CPA FAR F1

Full Set of Income Statements

• Statement of financial position (balance sheet)

• Statement of earnings (income statement)

• Statement of comprehensive income

• Statement of cash flows

• Statement of owner’s equity

Classified B/S distinguishes between current and non-current assets and liabilities

Purposes & Uses of Balance Sheet

• Provides list of assets, liabilities, and equity

• Used to evaluate liquidity and long-term solvency

• B/S Formula: Assets = Liabilities + Equity

Limitations of Balance Sheet

• Amounts don’t represent market value of entity

  • Many assets & equity issuance are measured at historical cost

  • EX: Depreciated building on B/S may have 0 value

• Some measurements are subjective, makes comparison difficult

  • EX: Different valuation methods for inventory & depreciation

• Estimates may be used in preparation of B/S

  • Ex: Useful life of depreciated asset

Purposes of Income Statement

• Indicates performance of company for a period of time

• Helps determine operating risk

• Provides info about Revenues, Expenses, Gains, Losses (REGL)

Users of Income Statement

Investors & stockholders use I/S to evaluate a company on

• Profitability, value, Operating income, ROE, & EPS 

Lenders use the I/S to evaluate creditworthiness

• Profit margin, EBIT

• Higher EBIT to cover interest = Higher credit rating

Internal users use it to evaluate ROA for particular product line

Risk & sales volatility is measured by standard deviation in

• Sales

• Operating income

Operating Revenue

• Mostly part of normal operating activity

• Put separately in I/S

• Presented as gross amoun

Nonoperating Revenue

• Part of exceptional/nonoperating activities (e.g., interest rev & exp if not a bank)

• Include other revs & exps

Gains & Losses

• Are nonoperating items

• Reported at net amount of transactions

Period Costs

• Expensed immediately

• Recurring in nature

  • EXs: selling, general, administrative, research

Unexpired Costs

• Capitalized as an asset for future

• Appears on B/S

• Expensed in future period according to matching principle

Nonoperating Items on Income Statement

Unusual and/or infrequent revenues & expenses not part of core business: come from nonoperating business such as:

• Sales of something other than inventory

• Write-downs/Write-offs

• Sale of PP&E

• Sale of investment in another company

• Unusual operating expense

Unusual or infrequent are reported under nonoperating

Income from Discontinued Operations

Includes selling of product line, separate division, or segment of a company’s operations

• Reported separately on I/S

• Comes after income from continuing operations in the I/S

• Reported as net of tax

Single-Step Income Statement

Benefits

• Gives net income in one step due to simple design

• Doesn’t make one item seem more important than others

Drawback

• Doesn’t distinguish between core & incidental business

Multi-Step Income Statement

Benefits:

• Enhances user info

• Separates operating and nonoperating business

• Provides readily available info for ratio analysis

• Assess if it’s due to core or infrequent business

• Calculate increase in EPS because of increase in net income

Limitations of Income Statement

• Subjective

• Management Bias

• Manipulation through assumptions/bias

Accrual basis

• Booking rev when earned: goods have been delivered or services performed

• Gives better assessment of performance

• Subjective

• Drawback is management may use it to disguise risk/alter performance

Cash Basis

• Booking rev & exps when cash is received or paid out

• Objective

• Poor indicator of performance

Reporting Discontinued Operations

• On I/S

• Separately from continuing operations, net of tax

• Below income from continuing operations, before net income

Results of operations of a component of an entity will be reported in discontinued operation if it

• Has been disposed of during that year

• Is classified as held for sale in that year

Held-for-Sale Criteria

All six must be met for business activity to be classified as held-for-sale

1. Management commits to plan to sell activity

2. Activity is available for immediate sale in present condition

3. Active program to locate a buyer has been initiated

4. Sale of activity is probable, and completion of sale is expected to occur within a year

5. Activity is actively marketed as reasonable sale price relative to current fair value

6. Significant changes in sale plan are not expected

If not all six are met, should be reclassified as held and used (default classification for PP&E)

Measurement and Valuation of Held-for-Sale Asset

Segment classified as held for sale is reported on B/S at lower of NRV or book value

