Warrants

A stock warrant is similar to a stock option in that it entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. Stock warrants, like options, are discretionary and it is not mandatory for the warrant holder to acquire the underlying stock. Warrants are frequently attached to bonds or preferred stock as an added bonus for the buyer. They benefit the warrant issuer by allowing the company to pay lower interest rates or dividends. They can be used to enhance the yield of the bond and make them more attractive to potential buyers. Warrants can also be used in private equity deals .

Sears Roebuck & Co. Bond Certificate

Public companies can offer company bonds for sale with stock warrants attached.

Stock Warrant Features

Since warrants are typically attached to other securities, in certain cases it is possible to detach them and sell them independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Therefore, it is sometimes beneficial to detach and sell a warrant as soon as possible. Stock warrants have several features that can make them more or less attractive investments:

• Premium (the extra amount paid for the shares when exercising the warrant as compared to the market price paid when acquiring the stock through the open market)
• Leverage (risk exposure to the underlying shares acquired through the warrant as compared to the risk exposure of shares purchased in the open market)
• Expiration Date (the date the warrant expires; the longer the time frame involved until expiration the greater the opportunities for stock price appreciation, which increases the price of the stock warrant until its value diminishes to zero on the expiration date)
• Restrictions on Exercise (American-style warrants must be exercised before the expiration date and European-style warrants can only be exercised on the expiration date.

Stock Warrants and Stockholder’s Equity

There are many types of stock warrants — equity, callable, putable, covered, basket, index, wedding, detachable, and naked warrants. No matter the type of warrant, all are reported in the stockholder’s equity section of the balance sheet as a line item under contributed capital. They are valued at their exercise price multiplied by the specified number of common shares the warrant provides.

12.8.4: Calculating Diluted Earnings per Share

Diluted earnings per share (EPS) takes the basic EPS formula and accounts for the effect of dilutive shares on earnings.

Learning Objective

Explain why a company would calculate diluted earning per share for its stock

Key Points

• Dilutive common shares from dilutive instruments, such as stock options or stock warrants, are added to the basic equation’s denominator (weighted average number of common shares outstanding), which decreases the value of earnings per share.
• Diluted earnings per share is the most conservative per share earnings number because the equation takes into account the largest number of common shares that could be outstanding.
• Basic EPS, based on net income and reported on the face of the income statement, is followed by diluted earnings per share, also reported on the income statement.

Key Terms

dilutive

Describing something that dilutes or causes dilution (reduces value).

weighted average

An arithmetic mean of values biased according to agreed weightings.

Example

• Sun Microsystems, Inc. has 3,417,000,000 weighted-average common shares outstanding with income available to common shareholders of USD 922,590,000 during a recent year. Stock warrants can be exercised for 1,000,000,000 common shares. Basic EPS = USD 922,590,000 / 3,417,000,000 = USD .27 per share. Diluted EPS = USD 922,590,000 / 3,417,000,000 + 1,000,000,000 = USD .20 per share.

Diluted Earnings Per Share

Definition

Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted common shares outstanding (i.e. which includes the impact of instruments such as stock option grants and convertible bonds). Fully diluted common shares consider securities with features that will increase the number of common shares outstanding and reduce (dilute) earnings per share. Diluted EPS indicates a “worst case” scenario, one in which everyone who could have received stock did so without purchasing shares directly for the full market value.

Earnings per share shows the amount of income applicable to each share of common stock.

Diluted earnings per share includes shares of common stock from dilutive securities, such as convertible debt or stock options, in its calculation.

Calculation

The basic earnings per share formula involves taking the income available for common shareholders (net income minus preferred stock dividends), divided by the weighted average number of common shares outstanding. Dilutive common shares from dilutive instruments, such as stock options or stock warrants, are added to the basic equation’s denominator (weighted average number of shares outstanding), which decreases the ending result of earnings per share. So, basic earnings per share tends to have a higher value than diluted earnings per share. Diluted earnings per share is the most conservative per share earnings number because the equation takes into account the largest number of common shares that could be outstanding.

Disclosure

Public companies calculate and disclose EPS for each major category on the face of the income statement. In other words, they make an EPS calculation for income from continuing operations, discontinued operations, extraordinary items, changes in accounting principle, and net income. Basic EPS, based on net income, is followed by diluted earnings per share and and both figures are reported on the income statement.

11.2: Valuing Bonds

11.2.1: Factors Affecting the Price of a Bond

Learning Objective

Explain how a bond’s value is affected by its term, face value, coupon and discount rate

Key Points

• A bond’s term, or maturity, is how long the issuing company has until it must repay the entirety of what it owes.
• Otherwise known as the principal or nominal amount, this is the amount of money that the organization issuing the bond has to pay interest on and generally has to repay when the bond is redeemed at the end of the term.
• A bond’s coupon is the interest rate that the business must pay on the bond’s face value.
• The discount rate is a a measure of what the bondholder’s return would be if he invested his money in something other than the bond. In practical terms, the discount rate generally equals the coupon rate or interest rate associated with similar investment securities.

Key Terms

bond

Evidence of a long-term debt, by which the bond issuer (the borrower) is obliged to pay interest when due, and repay the principal at maturity, as specified on the face of the bond certificate. The rights of the holder are specified in the bond indenture, which contains the legal terms and conditions under which the bond was issued. Bonds are available in two forms: registered bonds and bearer bonds.

discount rate

The interest rate used to discount future cashflows of a financial instrument; the annual interest rate used to decrease the amounts of future cashflows to yield their present value.

A bond is a financial security that is created when a person transfers funds to a company or government, with the understanding that at some point in the future the entity issuing the bond will have to repay the amount, plus interest . Generally, the person who holds the actual bond document is the one with the right to receive payment. This allows people who originally acquire a bond to sell it on the open market for an immediate payout, as opposed to waiting for the issuing entity to pay the debt back. Note that the trading value of a bond (its market price) can vary from its face value depending on differences between the coupon and market interest rates.

A bond from the Dutch East India Company

A bond is a financial security that represents a promise by a company or government to repay a certain amount, with interest, to the bondholder.

A bond’s book value is determined by several factors.

Term

A bond’s term, or maturity, is how long the issuing company has until it must repay the entirety of what it owes. Sometimes a business will make interest payments during the term of the bond, but a term ends when all of the payments associated with the bond are completed.

Face Value of Bond

Otherwise known as the principal or nominal amount, this is the amount of money that the organization issuing the bond has to pay interest on and generally has to repay when the bond is redeemed at the end of the term. The redemption amount generally equals how much the original investor paid to acquire the bond. However, the redemption amount can be different than the acquisition cost.

Coupon

A bond’s coupon is the interest rate that the business must pay on the bond’s face value. These interest payments are generally paid periodically during the bond’s term, although some bonds pay all the interest it owes at the end of the period. While the coupon rate is generally a fixed amount, it can also be “indexed. ” This means that the interest rate is calculated by taking an established rate that fluctuates over time, such as a bank’s lending rate, and adding a “premium” percentage amount to determine the bond’s coupon rate. As a result, the interest that is paid to the bond holder fluctuates over time with an indexed coupon rate.

Discount Rate

A bond’s value is measured based on the present value of the future interest payments the bond holder will receive. To calculate the present value, each payment is adjusted using the discount rate. The discount rate is a measure of what the bondholder’s return would be if he invested his money in another security. In practical terms, the discount rate generally equals the coupon rate or interest rate associated with similar investment securities.

11.2.2: Bond Valuation Method

Learning Objective

Summarize how a company would calculate the value of their bonds

Key Points

• When calculating the present value of a bond, use the market rate as the discount rate.
• Regardless of whether the bond is sold at a premium or discount, a company must list a “bond payable” liability equal to the face value of the bond.
• If the market rate is greater than the bond’s contract rate, the bond will be sold at a discount. If the market rate is less than the bond’s contract rate, the bond will be sold at a premium.

Key Terms

market interest rate

the interest rate determined through various investment systems, such as the stock market or the bond market

contract rate

Another term for coupon rate, this is the amount of interest the business will pay on the principal of the bond.

market rate

The interest rate associated with other bonds that have a similar risk factor.

Bond Valuation

A business must record a liability in its records when it issues a series of bonds. The value of the liability the business will record must equal the amount of money or goods it receives when it issues the bond. Whether the amount the business will receive equals its face value depends on the difference between the bond’s contract rate and the market rate of interest at the time the bond is issued .

Balance Sheet

A bond issued by a company is recorded as a liability on its balance sheet.

The bond’s contract rate is another term for the bond’s coupon rate. It is what the issuing company uses to calculate what it must pay in interest on the bond. The market rate is what other bonds that have a similar risk pay in interest.

Regardless of what the contract and market rates are, the business must always report a bond payable liability equal to the face value of the bonds issued. If the market rate is greater than the coupon rate, the bonds will probably be sold for an amount less than the bonds’ face value and the business will have to report a “bond discount. ” The value of the bond discount will be the difference between what the bonds’ face value and what the business received when it sold the bonds. If the market rate is less than the coupon rate, the bonds will probably be sold for an amount greater than the bonds’ value. The business will then need to record a “bond premium” for the difference between the amount of cash the business received and the bonds’ face value.

Calculating the Premium and Discount

If the market and coupon rates differ, the issuing company must calculate the present value of the bond to determine what price to charge when it sells the security on the open market. The present value of a bond is composed of two components; the principal and the interest payments. The discount rate for both the principal and interest payment components is the market rate when the bond was issued.

11.2.3: Bonds Issued at Par Value

Learning Objective

Explain how a company would record a bond issued a par value

Key Points

• Recording a bond issued at par value is a simple process, since there is generally no premium or discount associated with the bond’s sale.
• To record interest paid on a bond issued at par value, debit the amount paid to the bond interest expense account and credit the same amount to the cash account.
• When the bond is paid off, record any final interest payment. Then debit the bond payable account and credit the cash account for the full face value of the bonds.

Key Terms

no-par value stock

shares issued by a company without a minimum price for which they must be sold

par value stock

shares with a value stated in the corporate charter below which shares of that class cannot be sold upon initial offering

par value

The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

Example

• Consider a 3-year bond with a face value of $1,000 and an effective interest rate of 7%, sold at face value. Since the bond is sold at face value, the proceeds are $1,000. The journal entry would be: Cash $1,000 Bond Payable $1,000The interest payable for each period will be equal to 1,000 x 7%, or $70. The affected accounts will be interest expense and cash, and the journal entry will be as follows: Interest Expense $70 Cash $70At bond expiration, the creditor must make a journal entry for the last interest payment and the retirement of the bond through principal payment. The journal entry would be: Bond Payable $1,000 Cash $1,000

Bonds issued at par value are relatively simple to calculate and record. When a bond is issued at par value it is sold for the face value amount. This generally means that the bond’s market and contract rates are equal to each other, meaning that there is no bond premium or discount.

The General Ledger

All transactions made by the company in relation to the bond must be recorded in its general ledger. The general ledger contains all entries from both the General Journal and the Special Journals.

When a business issues a bond, it participates in three types of transactions. First, the business issues the bond in exchange for cash. Next, it generally pays interest during the term of the bond. Finally, it pays off the obligation by repaying the face amount and the last interest payment. Each of these transactions must be recorded in the company’s financial records with a series of journal entries.

Issuing the Bond

When the bond is issued, the company must record a liability called “bond payable. ” This is generally a long-term liability. It is created by recording a credit equal to the face value of all the bonds that are issued. To balance this entry, the company must also debit cash equal to the face value of all the bonds issued. Since the bonds are sold at par value, the amount of cash the company receives should equal the total face value of the issued bonds.

Cash – debit face value (increase cash balance)

Bond payable – credit face value (increase bonds payable)

Interest Payments

When the company makes an interest payment, it must credit, or decrease, its cash balance by the amount it paid in interest. To balance the entry, the company must record a debit equal to the amount it paid in its bond interest expense account.

Bond Interest Expense – debit interest payment (increase interest expense line)

Cash – credit interest payment (decrease cash balance)

Paying Off the Bond

When the bond is paid off, the company must record two transactions. First, it must record any final interest payments that are made. Then, it must record the bond principal being paid off. This is done by debiting the bond payable account and crediting the cash account for the full book value of the bond.

Bond Interest Expense – debit interest payment

Cash – credit final interest payment

Bond Payable – debit face value

Cash – credit face value

11.2.4: Bonds Issued at a Discount

Learning Objective

Explain how to record a bond issued at a discount

Key Points

• When the bond is sold, the company credits the “bonds payable” liability account by the bonds’ face value. The company debits the cash account by the amount of money it receives from the sale. The difference between the face value and sales price is debited as the discount value.
• The amortization rate for the bond’s discount balance is calculated by dividing the discount amount by the number of periods the company has to pay interest.
• To record interest expense, a business credits the bond discount account by the amortization rate and credits cash by the amount of money it pays in interest expense. Interest expense is debited by the sum of the amortization rate and how much it pays in interest to the bond holder.
• When the bond matures, the business must record the repayment of the principal to the bondholder, as well as all final interest payments. At this time, the discount on bond payable and bond payable accounts must be zeroed out, and all cash payments must be recorded.

Key Term

amortize

To wipe out (a debt, liability etc. ) gradually or in installments.

Example

• Assume a business sells a 10 year, $100,000 bond with an effective annual interest rate of 6% for $90,000. The journal entry for that transaction would be as follows: Cash $90,000 Discount $10,000 Bond Payable $100,000The interest expense each period is $6,000, and the amortization rate on the bond payable equals $1,000 ($100,000/10 years). The total expense each period is $7,000. The journal entry will be: Interest Expense $7,000 Discount $1,000 Cash $6,000When the bond matures, the business must record the repayment of the principal to the bondholder, as well as all final interest payments. In this example, the journal entries will be: Interest Expense $7,000 Discount $1,000 Cash $6,000 Bond Payable $100,000 Cash $100,000

Issuing Bonds at a Discount

For the issuer, recording a bond issued at a discount can be a little more difficult than recording a bond issued at par value. Because the issuer receives less cash for the bond than the face value, this difference must be recorded in the company records as a discount expense. When a bond is sold at a discount, the market rate of the bond exceeds the contract rate. As a result, the bond must be sold at an amount less than its face value. In addition, that discounted amount must be amortized over the term of the bond. When the company amortizes the discount associated with the bond, it increases its interest expense beyond what it actually pays to the bondholder.

Amortization & depreciation in the accounting cycle

A bond’s discount amount must be amortized over the term of the bond.

Recording the Bond Sale

When a bond is sold, the company records a liability by crediting the “bonds payable” account for the bond’s total face value. Next, the company debits the cash account by the amount of money it receives from the bond sale. The business then debits the difference between the bond’s face value and what it receives in cash from the sale. That is the discount amount.

Assume a business sells a 10 year, $100,000 bond for $90,000. The journal entry for that transaction would be as follows:

Cash $90,000 Dr.

Discount on Bond Payable $10,000 Dr.

Bond Payable $100,000 Cr.

Recording Interest Payments

As the company pays interest, the discount on the bond payable is amortized. Generally, the amortization rate is calculated by dividing the discount by the number of periods the company has to pay interest.

Using the example from above, assume the company pays 6% interest on the $100,000 bond annually. That means that the amortization rate on the bond payable equal $1,000 ($100,000/10 years). While the business would only have to pay the bondholder $6,000 in cash, its total interest expense equals $7,000, or the amount of interest it pays plus the amortization rate. The journal entry would be:

Bond Interest Expense $7,000 Dr.

Discount on Bond Payable $1,000 Cr.

Cash $6,000 Cr.

Recording Bond Maturity

When the bond matures, the business must record the repayment of the principal to the bondholder, as well as all final interest payments. At this time, the discount on bond payable and bond payable accounts must be zeroed out, and all cash payments must be recorded.

Using our example from above, the final set of bond journal entries should look like this:

Bond Interest Expense $7,000 Dr.

Discount on Cash Payable $1,000 Cr.

Cash $6,000 Cr.

Bond Payable $100,000 Dr.

Cash $100,000 Cr.

11.2.5: Bonds Issued at a Premium

Learning Objective

Explain how to record bonds issued at a premium

Key Points

• When the bond is issued, the company must debit the cash by the amount that the business receives, credit a bond payable liability account by an amount equal to the face value of the bonds, and credit a bond premium account by the difference between the sale price and the bond’s face value.
• To calculate the amortization rate of the bond premium, a company generally divides the bond premium amount by the number of interest payments that will be made during the term of the bond.
• When recording interest payments, the company credits cash by the amount paid to the bond holder, debits the bond premium account by the amortization rate, and debit interest expense for the difference between the amount paid in interest and the premium’s amortization for the period.
• When the bond reaches maturity, the company must pay the bondholder the face value of the bond, finish amortizing the premium, and pay any remaining interest obligations. When all the final journal entries are made, the bond premium and bond payable account must equal zero.

Key Term

amortize

To wipe out (a debt, liability etc. ) gradually or in installments.

Example

• Assume a business issues a 10-year bond that has an effective annual interest rate of 6%, with a face value of $100,000. This bond sells for $110,000. The resulting journal entry would be: Cash $110,000 Bond Payable $100,000The $10,000 premium would be divided by 10 annual interest payments. This would make the amortization rate of the bond’s premium equal to $1,000 per year. The company must pay $6,000 in interest annually, so the company’s annual interest expense equals $5,000. The resulting journal entry is: Bond Interest Expense $5,000 Bond Premium $1,000 Cash $6,000When the bond reaches maturity, the company must pay the bondholder the face value of the bond, finish amortizing the premium, and pay any remaining interest obligations. In this example, the final journal entries will be: Bond Interest Expense $5,000 Bond Premium $1,000 Cash $6,000 Bond Payable $100,000 Cash $100,000

When a bond is issued at a premium, that means that the bond is sold for an amount greater than the bond’s face value. This generally means that the bond’s contract rate is greater than the market rate. Like with a bond that is sold at a discount, the difference between the bond’s face value and sales price must be amortized over the term of the bond. However, unlike with a bond sold at a discount, the process of amortizing the premium will decrease the bond’s interest expense recorded on the issuing company’s financial records. The issuing company will still be required to pay the bondholder the interest payments guaranteed by the bond.

Amortization Schedule

An example of an amortization schedule of a $100,000 loan over the first two years.

Bond Issue

When the bond is issued, the company must debit the cash account by the amount that the business receives for the bond sale. A liability, titled “bond payable,” must be created and credited by an amount equal to the face value of the issued bonds. The difference between the cash from the bond sale and the face value of the bond must be credited to a bond premium account.

For example, assume a business issues a 10-year bond that pays 6% interest annually, with a face value of $100,000. This bond sells for $110,000. The resulting journal entry would be:

Cash – $110,000

Bond Payable – $100,000

Bond Premium – $100,000

Interest Payments on the Bond

When the business pays interest, it must also amortize the bond premium at that time. To calculate the amortization rate of the bond premium, a company generally divides the bond premium amount by the number of interest payments that will be made during the term of the bond. Every time interest is paid, the company must credit cash for the interest amount paid to the bond holder. The company must debit the bond premium account by the amortization rate. The difference between the amount paid in interest and the premium’s amortization for the period is the interest expense for that period.

Using the example from above, the $10,000 premium would be divided by 10 annual interest payments. This would make the amortization rate of the bond’s premium equal to $1,000 per year. The company must pay $6,000 in interest annually, so the company’s annual interest expense equals $5,000. The resulting journal entry is:

Bond Interest Expense – $5,000

Bond Premium – $1,000

Cash – $6,000

Bond Reaches Maturity

When the bond reaches maturity, the company must pay the bondholder the face value of the bond, finish amortizing the premium, and pay any remaining interest obligations. When all the final journal entries are made, the bond premium and bond payable account must equal zero.

Using the example, this is what the final journal entries must look like:

Bond Interest Expense – $5,000

Bond Premium – $1,000

Cash – $6,000

Bond Payable – $100,000

Cash – $100,000

11.2.6: Valuing Zero-Coupon Bonds

Learning Objective

Explain how to value a zero coupon bond

Key Points

• A zero-coupon bond is one that does not make ongoing interest payment to the bondholder over the term of the bond.
• The issuing entity will sell the zero-coupon bond at lower than face value. When the bond’s term is over, the issuing business will repay the bond at its face value.

Key Term

zero-coupon bond

A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity.

Example

• A zero-coupon bond with requires repayment of $100,000 in 3 years. If the effective interest rate is 7%, what are the proceeds? How much interest expense is recognized? The proceeds will be the present value of $100,000 at 7% for 3 years:
  which is equal to $81,629.79. The journal entry for the firm issuing the bond is: Cash 81,629.79 Discount 18,370.21 Bond Payable 100,000.00 The discount is the difference between the bond payable (how much will be repaid at maturity) and the proceeds (the cash initially received); zero-coupon bonds will always be issued at a discount. The discount is a contra-liability linked to the bond payable; this yields a net bond payable of 81,629.79, the bond payable less the discount. Note: this is also the initial proceeds. The effective interest rate method indicates that interest expense must be recognized each period the bond is outstanding, even if no cash interest is being paid. The interest expense is the net payable times the effective rate, in this example:
  %Which is 5,714.09. The journal entry to recognized the interest expense is: Interest Expense 5,714.09 Discount 5,714.09 The bond discount is reduced by 5,714.09 to 12,656.12, yielding a net bond payable of 87,343.88. Using the same calculation, the second and third years’ interest expenses of 6,114.07 and 6,542.06 can be calculated. The total interest expense recognized at the end of the third year is 18,370.21, the total of the original discount, which is fully amortized at maturity.

