Financial Statements II

Document Sample
Financial Statements II Powered By Docstoc
					ACCOUNTING 201                                                                SEPT. 15, 2008

                  FINANCIAL STATEMENTS, Part II
I. Assets

A. Classification of assets on the balance sheet

Assets are generally shown on the balance sheet in order from most liquid (readily convertible to
cash) to least liquid:

Current assets
Assets consumed within the normal operating cycle of the business (usually one year): Examples
are cash, inventory, accounts receivable.

Long-term assets (non-current)
   • Investments: long-term investments in government instruments or securities of other firms.

   • Property, plant, and equipment (PPE)/ plant assets/ fixed assets: assets used in carrying out
   the operations of the firm.

   • Intangible assets: patents, trademarks, software development costs, franchise, and goodwill

Other distinctions that are important

(1) Monetary vs. Nonmonetary
Monetary assets are fixed in terms of currency by statute or contract (e.g., cash, accounts
receivable, and investments in some debt instruments). Current monetary assets are carried at
nominal value. Long-term monetary assets are carried at NPV (which reflects the time value of

Nonmonetary assets (e.g., inventory, equipment) are carried at historical cost (possibly adjusted
for use).

(2) Tangible vs. Intangible assets
Tangible assets have physical existence (e.g., cash, inventory, equipment)

Intangible assets do not have physical existence (e.g., accounts receivable, leasehold, patent,
purchase option).

ACCOUNTING 201                                                                SEPT. 15, 2008

B. Definition/Criteria for recognition

The critical challenge for financial reporting is to determine which types of “costs” qualify as
assets. The GAAP criteria for an asset are:

         - Resources are owned by the firm
         - Resources are expected to provide future benefits sufficient to recover their cost
         - The future economic benefits are measurable with a reasonable degree of certainty.

KEY POINT: Not all of the firm’s “assets” can be included on the balance sheet as an
accounting asset.

Examples of “assets” that do not meet the GAAP definition of an asset.

Human Capital
Firms spend resources for formal training typically in anticipation that it will have long-term
benefits for the firm such as increased productivity and/or product or service quality. Is the
training a GAAP asset? Which criteria are/are not met? If not an asset, how do firms record the
cost of training…cr. Cash and debit????

Everyone in the room knows the name “Coca-cola”. Such brand recognition is clearly an “asset”
to Coca-cola. Is it a GAAP asset? Which criteria are/are not met? If not an asset, how does
Coke record the cost of advertising, special promotions, and packaging activities that builds
brand name recognition…cr. Cash and debit????


1) Coca-Cola Inc. reports a book value of equity (i.e., GAAP assets – GAAP liabilities) of $8.4
billion. The market value of Coke’s equity is $165 billion. One reason for the difference is that
the “market” attributes value to the brand name recognition even though GAAP does not
recognize it as an asset, which deflates the book value relative to the market value.

2) In Australia and the U.K., firms are permitted to report brand assets on their books.

C. Valuation
Asset valuation depends on whether the asset is monetary or nonmonetary, purchased or
developed internally, current or noncurrent, etc. This course is devoted to studying the valuation
of various types of assets.


ACCOUNTING 201                                                                 SEPT. 15, 2008

II. Liabilities

A. Classification of liabilities on the balance sheet
Liabilities are generally shown on the balance sheet in order from earliest “due date” to latest (or
most uncertain) due date:

Current liabilities
Liabilities due within one year. Examples include accounts payable, interest payable, current
portion of long-term debt.

Long-term debt: bonds, mortgages payable, capitalized lease obligations.

Other long-term liabilities: pensions, deferred taxes.

B. Definition/Criteria for recognition
Liabilities are economic obligations that are required to be met with reasonable degree of
certainty and at a reasonably well-defined time in the future.

C. Valuation
(i) Monetary liabilities:
Current monetary liabilities are measured at their nominal value (the amount of cash needed to
discharge the obligation). Since the obligation must be met within a year, the nominal value is
close to the present value of the future cash outflows.

Noncurrent monetary liabilities are measured at the present value of future required cash flows.
The exception is deferred taxes.

(ii) Nonmonetary liabilities:
Nonmonetary liabilities may be measured either in terms of the expected cost to discharge the
obligation (e.g., warrants) or the amount of cash received in advance (e.g., advances from

KEY POINT: Not all of a firm’s obligations are on the balance sheet. The obligations that
are on the BS are not necessarily carried at the current cash cost of relieving the liability.

III. Owner’s Equity
Owners’ equity represents owners’ claims on the assets of the firm. For firms with publicly-
traded stock, shareholders represent the owners. Owners’ are the residual claimants on the firm’s
assets, after creditors (and bankruptcy costs…lawyers and accountants): OE = A – L

The amounts on the balance sheet for the specific owners’ equity accounts represent the amounts
recorded at the time the event occurred (e.g., when the firm initially sold shares, or when the firm
initially earned income). Thus, the account balances are the accumulation of amounts related to
events that may have occurred very early in the history of the firm. You cannot ascribe much
economic significance to the dollar amounts in the owners’ equity section of the balance sheet.

