Financial Accounting and Reporting (FAR)

Class #1 Topics:

  1. F1 M1: Balance Sheet, Income Statement, and Comprehensive Income

  2. F1 M2: EPS and Public Company Reporting Topics

  3. F1 M3: Stockholders' Equity: Part 1

  4. F1 M4: Stockholders' Equity: Part 2

Balance Sheet

Full Set of Financial Statements

  • Under U.S. GAAP, general purpose financial reporting is defined as a full set of financial statements and notes to the financial statements. A full set typically includes:

    • Statement of financial position (balance sheet):

    • Short-term liquidity

    • Financial risk

    • Long-term solvency

    • Potential growth

    • Statement of earnings (income statement):

    • Statement of comprehensive income

    • Statement of cash flows:

    • Performance risk and operating risk

    • Net income per the income statement

    • Other comprehensive income

    • Cash changes: Indicator of quality of earnings and growth potential

    • Statement of owners' equity:

    • Changes in stockholders' equity (due to capital changes, retained earnings, or accumulated OCI)

  • Entities may present a classified balance sheet that distinguishes current and non-current assets and liabilities.

Purposes and Uses of the Balance Sheet

  • Evaluates short-term and long-term financial risk

  • Lists assets and liabilities (classified as current and non-current) and equity.

  • Shows types of assets and liabilities:

    • Current vs. long-term

    • Tangible vs. intangible

  • Used to evaluate liquidity and long-term solvency.

  • Balance sheet formula: extAssets=extLiabilities+extEquityext{Assets} = ext{Liabilities} + ext{Equity}

  • Key ratios include current ratio, quick ratio, and degree of financial leverage.

Components of the Balance Sheet

Assets

  • Defined as probable future economic benefit.

  • Current Assets: Cash and assets expected to convert to cash within one year (Examples include: cash, receivables, prepaids, inventory, short-term investments).

  • Investments and funds: Non-current, not used directly in operations (Stocks/bonds in other companies).

  • Property, Plant, and Equipment (PP&E): Tangible, long-lived, used in operations.

  • Intangibles: No physical substance, long-lived, used in operations (Examples: patents, copyrights, trademarks, franchises).

Liabilities

  • First claim on assets with a "maturity date".

  • Current liabilities: Obligations to be satisfied with current assets.

  • Long-term liabilities: Obligations to be satisfied beyond one year.

  • Equity represents the second and last claim on assets.

  • Key components include:

    • Preferred stock

    • Common stock

    • Additional paid-in capital (contributed equity)

    • Retained earnings and accumulated other comprehensive income (residual interest)

    • Treasury stock: Contra-equity that reduces stockholders' equity.

Income Statement: Overview

Purpose of the Income Statement

  • Indicates a company's performance for a period of time.

  • Helps determine operating risk:

    • Are company's sales relatively stable from one period to another or volatile?

    • Is its operating income relatively stable or volatile?

  • Provides information about its Revenues, Expenses, Gains, and Losses (REGL).

REGL on Income Statement

  • Revenues and Expenses:

    • Operating: Mostly part of normal operating activities, presented separately as a gross amount.

    • Nonoperating: Part of exceptional/nonoperating activities (e.g., interest revenue and interest expense if not a bank). Includes other revenues and other expenses.

Gains and Losses

  • Gains and losses are nonoperating items reported at net amounts (net gains or net losses).

Cost on Income Statement

  • Unexpired Cost (Assets) on Balance Sheet:

    1. Inventory

    2. Unexpired cost of insurance

    3. Net book value of fixed assets

    4. Unexpired cost of patents

  • Expired Cost (Expenses) in Income Statement includes:

    • Cost of goods sold

    • Insurance expenses

    • Depreciation expenses

    • Patents expenses (amortization).

Income from Continuing Operations

Calculation of Income from Continuing Operations

  • Formula: Income from continuing operations = Operating income + Nonoperating income (Gains and Losses).

  • Disclosure on the face of the income statement or in the footnotes concerning the nature of the item and its financial statement effects.

Income from Discontinued Operations

  • Includes selling off of product lines, separate divisions, or segments of operations.

  • Reported separately on the income statement after the income from continuing operations, net of tax.