“Beat Back the Hun with Liberty Bonds”

After war was declared, the moral imperative of liberty and the Allied cause was touted in official, government-sponsored propaganda.

A zero-coupon bond is one that does not pay interest over the term of the bond. Instead, the entity will sell the bond at lower than face value. When the bond’s term is over, the issuing business will repay the bond at its face value. The bondholder generates a return paying less than what he receives in payment at the end of the bond’s term.

While the business may not make periodic interest payments, interest income is still generated. The interest income is merely accumulated and paid at the end of the bond’s term.

Formula for Calculating Value of Zero-Coupon Bond

Zero-Coupon Bond Value = Face Value of Bond / (1+ interest Rate)

Generally, the price of a zero-coupon bond is based on the present value of the amount the issuing business will pay the bondholder when the bond matures. The amount the company pays at the end of the term equals the bond’s face value. The present value is determined using the interest rate stated on the bond. The bond’s term is used as the time period in the present value calculation.

It is important when completing the zero-coupon bond calculation to ensure the time period and term of the bond are expressed in similar terms. If the interest rate of the bond is expressed as a monthly rate and the term of the bond is 10 years, the bond term should be expressed as 120 months when making the calculation.

Example Calculation

Assume a business issues a 2 year note, paying 5% interest with a face value of $100,000. To calculate its present value, you would raise 1.05 to the tenth power. This equals 1.1025. You then divide $100,000 by 1.1025. The result is that the bond would have a present value of $90,702.95.

11.3: Bond Retirement

11.3.1: Redeeming at Maturity

The journal entry to record the retirement of a bond: Debit Bonds Payable & Credit Cash.

Learning Objective

Explain how to record the retirement of a bond at maturity

Key Points

• Unless the bond matures in a year or less it is shown on the balance sheet in the long term liabilities section.
• At maturity, all due payments are made, and the issuer has no further obligations to the bond holders after the maturity date.
• On the balance sheet the Bonds Payable account can be shown as different issues or consolidated into a single balance.
• Keep in mind the carrying value – cash paid to retire bonds = gain or loss on bond retirement.

Key Term

maturity

Date when payment is due

Bond Retirement

A maturity date is the date when the bond issuer must pay off the bond. Maturity is generally an indication of when you as an investor will get your money back. Typically, bonds stop earning interest after they mature. As long as all due payments have been made, the issuer has no further obligations to the bondholders after the maturity date.

A bond certificate

A bond certificate issued via the South Carolina Consolidation Act of 1873. How the sale of a bond is recorded on a company’s books depends on how the debt is initially classified by the acquiring investor. Debt securities can be classified as “held-to-maturity,” a “trading security,” or “available-for-sale. “

The carrying value of bonds at maturity will always equal their par value. In other words, par value (nominal, principal, par or face amount), the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. For a bond sold at discount, its carrying value will increase and equal their par value at maturity. For a bond sold at premium, its carrying value will decrease and equal the par value at maturity.

Some structured bonds can have a redemption amount that is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.

Bonds can be classified to coupon bonds and zero coupon bonds. For coupon bonds, the bond issuer is supposed to pay both the par value of the bond and the last coupon payment at maturity. In case of a zero coupon bond, only the amount of par value is paid when the bond is redeemed at maturity.

Bonds Payable & The Balance Sheet

Unless the bond matures in a year or less it is shown on the balance sheet in the long-term liabilities section. If current assets will be used to retire the bonds, a Bonds Payable account should be listed in the current liability section. If the bonds are to be retired and new ones issued, they should remain as a long-term liability. All bond discounts and premiums also appear on the balance sheet.

A separate account should be maintained for each bond issue. On the balance sheet, the Bonds Payable account can be shown as different issues or consolidated into a single balance. If a single balance is shown, then a schedule or note should disclose the details of the bond issues.

A description of bonds issued including the effective interest rate, maturity date, terms, and sinking fund requirements are included in the notes to financial statements.

Redeeming at Maturity

The journal entry to record the retirement of a bond:

Debit Bonds payable

Credit Cash

Keep in mind the carrying value – cash paid to retire bonds = gain or loss on bond retirement

11.3.2: Redeeming Before Maturity

Early redemption happens on issuers or holders’ intentions, more likely as interest rates are falling and bonds contain embedded options.

Learning Objective

Summarize what it means to redeem a bond before maturity

Key Points

• Bonds can be redeemed at or before maturity. Early redemption may happen on bond issuers or bondholders’ intentions.
• Before maturity, the bond is bought back at a premium to compensate for lost interest. It is notable that early repurchase happens more often when the interest rate in the market is on decline and when it is a callable bond.
• Putable bonds give the holder the right to force the issuer to repay the bond before maturity. The price at which bonds are redeemed in this case is predetermined in bond covenants.

Key Terms

callable bond

a type of debt security that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity

high-yield bonds

In finance, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors.

premium

A bonus paid in addition to normal payments.

Bonds can be redeemed at or before maturity. Early redemption may happen on bond issuers or bondholders’ intentions .

Pacific Railroad Bond

$1,000 (30 year, 7%) “Pacific Railroad Bond” (#93 of 200) issued by the City and County of San Francisco.

For bond issuers, they can repurchase a bond at or before maturity. Redemption is made at the face value of the bond unless it occurs before maturity, in which case the bond is bought back at a premium to compensate for lost interest. The issuer has the right to redeem the bond at any time, although the earlier the redemption takes place, the higher the premium usually is. This provides an incentive for companies to do this as rarely as possible. It is notable that early repurchase happens more often when the interest rate in the market is on decline and when the bond contains an embedded option. It grants option-like features to the holder or the issuer. To be detailed, the bond issuer will repurchase bonds with callability.

Some bonds give the issuer the right to repay the bond before the maturity date on the call dates. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so-called call premium. This is mainly the case for high-yield bonds. These have very strict covenants. They restrict the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

Bonds with embedded options can also be ones with putability. Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates. These are referred to as retractable or putable bonds. In this case, the price at which bonds are redeemed is predetermined in bond covenants.

11.4: Reporting and Analyzing Long-Term Liabilities

11.4.1: Reporting Long-Term Liabilities

Debts that become due more than one year into the future are reported as long-term liabilities on the balance sheet.

Learning Objective

Identify a long-term liability

Key Points

• Debts due greater than one year (12 months) into the future are considered long-term.
• If a classified balance sheet is being utilized, the current portion of the long-term liability, if any, needs to be backed out and reclassified as a current liability.
• “Notes payable” and “Bonds payable” are common examples of long-term liabilities.

Key Terms

current

A length of time less than one year (12 months) into the future.

Long-term

A length of time greater than one year (12 months) into the future.

long-term liabilities

obligations of the business that are to be settled in over one year

long-term investment

putting money into something with the expectation of gain, usually over multiple years

liability

An obligation, debt, or responsibility owed to someone.

Long-term liabilities are debts that become due, or mature, at a date that is more than a year into the future. An example of this is a student loan. Let’s say John, a freshman in college, obtains a student loan for 25,000 and the bank does not require loan payments until 6 months after he graduates, i.e. 4.5 years after the loan was originated. This is an example of a long-term liability.

“Notes Payable” and “Bonds Payable” are also examples of long-term liabilities, and they often introduce an interesting distinction between current liabilities and long-term liabilities presented on a classified balance sheet.

Let’s say Company X obtains a 100,000 Note Payable that requires 5 annual payments of 20,000 starting 1/1/14. On Company X’s 12/31/12 balance sheet, a long-term liability for 100,000 would be reported, but what about the balance sheet as of 12/31/13? Since Company X is required to make a 20,000 payment on 1/1/14, which is less than one year away, a current liability of 20,000 and a long-term liability of 80,000 would be reported on its balance sheet as of 12/31/13.

Continuing one year forward, Company X would report a current liability of 20,000 and a long-term liability of 60,000 on its balance sheet as of 12/31/2014.

Sallie Mae facilitates several long-term liabilities

Student Loans are a prime example.

What this example presents is the distinction between current liabilities and long-term liabilities. Despite a Note Payable, Bonds Payable, etc., starting out as a long-term liability, the portion of that debt that is due within a year has to be backed out of the long-term liability and reported as a current liability.

See below for the balance sheet reporting treatment of the current and long-term liability portions of the Note Payable from initiation to final payment.

12/31/12 ……Current Liability: 0 ……………Long-Term Liability: 100,000

12/31/13 ……Current Liability: 20,000 ……Long-Term Liability: 80,000

12/31/14 ……Current Liability: 20,000 ……Long-Term Liability: 60,000

12/31/15 ……Current Liability: 20,000 ……Long-Term Liability: 40,000

12/31/16 ……Current Liability: 20,000 ……Long-Term Liability: 20,000

12/31/17 ……Current Liability: 20,000 ……Long-Term Liability: 0

12/31/18 ……Current Liability: 0 ……………Long-Term Liability: 0

11.4.2: Analyzing Long-Term Liabilities

Analyzing long-term liabilities combines debt ratio analysis, credit analysis and market analysis to assess a company’s financial strength.

Learning Objective

Summarize how to analyze a company’s long-term debt

Key Points

• Financial data used to calculate debt-ratios can be found on a company’s balance sheet, income statement and statement of owner’s equity.
• Benchmarking a company’s credit rating and debt ratios will assist an analyst in determining a company’s financial strength relative to its peers.
• Reading the footnotes contained in a company’s financial statements can be crucial as the footnotes often contain valuable information regarding long-term liabilities and other factors that could immediately impact the company’s ability to pay it’s long-term debt.

Key Terms

insolvent

1. Unable to pay one’s bills as they fall due.2. Owing more than one has in assets.

Creditworthy

1. Deemed likely to repay debts.2. Having an acceptable credit rating.

Analyzing Long-Term Liabilities

Long-term liabilities are obligations that are due at least one year into the future, and include debt instruments such as bonds and mortgages. Analyzing long-term liabilities is done for assessing the likelihood the long-term liability’s terms will be met by the borrower. After analyzing long-term liabilities, an analyst should have a reasonable basis for a determining a company’s financial strength. Analyzing long-term liabilities is necessary to avoid buying the bonds of, or lending to, a company that may potentially become insolvent.

How is Long-Term Liability Analysis Performed?

Analyzing long-term liabilities often includes an assessment of how creditworthy a borrower is, i.e. their ability and willingness to pay their debt. Standard & Poor’s is a credit rating agency that issues credit ratings for the debt of public and private companies. As part of their analysis Standard & Poor’s will issue a credit rating that is designed to give lenders and investors an idea of the creditworthiness of the borrower. The best rating is AAA with the worst being D. Please consult the figure as an example of Standard & Poor’s credit ratings issued for debt issued by governments all over the world.

World countries Standard & Poor’s ratings

An example of the credit ratings prescribed by Standard & Poor’s as a result of their respective long-term liability analysis for debt issued at the national government level. Countries issue debt to build national infrastructure. Look how expensive it is to raise capital for such projects based on geographic region.

In addition to credit rating agencies such as Standard & Poor’s, analysts can use debt ratios to help benchmark a company to it’s industry peers. Comparing a company to its peers will give an analyst perspective about what is considered normal or abnormal for a respective industry. Popular debt ratios include: debt ratio, debt to equity, long-term debt to equity, times interest earned ratio (interest coverage ratio), and debt service coverage ratio. Data used to calculate these ratios are provided on a company’s balance sheet, income statement, and statement of changes in equity. Typically, company’s present liabilities with the earliest due dates first.

Debt Ratio:

Debt to Equity Ratio:

Long-Term Debt to Equity Ratio:

Times Interest Earned Ratio (aka Coverage Ratio):

Debt Service Coverage Ratio:

There is more to analyzing long-term liabilities than simply reading a company’s credit rating and performing independent debt ratio analysis. In addition, an analyst needs to consider the overall economy, industry trends and management’s experience when forming a conclusion about the strength or weakness of a company’s financial position. When gathering information, an analyst should always read the footnotes contained in financial statements to determine if there are any disclosures related to long-term liabilities or other factors that may impact the company’s ability to pay it’s long-term obligations.

11.4.3: Debt-to-Equity Ratio

The Debt-to-Equity Ratio is a financial ratio that compares the debt of a company to its equity and is closely related to leveraging.

Learning Objective

Summarize how to calculate a company’s debt to equity ratio

Key Points

• Debt and equity have very distinct pros and cons.
• The composition of debt and equity and its influence on the value of a firm is a much debated topic.
• Debt and equity book values can be found on a company’s balance sheet, and the debt portion of the ratio often excludes short-term liabilities.

Key Terms

equity

Ownership interest in a company, as determined by subtracting liabilities from assets.

debt

Money that one person or entity owes or is required to pay to another, generally as a result of a loan or other financial transaction.

Debt-to-Equity Ratio

The Debt-to-Equity Ratio is a financial ratio indicating the relative proportion of shareholder’s equity and debt used to finance a company’s assets, and is calculated as total debt / total equity.

In order to obtain assets used in operations, a company will raise capital through either issuing shareholder’s equity (e.g., publicly traded common stock) or debt (e.g., notes payable). Stakeholders, which include investors and lending institutions, provide companies with capital with an expectation that those companies generate net income through their respective operations.

Debt is typically a long-term liability that represents a company’s obligation to pay both principal and interest to purchasers of that debt.

Equity represents ownership of a company, and does not include any agreed upon repayment terms.

Each form of raising capital has its own set of pros and cons. Interest payments on debt are tax deductible, while dividends on equity are not. Returns to purchasers of debt are limited to agreed- upon terms (i.e., interest rates), however, they have greater legal protection in the event of a bankruptcy. The returns an equity holder can achieve have unlimited upside, however, they are typically the last to be paid in the event of a bankruptcy.

Calculating the Debt-to-Equity Ratio

Calculating a company’s debt to equity ratio is straight forward, and the debt and equity components can be found on a company’s respective balance sheet. For more advanced analysis, financial analysts can calculate a company’s debt to equity ratio using market values if both the debt and equity are publicly traded.

When used to calculate a company’s financial leverage , the debt-to-equity ratio includes only long-term liabilities in the numerator and can even go a step further to exclude the current portion of the long-term liabilities. This means that other short-term liabilities, such as accounts payable, are excluded when calculating the debt-to-equity ratio.

Leverage Ratios

Graph of how infamous investment banks were leveraged prior to the credit crisis of 2008.

11.4.4: Times Interest Earned Ratio

Times Interest Earned Ratio = (EBIT or EBITDA) / (Required Interest Payments), and is indicative of a company’s financial strength.

Learning Objective

Explain how a company uses the times interest earned ratio

Key Points

• Times Interest Earned Ratio is the same as the interest coverage ratio.
• The higher the Times Interest Earned Ratio, the better, and a ratio below 2.5 is considered a warning sign of financial distress.
• A company will eventually default on its required interest payments if it cannot generate enough income to cover its required interest payments.

Key Terms

Interest

The price paid for obtaining, or price received for providing, money or goods in a credit transaction, calculated as a fraction of the amount of value of what was borrowed.

times interest earned ratio

either EBIT or EBITDA divided by the total interest payable

EBIT

Earnings before interest and taxes.

EBITDA

Earnings before interest, taxes, depreciation and amortization.

Times Interest Earned Ratio

The Times Interest Earned Ratio indicates the ability of a company to meet its required interest payments , and is calculated as:

Long-Term Interest Rates

The Times Interest Earned Ratio is an indication of a company’s overall financial health.

Times Interest Earned Ratio =

Earnings

before Interest and Taxes (

EBIT

) / Interest

Expense

.

Earnings before Interest and Taxes (EBIT) can be calculated by taking net income, as reported on a company’s income statement, and adding back interest and taxes.

Analysts often use “Operating Income” as a proxy for EBIT when complex accounting situations, such as discontinued operations, changes in accounting principle, extraordinary items, etc., are reported in a company’s financial statements. Analysts will sometimes use EBITDA instead of EBIT when calculating the Times Interest Earned Ratio. EBITDA can be calculated by adding back Depreciation and Amortization expenses to EBIT.

The Times Interest Earned Ratio is used by financial analysts to assess a company’s ability to pay its required interest payments. The higher this ratio, or the more EBIT a company can produce relative to its required interest payments, the stronger the company’s creditworthiness and overall financial health are considered to be.

For example, if Company X’s EBIT is 500,000 and its required interest payments are 300,000, its Times Interest Earned Ratio would be 1.67. If Company A’s EBIT is 750,000 and its required interest payments are 150,000, itsTimes Interest Earned Ratio would be 5. Comparing the respective Times Interest Earned Ratios would lead an analyst to believe that Company A is in a much better financial position because its EBIT covers its required interest payments 5 times, relative to Company X, whose EBIT only covers its required interest payments 1.67 times.

If a company’s Times Interest Earned Ratio falls below 1, the company will have to fund its required interest payments with cash on hand or borrow more funds to cover the payments. Typically, a Times Interest Earned Ratio below 2.5 is considered a warning sign of financial distress.

11.4.5: Being Aware of Off-Balance-Sheet Financing

Off-Balance-Sheet-Financing represents rights to use assets or obligations that are not reported on balance sheets to pay liabilities.

Learning Objective

Explain what constitutes an off-balance-sheet financing item

Key Points

• Off-Balance-Sheet-Financing represents financial rights or obligations that a company is not required to report on their balance sheets.
• Off-Balance-Sheet-Financing can have a substantial effects on a company’s financial health: Enron is a great example of this.
• An analyst should always read the footnotes contained in the financial statements as they often either disclose off-balance-sheet-financing directly or provide enough information to determine if the company could potentially enter into off-balance-sheet-financing arrangements.

Key Terms

off-balance-sheet financing

capital expenditures financed and classified it in such a way that it does not appear on the company’s balance sheet

operating lease

A lease whose term is short compared to the useful life of the asset or piece of equipment being leased.

subsidiary

A company that is completely or partly owned and partly or wholly controlled by another company that owns more than half of the subsidiary’s equity.

Off-Balance-Sheet-Financing is associated with debt that is not reported on a company’s balance sheet. For example, financial institutions offer asset management or brokerage services, and the assets managed through those services are typically owned by the individual clients directly or by trusts. While these financial institutions may benefit from servicing these assets, they do not have any direct claim on them.

The formal accounting distinctions between on and off-balance sheet items can be complicated and are subject to some level of management judgment. However, the primary distinction between on and off-balance sheet items is whether or not the company owns, or is legally responsible for the debt. Furthermore, uncertain assets or liabilities are subject to being classified as “probable”, “measurable” and “meaningful”.

An example of off-balance-sheet financing is an unconsolidated subsidiary. A parent company may not be required to consolidate a subsidiary into its financial statements for reporting purposes; however the parent company may be obligated to pay the unconsolidated subsidiaries liabilities.

Another example of off-balance-sheet financing is an operating lease, which are typically entered into in order to use equipment on a short-term basis relative to the overall useful life of the asset. An operating lease does not transfer any of the rewards or risks of ownership, and as a result are not reported on the balance sheet of the lessee. A liability is not recognized on the lessee’s balance sheet even though the lessee has the obligation to pay an agreed upon amount in the future.

It is important to consider these off-balance-sheet-financing arrangements because they have an immediate impact on a company’s overall financial health. For example, if a company defaults on the rental payments required by an operating lease, the lessor could repossess the assets or take legal action, either of which could be detrimental to the success of the company.

Jeffrey Skilling

Jeffrey Skilling is the former CEO of Enron, which was notorious for it’s use of off-balance-sheet-financing.

10.2: Future Value, Single Amount

10.2.1: Multi-Period Investment

Learning Objective

Calculate the future value of a multi-period investment with simple and complex interest rates

Key Points

• Investments that accrue simple interest have interest paid based on the amount of the principal, not the balance in the account.
• Investments that accrue compound interest have interest paid on the balance of the account. This means that interest is paid on interest earned in previous periods.
• Simple interest increases the balance linearly, while compound interest increases it exponentially.

Key Terms

accrue

To add, or grow.

principal

The money originally invested or loaned, on which basis interest and returns are calculated.

There are two primary ways of determining how much an investment will be worth in the future if the time frame is more than one period.

The first concept of accruing (or earning) interest is called “simple interest. ” Simple interest means that you earn interest only on the principal. Your total balance will go up each period, because you earn interest each period, but the interest is paid only on the amount you originally borrowed/deposited. Simple interest is expressed through the formula in.

Simple Interest Formula

Simple interest is when interest is only paid on the amount you originally invested (the principal). You don’t earn interest on interest you previously earned.