Key Points about Impairement

• Possible to reverse impairment loss recorded in prior year

• Not possible to record a gain more than prior year’s impairment loss

• Carrying value can never exceed original book value

Presentation & Disclosure of Discontinued Operations

• Presented as separate component of income at bottom of I/S

• Present below income for continuing operations, net of tax

• Disclosed in the face or notes of financial statement

  • What product line

  • Why it was sold

  • Potential impact on business in future

Comprehensive Income

Net income + Other comprehensive income = Comprehensive income

• Change in (net assets) of a business enterprise during a period from transactions, other events, and circumstance from non-owner sources

• Includes all changes in equity during a period, except those resulting from investments by owners and distributions to owners

Net Income & Other Comprehensive Income

Net Income

• Income from continuing operations

• Discontinued operations

Other Comprehensive Income (OCI)

• PUFI items

Instrument-Specific Credit Risk

Changes in fair value that are attributable to instrument-specific credit risk

• When a company’s risk changes, that is going to affect the discount rate used to calculate the value of that security

  • If risk goes up, discount rate goes up and FMV goes down causing a gain

  • If risk goes down, then there is lower discount rate and FMV goes up, causing a loss

Accumulated Other Comprehensive Income

• Retained earnings are REGL that have been accumulated over time

• Gains and losses that go direct to equity accumulate in AOCI

• AOCI is a component of equity that income OCI for current and period periods

• Any gains and losses that on the I/S eventually become part of net income, and then they get closed out to retained earnings

How to know when a single-statement or two-statement approach is used

• If starting point is revenue, it’s a single-statement approach

• If starting point is net income, it’s a two-statement approach

Required Disclosures

• The tax effect of each component of comprehensive income

• Tax effects must be allocated to each component

  • On face or notes of the statement of comprehensive income

• All formats must disclose changes in accumulated balances for each of the components of OCI

• Can also have a change due to a reclassification adjustment

• Change in accumulated balances can be shown 

  • Face of the financial statement

  • Separately disclosed in the notes

• All formats must disclose:

  • Total AOCI in the B/S as an item of equity

• Changes in AOCI balances for each of the PUFI items must be shown

• Change can be caused either by

  • Current period or loss

  • Reclassification adjustments

• Significant items reclassified out of AOCI must be disclosed either:

  • On face of the financial statement

  • As a separate disclosure in the notes to the financial statements

Part II Item 7: “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (MD&A) Form 10-K

• Objective of this section is to provide perspective on business results in management’s own words

  • Known trends and uncertainties

• Includes following components

  • Material info relevant to an assessment of financial condition and results of operation of registrant. Includes info on liquidity, capital resources, and material impact of cybersecurity incidents

  • Summarized financial and operating results, trends, risks & uncertainties

  • Material changes & uncertainties relative to the prior period

  • Critical accounting estimates and assumptions

Part II Item 7A: “Quantitative and Qualitative Disclosures about Market Risk” Form 10-K

• Disclosures required include:

  • Quantitative info as of end of latest fiscal year, present in one of three disclosure alternatives

    • Tabular presentation of info related to market risk sensitive instruments

    • Sensitivity analysis & Value-at-risk disclosures expressing potential loss in future earnings, fair value, or cash flows of market risk sensitive instruments

  • Qualitative Info regarding:

    • Primary market exposures

    • Management of these exposures

    • Changes relative to most recently completed fiscal year & expectations for future periods

Part II Item 8: “Financial Statements and Supplementary Data” Form 10-K

• Audited financial statements and accompanying notes presented using GAAP

• Time period covered 

  • B/S for two most recent fiscal years

  • I/S, statement of comprehensive income, statement of cash flows, & changes in owner’s equity for each of the three fiscal years preceding the date of most recent audited B/S

• Auditor’s report

• Certification from CEO & CFO regarding accuracy and completeness of 10-K

Form 8-K

• Filed by US registered companies whenever a material event occurs

• Exs of material events

  • Bankruptcy

  • Acquisition or disposition of assets

  • Changes in fiscal year

  • New material financial obligations

  • Material asset impairments

• Companies generally have 4 business days to file for any event that triggers a filing requirement

Complex Capital Structure (Report Basic and Diluted EPS)

• Entity has complex capital structure when it has securities that

  • Can potentially be converted to common stock; and

  • Would dilute EPS (Diluted EPS <= Basic Amount)

• Both basic & diluted EPS must be presented

• Objective of diluted EPS is to measure performance of entity over reporting period while giving effect to all dilutive common shares outstanding during period