Components of the Income Statement (Multiple-Step)

  • Structure includes:

    • Sales

    • Cost of goods sold

    • Gross profit

    • Operating expenses

    • Operating income

    • Nonoperating gains and losses

    • Pretax income

    • Income tax expense

    • Net income

    • Discontinued operations (net of tax)

Limitations of the Income Statement

  • Accrual Basis vs. Cash Basis:

    • Accrual Basis: Not booking revenue until cash is received if goods/services haven’t been delivered/performed. Better for performance assessment but subjective.

    • Cash Basis: Records cash inflows/outflows as they occur. More objective but poor performance indicator.

Discontinued Operations: Introduction and Accounting Rules

Introduction to Accounting for Discontinued Operations

  • Reported separately from continuing operations, net of tax, on the income statement, below income from continuing operations and before net income.

Conditions for Discontinued Operations

  • Disposal must represent a strategic shift that significantly affects operational and financial results. Examples:

    • Major geographic area disposal

    • Major equity method investment disposal

    • Major line of business disposal.

Accounting Rules: Discontinued Operations Calculations

Reporting Specifications

  • Report results in the period disposed of or held for sale. Calculate for multiple years:

    • Impairment loss (to be written down)

    • Results of operations (moved down due to discontinuance)

    • Gain or loss on sale (reported in the period it occurs).

Presentation and Disclosure

  • Discontinued operations are presented as a separate component of income at the bottom of the income statement, below income from continuing operations, net of tax. Must disclose:

    • What product line was this?

    • Why is this segment being sold?

    • How might it affect future business?

Individual Foreign Transactions

Foreign Currency Transactions

  • Gains and losses must be recorded. Occurs when:

    • Company buys/sells to a foreign company without ownership interest and agrees to pay/receive payment in foreign currency.

    • Transactions between a subsidiary and a parent of permanent financing nature are not considered foreign currency transactions.

Foreign Currency Terminology

  • Exchange Rate: Price of one currency expressed in units of another currency. Can be:

    • Direct Method: Domestic price of another currency.

    • Indirect Method: Foreign price of domestic currency.

Foreign Currency Transaction Example

  1. On 12/1/Yr 1, Olinto Company purchased goods on credit for 100,000 pesos at $0.10 exchange rate.

  2. Payments made on 2/1/Yr 2 when the exchange rate was $0.09.

  3. Journal entries recorded for all transactions related to this foreign currency transaction to reflect the gain/loss acquired.

Statement of Comprehensive Income

Definitions and Items

  • Items included in an income statement (REGL).

  • Items not included (PUFI items - Pension Adjustments, Unrealized Gains/Losses, Foreign Currency Items, Instrument-Specific Credit Risk).

Comprehensive Income Equation

  • extComprehensiveIncome=extNetIncome+extOtherComprehensiveIncome(OCI)ext{Comprehensive Income} = ext{Net Income} + ext{Other Comprehensive Income (OCI)}

  • A change in equity during a period from non-owner sources.

Other Comprehensive Income (OCI)

  • Items include:

    • Pension adjustments

    • Unrealized gains and losses related to sales of debt securities/hedges

    • Foreign currency items

Financial Statement Reporting

  • Under U.S. GAAP, comprehensive income is presented in two ways:

    • Single statement of comprehensive income:

    • Revenue + Other Comprehensive Income = Comprehensive Income

    • Two-statement approach:

    • Income statement followed by statement of comprehensive income that begins with net income.

SEC Reporting Requirements

Form 10-K

  • Annual report filed by U.S. registered companies.

  • Provides details to investors on:

    • Business and relevant risk factors

    • Financial and operating results for the year

    • Executive leadership perspectives

Filing Deadlines for Form 10-K

  • 60 days for large accelerated filers;

  • 75 days for accelerated filers;

  • 90 days for all other registrants.

Form 10-Q

  • Quarterly report filed for the first three quarters of each fiscal year.

  • Includes business operations overview, financial statements, disclosures.

  • Filing deadline: 40 days for large/accelerated filers; 45 days for others.

Form 8-K

  • Filed to disclose material events like:

    • Bankruptcy

    • Asset acquisition/disposition

    • Changes in public accounting.

Earnings per Share and Simple Capital Structure

Basic EPS Formula

  • Time period specification (year or quarter).