Suppose you make a deposit of $100 in the bank and earn 5% interest per year. After one year, you earn 5% interest, or $5, bringing your total balance to $105. One more year passes, and it’s time to accrue more interest. Since simple interest is paid only on your principal ($100), you earn 5% of $100, not 5% of $105. That means you earn another $5 in the second year, and will earn $5 for every year of the investment. In simple interest, you earn interest based on the original deposit amount, not the account balance.

The second way of accruing interest is called “compound interest. ” In this case, interest is paid at the end of each period based on the balance in the account. In simple interest, it is only how much the principal is that matters. In compound interest, it is what the balance is that matters. Compound interest is named as such because the interest compounds: Interest is paid on interest. The formula for compound interest is.

Compound Interest

Interest is paid at the total amount in the account, which may include interest earned in previous periods.

Suppose you make the same $100 deposit into a bank account that pays 5%, but this time, the interest is compounded. After the first year, you will again have $105. At the end of the second year, you also earn 5%, but it’s 5% of your balance, or $105. You earn $5.25 in interest in the second year, bringing your balance to $110.25. In the third year, you earn interest of 5% of your balance, or $110.25. You earn $5.51 in interest bringing your total to $115.76.

Compare compound interest to simple interest. Simple interest earns you 5% of your principal each year, or $5 a year. Your balance will go up linearly each year. Compound interest earns you $5 in the first year, $5.25 in the second, a little more in the third, and so on. Your balance will go up exponentially.

Simple interest is rarely used compared to compound interest, but it’s good to know both types.

10.2.2: Approaches to Calculating Future Value

Learning Objective

Describe the difference between compounding interest and simple interest

Key Points

• The “present” can be moved based on whatever makes the problem easiest. Just remember that moving the date of the present also changes the number of periods until the future for the FV.
• To find FV, you must first identify PV, the interest rate, and the number of periods from the present to the future.
• The interest rate and the number of periods must have consistent units. If one period is one year, the interest rate must be X% per year, and vis versa.

Key Term

quarter

A period of three consecutive months (1/4 of a year).

The method of calculating future value for a single amount is relatively straightforward; it’s just a matter of plugging numbers into an equation. The tough part is correctly identifying what information needs to be plugged in.

As previously discussed, there are four things that you need to know in order to find the FV:

1. How does the interest accrue? Is it simple or compounding interest?
2. Present Value
3. Interest Rate
4. Number of periods

Let’s take one complex problem as an example:

On June 1, 2014, you will take out a $5000 loan for 8-years. The loan accrues interest at a rate of 3% per quarter. On January 1, 2015, you will take out another $5000, eight-year loan, with this one accruing 5% interest per year. The loan accrues interest on the principal only. What is the total future value of your loans on December 31, 2017?

First, the question is really two questions: What is the value of the first loan in 2017, and what is the value of the second in 2017? Once both values are found, simply add them together.

Let’s talk about the first loan first. The present value is $5,000 on June 1, 2014. It is possible to find the value of the loan today, and then find it’s value in 2017, but since the value is the same in 2017, it’s okay to just imagine it is 2014 today. Next, we need to identify the interest rate. The problem says it’s 3% per quarter, or 3% every three months. Since the problem doesn’t say otherwise, we assume that the interest on this loan is compounded. That means we will use the formula in . Finally, we need to identify the number of periods. There are two and a half years between the inception of the loan and when we need the FV. But recall that the interest rate and periods must be in the same units. That means that the interest must either be converted to % per year, or one period must be one quarter. Let’s take one period to be one quarter. That means there are 10 periods. Please note that we don’t really care when the loan ends in this problem–we only care about the value of the loan on December 31, 2017.

Compound Interest

Interest is paid at the total amount in the account, which may include interest earned in previous periods.

Next, we simply plug the numbers into . PV=5000, i=.03, and t=10. That gives us a FV of $6,719.58.

Now let’s find the value of the second loan at December 31, 2017. Again, PV=$5000, but this time, pretend it is January 1, 2015. This time, the interest is 5% per year and it is explicitly stated to be simple interest. That means we use the formula in . January 31, 2017 is exactly two years from the January 1, 2015 and since the interest is measured per year, we can set t=2 years.

When we plug all of those numbers into , we find that FV=$5,500.00

Simple Interest Formula

Simple interest is when interest is only paid on the amount you originally invested (the principal). You don’t earn interest on interest you previously earned.

Since the problem asks for the total FV of the loans, we add $6,719.58 to $5,500.00, and get a total value of $12,219.58

10.2.3: Calculating Future Value

Learning Objective

Distinguish between calculating future value with simple interest and with compound interest

Key Points

• The future value is the value of a given amount of money at a certain point in the future if it earns a rate of interest.
• The future value of a present value is calculated by plugging the present value, interest rate, and number of periods into one of two equations.
• Unless otherwise noted, it is safe to assume that interest compounds and is not simple interest.

Key Term

compound interest

Interest, as on a loan or a bank account, that is calculated on the total on the principal plus accumulated unpaid interest.

When calculating a future value (FV), you are calculating how much a given amount of money today will be worth some time in the future. In order to calculate the FV, the other three variables (present value, interest rate, and number of periods) must be known. Recall that the interest rate is represented by either r or i, and the number of periods is represented by either t or n. It is also important to remember that the interest rate and the periods must be in the same units. That is, if the interest rate is 5% per year, one period is one year. However, if the interest rate is 5% per month, t or n must reflect the number of periods in terms of months.

Example 1

What is the FV of a $500, 10-year loan with 7% annual interest?

In this case, the PV is $500, t is 10 years, and i is 7% per year. The next step is to plug these numbers into an equation. But recall that there are two different formulas for the two different types of interest, simple interest and compound interest . If the problem doesn’t specify how the interest is accrued, assume it is compound interest, at least for business problems.

Compound Interest

Interest is paid at the total amount in the account, which may include interest earned in previous periods.

Simple Interest Formula

Simple interest is when interest is only paid on the amount you originally invested (the principal). You don’t earn interest on interest you previously earned.

So from the formula, we see that FV=PV(1+i)^t so FV=500(1+.07)¹⁰. Therefore, FV=$983.58.

In practical terms, you just calculated how much your loan will be in 10 years. This assumes that you don’t need to make any payments during the 10 years, and that the interest compounds. Unless the problem states otherwise, it is safe to make these assumptions – you will be told if there are payments during the 10 year period or if it is simple interest.

Example 2

Suppose we want to again find the future value of a $500, 10-year loan, but with an interest rate of 1% per month. In order to get our total number of periods (t), we would multiply 12 months by 10 years, which equals 120 periods. Therefore:

FV=500(1+.01)¹²⁰

FV=$1,650.19

10.2.4: Single-Period Investment

Learning Objective

Calculate the future value of a single-period investment

Key Points

• Single-period investments use a specified way of calculating future and present value.
• Single-period investments take place over one period (usually one year).
• In a single-period investment, you only need to know two of the three variables PV, FV, and i. The number of periods is implied as one since it is a single-period.

Key Terms

Single-period investment

An investment that takes place over one period, usually one year.

Multi-period investment

An investment that takes place over more than one periods.

Periods (t or n)

Units of time. Usually one year.

Example

• What is the value of a single-period, $100 investment at a 5% interest rate? PV=100 and i=5% (or .05) so FV=100(1+.05). FV=100(1.05) FV=$105.

The amount of time between the present and future is called the number of periods. A period is a general block of time. Usually, a period is one year. The number of periods can be represented as either t or n.

Suppose you’re making an investment, such as depositing your money in a bank. If you plan on leaving the money there for one year, you’re making a single-period investment. Any investment for more than one year is called a multi-period investment.

Let’s go through an example of a single-period investment. As you know, if you know three of the following four values, you can solve for the fourth:

1. Present Value (PV)
2. Future Value (FV)
3. Interest Rate (i or r) [Note: for all formulas, express interest in it’s decimal form, not as a whole number. 7% is .07, 12% is .12, and so on. ]
4. Number of Periods (t or n)

In a single-period, there is only one formula you need to know: FV=PV(1+i). The full formulas, which we will be addressing later, are as follows:

Compound interest:
.

Simple interest:

We will address these later, but note that when
both formulas become $FV = PV \cdot (1+i)$.

For example, suppose you deposit $100 into a bank account that pays 3% interest. What is the balance in your account after one year?

In this case, your PV is $100 and your interest is 3%. You want to know the value of your investment in the future, so you’re solving for FV. Since this is a single-period investment, t (or n) is 1. Plugging the numbers into the formula, you get FV=100(1+.03) so FV=100(1.03) so FV=103. Your balance will be $103 in one year.

10.3: Annuities

10.3.1: Calculating Annuities

Understanding the relationship between each variable and the broader concept of the time value of money enables simple valuation calculations of annuities.

Learning Objective

Calculate the present or future value of various annuities based on the information given

Key Points

• Annuities are basically loans that are paid back over a set period of time at a set interest rate with consistent payments each period.
• A mortgage or car loan are simple examples of an annuity. Borrowers agree to pay a given amount each month when borrowing capital to compensate for the risk and the time value of money.
• The six potential variables included in an annuity calculation are the present value, the future value, interest, time (number of periods), payment amount, and payment growth (if applicable).
• Through integrating each of these (excluding payment growth, if payments are consistent over time), it is simple to solve for the present of future value of a given annuity.

Key Term

annuity

A right to receive amounts of money regularly over a certain fixed period in repayment of a loan or investment (or perpetually, in the case of a perpetuity).

Annuities Defined

To understand how to calculate an annuity, it’s useful to understand the variables that impact the calculation. An annuity is essentially a loan, a multi-period investment that is paid back over a fixed (or perpetual, in the case of a perpetuity)  period of time. The amount paid back over time is relative to the amount of time it takes to pay it back, the interest rate being applied, and the principal (when creating the annuity, this is the present value).

Generally speaking, annuities and perpetuities will have consistent payments over time. However, it is also an option to scale payments up or down, for various reasons.

Variables

This gives us six simple variables to use in our calculations:

1. Present Value (PV) – This is the value of the annuity at time 0 (when the annuity is first created)
2. Future Value (FV) – This is the value of the annuity at time n (i.e. at the conclusion of the life of the annuity).
3. Payments (A) – Each period will require individual payments that will be represented by this amount.
4. Number of Payments (n) – The number of payments (A) will equate to the number of expected periods of payment over the life of the annuity.
5. Interest (i) – Annuities occur over time, and thus a given rate of return (interest) is applied to capture the time value of money.
6. Growth (g) – For annuities that have changes in payments, there is a growth rate applied to these payments over time.

Calculating Annuities

With all of the inputs above at hand, it’s fairly simply to value various types of annuities. Generally investors, lenders, and borrowers are interested in the present and future value of annuities.

Present Value

The present value of an annuity can be calculated as follows:

For a growth annuity (where the payment amount changes at a predetermined rate over the life of the annuity), the present value can be calculated as follows:

Future Value

The future value of an annuity can be determined using this equation:

In a situation where payments grow over time, the future value can be determined using this equation:

Various Formula Arrangements

It is also possible to use existing information to solve for missing information. Which is to say, if you know interest and time, you can solve for the following (given the following):

Annuities Equations

This table is a useful way to view the calculation of annuities variables from a number of directions. Understanding how to manipulate the formula will underline the relationship between the variables, and provide some conceptual clarity as to what annuities are.

This table is a useful way to view the calculation of annuities variables from a number of directions. Understanding how to manipulate the formula will underline the relationship between the variables, and provide some conceptual clarity as to what annuities are.

10.3.2: Present Value of Annuity

The PV of an annuity can be found by calculating the PV of each individual payment and then summing them up.

Learning Objective

Calculate the present value of annuities

Key Points

• The PV for both annuities-due and ordinary annuities can be calculated using the size of the payments, the interest rate, and number of periods.
• The PV of a perpetuity can be found by dividing the size of the payments by the interest rate.
• Payment size is represented as p, pmt, or A; interest rate by i or r; and number of periods by n or t.

Key Term

perpetuity

An annuity in which the periodic payments begin on a fixed date and continue indefinitely.

The Present Value (PV) of an annuity can be found by calculating the PV of each individual payment and then summing them up . As in the case of finding the Future Value (FV) of an annuity, it is important to note when each payment occurs. Annuities-due have payments at the beginning of each period, and ordinary annuities have them at the end.

Recall that the first payment of an annuity-due occurs at the start of the annuity, and the final payment occurs one period before the end. The PV of an annuity-due can be calculated as follows:

where
is the size of the payment (sometimes
or
),
is the interest rate, and
is the number of periods.

An ordinary annuity has annuity payments at the end of each period, so the formula is slightly different than for an annuity-due. An ordinary annuity has one full period before the first payment (so it must be discounted) and the last payment occurs at the termination of the annuity (so it must be discounted for one period more than the last period in an annuity-due). The formula is:

where, again,
,
, and
are the size of the payment, the interest rate, and the number of periods, respectively.

Both annuities-due and ordinary annuities have a finite number of payments, so it is possible, though cumbersome, to find the PV for each period. For perpetuities, however, there are an infinite number of periods, so we need a formula to find the PV. The formula for calculating the PV is the size of each payment divided by the interest rate.

Example 1

Suppose you have won a lottery that pays $1,000 per month for the next 20 years. But, you prefer to have the entire amount now. If the interest rate is 8%, how much will you accept?

Consider for argument purposes that two people, Mr. Cash, and Mr. Credit, have won the same lottery of $1,000 per month for the next 20 years. Now, Mr. Credit is happy with his $1,000 monthly payment, but Mr. Cash wants to have the entire amount now. Our job is to determine how much Mr. Cash should get. We reason as follows: If Mr. Cash accepts x dollars, then the x dollars deposited at 8% for 20 years should yield the same amount as the $1,000 monthly payments for 20 years. In other words, we are comparing the future values for both Mr. Cash and Mr. Credit, and we would like the future values to be equal.

Since Mr. Cash is receiving a lump sum of x dollars, its future value is given by the lump sum formula:

Since Mr. Credit is receiving a sequence of payments, or an annuity, of $1,000 per month, its future value is given by the annuity formula:

The only way Mr. Cash will agree to the amount he receives is if these two future values are equal. So we set them equal and solve for the unknown:

The reader should also note that if Mr. Cash takes his lump sum of $119,554.36 and invests it at 8% compounded monthly, he will have $589,020.41 in 20 years.

Example 2

Find the monthly payment for a car costing $15,000 if the loan is amortized over five years at an interest rate of 9%.

Again, consider the following scenario: Two people, Mr. Cash and Mr. Credit, go to buy the same car that costs $15,000. Mr. Cash pays cash and drives away, but Mr. Credit wants to make monthly payments for five years. Our job is to determine the amount of the monthly payment.

We reason as follows: If Mr. Credit pays x dollars per month, then the x dollar payment deposited each month at 9% for 5 years should yield the same amount as the $15,000 lump sum deposited for 5 years. Again, we are comparing the future values for both Mr. Cash and Mr. Credit, and we would like them to be the same.

Since Mr. Cash is paying a lump sum of $15,000, its future value is given by the lump sum formula:

Mr. Credit wishes to make a sequence of payments, or an annuity, of x dollars per month, and its future value is given by the annuity formula:

We set the two future amounts equal and solve for the unknown:

10.3.3: Future Value of Annuity

The future value of an annuity is the sum of the future values of all of the payments in the annuity.

Learning Objective

Calculate the future value of different types of annuities

Key Points

• To find the FV, you need to know the payment amount, the interest rate of the account the payments are deposited in, the number of periods per year, and the time frame in years.
• The first and last payments of an annuity due both occur one period before they would in an ordinary annuity, so they have different values in the future.
• There are different formulas for annuities due and ordinary annuities because of when the first and last payments occur.

Key Terms

annuity-due

An investment with fixed-payments that occur at regular intervals, paid at the beginning of each period.

ordinary repair

expense accrued in normal maintenance of an asset

annuity-due

a stream of fixed payments where payments are made at the beginning of each period

ordinary annuity

An investment with fixed-payments that occur at regular intervals, paid at the end of each period.

The future value of an annuity is the sum of the future values of all of the payments in the annuity. It is possible to take the FV of all cash flows and add them together, but this isn’t really pragmatic if there are more than a couple of payments.

If you were to manually find the FV of all the payments, it would be important to be explicit about when the inception and termination of the annuity is. For an annuity-due, the payments occur at the beginning of each period, so the first payment is at the inception of the annuity, and the last one occurs one period before the termination.

For an ordinary annuity, however, the payments occur at the end of the period. This means the first payment is one period after the start of the annuity, and the last one occurs right at the end. There are different FV calculations for annuities due and ordinary annuities because of when the first and last payments occur.

There are some formulas to make calculating the FV of an annuity easier. For both of the formulas we will discuss, you need to know the payment amount (m, though often written as pmt or p), the interest rate of the account the payments are deposited in (r, though sometimes i), the number of periods per year (n), and the time frame in years (t).

The formula for an ordinary annuity is as follows:

where m is the payment amount, r is the interest rate, n is the number of periods per year, and t is the length of time in years.

In contrast, the formula for an annuity-due is as follows:

Provided you know m, r, n, and t, therefore, you can find the future value (FV) of an annuity.

10.3.4: Annuities

An annuity is a type of investment in which regular payments are made over the course of multiple periods.

Learning Objective

Classify the different types of annuity

Key Points

• Annuities have payments of a fixed size paid at regular intervals.
• There are three types of annuities: annuities-due, ordinary annuities, and perpetuities.
• Annuities help both the creditor and debtor have predictable cash flows, and it spreads payments of the investment out over time.

Key Term

period

The length of time during which interest accrues.

An annuity is a type of multi-period investment where there is a certain principal deposited and then regular payments made over the course of the investment. The payments are all a fixed size. For example, a car loan may be an annuity: In order to get the car, you are given a loan to buy the car. In return you make an initial payment (down payment), and then payments each month of a fixed amount. There is still an interest rate implicitly charged in the loan. The sum of all the payments will be greater than the loan amount, just as with a regular loan, but the payment schedule is spread out over time.

Suppose you are the bank that makes the car loan. There are three advantages to making the loan an annuity. The first is that there is a regular, known cash flow. You know how much money you’ll be getting from the loan and when you’ll be getting them. The second is that it should be easier for the person you are loaning to to repay, because they are not expected to pay one large amount at once. The third reason why banks like to make annuity loans is that it helps them monitor the financial health of the debtor. If the debtor starts missing payments, the bank knows right away that there is a problem, and they could potentially amend the loan to make it better for both parties.

Similar advantages apply to the debtor. There are predictable payments, and paying smaller amounts over multiple periods may be advantageous over paying the whole loan plus interest and fees back at once.

Since annuities, by definition, extend over multiple periods, there are different types of annuities based on when in the period the payments are made. The three types are:

1. Annuity-due: Payments are made at the beginning of the period . For example, if a period is one month, payments are made on the first of each month.
2. Ordinary Annuity: Payments are made at the end of the period . If a period is one month, this means that payments are made on the 28th/30th/31st of each month. Mortgage payments are usually ordinary annuities.
3. Perpetuities: Payments continue forever. This is much rarer than the first two types.

10.4: Additional Detail on Present and Future Values

10.4.1: Loans and Loan Amortization

When borrowing money to be paid back via a number of installments over time, it is important to understand the time value of money and how to build an amortization schedule.

Learning Objective

Understand amortization schedules

Key Points

• Amortization of a loan is the process of identifying a payment amount for each period of repayment on a given outstanding debt.
• Repaying capital over time at an interest rate requires an amortization schedule, which both parties agree to prior to the exchange of capital. This schedule determines the repayment period, as well as the amount of repayment per period.
• Time value of money is a central concept to amortization. A dollar today, for example, is worth more than a dollar tomorrow due to the opportunity cost of other investments.
• When purchasing a home for $100,000 over 30 years at 8% interest (consistent payments each month), for example, the total amount of repayment is more than 2.5 times the original principal of $100,000.

Key Term

amortization

This is the process of scheduling intervals of payment over time to pay back an existing debt, taking into account the time value of money.

 When lending money (or borrowing, depending on your perspective), it is common to have multiple payback periods over time (i.e. multiple, smaller cash flow installments to pay back the larger borrowed sum). In these situations, an amortization schedule will be created. This will determine how much will be paid back each period, and how many periods of repayment will be required to cover the principal balance. This must be agreed upon prior to the initial borrowing occurs, and signed by both parties.

Time Value of Money

Now if you add up all of the separate payments in an amortization schedule, you’ll find the total exceeds the amount borrowed. This is because amortization schedules must take into account the time value of money. Time value of money is a fairly simple concept at it’s core: a dollar today is worth more than a dollar tomorrow.

Why? Because capital can be invested, and those investments can yield returns. Lending your money to someone means incurring the opportunity cost of the other things you could do with that money. This gets even more drastic as the scale of capital increases, as the returns on capital over time are expressed in a percentage of the capital invested. Say you spend $100 on some stock, and turn 10% on that investment. You now have $110, a profit of $10. Say instead of only a $100, you put in $10,000. Now you have $11,000, a profit of $1,000.