• Potentially dilutive securities include:

  • Convertible securities (e.g., convertible preferred stock, convertible bonds, etc)

  • Warrants & other options

  • Contract that may be settled in cash or stock

  • Contingent shares

Dilution from Options, Warrants, and their Equivalents

• Dilutive effect of options & warrants and their equivalents is applied using treasury stock method

• Treasury stock method assumes that proceeds from exercise stock options, warrants, and their equivalents will be used by company to repurchase treasury shares at prevailing market price

  • Results in an incremental increase in shares outstanding, but not full amount of shares issued on exercise of C/S equivalents

Dilutive vs Antidilutive

• Options & similar instruments are only dilutive when average market price of underlying C/S exceeds exercise price of the options or warrants because it is unlikely they would be exercised if exercise price were higher than market price

• Options or warrants would be “out of money” and antidilutive

• Previously reported EPS should not be adjusted in the case of options or similar instruments to reflect subsequent changes in market prices of C/S

Treasury Stock Method

• If average market price of stock is greater than exercise price assume that the warrants or other options are exercised at the beginning of period

• Also assume that proceeds received (option or exercise pierce) are used to purchase C/S at average market price during period

• When the option/warrant is in the money (average market price > exercise price), the proceeds (assumed to be) received will not be sufficient to buy back an (assumed) equal number of shares

  • Will always results in dilution

• Difference between # of shares assumed issued to satisfy the options or warrants and the # of shares assumed to be purchased with the proceeds should be included in the # of shares (denominator) for diluted EPS

• Previously reported EPS data shouldn’t be retroactively adjusted for changes in market price

If-Converted Method

• Should be used to determine the dilutive effects of convertible securities

• Assumes that securities were converted to common stock at beginning of the period

Convertible Bonds

• Use following steps to apply if-converted method to convertible bonds:

  • Numerator: Interest expense x (1 -  Tax rate)

  • Denominator: # of bonds x # of common stock per bond

  • If convertible bonds were issued during period, assume that the stock issued at that date for the weighted average calculation

Antidilution

• Use the results of each assumed conversion only if it results in dilution

• Don’t include results of assumed conversion if it is antidilutive

• In determining whether potential common shares are dilutive or antidilutive, each issue will be considered separately from most to least dilutive, with options and warrants generally included first

• Tests for dilutive or antidilutive effects should be based on income from continuing operations

EPS Disclosures

• Basic EPS and diluted EPS for both income from continuing operations and net income and the effects of discontinued operations should be reported

• Following disclosure requirements should also be met

  • Reconciliation of the numerators and denominators of the basic and diluted per share computations for income from continuing operations

  • Effect that has been given to preferred dividends in arriving at income available to common stocks holders in computing basic EPS

  • Securities that could potentially dilute basic EPS in future that were not included in computation of diluted EPS because the effect was antidilutive for period(s) presented

  • Description of any transaction that occurred after period end that would have materially affected the number of actual and/or potential common shares outstanding

Retained Earnings

• Most REGLs flow through the I/S and then to retained earnings/equity

• Accumulated earnings (or losses) during the life of the corporation that hasn’t been paid out as dividends

• Amount of accumulated retained earnings is reduced by:

  • Distributions to stockholders; and

  • Transfers to additional paid-in capital for stock dividends

• Doesn’t include

  • Treasury stock

  • AOCI

• If retained earnings has a negative balance, it is called a deficit

Cost Method (Used by entities 95% of time)

Treasury stocks recorded and carried at reacquisition cost

• Gain or loss determined

  • When T/S reissued or retired

  • Original issue price and book value of stock don’t enter into the accounting

• The accounting “additional paid-in capital from treasury stock” is credited for gains and debited for losses when treasury stock is reissued at prices that differ from the reacquisition cost

  • Excess losses reduced retained earnings

  • T/S gains & losses never affect the income statement (regardless of method used)

• Net income or retained earnings will never increase through treasury stock transactions

Legal (Par) Method (Used 5% of time)

• T/S are recorded by reducing the amounts of par (or stated) value and additional paid-in capital received at the time of the original sale

• T/S is debited for its par value

• APIC-common stock is debited for the pro rata share of the original issue price attributable to the reacquired shares

• APIC-from treasury stock is credited for gains and debited for losses when T/S is repurchased at prices that differ from the original selling price