ACCOUNTING 201                                                                 SEPT. 15, 2008

However, from the amounts you can derive other information that is useful to generate
economically significant amounts or ratios.

Common components of owners’ equity:

        Common stock: the par or stated value (a legal term in state corporation law) of shares
        that the corporation has issued.

        Additional paid-in capital: amounts contributed by equity holders in excess of par or
        stated value.

        Retained earnings: accumulated earnings less dividends of the firm since its inception.

        Preferred stock: amount contributed by holders of preferred shares which represent a
        senior (to common stock) form of ownership.

        Treasury stock: common stock of the firm that has been repurchased from outside
        common shareholders and is owned by the firm.

IV. Events subsequent to the balance sheet date
A “subsequent event” is one that occurs after the financial statement date (e.g., December 31,
2003) but before the financial statements are filed with the SEC (e.g., March 1, 2004). When a
subsequent event occurs, the accounting issue is whether it is appropriate to:

        1) Adjust the numbers on the year t financial statements to reflect the year t+1 event.
        2) Disclose that the subsequent event occurred (e.g., in the footnotes) but do not adjust
           the numbers on the financial statements.
        3) Do nothing.

RULE: Adjust the period t financial statements if the event provides information that changes the
valuation of year t assets or liabilities. Example: Settlement in Spring 2000 of IRS claim for
1999 tax adjustments. Do not adjust the financial statements if the event does not affect year t
assets and liabilities. If it is material, however, disclose it. Example: Major acquisition.

Types of subsequent events and frequency of occurrence (600 companies surveyed):

                                                                        2001               2000
Debt incurred, reduced or refinanced                                     83                 72
Business combinations pending or effected                                72                 63
Discontinued operations                                                  50                 33
Litigation                                                               30                 31
Capital stock issued or purchased                                        20                 16
Employee benefits                                                        12                  4
Reorganization/bankruptcy                                                11            Not compiled
Stock splits or dividends                                                7                   5
Stock purchase rights                                                    5                   2
Other-described                                                          76                 84

ACCOUNTING 201                                                                              SEPT. 15, 2008

The first example illustrates the reporting for a debt issuance after the balance sheet date (11-30-
2001). The debt issuance is not recorded even though the shelf registration existed prior to the
balance sheet date. The transaction is disclosed.
   KB Home, 11-30-2001
   On December 14, 2001, pursuant to the 1997 Shelf Registration, the Company issued $200,000,000 of
   8-5/8% senior subordinated notes at 100% of the principal amount of the notes. The notes, which are
   due December 15, 2008, with interest payable semi-annually, represent unsecured obligations of the
   Company and are subordinated to all existing and future senior indebtedness of the Company. Before
   December 15, 2004, the Company may redeem up to 35% of the aggregate principal amount of the
   notes with the net proceeds of one or more public or private equity offerings at a redemption price of
   108.625% of their principal amount, together with accrued and unpaid interest. The notes are not
   otherwise redeemable at the option of the Company. The Company used $175,000,000 of the net
   proceeds from the issuance of the notes to redeem all of its outstanding 9-3/8% senior subordinated
   notes due 2003. The remaining net proceeds were used for general corporate purposes.

   The 2001 Shelf Registration for $500,000,000 filed on October 15, 2001 was at that time intended to
   combine with $250,000,000 of capacity then remaining under the 1997 Shelf Registration to provide
   the Company with a total issuance capacity of $750,000,000. However, the issuance of the
   $200,000,000 8-5/8% senior subordinated notes in December 2001 reduced the remaining capacity
   under the 1997 Shelf Registration to $50,000,000. Following the issuance of the $200,000,000 8-5/8%
   senior subordinated notes, the Company increased the 2001 Shelf Registration to $700,000,000. The
   2001 Shelf Registration was subsequently declared effective on January28, 2002, at which time the
   remaining capacity under the 1997 Shelf Registration was rolled in, thereby providing the Company
   with a total issuance capacity of $750,000,000 as originally contemplated.

The next two examples illustrate subsequent events that provide information about the valuation
of the firms’ assets. In one case, the financial statements are adjusted (Occidental); in the other
case they are not (Toro).
   Occidental Petroleum Corp. and Subsidiaries, 12-31-2001
   In January 2002, Occidental and Lyondell Chemical Company (Lyondell) agreed, in principle, for
   Occidental to sell its share of Equistar to Lyondell and to purchase an equity interest of approximately
   21 percent in Lyondell. These transactions are subject to the execution of definitive documents and
   corporate and regulatory approvals. In connection with the agreement in principle, Occidental wrote
   down its investment in the Equistar partnership by $240 million, after tax, in December 2001. The
   transactions are expected to close in the second quarter of 2002.