Principle and Interest

As a result of this calculation, amortization schedules charge interest over time as a percentage of the principal borrowed. The calculation will incorporate the number of payment periods (n), the principal (P), the amortization payment (A) and the interest rate (r).

To make this a bit more realistic, let’s insert some numbers. Let’s say you find a dream house, at the reasonable rate of $100,000. Unfortunately, a bit of irresponsible borrowing in your past means you must pay 8% interest over a 30 year loan, which will be paid via a monthly amortization schedule (12 months x 30 years = 360 payments total). If you do the math, you should find yourself paying $734 per month 360 times. 360 x 734 will leave you in the ballpark of $264,000 in total repayment. that means you are paying more than 2.5 times as much for this house due to time value of money! This bit of knowledge is absolutely critical for personal financial decisions, as well as for high level business decisions.

Amortization Schedule Example

This shows the first few installments in the example discussed above (i.e. borrowing $100,000 at 8% interest paid monthly over 30 years).

This shows the first few installments in the example discussed above (i.e. borrowing $100,000 at 8% interest paid monthly over 30 years).

10.4.2: Calculating Values for Fractional Time Periods

The value of money and the balance of the account may be different when considering fractional time periods.

Learning Objective

Calculate the future and present value of an account when a fraction of a compounding period has passed

Key Points

• The balance of an account only changes when interest is paid. To find the balance, round the fractional time period down to the period when interest was last accrued.
• To find the PV or FV, ignore when interest was last paid an use the fractional time period as the time period in the equation.
• The discount rate is really the cost of not having the money over time, so for PV/FV calculations, it doesn’t matter if the interest hasn’t been added to the account yet.

Key Terms

time period assumption

business profit or loses are measured on timely basis

compounding period

The length of time between the points at which interest is paid.

time value of money

the value of an asset accounting for a given amount of interest earned or inflation accrued over a given period

Up to this point, we have implicitly assumed that the number of periods in question matches to a multiple of the compounding period. That means that the point in the future is also a point where interest accrues. But what happens if we are dealing with fractional time periods?

Compounding periods can be any length of time, and the length of the period affects the rate at which interest accrues.

Compounding Interest

The effect of earning 20% annual interest on an initial $1,000 investment at various compounding frequencies.

Suppose the compounding period is one year, starting January1, 2012. If the problem asks you to find the value at June 1, 2014, there is a bit of a conundrum. The last time interest was actually paid was at January 1, 2014, but the time-value of money theory clearly suggests that it should be worth more in June than in January.

In the case of fractional time periods, the devil is in the details. The question could ask for the future value, present value, etc., or it could ask for the future balance, which have different answers.

Future/Present Value

If the problem asks for the future value (FV) or present value (PV), it doesn’t really matter that you are dealing with a fractional time period. You can plug in a fractional time period to the appropriate equation to find the FV or PV. The reasoning behind this is that the interest rate in the equation isn’t exactly the interest rate that is earned on the money. It is the same as that number, but more broadly, is the cost of not having the money for a time period. Since there is still a cost to not having the money for that fraction of a compounding period, the FV still rises.

Account Balance

The question could alternatively ask for the balance of the account. In this case, you need to find the amount of money that is actually in the account, so you round the number of periods down to the nearest whole number (assuming one period is the same as a compounding period; if not, round down to the nearest compounding period). Even if interest compounds every period, and you are asked to find the balance at the 6.9999^th period, you need to round down to 6. The last time the account actually accrued interest was at period 6; the interest for period 7 has not yet been paid.

If the account accrues interest continuously, there is no problem: there can’t be a fractional time period, so the balance of the account is always exactly the value of the money.

10.4.3: The Relationship Between Present and Future Value

Present value (PV) and future value (FV) measure how much the value of money has changed over time.

Learning Objective

Discuss the relationship between present value and future value

Key Points

• The future value (FV) measures the nominal future sum of money that a given sum of money is “worth” at a specified time in the future assuming a certain interest rate, or more generally, rate of return. The FV is calculated by multiplying the present value by the accumulation function.
• PV and FV vary jointly: when one increases, the other increases, assuming that the interest rate and number of periods remain constant.
• As the interest rate (discount rate) and number of periods increase, FV increases or PV decreases.

Key Terms

discounting

The process of finding the present value using the discount rate.

present value

a future amount of money that has been discounted to reflect its current value, as if it existed today

capitalization

The process of finding the future value of a sum by evaluating the present value.

The future value (FV) measures the nominal future sum of money that a given sum of money is “worth” at a specified time in the future assuming a certain interest rate, or more generally, rate of return. The FV is calculated by multiplying the present value by the accumulation function. The value does not include corrections for inflation or other factors that affect the true value of money in the future. The process of finding the FV is often called capitalization.

On the other hand, the present value (PV) is the value on a given date of a payment or series of payments made at other times. The process of finding the PV from the FV is called discounting.

PV and FV are related , which reflects compounding interest (simple interest has n multiplied by i, instead of as the exponent). Since it’s really rare to use simple interest, this formula is the important one.

FV of a single payment

The PV and FV are directly related.

PV and FV vary directly: when one increases, the other increases, assuming that the interest rate and number of periods remain constant.

The interest rate (or discount rate) and the number of periods are the two other variables that affect the FV and PV. The higher the interest rate, the lower the PV and the higher the FV. The same relationships apply for the number of periods. The more time that passes, or the more interest accrued per period, the higher the FV will be if the PV is constant, and vice versa.

The formula implicitly assumes that there is only a single payment. If there are multiple payments, the PV is the sum of the present values of each payment and the FV is the sum of the future values of each payment.

10.4.4: Comparing Interest Rates

Variables, such as compounding, inflation, and the cost of capital must be considered before comparing interest rates.

Learning Objective

Discuss the differences between effective interest rates, real interest rates, and cost of capital

Key Points

• A nominal interest rate that compounds has a different effective rate (EAR), because interest is accrued on interest.
• The Fisher Equation approximates the amount of interest accrued after accounting for inflation.
• A company will theoretically only invest if the expected return is higher than their cost of capital, even if the return has a high nominal value.

Key Term

inflation

An increase in the general level of prices or in the cost of living.

The amount of interest you would have to pay on a loan or would earn on an investment is clearly an important consideration when making any financial decisions. However, it is not enough to simply compare the nominal values of two interest rates to see which is higher.

Effective Interest Rates

The reason why the nominal interest rate is only part of the story is due to compounding. Since interest compounds, the amount of interest actually accrued may be different than the nominal amount. The last section went through one method for finding the amount of interest that actually accrues: the Effective Annual Rate (EAR).

The EAR is a calculation that account for interest that compounds more than one time per year. It provides an annual interest rate that accounts for compounded interest during the year. If two investments are otherwise identical, you would naturally pick the one with the higher EAR, even if the nominal rate is lower.

Real Interest Rates

Interest rates are charged for a number of reasons, but one is to ensure that the creditor lowers his or her exposure to inflation. Inflation causes a nominal amount of money in the present to have less purchasing power in the future. Expected inflation rates are an integral part of determining whether or not an interest rate is high enough for the creditor.

The Fisher Equation is a simple way of determining the real interest rate, or the interest rate accrued after accounting for inflation. To find the real interest rate, simply subtract the expected inflation rate from the nominal interest rate.

Fisher Equation

The nominal interest rate is approximately the sum of the real interest rate and inflation.

For example, suppose you have the option of choosing to invest in two companies. Company 1 will pay you 5% per year, but is in a country with an expected inflation rate of 4% per year. Company 2 will only pay 3% per year, but is in a country with an expected inflation of 1% per year. By the Fisher Equation, the real interest rates are 1% and 2% for Company 1 and Company 2, respectively. Thus, Company 2 is the better investment, even though Company 1 pays a higher nominal interest rate.

Cost of Capital

Another major consideration is whether or not the interest rate is higher than your cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. Many companies have a standard cost of capital that they use to determine whether or not an investment is worthwhile.

In theory, a company will never make an investment if the expected return on the investment is less than their cost of capital. Even if a 10% annual return sounds really nice, a company with a 13% cost of capital will not make that investment.

10.4.5: Calculating Values for Different Durations of Compounding Periods

Finding the Effective Annual Rate (EAR) accounts for compounding during the year, and is easily adjusted to different period durations.

Learning Objective

Calculate the present and future value of something that has different compounding periods

Key Points

• The units of the period (e.g. one year) must be the same as the units in the interest rate (e.g. 7% per year).
• When interest compounds more than once a year, the effective interest rate (EAR) is different from the nominal interest rate.
• The equation in skips the step of solving for EAR, and is directly usable to find the present or future value of a sum.

Key Terms

Future Value

The value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is “worth” at a specified time in the future, assuming a certain interest rate, or more generally, rate of return, it is the present value multiplied by the accumulation function.

present value

Also known as present discounted value, is the value on a given date of a payment or series of payments made at other times. If the payments are in the future, they are discounted to reflect the time value of money and other factors such as investment risk. If they are in the past, their value is correspondingly enhanced to reflect that those payments have been (or could have been) earning interest in the intervening time. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful “like to like” basis.

Sometimes, the units of the number of periods does not match the units in the interest rate. For example, the interest rate could be 12% compounded monthly, but one period is one year. Since the units have to be consistent to find the PV or FV, you could change one period to one month. But suppose you want to convert the interest rate into an annual rate. Since interest generally compounds, it is not as simple as multiplying 1% by 12 (1% compounded each month). This atom will discuss how to handle different compounding periods.

Effective Annual Rate

The effective annual rate (EAR) is a measurement of how much interest actually accrues per year if it compounds more than once per year. The EAR can be found through the formula in where i is the nominal interest rate and n is the number of times the interest compounds per year (for continuous compounding, see ). Once the EAR is solved, that becomes the interest rate that is used in any of the capitalization or discounting formulas.

EAR with Continuous Compounding

The effective rate when interest compounds continuously.

Calculating the effective annual rate

The effective annual rate for interest that compounds more than once per year.

For example, if there is 8% interest that compounds quarterly, you plug .08 in for i and 4 in for n. That calculates an EAR of .0824 or 8.24%. You can think of it as 2% interest accruing every quarter, but since the interest compounds, the amount of interest that actually accrues is slightly more than 8%. If you wanted to find the FV of a sum of money, you would have to use 8.24% not 8%.

Solving for Present and Future Values with Different Compounding Periods

Solving for the EAR and then using that number as the effective interest rate in present and future value (PV/FV) calculations is demonstrated here. Luckily, it’s possible to incorporate compounding periods into the standard time-value of money formula. The equation in is the same as the formulas we have used before, except with different notation. In this equation, A(t) corresponds to FV, A₀ corresponds to Present Value, r is the nominal interest rate, n is the number of compounding periods per year, and t is the number of years.

FV Periodic Compounding

Finding the FV (A(t)) given the PV (Ao), nominal interest rate (r), number of compounding periods per year (n), and number of years (t).

The equation follows the same logic as the standard formula. r/n is simply the nominal interest per compounding period, and nt represents the total number of compounding periods.

Solving for n

The last tricky part of using these formulas is figuring out how many periods there are. If PV, FV, and the interest rate are known, solving for the number of periods can be tricky because n is in the exponent. It makes solving for n manually messy. shows an easy way to solve for n. Remember that the units are important: the units on n must be consistent with the units of the interest rate (i).

Solving for n

This formula allows you to figure out how many periods are needed to achieve a certain future value, given a present value and an interest rate.

10.4.6: Calculating Perpetuities

The present value of a perpetuity is simply the payment size divided by the interest rate and there is no future value.

Learning Objective

Calculate the present value of a perpetuity

Key Points

• Perpetuities are a special type of annuity; a perpetuity is an annuity that has no end, or a stream of cash payments that continues forever.
• To find the future value of a perpetuity requires having a future date, which effectively converts the perpetuity to an ordinary annuity until that point.
• Perpetuities with growing payments are called Growing Perpetuities; the growth rate is subtracted from the interest rate in the present value equation.

Key Term

growth rate

The percentage by which the payments grow each period.

Perpetuities are a special type of annuity; a perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. Essentially, they are ordinary annuities, but have no end date. There aren’t many actual perpetuities, but the United Kingdom has issued them in the past.

Since there is no end date, the annuity formulas we have explored don’t apply here. There is no end date, so there is no future value formula. To find the FV of a perpetuity would require setting a number of periods which would mean that the perpetuity up to that point can be treated as an ordinary annuity.

There is, however, a PV formula for perpetuities . The PV is simply the payment size (A) divided by the interest rate (r). Notice that there is no n, or number of periods. More accurately, is what results when you take the limit of the ordinary annuity PV formula as n → ∞.

It is also possible that an annuity has payments that grow at a certain rate per period. The rate at which the payments change is fittingly called the growth rate (g). The PV of a growing perpetuity is represented as
. It is essentially the same as in except that the growth rate is subtracted from the interest rate. Another way to think about it is that for a normal perpetuity, the growth rate is just 0, so the formula boils down to the payment size divided by r.

10.5: Yield

10.5.1: Calculating the Yield of a Single-Period Investment

The yield of a single period investment is simply
.

Learning Objective

Differentiate between the different methods of calculating yield of a single period investment

Key Points

• There are a number of ways to calculate yield, but the most common ones are to calculate the percent change from the initial investment, APR, and APY (or EAR).
• APR (annual percentage rate) is a commonly used calculation that figures out the nominal amount of interest accrued per year. It does not account for compounding interest.
• APY (annual percentage yield) is a way of using the nominal interest rate to calculate the effective interest rate per year. It accounts for compounding interest.
• EAR (effective annual rate) is a special type of APY that uses APR as the nominal interest rate.

Key Terms

effective-interest method

amortizing a debt according to the effective interest rate paid

Nominal Interest

The amount of interest accrued per year without accounting for compounding.

Effective Interest

The amount of interest accrued per year after accounting for compounding.

Determining Yield

The yield on an investment is the amount of money that is returned to the owner at the end of the term. In short, it’s how much you get back on your investment.

Naturally, this is a number that people care a lot about. The whole point of making an investment is to get a yield. There are a number of different ways to calculate an investment’s yield, though. You may get slightly different numbers using different methods, so it’s important to make sure that you use the same method when you are comparing yields. This section will address the yield calculation methods you are most likely to encounter, though there are many more.

Change-In-Value

The most basic type of yield calculation is the change-in-value calculation. This is simply the change in value (FV minus PV) divided by the PV times 100%. This calculation measures how different the FV is from the PV as a percentage of PV.

Percent Change

The percent change in value is the change in value from PV to FV (V2 to V1) divided by PV (V1) times 100%.

Annual Percentage Rate

Another common way of calculating yield is to determine the Annual Percentage Rate, or APR. You may have heard of APR from ads for car loans or credit cards. These generally have monthly loans or fees, but if you want to get an idea of how much you will accrue in interest per year, you need to calculate an APR. Nominal APR is simply the interest rate multiplied by the number of payment periods per year. However, since interest compounds, nominal APR is not a very accurate measure of the amount of interest you actually accrue.

Effective Annual Rate

To find the effective APR, the actual amount of interest you would accrue per year, we use the Effective Annual Rate, or EAR.

EAR

The Effective Annual Rate is the amount of interest actually accrued per year based on the APR. n is the number of compounding periods of APR per year.

For example, you may see an ad that says you can get a car loan at an APR of 10% compounded monthly. That means that APR=.10 and n=12 (the APR compounds 12 times per year). That means the EAR is 10.47%.

The EAR is a form of the Annual Percentage Yield (APY). APY may also be calculated using interest rates other than APR, so a more general formula is in . The logic behind calculating APY is the same as that used when calculating EAR: we want to know how much you actually accrue in interest per year. Interest usually compounds, so there is a difference between the nominal interest rate (e.g. monthly interest times 12) and the effective interest rate.

Annual Percentage Yield

The Annual Percentage Yield is a way or normalizing the nominal interest rate. Basically, it is a way to account for the time factor in order to get a more accurate number for the actual interest rate.inom is the nominal interest rate.N is the number of compounding periods per year.

10.5.2: Calculating the Yield of an Annuity

The yield of an annuity is commonly found using either the percent change in the value from PV to FV, or the internal rate of return.

Learning Objective

Calculate the yield of an annuity using the internal rate of return method

Key Points

• The yield of an annuity may be found by discounting to find the PV, and then finding the percentage change from the PV to the FV.
• The Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment equals 0.
• The IRR calculates an annualized yield of an annuity.

Key Terms

Net Present Value (NPV)

The present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision.

Internal Rate of Return (IRR)

The discount rate that will cause the NPV of an investment to equal 0.

yield

In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return. Yield applies to various stated rates of return on stocks (common and preferred, and convertible), fixed income instruments (bonds, notes, bills, strips, zero coupon), and some other investment type insurance products

The yield of annuity can be calculated in similar ways to the yield for a single payment, but two methods are most common.

The first is the standard percentage-change method. Just as for a single payment, this method calculated the percentage difference between the FV and the PV. Since annuities include multiple payments over the lifetime of the investment, the PV (or V₁ in is the present value of the entire investment, not just the first payment.

The second popular method is called the internal rate of return (IRR). The IRR is the interest rate (or discount rate) that causes the Net Present Value (NPV) of the annuity to equal 0. That means that the PV of the cash outflows equals the PV of the cash inflows. The higher the IRR, the more desirable is the investment. In theory, you should make investment with an IRR greater than the cost of capital.

Let’s take an example investment: It is not technically an annuity because the payments vary, but still is a good example for how to find IRR:

Suppose you have a potential investment that would require you to make a $4,000 investment today, but would return cash flows of $1,200, $1,410, $1,875, and $1,050 in the four successive years. This investment has an implicit rate of return, but you don’t know what it is. You plug the numbers into the NPV formula and set NPV equal to 0. You then solve for r, which is your IRR (it’s not easy to solve this problem by hand. You will likely need to use a business calculator or Excel). When r = 14.3%, NPV = 0, so therefore the IRR of the investment is 14.3%.

IRR Example

The setup to find the IRR of the investment with cash flows of -4000, 1200, 1410, 1875, and 1050. By setting NPV = 0 and solving for r, you can find the IRR of this investment.

10.6: Valuing Multiple Cash Flows

10.6.1: Present Value, Multiple Flows

The PV of multiple cash flows is simply the sum of the present values of each individual cash flow.

Learning Objective

Calculate the present value of an investment portfolio that has multiple cash flows

Key Points

• To find the PV of multiple cash flows, each cash flow much be discounted to a specific point in time and then added to the others.
• To discount annuities to a time prior to their start date, they must be discounted to the start date, and then discounted to the present as a single cash flow.
• Multiple cash flow investments that are not annuities unfortunately cannot be discounted by any other method but by discounting each cash flow and summing them together.

Key Terms

discount

To find the value of a sum of money at some earlier point in time. To find the present value.

net present value

the present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision

The PV of multiple cash flows follows the same logic as the FV of multiple cash flows. The PV of multiple cash flows is simply the sum of the present values of each individual cash flow .

Sum FV

The PV of an investment is the sum of the present values of all its payments.

Each cash flow must be discounted to the same point in time. For example, you cannot sum the PV of two loans at the beginning of the loans if one starts in 2012 and one starts in 2014. If you want to find the PV in 2012, you need to discount the second loan an additional two years, even though it doesn’t start until 2014.

The calculations get markedly simpler if the cash flows make up an annuity. In order to be an annuity (and use the formulas explained in the annuity module), the cash flows need to have three traits:

1. Constant payment size
2. Payments occur at fixed intervals
3. A constant interest rate

Things may get slightly messy if there are multiple annuities, and you need to discount them to a date before the beginning of the payments.

Suppose there are two sets of cash flows which you determine are both annuities. The first extends from 1/1/14 to 1/1/16, and the second extends from 1/1/15 to 1/1/17. You want to find the total PV of all the cash flows on 1/1/13.

The annuity formulas are good for determining the PV at the date of the inception of the annuity. That means that it’s not enough to simply plug in the payment size, interest rate, and number of periods between 1/1/13 and the end of the annuities. If you do, that supposes that both annuities begin on 1/1/13, but neither do. Instead, you have to first find the PV of the first annuity on 1/1/14 and the second on 1/1/15 because that’s when the annuities begin.

You now have two present values, but both are still in the future. You then can discount those present values as if they were single sums to 1/1/13.

Unfortunately, if the cash flows do not fit the characteristics of an annuity, there isn’t a simple way to find the PV of multiple cash flows: each cash flow much be discounted and then all of the PVs must be summed together.