  • Formula:
    extBasicEPS=Net income - Preferred dividendsWeighted average number of common shares outstanding (WACSO)ext{Basic EPS} = \frac{\text{Net income - Preferred dividends}}{\text{Weighted average number of common shares outstanding (WACSO)}}

Income Available to Common Shareholders

  • Determined by deducting from continuing operations/net income:

    • Dividends declared on noncumulative preferred stock;

    • Dividends accumulated on cumulative preferred stock.

Weighted Average Number of Common Shares Outstanding

  • Means of shares considered for EPS calculations, adjusting for any share transactions.

  • Formula incorporates adjustments for stock dividends or splits, purchases, etc.

Example

  • Calculation of weighted average shares outstanding through detailed transactions and adjustments for stock splits or reacquisitions to find WACSO.

Complex Capital Structure and Earnings Per Share

Report Basic and Diluted EPS

  • A complex capital structure includes securities convertible to common stock, diluting EPS.

  • Both Basic EPS and Diluted EPS must be presented.

Diluted EPS Formula

  • Diluted EPS=Income available to common stockholder+Interest on dilutive securitiesWeighted average number of common shares (assuming all dilutive securities are converted)\text{Diluted EPS} = \frac{\text{Income available to common stockholder} + \text{Interest on dilutive securities}}{\text{Weighted average number of common shares (assuming all dilutive securities are converted)}}

Dilution from Options and Warrants

  • Assessed via the treasury stock method.

  • Only dilutive when the average market price exceeds the exercise price.

Dilution from Convertible Securities

  • Steps for conversion with related interest expense adjustments. Antidilution rules must apply.

Stockholders' Equity Overview

Stockholders' Equity

  • Owners’ claim to net assets. 卨 Assets−Liabilities=Residual Interest\text{Assets} - \text{Liabilities} = \text{Residual Interest}

  • Also known as shareholders' or owners' equity, it is the last major section on the balance sheet.

  • Classified according to sources.

Legal Capital of Capital Stock

  • Retained for creditor protection. Includes par/stated values.

Components

  • Authorized Capital Stock: Amounts a corporation can issue as per charter.

  • Issued Capital Stock: Portion of authorized stock that is issued.

  • Outstanding Capital Stock: Stock issued but not held in treasury.

  • Common Stock: Rights entitled to shareholders, including voting and sharing profits upon liquidation.

  • Preferred Stock: Equity features not seen in common stock, with some possessing a liquidity preference.

Additional Paid-in Capital, Retained Earnings, and Accumulated OCI

  • Additional Paid-in Capital: Surplus amounts over par value.

  • Retained Earnings: Accumulated earnings not paid as dividends. Changes included in formula:
    Ending Retained Earnings=Beginning Retained Earnings+Current Year Change\text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Current Year Change}

  • Accumulated Other Comprehensive Income: Includes OCI components.

Treasury Stock

Definition and Accounting Methods

  • Treasury stock refers to stock reacquired by the corporation. No owner rights are preserved.

  • Two methods of accounting:

    • Cost Method: Calculated gain/loss upon reissue.

    • Legal/Par Method: Recognizes gains/losses at repurchase.

Example Question

  • Determining paid-in capital related to treasury stock transactions based on specific transactions undertaken by a corporation.

Accounting for a Stock Issuance (to Nonemployees)

Issuance Methods

  • Stocks may be issued at a price above, at, or below par (stated) value.

  • Stock subscriptions involve contractual agreements.

Distributions to Shareholders

Types of Distributions

  • Distributions can take the form of cash, stock, or property. Dividends are pro-rata from earnings, most commonly cash.

  • Special dates for dividends include declaration, record, and payment dates.

Liquidating Dividends

  • Occur when distributions exceed retained earnings and reduce total paid-in capital.

Stock Dividends

  • Distribute additional shares without cash. Treatment depends on the size of the dividend.

Stock Splits

  • Change share count without affecting total stated capital. Affects the par value but not total equity.

Statement of Changes in Shareholders' Equity

  • Provides detailed accounts of changes in equity components, capital transactions, and reconciliations of retained earnings.

Homework Reminder

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  • Complete all MCQs and TBS for today’s modules using texts/videos as references.