• Losses may also decrease retained earnings if APIC-from treasury stock account doesn’t have balance large enough to absorb loss

• Sources of capital associated with original issue are maintained

Retirement of Treasury Stock

• When treasury stock is acquired with the intent of retiring the stock (regardless of if it is accomplished) and price to reacquire is less than par value, difference must be credited to paid-in capital account

• When price paid is in excess of par, excess may be charged against either

  • All paid-in capital arising from past transactions in the same class of stock

  • Retained earnings

Donated Stock

• Company’s own stock received from a shareholder

• No change in total stockholder’s equity, but number of shares outstanding decreases, raising book value per common share

• Company may choose to directly retire shares upon repurchase rather than holding the shares in treasury

• In the retirement entry, common stock and APIC-C/S is debited based on the original issuance price of the stock and cash is credited

  • If price paid to retire stock is more than OG issuance price, difference is debited to APIC-retired stock, to extent that the balance in this account can absorb the debit

    • Any excess amount is debited to retained earnings

  • If price paid to retire the stock is less than OG issuance price, difference is credit to APIC-retired stock

Stock Subscription

• Frequently, a corporation sells its capital stock by subscription

• This means that a contractual agreement to sell a specified number of shares at an agreed-upon price on credit is entered into

• Upon full payment of the subscription, a stock certificate evidencing ownership in the corporation is issued

• Subscription not paid for at year-end are treated as a contra-equity item, offsetting the amount of par value and APIC related to subscription not paid for at year-end

• If subscriptions are paid after year-end but before the financial statements are issued, the subscriptions receivable may be reported as an asset and will increase paid-in capital at year-end

Default/Forfeiture of a Subscription

• If all or part of a subscription is not collected, the terms of the subscription agreement and corporate policy will determine the appropriate accounting treatment

• Generally the treatment is to reverse the applicable portion of the OG entry and either:

  • Issue stock in proportion to the amount paid

  • Refund the partial payment

  • Retain the partial payments (as liquidated damaged for breach of contract) by a credit to additional paid-in capital

Stock Rights

• Provides an existing shareholder with opportunity to buy additional shares

• Right usually carries a price below the stock’s market price on the date the rights are granted

• Issuance of stock rights requires a memorandum entry only

• It is possible that the rights may subsequently be redeemed by the company, which will cause a decrease in stockholders’ equity in the amount of the redemption price

Property (In-Kind) Dividends

• Distribute noncash assets to shareholders

  • No cash outflows

  • Use fair market value of property

• Nonreciprocal transfers of nonmonetary assets from the company to its shareholders

• On date of declaration

  • Property to be distributed should be restated to fair value

  • Gains/losses recognized in income

Scrip Dividends

• May be used when there is a cash shortage

• A special form of notes payable whereby a corporation commits to paying a dividend at some later date

• On date of declaration

  • Retained earnings is debited

  • Notes payable is credited

• Some scrip dividends even bear interest from the declaration date to the date of payment (and, thus, require accrual)

Liquidating Dividends

• Occur when dividends to shareholders exceed retained earnings

• Dividends in excess of retained earnings would be charged (debited) first to APIC and then to common or preferred stock

• Reduce total paid-in capital

Treatment of a Small Stock Dividend (<20%-25%)

• When less than 20 to 25 percent of shares are distributed, is treated as a small stock dividend because issuance isn’t expected to affect stock’s market price

• FMV of stock dividend at date of declaration from retained earnings to capital stock and APIC

• No effect on stockholders’ equity, as paid-in capital is substituted for retained earnings (i.e., retained earnings is “capitalized” and made part of paid-in capital)

Treatment of a Large Stock Dividend (> 20-25 percent)

• When more than 20 to 25 percent of previously issued shares outstanding are distributed, dividend is treated as a large stock dividend, as it may be expected to reduce the market price of stock (similar to a stock split)

• Par value of stock dividend is normally transferred from retained earnings to meet legal requirements 

• Amount transferred is the number of shares issued multiplied by the par value of stock

Stock Dividend Distribution Exception

• If state law doesn’t require capitalization of retained earnings for stock dividends (which is rate because it requires amendment to articles of incorporation), record the stock dividend distribution (like a stock split) by changing:

  • Number of shares outstanding ⬆; and

  • Par value per share ⬇