Example

A corporation must decide whether to introduce a new product line. The new product will have start-up expenditures, operational expenditures, and then it will have associated incoming cash receipts (sales) and disbursements (Cash paid for materials, supplies, direct labor, maintenance, repairs, and direct overhead) over 12 years. This project will have an immediate (t=0) cash outflow of 100,000 (which might include all cash paid for the machinery, transportation-in and set-up expenditures, and initial employee training disbursements. ) The annual net cash flow (receipts less disbursements) from this new line for years 1-12 is forecast as follows: -54672, -39161, 3054, 7128, 25927, 28838, 46088, 77076, 46726, 76852, 132332, 166047, reflecting two years of running deficits as experience and sales are built up, with net cash receipts forecast positive after that. At the end of the 12 years it’s estimated that the entire line becomes obsolete and its scrap value just covers all the removal and disposal expenditures. All values are after-tax, and the required rate of return is given to be 10%. (This also makes the simplifying assumption that the net cash received or paid is lumped into a single transaction occurring on the last day of each year. )

The present value (PV) can be calculated for each year:

T=0:

T=1:

T=2:

T=3:

T=4:

T=5:

T=6:

T=7:

T=8:

T=9:

T=10:

T=11:

T=12:

The sum of all these present values is the net present value, which equals 65,816.04. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no alternative with a higher NPV.

10.6.2: Future Value, Multiple Flows

To find the FV of multiple cash flows, sum the FV of each cash flow.

Learning Objective

Calculate the Future Value of Multiple Annuities

Key Points

• The FV of multiple cash flows is the sum of the FV of each cash flow.
• To sum the FV of each cash flow, each must be calculated to the same point in the future.
• If the multiple cash flows are a fixed size, occur at regular intervals, and earn a constant interest rate, it is an annuity. There are formulas for calculating the FV of an annuity.

Key Terms

incremental cash flows

the additional money flowing in or out of a business due to a project

annuity

A specified income payable at stated intervals for a fixed or a contingent period, often for the recipient’s life, in consideration of a stipulated premium paid either in prior installment payments or in a single payment. For example, a retirement annuity paid to a public officer following his or her retirement.

cash flow

The sum of cash revenues and expenditures over a period of time.

Future Value, Multiple Cash Flows

Finding the future value (FV) of multiple cash flows means that there are more than one payment/investment, and a business wants to find the total FV at a certain point in time. These payments can have varying sizes, occur at varying times, and earn varying interest rates, but they all have a certain value at a specific time in the future.

The first step in finding the FV of multiple cash flows is to define when the future is. Once that is done, you can determine the FV of each cash flow using the formula in . Then, simply add all of the future values together.

FV of a single payment

The FV of multiple cash flows is the sum of the future values of each cash flow.

Manually calculating the FV of each cash flow and then summing them together can be a tedious process. If the cash flows are irregular, don’t happen at regular intervals, or earn different interest rates, there isn’t a special way to find the total FV.

However, if the cash flows do happen at regular intervals, are a fixed size, and earn a uniform interest rate, there is an easier way to find the total FV. Investments that have these three traits are called “annuities. “

There are formulas to find the FV of an annuity depending on some characteristics, such as whether the payments occur at the beginning or end of each period. There is a module that goes through exactly how to calculate the FV of annuities.

If the multiple cash flows are a part of an annuity, you’re in luck; there is a simple way to find the FV. If the cash flows aren’t uniform, don’t occur at fixed intervals, or earn different interest rates, the only way to find the FV is do find the FV of each cash flow and then add them together.

10.7: Present Value, Single Amount

10.7.1: The Discount Rate

Discounting is the procedure of finding what a future sum of money is worth today.

Learning Objective

Describe what real world costs to the investor comprise an investment’s interest rate

Key Points

• The discount rate represents some cost (or group of costs) to the investor or creditor.
• Some costs to the investor or creditor are opportunity cost, liquidity cost, risk, and inflation.
• The discount rate is used by both the creditor and debtor to find the present value of an amount of money.

Key Terms

discount rate

The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used to decrease the amounts of future cash flow to yield their present value.

discounting

The process of finding the present value using the discount rate.

discount

to account for the time value of money

Another common name for finding present value (PV) is discounting. Discounting is the procedure of finding what a future sum of money is worth today. As you know from the previous sections, to find the PV of a payment you need to know the future value (FV), the number of time periods in question, and the interest rate. The interest rate, in this context, is more commonly called the discount rate.

The discount rate represents some cost (or group of costs) to the investor or creditor. The sum of these costs amounts to a percentage which becomes the interest rate (plus a small profit, sometimes). Here are some of the most significant costs from the investor/creditor’s point of view:

Borrowing and lending

Banks like HSBC take such costs into account when determining the terms of a loan for borrowers.

1. Opportunity Cost: The cost of not having the cash on hand at a certain point of time. If the investor/creditor had the cash s/he could spend it, but since it has been invested/loaned out, s/he incurs the cost of not being able to spend it.
2. Inflation: The real value of a single dollar decreases over time with inflation. That means that even if everything else is constant, a $100 item will retail for more than $100 in the future. Inflation is generally positive in most countries at most times (if it’s not, it’s called deflation, but it’s rare).
3. Risk: There is a chance that you will not get your money back because it is a bad investment, the debtor defaults. You require compensation for taking on that risk.
4. Liquidity: Investing or loaning out cash necessarily reduces your liquidity.

All of these costs combine to determine the interest rate on an account, and that interest rate in turn is the rate at which the sum is discounted.

The PV and the discount rate are related through the same formula we have been using,
.

If FV and n are held as constants, then as the discount rate (i) increases, PV decreases. PV and the discount rate, therefore, vary inversely, a fundamental relationship in finance. Suppose you expect $1,000 dollars in one year’s time (FV = $1,000) . To determine the present value, you would need to discount it by some interest rate (i). If this discount rate were 5%, the $1,000 in a year’s time would be the equivalent of $952.38 to you today (1000/[1.00 + 0.05]).

10.7.2: Number of Periods

The number of periods corresponds to the number of times the interest is accrued.

Learning Objective

Define what a period is in terms of present value calculations

Key Points

• A period is just a general term for a length of time. It can be anything- one month, one year, one decade- but it must be clearly defined and fixed.
• For both simple and compound interest, the number of periods varies jointly with FV and inversely with PV.
• The number of periods is also part of the units of the discount rate: if one period is one year, the discount rate must be defined as X% per year. If one period is one month, the discount rate must be X% per month.

Key Term

period

The length of time during which interest accrues.

In , nrepresents the number of periods. A period is just a general term for a length of time. It can be anything- one month, one year, one decade- but it must be clearly defined and fixed. The length of one period must be the same at the beginning of an investment and at the end. It is also part of the units of the discount rate: if one period is one year, the discount rate must be defined as X% per year. If one period is one month, the discount rate must be X% per month.

FV of a single payment

The PV and FV are directly related.

The number of periods corresponds to the number of times the interest is accrued. In the case of simple interest the number of periods, t, is multiplied by their interest rate. This makes sense because if you earn $30 of interest in the first period, you also earn $30 of interest in the last period, so the total amount of interest earned is simple t x $30.

Simple interest is rarely used in comparison to compound interest . In compound interest, the interest in one period is also paid on all interest accrued in previous periods. Therefore, there is an exponential relationship between PV and FV, which is reflected in (1+i)ⁿ .

Car

Car loans, mortgages, and student loans all generally have compound interest.

For both forms of interest, the number of periods varies jointly with FV and inversely with PV. Logically, if more time passes between the present and the future, the FV must be higher or the PV lower (assuming the discount rate remains constant).

10.7.3: Calculating Present Value

Calculating the present value (PV) is a matter of plugging FV, the interest rate, and the number of periods into an equation.

Learning Objective

Distinguish between the formula used for calculating present value with simple interest and the formula used for present value with compound interest

Key Points

• The first step is to identify if the interest is simple or compound. Most of the time, it is compound.
• The interest rate and number of periods must have consistent units.
• The PV is what a future sum is worth today given a specific interest rate (often called a “discount rate”).

Key Terms

compound interest

Interest, as on a loan or a bank account, that is calculated on the total on the principal plus accumulated unpaid interest.

simple interest

interest paid only on the principal.

Finding the present value (PV) of an amount of money is finding the amount of money today that is worth the same as an amount of money in the future, given a certain interest rate.

Calculating the present value (PV) of a single amount is a matter of combining all of the different parts we have already discussed. But first, you must determine whether the type of interest is simple or compound interest. If the interest is simple interest, you plug the numbers into the simple interest formula.

Simple Interest Formula

Simple interest is when interest is only paid on the amount you originally invested (the principal). You don’t earn interest on interest you previously earned.

If it is compound interest, you can rearrange the compound interest formula to calculate the present value.

Present Value Single Payment

Finding the PV is a matter of plugging in for the three other variables.

Inputs

• Future Value: The known value of the money at a declared point in the future.
• Interest Rate (Discount Rate): Represented as either i or r. This is the percentage of interest paid each period.
• Number of periods: Represented as n or t.

Once you know these three variables, you can plug them into the appropriate equation. If the problem doesn’t say otherwise, it’s safe to assume the interest compounds. If you happen to be using a program like Excel, the interest is compounded in the PV formula. Simple interest is pretty rare.

One area where there is often a mistake is in defining the number of periods and the interest rate. They have to have consistent units, which may require some work. For example, interest is often listed as X% per year. The problem may talk about finding the PV 24 months before the FV, but the number of periods must be in years since the interest rate is listed per year. Therefore, n = 2. As long as the units are consistent, however, finding the PV is done by plug-and-chug.

10.7.4: Multi-Period Investment

Multi-period investments require an understanding of compound interest, incorporating the time value of money over time.

Learning Objective

Calculate the return on a multi-period investment over time

Key Points

• A dollar today is worth more than a dollar tomorrow, and the time value of money must take into account foregone opportunities.
• Single period investments are relatively simple to calculate in terms of future value, applying the interest rate to a present value a single time.
• Multi-period investments require a slightly more complex equation, where interest gets compounded based on the number of periods the investment spans.
• As a result of multiple periods, it is usually a good idea to calculate the average rate of return (cumulatively) over the lifetime of the investment.

Key Term

Compound interest

An interest rate applied to multiple applications of interest during the lifetime of the investment.

When investing, the time value of money is a core concept investors simply cannot ignore. A dollar today is valued higher than a dollar tomorrow, and when utilizing the capital it is important to recognize the opportunity cost involved in what could have been invested in instead.

Single Period Investments

With single period investments, the concept of time value of money is relatively straightforward. The future value is simply the present value applied to the interest rate compounded one time. When comparing this to the opportunity costs involved, the rate of return of an alternative investment during the same time is similarly straightforward.

The variables involved in understanding the time value of money in these investments are:

• Present Value (PV)
• Future Value (FV)
• Interest Rate (i or r) [Note: for all formulas, express interest in its decimal form, not as a whole number. 7% is .07, 12% is .12, and so on. ]
• Number of Periods (t or n)

With these variables, a single period investment could be calculated as follows:

‘t’ in this equation would simply be 1, simplifying this equation to FV = PV(1+r).

Multi-period Investments

With multi-periods in mind, interest begins to compound. Compound interest simple means that the interest from the first period is added to the future present value, and the interest rate the next time around is now being applied to a larger amount. This turns into an exponential calculation of interest, calculated as follows:

This means that the interest rate of a given period may not be the same percentage as the interest rate over multiple periods (in most situations). A useful tool at this point is a way to create an average rate of return over the life of the investment, which can be derived with the following:

Conclusion

All and all, the difference from a time value of money perspective between single and multiple period investments is relatively straightforward. Normalizing expected returns in present value terms (or projecting future returns over multiple time periods of compounding interest) paints a clearer and more accurate picture of the actual worth of a given investment opportunity.

Time Value of Money

Time value of money requires an understanding of how return rates impact fixed values over time.

Time value of money requires an understanding of how return rates impact fixed values over time.

10.7.5: Single-Period Investment

When considering a single-period investment, n is one, so the PV is simply FV divided by 1+i.

Learning Objective

Calculate the present value of a future, single-period payment

Key Points

• A single period investment has the number of periods (n or t) equal to one.
• For both simple and compound interest, the PV is FV divided by 1+i.
• The time value of money framework says that money in the future is not worth as much as money in the present.

Key Terms

interest rate

The percentage of an amount of money charged for its use per some period of time. It can also be thought of as the cost of not having money for one period, or the amount paid on an investment per year.

period

The length of time during which interest accrues.

The time value of money framework says that money in the future is not worth as much as money in the present. Investors would prefer to have the money today because then they are able to spend it, save it, or invest it right now instead of having to wait to be able to use it.

The difference between what the money is worth today and what it will be worth at a point in the future can be quantified. The value of the money today is called the present value (PV), and the value of the money in the future is called the future value (FV). There is also a name for the cost of not having the money today: the interest rate or discount rate (i or r). For example, if the interest rate is 3% per year, it means that you would be willing to pay 3% of the money to have it one year sooner. The amount of time is also represented by a variable: the number of periods (n). One period could be any length of time, such as one day, one month, or one year, but it must be clearly defined, consistent with the time units in the interest rate, and constant throughout your calculations.

FV of a single payment

The FV is related to the PV by being i% more each period.

All of these variables are related through an equation that helps you find the PV of a single amount of money. That is, it tells you what a single payment is worth today, but not what a series of payments is worth today (that will come later). relates all of the variables together. In order to find the PV, you must know the FV, i, and n.

When considering a single-period investment, n is, by definition, one. That means that the PV is simply FV divided by 1+i. There is a cost to not having the money for one year, which is what the interest rate represents. Therefore, the PV is i% less than the FV.

9.2: Current Liabilities

9.2.1: Defining Current Liabilities

Learning Objective

Identify a current liability

Key Points

• A current liability can be defined in one of two ways: (1) all liabilities of the business that are to be settled in cash within a firm’s fiscal year or operating cycle, or (2) all liabilities of the business that are to be settled by current assets or by the creation of new current liabilities.
• Common characteristics of liabilities are (1) borrowed funds for use that must be repaid, (2) a duty to another party that involves the payment of an economic benefit, (3) a duty that obligates the entity to another without avoiding settlement, and (4) a past transaction that obligates the entity.
• Current liabilities are many times not “current” and are actually past due. For example, accounts payable are due within 30 days and are typically paid within 30 days. However, they do often run past 30 days in some situations.

Key Terms

obligation

A legal agreement stipulating a specified payment or action; the document containing such agreement.

settlement

The delivery of goods by the seller and payment for them by the buyer, under a previously agreed trade or transaction or contract entered into.

Definition of a Liability

In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of future economic benefits. Liabilities are reported on the balance sheet, along with assets and owner’s equity. They are an important part of the basic accounting equation — assets = liabilities + owner’s equity. A liability is defined by one of the following characteristics:

1. A borrowing of funds from individuals or banks for improving a business or personal income that is payable during a short or long time period.
2. A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified date, on occurrence of a specified event, or on demand.
3. A duty or responsibility that obligates the entity to another entity, with no option to avoid settlement.
4. A transaction or event that has already occurred and obligates the entity .

Definition of a Current Liability

A current liability can be defined in one of two ways: (1) all liabilities of the business that are to be settled in cash within a firm’s fiscal year or operating cycle, whichever period is longer or (2) all liabilities of the business that are to be settled by current assets or by the creation of new current liabilities. Another important point is that current liabilities are many times not “current” and are actually past due. For example, accounts payable are due within 30 days and are typically paid within 30 days. However, they do often run past 30 days or 60 days in some situations. So, the accounts payable balance reported on the balance sheet under “current” liabilities may include amounts that are over 30 days due.

A current liability, such as a credit purchase, can be documented with an invoice.

Current liabilities are debt owed and payable no later than the current accounting period.

9.2.2: Accounts Payable

Learning Objective

Differentiate between trade and expense payables and give examples of common accounts-payable terms

Key Points

• Accounts payable is recorded in the A/P sub-ledger at the time an invoice is vouchered for payment. Vouchered means that an invoice is approved for payment and has been recorded in the general ledger or A/P subledger as an outstanding, or open, liability because it has not been paid.
• Payables are often categorized as trade payables, which are for the purchase of physical goods that are recorded in inventory; another category is expense payables or purchases of goods or services that are expensed.
• Common examples of expense payables are advertising, travel, entertainment, office supplies, and utilities. These items are obtained through credit that suppliers offer to their customers by allowing them to pay for a product or service after it has been received or used.

Key Term

sub-ledger

A subset of the general ledger used in accounting. The subledger shows detail for part of the accounting records such as property and equipment, prepaid expenses, etc.

Definition of Accounts Payable

Accounts payable (A/P) is money owed by a business to its suppliers and creditors. It is typically shown on its balance sheet as a current liability. In addition to its disclosure on the balance sheet, accounts payable is recorded in the A/P sub-ledger at the time an invoice is vouchered for payment. Vouchered, or vouched, means that an invoice is approved for payment and has been recorded in the general ledger or A/P sub-ledger as an outstanding, or open, liability because it has not been paid. Payables are often categorized as trade payables, or purchases of physical goods that are recorded in inventory. Another category is expense payables, or purchases of goods or services that are expensed. Common examples of expense payables are advertising, travel, entertainment, office supplies, and utilities. A/P is a form of credit that suppliers offer to their customers by allowing them to pay for a product or service after it has been received. Suppliers offer various payment terms for an invoice .

An invoice payable in 30 days is typically recorded as accounts payable.

In most businesses, accounts payable is a common type of current liability.

Processing Accounts Payable

A/P payment terms may include the offer of a cash discount for paying an invoice within a defined number of days. For example, the 2/10 Net 30 term means that the seller will deduct 2% from the invoice total if payment is made within 10 days and the invoice must be paid within 30 days. If the payment is delayed until Day 31 then the full amount of the invoice is due and past due charges may apply. As invoices are paid, the amounts are recorded as reductions to the accounts payable balance in the liability section and cash in the assets section of the balance sheet. The A/P payment process begins as an invoice is received by the purchaser and matched to a packing (receiving) slip and purchase order. When the three documents are matched, the invoice is paid. This is referred to as the three-way match. The three-way match can be modified to expedite payments. For example, three-way matching may be limited solely to large-value invoices, or the matching is automatically approved if the received quantity is within a certain percentage of the amount authorized in the purchase order.

9.2.3: Notes Payable

Learning Objective

Explain how a note payable differs from other liabilities

Key Points

• The terms of a note usually include the principal amount, interest rate (if applicable), parties involved, date, terms of repayment (which may include interest), and maturity date.
• Negotiable promissory notes are used extensively in combination with mortgages in the financing of real estate transactions. Notes are also issued, along with commercial papers, to provide capital to businesses.
• To report the note as a current liability it should be due within a 12-month period or current operating cycle, whichever is longer. The note payable amount can include the principal as well as the interest payment amounts due.

Key Terms

mortgage notes payable

a written promise to repay a specified sum of money plus interest at a specified rate and length of time to fulfill the promise, specifically for a loan secured by real property

notes payable

promisory notes due to the company

default

The condition of failing to meet an obligation.

negotiable

Able to be transferred to another person, with or without endorsement.

Definition of Promissory Note

A promissory note is a negotiable instrument, where one party (the maker or issuer) makes, under specific terms, an unconditional promise in writing to pay a determined sum of money to the other (the payee), either at a fixed or determinable future time or on demand by the payee. The terms of a note usually include the principal amount, interest rate (if applicable), parties involved, date, terms of repayment (which may include interest), and maturity date. Sometimes, provisions are included concerning the payee’s rights in the event of a default, which may include foreclosure of the maker’s assets. Demand promissory notes are notes that do not carry a specific maturity date, but are due on demand by the lender. Usually the lender will only give the borrower a few days notice before the payment is due. For loans between individuals, writing and signing a promissory note are often instrumental for tax and record keeping purposes .

A 1926 promissory note from the Bank of India.

A promissory note due in less than a year is reported under current liabilities.

Accounting for Notes Payable

Negotiable promissory notes are used extensively in combination with mortgages in the financing of real estate transactions. Notes are also issued, along with commercial papers, to provide capital to businesses. When a note is signed and it becomes a binding agreement, a notes payable can be recorded to report the debt on the balance sheet. To report the note as a current liability it should be due within a 12-month period or current operating cycle, whichever is longer. The note payable amount can include the principal as well as the interest payment amounts due. If periodic payments are made throughout the term of the note, the payments will reduce the notes payable balance. It’s important not to confuse a note with a loan contract, which is a legally distinct document from a note. It is non-negotiable, and does not include an unconditional promise to pay clause.

9.2.4: Current Maturities of Long-Term Debt

Learning Objective

Explain the reporting of the current portion of a long-term debt

Key Points

• Long-term liabilities are liabilities with a due date that extends over one year, such as bonds payable with a maturity date of 10 years. Long-term liabilities are a way to show the existence of debt that can be paid in a time period longer than one year.
• The portion of long-term liabilities that must be paid in the coming 12-month period are moved from the long-term liability section to the current liability section of the balance sheet.
• Current debt on the balance sheet is listed by maturity date, in relation to the due date of other current liabilities. If a current liability section has an accounts payable account (due in 30 days), a current balance of loans payable (due in 12 months) would be listed after accounts payable.