   Toro Company, 10-31-2001
   Toro has announced several significant events subsequent to October 31, 2001. On November 28, 2001
   and December 6, 2001, respectively, the company announced that it will be closing its Evansville,
   Indiana and Riverside, California manufacturing facilities during fiscal 2002. These actions are part of
   Toro's overall long-term strategy to reduce production costs and improve long-term competitiveness.
   The closure of these facilities is expected to result in a pre-tax restructuring and other expense charge
   ranging from $7.4 million to $7.9 million in the first quarter of fiscal 2002.

The difference between the two situations is subtle. At Occidental, the information that is
learned in January 2002 is that the fair value of the Equistar assets was less than book value in
January. It is likely that the fair value was also less in December 2001 because nothing about
the assets has changed (occidental just didn’t know it). At Toro, however, the fact that the fair
value of the assets is less than book value results (apparently) from the firm’s decision to
restructure. Since the restructuring event takes place after the balance sheet date, there is no
write down.

ACCOUNTING 201                                                                   SEPT. 15, 2008

V. Significant risks and uncertainties
SOP 94-6 requires disclosure of significant risks and uncertainties that confront entities in the
following areas: nature of operations, use of estimates in the preparation of financial statements,
certain significant estimates, and current vulnerability due to certain concentrations.

Nature of operations
Financial statements should include a description of the major products or services an entity sells
or provides and its principal markets and locations of those markets.

Use of Estimates
Financial statements should include an explanation that their preparation in conformity with
GAAP requires the application of management's estimates.

Significant Estimates
Firms must disclose the significant estimates that affect the financial statements if:

   1.   It is at least reasonably possible that the estimate of the effect on the financial statements
        of a condition, situation, or set of circumstances that existed at the date of the financial
        statements will change in the near term due to one or more future confirming events.
   2.   The effect of the change would have a material effect on the financial statements.

Vulnerability from Concentrations
Vulnerability from concentrations exists because of an enterprise's greater exposure to risk than
would be the case had the enterprise mitigated its risk through diversification. Examples are:

    1. Concentrations in the volume of business transacted with a particular customer, supplier,
       lender, grantor, or contributor
    2. Concentrations in revenue from particular products, services, or fundraising events
    3. Concentrations in the available sources of supply of materials, labor, or services, or of
       licenses or other rights used in the entity's operations
    4. Concentrations in the market or geographic area in which an entity conducts its

Gain contingencies – May be disclosed in the financial statements by note, but should not be
reflected in income, because doing so may result in recognizing revenue prior to its realization.
The standard states that “Care should be exercised in disclosing gain contingencies to avoid
misleading implications as to the recognition of revenue prior to its realization.” The table below
shows that firms rarely report gain contingencies other than tax-related carryforwards that the
firm might be able to use.

Loss contingencies
Note that most firms have a line item on the balance sheet in the liabilities section called
“Commitments and contingencies” that shows a balance of ZERO. Firms are required to include
this line on the balance sheet when potential obligations exist that do not meet the GAAP
definition of a liability. A footnote will further describe the obligations.

ACCOUNTING 201                                                                 SEPT. 15, 2008

The following table reports the frequencies of reporting of loss and gain contingencies:

                                                  2001               2000                1999
Loss contingencies
Litigation                                        461                 468                  469
Environmental                                     249                 249                  261
Insurance                                          76                  58                   67
Government investigations                          61                  45                   51
Possible tax assessments                          44                  47                   45
Other-described                                    69                  47                   51
Gain contingencies
Operating loss carryforwards                      350                 353                  333
Other tax carryforwards                           128                 122                   86
AMT carryforwards                                 79                  80                   80
Capital loss carrforwards                         29                  28                   25
Plaintiff litigation                              25                  29                    27
ITC carryforwards                                  23                  39                   49
Other-described                                     6                   5                    5

See Baxter’s footnotes for an illustration of disclosures re: litigation (Note 10) and other
contingencies (page A-11).

ACCOUNTING 201                                                              SEPT. 15, 2008

VI. Segment disclosures
Firms are required to report summary financial information for operating segments. Firms define
their operating segments using the “management approach,” which is required under GAAP.
Essentially, the management approach requires that the firm consider as a potential reportable
segment any operating unit that they “manage” separately. For some firms, this may mean that
their segments are defined based on the customer: Wholesale segment and retail segment. For
other firms, the segments may be defined based on product: Oil, natural gas, etc. Note that the
management approach may lead to geographic segments and/or business segments. In addition,
the type of segments and definitions will vary across firms. As a result, the data are useful for
explaining within-firm trends/amounts. However, you must be careful comparing across firms
because the definition of a “segment” is firm-specific.

From the set of possible reporting segments identified using the management approach, the firm
reports only those segments that meet technical size requirements based on the following tests:

* Revenue test
* Operating profit test
* Assets test

and the end result must meet the following two tests:

* Combined sales test
* No more than 10 segments total

See Baxter Note 11 for an illustration.