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This 19 page Class Notes was uploaded by Petey Martin on Tuesday December 8, 2015. The Class Notes belongs to ACC 201 at University of Rochester taught by WOJDAT K in Summer 2015. Since its upload, it has received 37 views. For similar materials see FINANCIAL ACCOUNTING in Accounting at University of Rochester.
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Date Created: 12/08/15
Petey Martin Notes (12-1-15) o Repurchased shares of previously issued stock are called treasury stock if the repurchased shares are not canceled. Treasury stock is not included in shares outstanding. Treasury stock has no right to receive dividends or vote. o Accounting for the acquisition of treasury stock – using the cost method. Debit Treasury Stock account for cost of acquisition. credit Cash account for same amount Treasury stock account is a contra equity account reducing total stockholder’s equity. Treasury stock account is not an asset account. o Accounting for sale of treasury stock previously acquired. Firms do not recognize gains or losses from their treasury stock transactions. If treasury stock is sold for more than it was purchased for: Debit cash account for amount of cash received. o Credit treasury stock account for the amount the stock cost the firm to reacquire. o Remainder is a credit to the “paid in capital in excess of par” account. If treasury stock is sold for less than it cost the firm to reacquire: Debit cash account for amount of cash received o Credit treasury stock account for amount stock cost the firm to reacquire. Remaining debit is applied to “paid in capital in excess of par” account. For each sale of treasury stock, the “Treasury Stock” account is reduced by the number of shares sold times their acquisition cost. Dividends o Dividends are periodic payouts of a portion of the corporation’s profits involving transfers of assets from a corporation to its stockholders as a return on their investment. Cash dividends, transfers of cash to a firm’s stockholders, are the most common. o Dividends must be declared by the Board of Directors before they can be paid. But a U.S. corporation does not have a legal obligation to pay a dividend so the board is not obligated to declare dividends and stockholders can not force a firm into bankruptcy for not paying dividends. Text notes that Brazil requires corporation to pay at least 25% of net income as a dividend each year. o On the declaration date, the board of directors formally declares a dividend, The dividend becomes a legal liability (legally enforceable claim in bankruptcy) of the corporation once it is declared, and the following entry is required: Retained Earnings or Dividends Dividends Payable Earnings are no longer retained once a dividend is declared. o Checks will be sent to all stockholders who where listed in the corporation’s records as owning the stock as of the date of record, even if they no longer own the stock as of the time the dividend is actually paid. Treasury stock receives no dividend, so total dividends are shares outstanding (not issued) times dividend per share. No journal entry is required on the date of record. o On the payment date payment is made, the dividend liability is satisfied, and the following entry is required: Dividends Payable Cash o Two requirements exist for the board to be able to declare a cash dividend: Normally the firm must have sufficient RE to cover the dividend State law often limits cash dividends to the balance in the retained earnings account. But, as long as there is sufficient retained earnings, dividend can be paid even if current year net income is less than the dividend, or is a loss. The firm also must have sufficient cash to pay the dividend. It is possible for a firm to have sufficient retained earnings but not sufficient cash because funds retained may have been spent on inventory, equipment, etc. Preferred Dividends o The preferred dividend for the current period must always be paid before any common dividend can be paid. But, the board may elect to not pay a preferred dividend in a period where no common dividend is paid. o Cumulative preferred stock also requires that before any common dividend is paid in any period, preferred stockholders must get that period's preferred dividends PLUS all prior year preferred dividends that had not been paid in the past. For non cumulative preferred stock, preferred shareholders lose their claim to dividends that are not declared in a given period. In this case, management can manipulate the total payments the preferred shareholders receive by changing the timing of the common dividends. Preferred stock is usually cumulative. o Dividends in arrears is the amount of prior periods' preferred dividends not paid on cumulative preferred stock as of a given point in time. Dividends in arrears is not reported in the balance sheet. Dividends in arrears is not a liability until dividends are declared by the board of directors. Dividends in arrears must be disclosed in the notes to the financial statements. Dividends in arrears is important information as it represents assets not available to common stockholders. Dividends in arrears is relevant to common stock values. o A Participation provision may also be part of the terms of a preferred stock offering. o Participating preferred stock entitles the holder to receive more than the specified preferred dividend if the common dividend in a year is higher than the specified preferred dividend. Fully participating preferred stock entitles holders to receive the same dividend per share as common stockholders receive, if the common dividend per share is larger than the stated preferred dividend per share. Otherwise, preferred stockholders receive the stated preferred dividend. Stockholders’ Equity section of the Balance Sheet and Statement of Changes in Stockholder’s Equity o Generally Accepted Accounting Principles require a Statement of Changes in Stockholder Equity. Must show three years of data. o Common Stock and Preferred Stock balances in the balance sheet disclose the legal capital associated with sales, by the corporation, of these two types of stock. Balance sheet totals in these accounts equal the cumulative legal capital from the sale of the respective type of stock. May be called issued capital or share capital under IFRS. Statement of Changes in Stockholder Equity shows legal capital associated with additional stock issued during the year as additions to these accounts in. o The number of shares authorized, issued and outstanding is displayed alongside the Common Stock and Preferred Stock lines of the balance sheet. Authorized # of shares is the max. # shares that may be issued as designated by the Corporate Charter. Stockholders must amend the Corporate Charter if firm wishes to issue more than # of shares authorized. Typically, to provide future flexibility, firms authorize many more shares than they initially plan to issue. Number of issued shares is the total number of shares the corporation has sold less any canceled. Number of unissued shares is the number of authorized shares not yet issued, which still could be issued. Number of outstanding shares is the number of shares issued less the number of shares of treasury stock. Treasury stock is shares a firm has issued and then repurchased from stockholders. Earnings per share (EPS) = Net Income less any preferred dividends / Avg. # of common shares outstanding. Preferred dividend is not available to common shareholders even though it is not subtracted in calculating net income. Treasury stock does not receive distributions of income. Calculation of the # of shares is actually complex. It is required that the ratio be presented either in the statements themselves or in the notes to those statements. o Additional Paid-In Capital (Paid in Capital in Excess of Par or Stated Value) Total of the proceeds the corporation receives from stock sales to investors less the portion recorded above. Adjusted by treasury stock transactions and small stock dividends. (may be called share premium under IFRS). Statement of Changes in Stockholder Equity shows affect on this account of issuance of additional stock during the year. o Contributed Capital is the amount of money stockholders have invested in the corporation through the purchase of stock issued by the corporation. Contributed Capital is accounted for as legal capital plus amounts paid to the firm for its stock in excess of legal cap. Contributed Capital normally equals the balance sheet totals for Common Stock and Preferred Stock plus Additional Paid in Capital or Paid in Capital in Excess of Par or Stated Value, as alluded to before (although see discussion of Treasury Stock and Stock Dividends re Additional Paid in Capital (Paid in Capital in Excess of Par)). o Treasury Stock Balance Sheet total equals the cost to acquire all of the treasury stock the firm has purchased and retained as of the balance sheet date. Has a debit balance, reduces stockholders equity. Statement of Changes in Stockholder Equity shows additional repurchases of the firm’s stock during the year. o Other Comprehensive Income (OCI) and Accumulated Other Comprehensive Income (AOCI) Changes in Stockholder’s Equity that bypasses the income statement, and also do not represent owner contributions. E.g., change in value of securities classified as available for sale. o Gain and loss for this type of investment only recognized at sale of the investment. Other Comprehensive income, which is closed into Accumulated Other Comprehensive Income, balances change in asset value. E.g., currency translation adjustment (changes to non dollar denominated assets dollar value). o Gain and loss only recognized at actual conversion of foreign currency into dollars. Other Comprehensive income, which is closed into Accumulated Other Comprehensive Income, balances change in asset value. Statement of Changes in Stockholder Equity shows Other Comprehensive Income or Loss. Balance Sheet reports Accumulated Other Comprehensive Income. o Retained Earnings Cumulative earnings less cumulative dividends since the corporation's inception. Add each year’s net income and subtract each year’s dividends. Balance Sheet shows the ending balance and Statement of Changes in Stockholder Equity shows each year’s Net Income as an addition to Retained Earnings and each year’s dividends as a subtraction from Retained Earnings. If the firm has losses, retained earnings can become negative. Sometimes referred to as the deficit in the statements (similar to gov’t debt, but not similar to government deficit which refers to a single year). Some business transactions may result in retained earning being unavailable to pay dividends. E.g., some loan agreements require a minimum amount of retained earnings be maintained for the duration of the loan. These restrictions should be reported in the notes to the financial statements. Petey Martin Notes (12-3-15) Stock Dividends o A stock dividend is a pro rata distribution of additional shares of a corporation’s stock to current stockholders. Pro rata means each shareholder receives the same percentage of new shares issued as the percentage of shares owned by that stockholder prior to the dividend. The stock is distributed as a dividend, but no assets are transferred from the corporation. Number of shares of treasury stock is unaffected because a firm’s treasury stock receives no stock dividend and is excluded from the calculations above. o The accounting for stock dividends depends on the size of the stock dividend as a percentage of the pre