Key Terms

bond

Evidence of a long-term debt, by which the bond issuer (the borrower) is obliged to pay interest when due, and repay the principal at maturity, as specified on the face of the bond certificate. The rights of the holder are specified in the bond indenture, which contains the legal terms and conditions under which the bond was issued. Bonds are available in two forms: registered bonds and bearer bonds.

debenture

A certificate that certifies an amount of money owed to someone; a certificate of indebtedness.

declaration date

the day the Board of Directors announces its intention to pay a dividend

current liability

all liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer

Definition of Long-Term Debt

Long-term liabilities are liabilities with a due date that extends over one year, such as a notes payable that matures in 2 years. In accounting, the long-term liabilities are shown on the right side of the balance sheet, along with the rest of the liability section, and their sources of funds are generally tied to capital assets. Examples of long-term liabilities are debentures, bonds, mortgage loans and other bank loans (it should be noted that not all bank loans are long term since not all are paid over a period greater than one year. ) Also long-term liabilities are a way for a company to show the existence of debt that can be paid in a time period longer than one year, a sign that the company is able to obtain long-term financing .

War bonds were used to support World War II.

Bonds are a form of long-term debt because they typically mature several years after their original issue date.

Long-Term Debt Due in the Current Period

The portion of long-term liabilities that must be paid in the coming 12-month period are classified as current liabilities. The portion of the liability considered “current” is moved from the long-term liabilities section to the current liabilities section. The position of where the debt should be disclosed is based on its maturity date in relation to the due date of other current liabilities. For example, a loan for which two payments of USD 1,000 are due–one in the next 12 months and the other after that date–would be split into one USD 1000 portion of the debt classified as a current liability, and the other USD 1000 as a long-term liability (note this example does not take into account any interest or discounting effects, which may be required depending on the accounting rules that may apply). If the current liability section already has an accounts payable account (balance which is usually paid off in 30 days), the current portion of the loan payable (due within 12 months) would be listed after accounts payable.

9.2.5: Current Obligations Expected to Be Refinanced

Learning Objective

Explain why a company would refinance a debt

Key Points

• Refinancing may refer to the replacement of an existing debt obligation, or current liability, with a debt obligation under different terms.
• The most common type of debt refinancing occurs in the home mortgage market. Reasons to refinance include to obtain a better interest rate; to consolidate current debt; to free up cash and reduce periodic payments; and to reduce debt risk.
• Calculating the up-front, ongoing, and potentially variable transaction costs of refinancing is an important part of the decision on whether or not to refinance, since they can wipe out any savings generated by the new loan terms.

Key Terms

closing fees

a variety of costs associated with the transaction (above and beyond the price of the asset itself) and incurred by either the buyer or the seller. These costs are typically paid at a future point in time, known as the “closing” when title switches hands.

non-recourse debt

a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender’s recovery is limited to the collateral.

recourse debt

a debt that is not backed by collateral from the borrower.

current replacement cost

the amount that an entity would have to pay to replace an asset at the present time, according to its current worth

Definition of Refinancing

Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by the type of debt involved and is based on several economic factors such as:

• the inherent and projected risk of the asset(s) backing the loan,
• the financial stability of the lender,
• credit availability,
• banking regulations,
• the borrower’s credit worthiness, and
• the borrower’s net worth.

If the replacement of debt occurs under financial distress, refinancing might be referred to as debt restructuring. The most common type of debt refinancing occurs in the home mortgage market.

Deciding to refinance debt can be a balancing act between the funds requested and the interest rate charged on the funds.

Refinanced debt must be finalized and the new loan terms approved before reporting it and replacing it for the old debt in the liability section.

Reasons to Refinance Debt

A loan or other type of debt can be refinanced for various reasons:

1. To take advantage of a better interest rate or loan terms (a reduced monthly payment or a reduced term)
2. To consolidate other debt(s) into one loan (a potentially longer/shorter term contingent on interest rate differential and fees)
3. To reduce the monthly repayment amount (often for a longer term, contingent on interest rate differential and fees)
4. To reduce or alter risk (e.g. switching from a variable-rate to a fixed-rate loan)
5. To free up cash (often for a longer term, contingent on interest rate differential and fees)

Risks of Refinanced Debt

Calculating the up-front, ongoing, and potentially variable transaction costs of refinancing is an important part of the decision on whether or not to refinance. If the refinanced loan has lower monthly repayments or consolidates other debts for the same repayment, it will result in a larger total interest cost over the life of the loan and will result in the borrower remaining in debt for many more years. Most fixed-term loans are subject to closing fees and points and have penalty clauses that are triggered by an early repayment of the loan, in part or in full.

Penalty clauses are only applicable to loans paid off prior to maturity and involve the payment of a penalty fee. The above-mentioned items are considered the transaction fees on the refinancing. These fees must be calculated before substituting an old loan for a new one, as they can wipe out any savings generated through refinancing.

In some jurisdictions, refinanced mortgage loans are considered recourse debt, meaning that the borrower is liable in case of default, while un-refinanced mortgages are non-recourse debt.

9.2.6: Dividends Payable

Learning Objective

Explain what a dividend is and how it is reported on the financial statements

Key Points

• There are two ways to distribute cash to shareholders: share repurchases (reported as treasury stock in the owner’s equity section of the balance sheet) and dividends (liability).
• A shareholder receives a dividend in proportion to the shares he owns. He must also be a shareholder on the date of record in order to be eligible for the dividend.
• The declared per share dividend amount is multiplied by the number of shares outstanding and this result is debited to retained earnings and credited to dividends payable. Dividends payable is recorded as a current liability on the company’s books when the dividend is declared.

Key Terms

treasury stock

A treasury or “reacquired” stock is one which is bought back by the issuing company, reducing the amount of outstanding stock on the open market (“open market” including insiders’ holdings).

retained earnings

Retained earnings are the portion of net income that is retained by the corporation rather than distributed to its owners as dividends.

Dividends are the portion of corporate profits paid out to shareholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be distributed to shareholders as dividends.

There are two ways to distribute cash to shareholders: share repurchases (reported as treasury stock in the owner’s equity section of the balance sheet) or dividends.

Many corporations retain a portion of their earnings and pay out the remaining earnings as a dividend. A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to the shares he owns — for example, if shareholder Y owns 100 shares when company Z declares a dividend of USD 1.00 per share. then shareholder Y will receive a dividend of USD 100 for his shares.

Dividends are considered a form of passive income for investors.

Companies that declare dividends must record a liability for the amount of the dividends that will be paid to investors.

For the company, a dividend payment is not an expense, but the division of after tax profits among shareholders. On the dividend declaration date, a company’s board of directors announces its intention to pay a dividend to shareholders on record as of a certain date (date of record). The per share dividend amount is multiplied by the number of shares outstanding and this result is debited to retained earnings and credited to dividends payable.

Dividends payable is recorded as a current liability on the company’s books; the journal entry confirms that the dividend payment is now owed to the stockholders. On the declaration date, the Board announces the date of record and a payment date; the payment date is the date when the funds are sent to the shareholders and the dividends payable account is reduced for the payment amount.

9.2.7: Unearned and Deferred Revenues

Learning Objective

Explain the purpose of classifying transactions as either deferred or unearned revenue

Key Points

• A deferred item, in accrual accounting, is any account where a revenue or expense, recorded as an liability or asset, is not realized until a future date (accounting period) or until a transaction is completed.
• Unearned revenues are recorded because the earnings process is not complete when the cash is received, so the cash is recorded as a liability for the products or services that are due to the buyer.
• An example of a deferred revenue is the monies received for a 12-month magazine subscription. The proceeds on the subscription relate to a future benefit (magazine) for the buyer that he will receive over the course of 12 months.

Key Terms

unearned revenue

money received for goods or services which have not yet been delivered

expense

In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

Definition of Deferred and Unearned Revenues

A deferred item, in accrual accounting, is any account where a revenue or expense, recorded as an liability or asset, is not realized until a future date (accounting period) or until a transaction is completed. Examples of deferred items include annuities, charges, taxes, income, etc. If the deferred item relates to an expense (cash has been paid out), it is carried as an asset on the balance sheet. If the deferred item relates to revenue (cash has been received), it is carried as a liability. A deferred revenue is specifically recognized when cash is received upfront for a product before delivery or for a service before rendering. In these cases, the earnings process is not complete when the cash is received, so the cash is recorded as a liability for the products or services that are due to the buyer .

Receipts for magazine subscriptions are a type of deferred revenue.

A deferred revenue item involves cash received before the earnings process is complete.

Accounting for Deferred and Unearned Revenues

An example of a deferred revenue is the monies received for a 12-month magazine subscription. The proceeds on the subscription relate to a future benefit (magazine) for the buyer that he will receive over the course of 12 months. Since the seller has received full payment for all 12 issues that will be delivered over the course of the year, the payment is recorded as unearned or deferred revenue in the current liability section of the balance sheet. If cash received is for benefits that extend past the current accounting period, a long-term liability would be recorded instead. As each magazine is delivered to the buyer (earnings process is now complete), the applicable “earned” portion of the original payment is transferred from the liability account to subscription revenue, which is disclosed on the income statement.

9.2.8: Other Current Liabilities: Sales Tax, Income Tax, Payroll, and Customer Advances

Learning Objective

Explain how sales tax payable, income tax payable, salaries and wages payable and deferred revenue appear on the financial statements

Key Points

• A sales and use tax is a tax paid to a governing body by a seller for the sales of certain goods and services.
• An income tax is a tax levied on the income of individuals or businesses (corporations or other legal entities).
• Wages and salaries in cash consist of wages or salaries payable at regular weekly, monthly or other intervals. This includes payments by results and piecework payments, plus allowances such as those for working overtime.
• Deferred revenue is, in accrual accounting, money received for goods or services which have not yet been delivered and revenue on the sale has not been earned.

Key Terms

capital gains

a profit that results from a disposition of a capital asset , such as stock , bond or real estate , where the amount realized on the disposition exceeds the purchase price.

jurisdiction

the limits or territory within which authority may be exercised

deferred tax

A timing difference arises when an item of income or expense is recognized for tax purposes but not accounting purposes, or vice versa, creating an asset or liability.

Other Current Liabilities

Sales Tax Payable

The sales and use tax is a tax paid to a governing body by a seller for the sales of certain goods and services. The payment of the tax by the seller occurs periodically and varies depending on the jurisdiction. Usually laws allow (or require) the seller to collect funds for the tax from the consumer at the point of purchase. Laws may allow sellers to itemized the tax separately from the price of the goods or services, or require it to be included in the price (tax-inclusive). The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale. Sales tax payable can be accrued on a monthly basis by debiting sales tax expense and crediting sales tax payable for the tax amount applicable to monthly sales. The sales tax payable account is reported in the current liability section of the balance sheet until the tax is paid.

A company can incur different types of tax liabilities.

Taxes, employee salaries, and customer advances that will be payable or earned within a 12-month period can be reported as current liabilities.

Income Tax Payable

Income tax is a tax levied on the income of individuals or businesses (corporations or other legal entities). Corporate tax refers to a direct tax levied on the net earnings made by companies or associations and often includes the capital gains of a company. Net earnings are generally considered gross revenue minus expenses. Expenses can vary; for example, corporate expenses related to fixed assets are usually deducted in full over their useful lives by using percentage rates based on the class of asset to which they belong. Accounting principles and tax rules about recognition of expenses and revenue will vary at times, giving rise to book-tax differences. If the book-tax difference is carried over more than a year, it is referred to as a deferred tax. Future assets and liabilities created by a deferred tax are reported on the balance sheet. Income tax payable can be accrued by debiting income tax expense and crediting income tax payable for the tax owed; the payable is disclosed in the current liability section until the tax is paid.

Salaries and Wages Payable

Wages and salaries in cash consist of wages or salaries payable at regular weekly, monthly, or other intervals, including payments by results and piecework payments, plus allowances like:

• working overtime;
• amounts paid to employees away from work for short periods (e.g., on holiday);
• ad hoc bonuses and similar payments;
• commissions, gratuities and tips received by employees.

Customer Advances (Deferred Revenue)

Deferred revenue is, in accrual accounting, money received for goods or services that have not yet been delivered and revenue on the sale has not been earned. According to the revenue recognition principle, the deferred amount is recorded as a liability until delivery is made, at which time it is converted into revenue. An example of a typical customer advance is the receipt of an annual maintenance contract fee, where the entire contract is paid up front. The receipt of $12,000 for the annual maintenance contract is initially recorded as deferred revenue. As the maintenance service is rendered and a portion of the fee is earned, $1,000 is recognized periodically each month as revenue and the deferred revenue account is reduced.

9.3: Contingencies

9.3.1: Gain Contingencies

Gain contingencies, or possible occurrences of a gain on a claim or obligation involving the entity, are reported when realized (earned).

Learning Objective

Explain how a company reports a gain contingency on their financial statements

Key Points

• If a specific event that can cause the gain occurs, and the gain is realized, then the gain is accrued for and reported in the financial statements. It is also disclosed in the notes section.
• Probable and quantifiable gains are not accrued for reporting purposes, but they can be disclosed in the notes to the financial statements if they are material. If the gain is not probable or reasonably estimated, but could materially effect financial statements, the gain is disclosed in a note.
• The materiality concept states that if a gain contingency, that remains unrealized, affects the economic decision of statement users, it should be disclosed in the notes.
• Following conservative constraints for a gain contingency, only a realized gain should be accrued for and disclosed on an income statement.

Key Terms

Contingency

A possibility; something which may or may not happen. This also can mean a chance occurrence, especially in, unexpected expenses

unrealized

Not realized; possible to obtain, yet not obtained.

Gain Contingency

Gain contingencies, or the possible occurrences of a gain on a claim or obligation that involves the entity, are reported when realized (earned). If a specific event that can cause the gain occurs, and the gain is realized, then the gain is disclosed . If the gain is probable and quantifiable, the gain is not accrued for financial reporting purposes, but it can be disclosed in the notes to financial statements. If the gain is not probable or its amount cannot be reasonably estimated, but its effect could materially affect financial statements, a note disclosing the nature of the gain is also disclosed in the notes. Care should be taken that misleading language is not used regarding the potential for the gain to be realized. The disclosure of gain contingencies is affected by the materiality concept and the conservatism constraint.

Renovation

Renovation plans and projects can increase the value of a building and eventually bring about a gain. However these gains should only be accrued when the gain is realized.

Materiality

Materiality is a concept or convention within auditing and accounting that relates to the importance/significance of an amount, transaction, or discrepancy. For example, an auditor expresses an opinion on whether financial statements are prepared, in all material aspects, in conformity with generally accepted accounting principles (GAAP). Professional judgment is required to determine what is material and what isn’t. Generally, if the omission or misstatement of information can influence the economic decision of financial statement users, the missing or incorrect information is considered material. Thus, if a gain contingency, that remains unrealized, affects the economic decision of statement users, it should be disclosed in the notes.

Conservatism

Most accounting principles follow the conservative constraint, which encourages the immediate disclosure of losses and expenses on the income statement. This constraint also encourages the omission of revenues and gains until those gains are realized. Thus, for a gain contingency, only a realized gain is accrued for and disclosed on the income statement. A material gain contingency that is both probable and reasonably estimated can be disclosed in the notes to financial statements.

9.3.2: Loss Contingencies

A loss contingency may be incurred by the entity based on the outcome of a future event, such as litigation.

Learning Objective

Summarize how a company would report a loss contingency on their financial statements

Key Points

• Due to conservative accounting principles, loss contingencies are reported on the balance sheet and footnotes on the financial statements, if they are probable and their quantity can be reasonably estimated.
• Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet.
• For losses that are material, but may not occur and their amounts can not be estimated, a note to the financial statements disclosing the loss contingency is reported.

Key Terms

incur

To render somebody liable or subject to.

probable

Likely or most likely to be true.

Definition of Loss Contingencies

A loss contingency is incurred by the entity based on the outcome of a future event, such as litigation. Due to conservative accounting principles, loss contingencies are reported on the balance sheet and footnotes on the financial statements, if they are probable and their quantity can be reasonably estimated. A footnote can also be included to describe the nature and intent of the loss. The likelihood of the loss is described as probable, reasonably possible, or remote. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable .

Calculating cash flow

The indirect method adjusts net income (rather than adjusting individual items in the income statement).

Contingent Liabilities for Losses

Loss contingencies can refer to contingent liabilities that may arise from discounted notes receivable, income tax disputes, or penalties that may be assessed because of some past action or failure of another party to pay a debt that a company has guaranteed. Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet. At least a minimum amount of the loss expected to be incurred is accrued. For losses that are material, but may not occur and their amounts cannot be estimated, a note to the financial statements disclosing the loss contingency is reported.

Example of a Disclosed Loss Contingency

A jury awarded $5.2 million to a former employee of the Company for an alleged breach of contract and wrongful termination of employment. The Company has appealed the judgment on the basis of errors in the judge’s instructions to the jury and insufficiency of evidence to support the amount of the jury’s award. The Company is vigorously pursuing the appeal. The Company and its subsidiaries are also involved in other litigation arising in the ordinary course of business. Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution. The resolution of the appeal of the jury award could have a significant effect on the Company’s earnings in the year that a determination is made. However, in management’s opinion, the final resolution of all legal matters will not have a material adverse effect on the Company’s financial position.

9.4: Reporting and Analyzing Current Liabilities

9.4.1: Reporting Current Liabilities

Current liabilities are reported first in the liability section of the balance sheet because they have first claim on company assets.

Learning Objective

Explain how current liabilities are shown on the financial statements

Key Points

• Current liabilities are typically due and paid for during the current accounting period or within a one year period. They are paid off with assets or other current liabilities.
• For many companies, accounts payable is the first balance sheet account listed in the current liabilities section. Accounts payable includes goods, services, or supplies that were purchased with credit and for use in the operation of the business and payable within a one year period.
• Long-term liabilities are listed in a separate section after current debt; however, for all long-term liabilities, any amounts due in the current fiscal year are reported under the current liability section.

Key Terms

bond

Evidence of a long-term debt, by which the bond issuer (the borrower) is obliged to pay interest when due, and repay the principal at maturity, as specified on the face of the bond certificate. The rights of the holder are specified in the bond indenture, which contains the legal terms and conditions under which the bond was issued. Bonds are available in two forms: registered bonds and bearer bonds.

audit

An independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures

Current Liabilities in the Balance Sheet

The balance sheet, or statement of financial position, is a snapshot of a company’s assets, liabilities, and owner’s equity on a given date. The presentation of the balance sheet should support the accounting equation of assets = liabilities + owner’s equity. Liabilities are disclosed in a separate section that distinguishes between short-term and long-term liabilities. Short-term, or current liabilities, are listed first in the liability section of the statement because they have first claim on company assets. Current liabilities are typically due and paid for during the current accounting period or within a one year period. They are paid off with assets or other current liabilities .

Most current liabilities have a claim on cash or other assets.

Current liabilities is the first section reported under liabilities on the balance sheet.

Accounts Payable

For many companies, accounts payable is the first balance sheet account listed in the current liabilities section. For example, accounts payable for goods, services, or supplies that were purchased with credit and for use in the operation of the business and payable within a one-year period would be current liabilities. Accounts payable are typically due within 30 days. Amounts listed on a balance sheet as accounts payable represent all bills payable to vendors of a company, whether or not the bills are more or less than 30 days old. Therefore, late payments are not disclosed on the balance sheet for accounts payable. An aging schedule showing the amount of time certain amounts are past due may be presented in the notes to audited financial statements; however, this is not common accounting practice.

Other Liabilities

In addition to current liabilities, long-term liabilities are listed in a separate section after current debt. Long-term liabilities can include bonds, mortgages, and loans that are payable over a term exceeding one year. However, for all long-term liabilities, any amounts due in the current fiscal year are reported under the current liability section.

9.4.2: What Goes on the Balances Sheet and What Goes in the Notes

The balance sheet lists current liability accounts and their balances; the notes provide explanations for the balances, which are sometimes required.

Learning Objective

Explain why a company would use a note to the balance sheet

Key Points

• All liabilities are typically placed on the same side of the balance sheet as the owner’s equity because both those accounts have credit balances.
• Current liabilities and their account balances as of the date on the balance sheet are presented first on the balance sheet, in order by due date. The balances in these accounts are typically due in the current accounting period or within one year.
• Current liability information found in the notes to the financial statements provide additional explanation on the account balances and any circumstances affecting them. Accounting principles can sometimes require this type of disclosure.

Key Terms

LLP

Limited liability partnership.

pension

A regularly paid gratuity paid regularly as benefit due to a person in consideration of past services; notably to one retired from service, on account of retirement age, disability, or similar cause; especially, a regular stipend paid by a government to retired public officers, disabled soldiers; sometimes passed on to the heirs, or even specifically for them, as to the families of soldiers killed in service.

LLC

Limited liability company.

The Balance Sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation, or other business organization, such as an LLC or an LLP. Assets, liabilities, and the equity of stockholders are listed as of a specific date, such as the end of a fiscal year or accounting period. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a company’s calendar year. Balance sheets are presented with assets in one section, and liabilities and equity in the other section, so that the two sections “balance. ” The fundamental accounting equation is: assets = liabilities + equity ([).

The Balance Sheet

If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

Current Liabilities on the Balance Sheet

All liabilities are typically placed on the same side of the report page as the owner’s equity because both those accounts have credit balances (asset accounts, on the other hand, have debit balances). Current liabilities and their account balances as of the date on the balance sheet are presented first, in order by due date. The balances in these accounts are typically due in the current accounting period or within one year. Current liabilities can represent costs incurred for employee salaries and wages, production and build up of inventory, and acquisition of equipment which are needed and used up during normal business operations.

Information in the Notes

Current liability information found in the notes to the financial statements provide additional explanation on the liability balances and any circumstances affecting them. Accounting principles can sometimes require the disclosure of specific information for the benefit of the financial statement user. For example, companies that pay pension plan benefits require additional footnote disclosure that provide the user with additional details on pension costs and the assets used to fund it.

9.4.3: Reporting Contingencies

Contingencies are reported as liabilities if it is probable they will incur a loss, and their amounts can be reasonably estimated.

Learning Objective

Summarize how contingencies are reported on the financial statements

Key Points

• A loss contingency is not reported if it can not be recognized due to improbability (not more than 50% likely to occur) and/or the amount of the loss can not be reliably measured or estimated. Gain contingencies are reported on the income statement when they are realized (earned).
• A probable contingency is defined as more than 50% likely to occur because there was a past obligating event.
• If a probable loss can be estimated based on historical information, then it can be reliably measured.

Key Terms

product warranty

In retail, a guarantee of the reliability of a product under conditions of ordinary use; should the product malfunction within a stipulated amount of time after the purchase, the manufacturer or distributor is typically required to provide the customer with a replacement, repair, or refund.

obligation

A legal agreement stipulating a specified payment or action; the document containing such agreement.

Reporting Contingencies

Loss Contingencies and Liabilities

Contingencies are reported as liabilities on the balance sheet and/or disclosed in the notes to the financial statements when it is probable they will incur a loss and when the loss can be reasonably estimated.

Probability

Probable is defined as more than 50% likely to occur due to a past obligation. The past obligating event defines a future payment event as a payment due on a specific date from the company, who is linked to an obligating event by a specific agreement.

Loss Contingency

A loss contingency is not reported if:

• A loss contingency is less than 50% likely to occur due to a past obligation.
• The amount of the loss can not be reliably measured or estimated.

Gain Contingency

Gain contingencies are reported on the income statement when they are realized (earned).

Funds may be lost due to contingent liabilities.

Conservative accounting principles state that companies should report loss contingencies as they occur.

Estimating a Loss Contingency

Reliability

A probable loss contingency can be measured reliably if it can be estimated based on historical information. For example, to accrue a provision for product warranty costs, assume that minor repairs cost 5% of the total product sales and an estimated 5% of products may require minor repairs within 1 year of sale. Major repairs cost 20% and 1% of products may require major repairs in 3 years.

Car Repairs

Cars require regular maintenance. Such contingent liabilities can be estimated reliably based on historical cost and readily available information.

Provision Estimation

The provision is calculated by multiplying 5% of total product cost by 5% of products needing minor repair and then adding 20% of cost for major repair, multiplied by 1% of products needing major repair.

5% x 5% + 20 % x 1% (of budgeted total sales)

A warranty expense is debited for the provision amount that will offset product sales revenue in the income statement and a credit is posted to warranty provision liability. The amount for repairs occurring in year one is reported in the current liability section of the balance sheet; the portion relating to major repairs in three years is disclosed as long-term liability. As the warranty claims are made, the liability account is debited and cash is credited for the cost of the repair. The long-term liability warranty provision is moved to the current liability section in the accounting period occurring three years after the product sale.

9.4.4: Current Ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.

Learning Objective

Explain how a company would use the current ratio

Key Points

• The current ratio is calculated by taking total current assets and dividing by total current liabilities. The ratio is an indication of a firm’s market liquidity and ability to meet creditor’s demands.
• Acceptable current ratios vary from industry to industry and are generally between 1.5% and 3% for healthy businesses. If a company’s current ratio is in this range, then it generally indicates good short-term financial strength.
• If the value of a current ratio is considered high, then the company may not be efficiently using its current assets, specifically cash, or its short-term financing options. A high current ratio can be a sign of problems in managing working capital.
• When a current ratio is low and current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations (current liabilities).

Key Terms

current ratio

current assets divided by current liabilities

current liabilities

obligations of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer

liquidity

An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.

creditor

A person to whom a debt is owed.

Current & Financial Ratios

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm’s current assets to its current liabilities. Along with other financial ratios, the current ratio is used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10% .

Ratios can be used to analyze financial trends.

The current ratio can be use to evaluate a company’s liquidity.

The current ratio is calculated by taking total current assets and dividing by total current liabilities.

Uses for Current Ratio

The ratio is an indication of a firm’s market liquidity and ability to meet creditor’s demands. Acceptable current ratios vary from industry to industry and are generally between 1.5% and 3% for healthy businesses.

If a company’s current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations (current liabilities).

High vs. Low Current Ratio

If the value of a current ratio is considered high, then the company may not be efficiently using its current assets, specifically cash, or its short-term financing options. A high current ratio can be a sign of problems in managing working capital (what is leftover of current assets after deducting current liabilities). While a low current ratio may indicate a problem in meeting current obligations, it is not indicative of a serious problem. If an organization has good long-term revenue streams, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio of less than one. For example, when inventory turns over more rapidly than accounts payable becomes due, the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

9.4.5: Acid Test Ratio

The acid-test, or quick ratio, measures the ability of a company to use its near cash or quick assets to pay off its current liabilities.

Learning Objective

Describe how a company uses the acid test ratio

Key Points

• The acid-test ratio is calculated by adding cash, cash equivalents, marketable securities, and accounts receivable. The sum is then divided by current liabilities.
• Generally, the acid test ratio should be 1:1 or higher; however, this varies widely by industry. In general, the higher the ratio is, the greater the company’s liquidity (i.e., the better able to meet current obligations using liquid assets).
• The acid-test ratio, like other financial ratios, is a test of viability for business entities but does not give a complete picture of a company’s health.

Key Terms

liquidity

An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.

inventory

A detailed list of all of the items on hand.

Acid-Test and Financial Ratios

The acid-test ratio, also known as the quick ratio, measures the ability of a company to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include the current assets that can presumably be quickly converted to cash at close to their book values. The numerator of the ratio includes “quick assets,” such as cash, cash equivalents, marketable securities, and accounts receivable.

The acid-test ratio, like other financial ratios, is a test of viability for business entities but does not give a complete picture of a company’s health. For example, if a business has large amounts in accounts receivable which are due for payment after a long period (say 120 days) and essential business expenses and accounts payable are due for immediate payment, the quick ratio may look healthy when the business is actually about to run out of cash. In contrast, if the business has negotiated fast payment terms with customers and long payment terms from suppliers, it may have a very low quick ratio yet good liquidity .

A low acid-test ratio may be a sign of poor use of cash by a business.

The acid-test ratio is similar to the current ratio except the value of inventory is omitted from the calculation.

Uses of Acid-Test Ratio

The acid-test ratio is calculated by adding cash, cash equivalents, marketable securities, and accounts receivable. The sum is then divided by current liabilities. Note that the calculation omits inventory and a different version of the formula involves subtracting inventory from current assets and dividing by current liabilities. Generally, the acid test ratio should be 1:1 or higher; however, this varies widely by industry. In general, the higher the ratio is, the greater the company’s liquidity (i.e., the better able to meet current obligations using liquid assets). A company with a quick ratio of less than 1 cannot currently pay back its short-term liabilities.

9.4.6: Working Capital Management Analysis

Working capital is a financial metric that represents the operational liquidity of a business, organization, or other entity.

Learning Objective

Identify working capital and discuss how a company would use it

Key Points

• Net working capital is calculated as current assets minus current liabilities. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
• Cash flows can be evaluated using the cash conversion cycle — the net number of days from the outlay of cash for raw material to receiving payment from the customer.
• Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.

Key Terms

discounted cash flows

A method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

deficiency

Inadequacy or incompleteness.

Definition of Working Capital

Working capital (abbreviated WC) is a financial metric that represents the operational liquidity of a business, organization, or other entity. Along with fixed assets, such as property, plant, and equipment, working capital is considered a part of operating capital. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. A company can be endowed with assets and profitability but short on liquidity if its assets cannot be converted into cash .

If money grew on trees, companies would never have a working capital shortage.

Sufficient working capital ensures a company is able to meet its short term obligations.

Uses of Working Capital

Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital commonly used in valuation techniques such as discounted cash flows (DCFs). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. The ability to meet the current portion of debt (payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.

Managing Working Capital

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Working capital management entails short-term decisions, usually relating to the next one-year period and are based in part on cash flows and/or profitability.

Evaluating Working Capital Management

Cash flows can be evaluated using the cash conversion cycle — the net number of days from the outlay of cash for raw material to receiving payment from the customer. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims for a low net count.

Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.

8.2: Debt Held to Maturity

8.2.1: Amortized Cost Method

Learning Objective

Explain how a company would apply the amortized cost method to a debt held to maturity

Key Points

• To find the the amortized acquisition cost the securities are amortized like a mortgage or a bond.
• All changes in market value are ignored for debt held to maturity.
• Debt held to maturity is classified as a long-term investment and it is recorded at the market value (original cost) on the date of acquisition.

Key Terms

acquisition

The thing acquired or gained; a gain.

maturity

Date when payment is due

Debt Held to Maturity

The definition of a debt is held-to-maturity is a debt which the company has both the ability and intent to hold until maturity. Debt held to maturity is classified as a long-term investment and it is recorded at the market value (original cost) on the date of acquisition. All changes in market value are ignored for debt held to maturity.

Debt held to maturity is shown on the balance sheet at the amortized acquisition cost. To find the amortized acquisition cost the securities are amortized like a mortgage or a bond.

Amortization Schedule

Debt held to maturity is shown on the balance sheet at the amortized acquisition cost. To find the amortized acquisition cost the securities are amortized like a mortgage or a bond.

Example:

Z company purchases 40,000 of the 8%, 5-year bonds of Tee Company for $43,412. The bonds provide a 6% return, with interested paid semiannually. Z Company has both the ability and intent to hold the securities until the maturity date.

The journal entry to record the purchase:

Investment in bonds debit ——— 40,000

Premium on bonds debit ———— 3,412

Cash credit ——————————43,412

The accounting records show the debt at the amortized cost (face amount plus premium/less discount) and the difference between the maturity value and the cost of the bonds is amortized to the income statement over the life of the bonds.

In order to record the interim interest revenue and report the investment on the balance sheet, it is necessary to prepare an amortization schedule for the debt.

The first interest payment is $1,600, but since the company paid a premium, the effective interest earned is $1,302 (net the amortization of the premium).

Example:

The Journal Entry:

Cash debit ———————$1,600

Premium on bonds credit —-$298

Interest revenue credit ——- 1,302

The Z Company’s investment in Tee company is shown on the balance sheet as follows:

Held-to-Maturity Investments

Corporate bonds —————— $40,000

Plus: unamortized premium —– 2,166

Book value (amortized cost)—- $42,166

8.2.2: Accounting for Interest Earned and Principal at Maturity

Learning Objective

Summarize the journal entry required to record a debt held to maturity

Key Points

• When money is borrowed, interest is typically paid to the lender as a percentage of the principal, the amount owed to the lender.
• Nominal, principal, par, or face amount is the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term.
• The issuer has to repay the nominal amount on the maturity date. As long as all due payments have been made, the issuer has no further obligations to the bond holders after the maturity date.

Key Terms

maturity date

the date on which a principal amount of a note, draft, acceptance bond, or other debt instrument becomes due or payable

maturity

Date when payment is due

Interest

The price paid for obtaining, or price received for providing, money or goods in a credit transaction, calculated as a fraction of the amount of value of what was borrowed.

Interest Defined

Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds.

When money is borrowed, interest is typically paid to the lender as a percentage of the principal, the amount owed to the lender. The percentage of the principal that is paid as a fee over a certain period of time (typically one month or year) is called the interest rate.

Principal At Maturity

Nominal, principal, par, or face amount —is the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate, or a fund. This can result in an investor receiving less or more than his original investment at maturity.

Principal is repaid at maturity

Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate, or a fund. This can result in an investor receiving less or more than his original investment at maturity

The issuer has to repay the nominal amount on the maturity date (which can be any length of time). As long as all due payments have been made, the issuer has no further obligations to the bond holders after the maturity date. The maturity can be any length of time, although debt securities with a term of less than one year are generally

Accounting for Interest Earned and Principal at Maturity

During the life of the debt held to maturity, the company holding the debt will record the interest received at the designated payment dates.

Journal
entry

Debit cash

Credit interest revenue

If a company paid $10,000 for 8% bonds, a journal entry is required to record the payment of principal at maturity.

Journal entry

Debit cash $10,000

Credit held to maturity investments $10,000

Remember the original entry debited the held to maturity investment account and credit cash.

8.3: Debt for Sale

8.3.1: Accounting for Sale of Debt

How debt sales are recorded depends on whether the debt is classified as “held-to-maturity,” “a trading security,” or “available-for-sale”.

Learning Objective

Summarize how to record the sale of a held-to-maturity, trading security and available for sale debt

Key Points

• Because of fluctuations in market value, held-to-maturity debt is not periodically adjusted while owned. Recording the sale is simply a matter of recording how much cash was received and recording any gain or loss from the transaction.
• The book value of trading security debt changes based on its market value. Any increase or decrease in the value of the debt is recorded as an unrealized gain or loss in a company’s income statement. Any gain or loss from the sale is based on the current book value of the debt.
• The book value of available-for-sale debt changes based on market value. Any increase/decrease in the value of the debt is recorded as an unrealized gain/loss in equity. When debt is sold, the company should recognize all unrecognized gain/loss, and the gain/loss based on the current book value.

Key Terms

trading securities

any financial instrument an investor acquires and intends to resell in the short-term

available-for-sale

securities that do not qualify as “held-to-maturity” or as a “trading security”

Held-to-maturity

any security that an investor intends to retain until its term expires

Under FASB 115, a part of US GAAP (Generally Accepted Accounting Principles), a company must classify all of the debt securities it owns into one of three categories. If the company intends to hold the debt until it matures, it must be classified as a “held-to-maturity” security. If the company acquires the debt with the intent to resell it in the short-term, then it must be listed as a “trading security. ” If the debt is acquired without the intent to resell it in the short-term, nor the intent to hold it to maturity, it should be classified as “available-for-sale” . Each of these three classifications is treated differently for accounting purposes, both prior to sale and during the sale.

A bond certificate

A bond certificate issued via the South Carolina Consolidation Act of 1873. How the sale of a bond is recorded on a company’s books depends on how the debt is initially classified by the acquiring investor. Debt securities can be classified as “held-to-maturity,” a “trading security,” or “available-for-sale. “

Held-to-Maturity

When debt is acquired and is intended to be held until maturity, it is recorded first by debiting a “Debt Investment Account,” and then by crediting “Cash” for the amount the debt was purchased. For example, if a company purchased $1000 in debt securities, the transaction would be recorded like this:

Investments – Corporate Debt : $1000

Cash : $1000.

While the market value of the debt may vary over time, the company does not need to adjust the value of the debt on its books. Once the company sells the bond, it must report any gains or losses on the sale of the debt. So, in the example above, if the company sold the debt for $1200, it would need to make the following journal entry.

Investments : $1000

Net Gain on Sale : $200

Cash : $1200

If the company sold the debt for $800, it would need to make the following journal entry:

Investments : $1000

Cash : $800

Net Loss on Sale : $200

Trading Securities

If a company acquires debt that it intends to sell in the short-term, it must still record the sale. If a company acquired debt for $1000, and this debt is classified as a trading security, the company would still need to make the first journal entry in the aforementioned manner.That being said, the value of the debt on the owner’s books must be adjusted to match the market value of the debt. For example, if the market value of the debt declined $200 from its original value to $800, a company would need to make the following journal entry:

Unrealized loss on trading security : $200

Investments : $200

The unrealized loss would be included on the company’s income statement for the period it was recorded. If immediately after the accounting period, the company sold the debt for $800, it would need to make the following journal entry:

Cash : $800

Investments : $800

Because both the loss and the decrease in the debt asset’s value were already recorded in the prior accounting period, the company would not have to make any additional adjustments.

Available-for-Sale

If a company acquires debt that is available-for-sale, it would still need to make a first journal entry in the same way that it would if the debt was “held-to-maturity” or a “trading security. ” It would also need to adjust the value of its debt asset in relation to its current market value. Using the same example above, assume a debt asset was acquired for $1000 but declined in value by $200. In the case of an available-for-sale asset, the following journal entry should be made in the following accounts:

(Equity) Unrealized loss on security investment : $200

(Asset) Investments : $200

Unlike trading securities, the unrealized gain is recorded in the equity section of the balance sheet and does not effect the current year income statement at all. This is because, unlike trading securities, the loss from an available-for-sale security is not expected to be realized in the near future. Returning to the example, assume that the debt asset is sold immediately after the end of the accounting period where it first recognized the unrealized loss. The asset is sold for $800. In such a case, the following entries would be appropriate:

(Asset) Cash : $800

(Income Statement) Loss on Investment : $200

(Asset) Investments : $800

(Equity) Unrealized loss on security investment : $200

The result of the journal entry is that the unrealized loss is realized, so the company’s profit for the period is decreased by $200. The debt asset, as well as the unrealized loss, is removed from the company’s books.

8.3.2: Accounting for Sale of Stock

How the stock sale is accounted for depends on the type of stock sold.

Learning Objective

Summarize how to account for the sale of common stock, preferred stock and treasury stock

Key Points

• For common stock at par value, debit cash and credit common stock. For common stock sold above par, debit cash, credit common stock, and credit additional paid in capital.
• For preferred stock, debit cash and credit preferred stock.
• For sales of treasury stock, debit cash and credit treasury stock.

Key Terms

preferred

Preferred stock.

par value

The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

Accounting for the Sale of Stock

Often times companies offer their stock for sale as a way to generate cash. How the stock sale is accounted for depends on the type of stock sold. Most stock sales involve common stock or preferred stock.

Sale of Stock.

Often times companies offer their stock for sale as a way to generate cash. How the stock sale is accounted for depends on the type of stock sold. Most stock sales involve common stock or preferred stock.

Common Stock-sold at par value

Journal
entry

Debit cash

Credit common stock

If the common stock is sold above par value the journal entry is slightly different.

Debit cash

Credit common stock

Credit additonal paid in capital (to account for the difference between par value and sell value)

Preferred Stock

The sale of preferred stock is similarly treated, but a separate accounts should be established to record preferred stock and any additional paid in capital for preferred stock sold at above par value.

Journal entry

Debit cash

Credit preferred stock

Credit additional paid in capital preferred stock (if needed)

Treasury stock

Treasury stock is issued stock that the company has bought back from its shareholders. Since a corporation can’t be its own shareholder, the “bought back” stocks are not considered assets of the corporation. Treasury stock also doesn’t have the right to vote, receive dividends or receive liquidation value.

If the company plans to re issue the shares in the future, it would hold them in treasury and report the reduction in stockholder’s equity on the balance sheet.

There are several reasons a company may purchase treasury stock, it may need it for employee compensation plans, to buy another company or to reduce the number of outstanding shares.

Journal entry

Debit treasury stock

Credit cash

When treasury stock is sold the accounts used to record the transaction will vary depending on whether the stock sold above or below the cost of purchase.

Sold above purchase cost

Debt cash

Credit treasury stock

Credit additional paid in capital (the difference between sale price and purchase price)

8.3.3: Assessing Fair Value

Companies must calculate the fair market value for these available for sale securities at the end of each subsequent accounting period.

Learning Objective

Explain why a company calculates the fair market value of available for sale securities

Key Points

• The difference between the purchase price and the current fair market value results in a an unrealized gain or loss.
• Realized gains and losses are included in income; unrealized amounts are included in income (trading investments) or in other comprehensive income (available-for-sale investments).
• Unrealized holding gains (unrealized because asset is not sold yet)-increase in fair value of an asset while held.
• Realized holding gain (realized through sale) increase in fair value of an asset while held.

Key Term

unrealized

Not realized; possible to obtain, yet not obtained.

Fair Value Method

Often companies use excess cash to purchase stocks and bonds from other companies. If a company purchases stocks or bonds with the intent to sell these items at a future date when they need cash, these are referred to as “Available-for-sale securities”.

A company initially records the “available for sale securities” at cost. While holding onto the securities the company must calculate the fair market value for these securities at the end of each subsequent accounting period.

Debt

A company initially records the “available for sale securities” at cost. While holding onto the securities the company must calculate the fair market value for these securities at the end of each subsequent accounting period.

The difference between the purchase price and the current fair market value results in an unrealized gain or loss. The unrealized gain or loss affects the company’s accumulated other comprehensive income, a component of stockholders’ equity.

Realized gains and losses are included in income; unrealized amounts are included in income (trading investments) or in other comprehensive income (available-for-sale investments).

Unrealized holding gains (unrealized because asset is not sold yet)-increase in fair value of an asset while held.

Realized holding gain (realized through sale) increase in fair value of an asset while held.

Using the fair value method, available for sale investment with unrealized gains and losses included in other comprehensive income should have:

• The original investment is recorded at its investment cost.
• Transaction costs, such as brokerage fees, included in acquisition cost and capitalized, or immediately expensed.
• Interest or dividends declared are recorded as investment income.
• Interest income includes amortization of any premium or discount inherent in the initial purchase price
• At the end of each reporting period, the investments are revalued to fair value (market
• value), whether this is higher or lower than the existing balance in the investment account.
• Unrealized holding gains, defined as the difference between the existing balance in the
• investment account (the new fair value) and the old fair value, are recorded in other comprehensive income.
• The investment is reported at fair value on the balance sheet.

Using the fair value method, available for sale investment with unrealized gains and losses recognized in net income should have:

• The original investment is recorded at its investment cost. This is fair value on the purchase date.
• Transaction costs, such as brokerage fees, may be included in acquisition cost and capitalized, or immediately expensed.
• Interest or dividends declared are recorded as investment income.
• At the end of each reporting period, the investments are revalued to fair value, whether
• this is higher or lower than the existing balance in the investment account.
• Holding gains, defined as the difference between the existing balance in the investment
• account (the new fair value) and the old fair value, are recorded in net income.
• The investment is reported at fair value on the balance sheet.

8.4: Holding Less than 20% of Shares

8.4.1: Fair Value Method

The ownership of less than 20% creates an investment position carried at fair market value in the investor’s balance sheet.

Learning Objective

Explain how the Fair Value Method is used to calculate the value of holding of less than 20%

Key Points

• Fair market value (FMV) is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market.
• An estimate of Fair Market Value is usually subjective due to the circumstances of place, time, the existence of comparable precedents, and the evaluation principles of each involved person.
• The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
• For assets carried at historical cost, the fair value of the asset is not used.

Key Terms

book value

The value of an asset as reflected on an entity’s accounting books, net of depreciation, but without accounting for market value appreciation.

fair market value

The price at which the buyer and seller are willing to do business.

eminent domain

(US) The right of a government over the lands within its jurisdiction. Usually invoked to compel land owners to sell their property in preparation for a major construction project such as a freeway.

Fair Value Method

The ownership of less than 20% creates an investment position carried at historic book value or fair value (if available for sale or held for trading) in the investor’s balance sheet.

In accounting, fair value (also knows as “fair market value”) is used as a certainty of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used.

A gold nugget

Fair market value (FMV) is an estimate of the market value of a property.

Since market transactions are often not observable for assets such as privately held businesses and most personal and real property, fair value must be estimated. An estimate of fair value is usually subjective due to the circumstances of place, time, the existence of comparable precedents, and the evaluation principles of each involved person. Opinions on value are always based upon subjective interpretation of available information at the time of assessment. This is in contrast to an imposed value, in which a legal authority (law, tax regulation, court, etc.) sets an absolute value upon a product or a service.

A property sale, in lieu of an eminent domain taking, would not be considered a fair market transaction since one of the parties (i.e., the seller) was under undue pressure to enter into the transaction. Other examples of sales that would not meet the test of fair market value include a liquidation sale, deed in lieu of foreclosure, distressed sale, and similar types of transactions.

In United States tax law, the definition of fair value is found in the United States Supreme Court decision in the Cartwright case: the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

The term fair market value is used throughout the Internal Revenue Code among other federal statutory laws in the USA including bankruptcy, many state laws, and several regulatory bodies.

8.4.2: Calculating Fair Value

Calculating fair value involves considering objective factors including acquisition, supply vs. demand, actual utility, and perceived value.

Learning Objective

Summarize how to calculate fair value for holdings of less than 20%

Key Points

• Fair value, also called “fair price”, is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.
• In accounting, a three-level framework is used to calculate an asset or liability’s fair value — Level 1 is based on quoted market prices, Level 2 is based on estimated market observables, and Level 3 uses unobservable inputs derived internally by the company.
• Under US GAAP, when purchasing less than 20% of a company’s stock, the cost method is used to account for the investment.
• As required by FAS 115, investments accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable.

Key Terms

supply vs. demand

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium of price and quantity.

return on capital

Return on capital (ROC) is a ratio used in finance, valuation, and accounting. The ratio is estimated by dividing the after-tax operating income (NOPAT) by the book value of invested capital.

Example

• An example of how to determine fair value can involve the purchase of company shares of less than 20% total equity — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000.

Determining Fair Value

Fair value, is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:

Fair value

Fair value is defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.

• acquisition/production/distribution costs, replacement costs, or costs of close substitutes
• actual utility at a given level of development of social productive capability
• supply vs. demand
• subjective factors such as: risk characteristics; cost of and return on capital; individually perceived utility

In accounting, fair value is used as an approximation of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). When an active market does not exist other methods have to be used to estimate the fair value. Assumptions used to estimate fair value should be from the perspective of an unrelated market participant. This necessitates identification of the market in which the asset or liability trades. If more than one market is available, the “most advantageous market” should be used. Both the price and costs to do the transaction must be considered in determining which market is the most advantageous market.

A three-level framework is used to determine an asset or liability’s fair value:

1. Level One — The preferred inputs to valuation are “quoted prices in active markets for identical assets or liabilities,” with the caveat that the reporting entity must have access to that market. An example would be a stock trade on the New York Stock Exchange. Information at this level is based on direct observations of transactions involving the identical assets or liabilities being valued.
2. Level Two — This valuation is based on market observables. FASB indicates that assumptions enter into models that use Level 2 inputs, a condition that reduces the precision of the outputs (estimated fair values), but nonetheless produces reliable numbers that are representationally faithful, verifiable and neutral.
3. Level Three — The FASB describes Level 3 inputs as “unobservable.” If observable inputs from levels 1 and 2 are not available, the entity may only rely on internal information if the cost and effort to obtain external information is too high. Within this level, fair value is also estimated using a valuation technique. Significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and are based on internal information. This category allows “for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties or transferred to an equivalent party other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used.

An example of how to determine fair value can involve the purchase of company shares of less than 20% total equity — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000.

Adjusting Fair Value

As required by FAS 115, investments accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable. Adjustments are debited (for gains in fair value) or credited (for losses) to a fair value adjustment account that will adjust the investment account balance to its fair value at the end of the reporting period.

If the investment is considered a “trading security” or stock purchased for the purpose of selling it in the near term, the balancing debit or credit is charged to an unrealized loss or gain account. If the investment is an “available for sale” security, the balancing debit or credit also goes to an unrealized loss or gain account. For investments where the fair value is not readily determinable, the investment is carried at cost.

8.4.3: Reporting Fair Value

Stock investments of 20% or less are recorded at cost (considered its fair value) and reported as an asset on the balance sheet.

Learning Objective

Explain how to record stock investments of less than 20% using Fair Value

Key Points

• Fair value accounting, also known as mark-to-market accounting, can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value.
• Ownership of less than 20% of a company’s stock dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions are made.
• Dividends declared on investments of less than 20% equity are reported as current assets on the balance sheet and other income on the income statement.

Key Terms

journal entry

A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).

Example

• The following is an example of how to report investments of less than 20% of shares — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000. The investment in XYZ Corporation is reported at cost in the asset section of the balance sheet. If the investee declares dividends, the investor records a journal entry for their share of the investment. Assume XYZ Corporation declares a dividend of USD 1 per share. ABC records a journal entry debiting Dividends Receivable for USD 50,000 and crediting Dividend Income for USD 50,000. The Dividend Receivable is reported on the balance sheet under current assets and Dividend Income is reported on the income statement under a section for other income.

Fair Value Accounting and Financial Statements

Fair value accounting, also known as mark-to-market accounting, can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions instead. Mark-to-market accounting can become inaccurate if market prices fluctuate greatly or change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to value the future income and expenses on the income statement accurately and collectively, often due to unreliable information, or overly-optimistic/ overly-pessimistic expectations.

Reporting Stock Investments of Less Than 20% of Shares

Ownership of less than 20% of a company’s stock dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions affecting the company are made. Ownership of this quantity of stock is recorded using the cost method.

The following is an example of how to report investments of less than 20% of shares — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000. The investment in XYZ Corporation is reported at cost in the asset section of the balance sheet.

If the investee declares dividends, the investor records a journal entry for their share of the investment. Assume XYZ Corporation declares a dividend of USD 1 per share. ABC records a journal entry debiting Dividends Receivable for USD 50,000 and crediting Dividend Income for USD 50,000. The Dividend Receivable is reported on the balance sheet under current assets and Dividend Income is reported on the income statement under a section for other income.

Reporting Adjustments in Fair Value

As required by FAS 115, the value of an investment accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable. Changes in fair value are debited (for gains in fair value) or credited (for losses) to a fair value adjustment account reported on the balance sheet to adjust the investment account balance to its end of period fair value.

If the investment is considered a “trading security” or stock purchased for the purpose of selling it in the near term, the balancing debit or credit is charged to an unrealized loss or gain reported on the income statement. If the investment is an “available for sale” security, the balancing debit or credit goes to an unrealized loss or gain account reported in the other comprehensive income section of owner’s equity on the balance sheet. When the investment is sold, all losses or gains from the transaction become realized and flow through into the income statement to adjust revenues for the period.

8.5: Holding 20-50% of Shares

8.5.1: Equity Method

Equity method is the process of treating equity investments (usually 20–50%) of companies. The investor keeps such equities as an asset.

Learning Objective

Summarize how a company uses the Equity Method to record their investment in another company

Key Points

• Equity method in accounting is the process of treating equity investments, usually 20–50%, in associate companies. The investor keeps such equities as an asset.
• The investor’s proportional share of the associate company’s net income increases the investment; net loss, and proportional payment of dividends, decreases it.
• Typically, equity holders receive voting rights on certain issues, residual rights, meaning that they share the company’s profits, and are allowed to recover some of the company’s assets in the event that it folds (although they generally have the lowest priority in recovering their investment).

Key Terms

Pension funds

A pension fund is any plan, fund, or scheme which provides retirement income.

mutual funds

A mutual fund is a type of professionally-managed collective investment vehicle that pools money from many investors to purchase securities.

Equity method in accounting is the process of treating equity investments, usually 20–50%, in associate companies. The investor keeps such equities as an asset. The investor’s proportional share of the associate company’s net income increases the investment; a net loss, or proportional payment of dividends, decreases the investment. In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item .

Equity

Investors keep equities as assets using equity method.

An equity investment generally refers to the buying and holding of shares of stock by individuals and firms in anticipation of income from dividends and capital gains. Typically, equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a proxy statement received by the investor) as well as certain major transactions. Equity holders also receive residual rights, meaning that they share the company’s profits, as well as the right to recover some of the company’s assets in the event that it folds—although they generally have the lowest priority in recovering their investment. It may also refer to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup company. When the investment is in infant companies, it is referred to as venture capital investing and is generally regarded as a higher risk than investment in listed going-concern situations.

Equities held by private individuals are often held as mutual funds or as other forms of collective investment schemes, many of which have quoted prices that are listed in financial newspapers or magazines. Mutual funds are typically managed by prominent fund management firms, such as Schroders, Fidelity Investments, or The Vanguard Group. Such holdings allow individual investors to obtain diversification of the fund(s) and to make use of the skill of the professional fund managers in charge of the fund(s). An alternative, which is usually employed by large private investors and pension funds, is to hold shares directly. In the institutional environment, many clients who own portfolios have what are called segregated funds, as opposed to or in addition to the pooled mutual fund alternatives.

A calculation can be made to assess whether an equity is over- or under-priced, compared with a long-term government bond. This is called the Yield Gap or Yield Ratio. It is the ratio of the dividend yield of an equity and that of the long-term bond.

8.5.2: Assessing Control

20-50% of overall shares in a firm is referred to as a minority interest, which is a non-controlling position from a strategic frame.

Learning Objective

Understand the role minority interest shareholders hold in decision-making, and the accounting method used to report it

Key Points

• Holding company shares in an organization technically imparts voting rights to the shareholder, though the percentage of the organization owned impacts the scale of this influence.
• Ownership between 20-50% is referred to as a minority interest in the organization, and must be reported using the equity method.
• In regards to control, minority interest is a not a controlling position in the firm. In most situations, 51% ownership is required (majority).
• However, a minority interest stakeholder may be consulted on certain strategic decisions and may be on the board of directors.

Key Term

minority interest

Ownership between 20-50% in an organization.

Holding shares in an organization grants a certain level of voting rights and ownership of that organization. This becomes particularly relevant when ownership of the firm reaches or exceeds 20% of the overall value of the organization. Over 50% ownership indicates an actual transfer of ownership, often recorded as a subsidiary by the owning party.

The space between 20% and 50% has specific guidelines in regards to reporting, ownership, and the assessment of control. This is referred to as an associate company, and must be reported utilizing the equity method.

The Equity Method

This is the method used to record an investment at the level of an associate company (20-50% ownership). This is considered an asset on behalf of the investor, and reported accordingly. An investment’s percentage ownership of the company appreciates when the net income increases and depreciates when it decreases. This share is reported on the investor’s income statement as a single-line item.

Assessing Control

Control of an organization is in the hands of the owners. The owners, in most publicly traded situations, are represented by the individual who hold significant percentages of the overall organization’s value. In a situation where an individual or organization owns more than 20% and less than 50% of the overall shares, this control is referred to as a minority interest.

Minority Interest

Owning 50% or more of the shares is a majority interest, granting the owner volume control over significant organizational decisions. However, a minority interest is still a primary shareholder that will (in most situations) have influence on the decisions being made at the strategic level.

Generally speaking, minority interest is still non-controlling interest. 51% is required to make substantial decisions regarding the organization itself. That being said, a minority interest is still a significant share of the organization. As a result, it is not uncommon for minority interest shareholders to hold a seat on the board of directors, or to be consulted regarding the decisions.

Intel Board of Directors

This image is from Intel’s Board of Directors.

This image is from Intel’s Board of Directors.

8.5.3: Reporting Equity Investments

Investments recorded under the equity method usually consist of stock ownership of a company between 20% to 50%.

Learning Objective

Explain why a company would use the Equity Method to determine how to report their 20-50% investment

Key Points

• When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company’s influence over the acquired company is often significant and the investor participates in business decision-making.
• Under the equity method, the purchaser records its investment at the original cost. The balance of the investment increases by the pro-rata share of the investee’s income and decreases by the pro-rata share of dividends declared by the subsidiary.
• At the time of purchase, goodwill can arise from the difference between the cost of the investment and the book value of the underlying assets.

Key Terms

pro forma income

a statement of the company’s revenue while excluding “unusual and nonrecurring transactions” when stating how much money the company actually made

pro-rata

in proportion to some other factor, such as shares owned

FASB

The Financial Accounting Standards Board (FASB) is a private, not-for-profit organization whose primary purpose is to developgenerally accepted accounting principles (GAAP) within the United States in the public’s interest.

Reporting Stock Investments of 20-50% of Equity

When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company’s influence over the acquired company is often significant. The deciding factor, however, is significant influence or the ability for the investor to have a say in business decisions made by company owners. If other factors exist that reduce the influence, or if significant influence is gained at an ownership of less than 20%, the equity method may be appropriate. FASB interpretation 35 (FIN 35) underlines the circumstances where the investor is unable to exercise significant influence).

To account for this type of investment, the purchasing company uses the equity method. Under the equity method, the purchaser records its investment at the original cost. The balance of the investment increases by the pro-rata share of the investee’s income and decreases by the pro-rata share of dividends declared by the subsidiary.

An example of how to apply the equity method to a stock investment — assume ABC Corporation purchases 30% of XYZ Corporation (or 80,000 shares) and can exercise significant influence. The market price of the stock is USD 1. At the end of 201X, XYZ earns net income of 100,000 and declares a dividend of USD 1 per share. The following journal entries are made by ABC to record the investment in XYZ:

Journal entry for the stock investment purchase:

• DR – Investment in XYZ Corporation USD 80,000 (80,000 shares * USD 1 market price/share)
• CR – Cash USD 80,000

Journal entry to account for the pro-rata share of XYZ annual income:

• DR – Investment in XYZ Corporation USD 30,000 (100,000 net income * .30)
• CR – Equity in XYZ Corp. Income USD 30,000

Journal entry to account for the pro-rata share of XYZ dividends:

• DR – Dividends Receivable 80,000 (80,000 shares * USD 1 dividend per share)
• CR – Investment in XYZ Corporation 80,000

Goodwill and Equity Investments

At the time of purchase, goodwill can arise from the difference between the cost of the investment and the book value of the underlying assets. The component that can give rise to goodwill is: the difference between the fair market value of the underlying assets and their book value .

Goodwill

Goodwill is an accounting concept meaning the excess value of an asset acquired over its book value due to a company’s competitive advantages.

Goodwill is no longer amortized under U.S. GAAP (FAS 142) of June 2001. Companies objected to the removal of the option to use pooling-of-interests, so amortization was removed by the Financial Accounting Standards Board as a concession. As of January 1, 2005, it is also forbidden under International Financial Reporting Standards. Goodwill can now only be impaired under these GAAP standards.

To test goodwill for impairment, companies are now required to determine the fair value of the reporting units, using the present value of future cash flow, and compare it to their carrying value (book value of assets plus goodwill minus liabilities). If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so that the fair value is equal to the carrying value. The impairment loss is reported as a separate line item on the income statement, and the new adjusted value of goodwill is reported in the balance sheet.

8.6: Holding More than 50% of Shares (Ownership)

8.6.1: Reporting for a Combined Entity

When the amount of stock owned is >50% of common stock, a parent-subsidiary relationship is formed that requires consolidated reporting.

Learning Objective

Explain how to report for a combined entity

Key Points

• A subsidiary company, or daughter company is a company that is completely or partly owned and partly or wholly controlled by another company that owns more than half of the subsidiary’s stock.
• Consolidated financial statements show the parent and subsidiary as one single entity. During the year, the parent company uses the equity method to account for its investment. At the end of the year, a consolidation working paper eliminates intercompany transactions between parent and subsidiary.
• As of 2004, the acquisition method is the only allowable method that can be used to prepare consolidated financial statements for companies that combined after 2004. Other consolidation methods previously used were the purchase and the pooling of interests methods.

Key Term

state-owned enterprise

A government-owned corporation, state-owned company, state-owned entity, state enterprise, publicly owned corporation, government business enterprise, commercial government agency,public sector undertaking or parastatal is a legal entity created by a government to undertake commercial activities on behalf of an owner government.

Reporting for a Combined Entity

The ownership of more than 50% of voting stock creates a subsidiary. The financial statements of the parent and subsidiary are consolidated for reporting purposes.

A subsidiary company, or daughter company is a company that is completely or partly owned and partly or wholly controlled by another company that owns more than half of the subsidiary’s stock. The subsidiary can be a company, corporation, or limited liability company. In some cases it is a government or state-owned enterprise. The controlling entity is called its parent company, parent, or holding company.

An operating subsidiary is a business term frequently used within the United States’s railroad industry. In the case of a railroad, it refers to a company that is a subsidiary but operates with its own identity, locomotives, and rolling stock. In contrast, a non-operating subsidiary would exist on paper only (i.e. stocks, bonds, articles of incorporation) and would use the identity and rolling stock of the parent company.

When the amount of stock purchased is more than 50% of the outstanding common stock, the purchasing company usually has control over the acquired company. Control in this context is defined as ability to direct policies and management. In this type of relationship the controlling company is the parent and the controlled company is the subsidiary. The parent company needs to issue consolidated financial statements at the end of the year to reflect this relationship.

Consolidated financial statements show the parent and the subsidiary as one single entity. During the year, the parent company can use the equity or the cost method to account for its investment in the subsidiary. Each company keeps separate books. However, at the end of the year, a consolidation working paper is prepared to combine the separate balances and to eliminate the intercompany transactions between the parent and the subsidiary, along with the subsidiary’s stockholder equity and the parent’s subsidiary investment account. The result is one set of financial statements that reflect the financial results of the consolidated entity. As of 2004, the acquisition method is the only allowable method that can be used to prepare consolidated financial statements for companies that combined after 2004. Other consolidation methods previously used were the purchase and the pooling of interests methods .

The following is an example of how to calculate consolidated net income — assume ABC Corporation owns 80% of XYZ Corporation; the remaining 20% is a non-controlling ownership interest.

Net Income for 201X for ABC is USD 20,000 and for XYZ net income is USD 8,000. First, to arrive at consolidated net income for the two companies, ABC must eliminate the effect of the equity method used to account for its investment.

ABC’s net income for the year includes 80% of XYZ’s net income, or USD 6,400. This amount must be subtracted from the net income figure to arrive at 13,600 (20,000 – 6,400).

The consolidated net income for both companies after this adjustment is USD 21,600 (20,000 – 6,400 + XYZ’s total net income of 8,000). Second, the portion of net income attributed to the non-controlling ownership interest must be deducted, or USD 1,600 (8,000 * .20).

Therefore, consolidated income for ABC and its controlling interest in XYZ is USD 20,000 (21,600 – 1,600).