dividend number of shares outstanding (makes no sense, but is the rule). For a small stock dividend: new shares issued are less than 20 - 25% of the shares already outstanding For small stock dividends, an amount equal to the Fair Market Value of the stock issued is transferred out of retained earnings and into the common stock and paid in capital in excess of par accounts. Retained Earnings FMV of shares issued Common (or Preferred) Stock legal capital* PIC Excess of Par balance * par value or stated value of new shares issued, or entire amount if stock has no par or stated value. For a large stock dividend: new shares issued are more than 20 - 25% of the shares already outstanding. For large stock dividends, an amount equal to the Par Value (or Stated Value) of the stock issued is transferred out of retained earnings and into the common stock account. Retained Earnings total par or stated value* Common (or Preferred) Stock legal capital * * par value or stated value of new shares issued. o The reported number of shares issued and outstanding is increased by the number of new shares issued for both large and small stock dividends. o For either a small or a large stock dividend, total stockholders’ equity remains unchanged. Only the composition of stockholders’ equity changes. Stock Splits o Corporations also sometimes split their stocks. A purpose of this is to bring the stock price down to a level where small investors are more likely to buy the stock. Same purpose applies to stock dividends. o In a stock split, a corporation converts all its issued shares into 2 or 4 (or some other number) shares of stock, but also reduces the par value per share sufficiently so that legal capital is unaffected. 2 for 1 split means every share previously issued becomes 2 shares, and par value is cut to 1⁄2 the level it began at. 4 for 1 split means every share previously issued becomes 4 shares, and par value is cut to 1⁄4 the level it began at. The board of directors can authorize the stock split, while shareholder approval is usually required for the change in par value. o All shares already issued as of stock split date are called in and the increased number of new shares is distributed. Number of treasury shares is affected by a stock split. Again, no assets are transferred from the corporation. o No journal entry is required with a stock split. No dollars are transferred from retained earning to any other stockholders’ equity accounts because the per share par value reduction offsets the increase in the number of shares issued. o But the stock split is disclosed in the notes to the financial statements. o The number of authorized shares is also usually increased when a stock split occurs, but this typically requires separate approval from the stockholders. o 2 for 1 stock splits differ from 100% stock dividends With stock splits, legal capital is unaffected; but legal capital increases with stock dividends. $10 par value x 100,000 shares issued becomes $5 par value x 200,000 shares issued with stock split. $10 par value x 100,000 shares outstanding becomes $10 par value x 200,000 shares outstanding with a 100% stock dividend. With stock splits, retained earnings is unaffected; but retained earnings decreases with stock dividends. The number of treasury shares increases in a stock split but is unaffected by a 100% stock dividend. Only outstanding shares partake in dividends of any kind. Theoretically, neither a stock dividend nor a stock split has any economic value to any stockholder o Stockholders continue to own the same percentage of the firm as they did prior to the dividend or split. E.g., 100 out of 1,000 becomes 150 out of 1,500. o Theoretically, stock prices should fall enough to offset the increase in the number of shares owned by each stockholder, assuming no other events affecting share price occur. E.g., 100 shares owned prior to a stock dividend or split at a market price of $60 per share becomes 150 shares owned post dividend at a market price of $40 per share. One purpose of stock dividends and stock splits is to reduce the market value of each share of stock. o In reality though, the stock price may not fall by the full amount discussed above. The additional number of shares resulting from a stock dividend can reduce the per share stock price enough so smaller investors find the stock more appealing. Can cause an influx of investors who may place a higher value on the company, which could result in the market value of each share falling by less than the theoretical amount. Example – Stock Dividend and Stock Split o Pre – transaction partial balance sheet Common Stock ($2 par value; 2,000,000 Shares authorized; 100,000 shares issued; 90,000 outstanding). $200,000 Paid in Capital in Excess of Par $2,800,000 Retained Earnings $3,000,000 Treasury Stock (10,000 shares) ($250,000) Total Stockholder’s Equity $5,750,000 o Small stock dividend A 10% stock dividend is declared on a day the stock is selling for $30. 90,000 10% = 9,000 shares issued. Retained Earnings is reduced by the amount of the dividend, which is set equal to the fair market value of the shares issued. Common Stock and to Paid in Capital in excess of par are increased by an equal amount in total. Total Equity is unchanged, no assets are transferred from the corporation. o Large stock dividend (independent case) A 100% stock dividend is declared on a day the stock is selling for $30. (independent case). 90,000 100% = 90,000 shares issued. Retained Earnings is reduced by the amount of the dividend, which is set equal to the legal capital associated with the shares issued. Common Stock is increased by an equal amount in total. Total Equity unchanged, no assets transferred from the corporation. o 2 for 1 stock split (independent case) All shares double (one becomes two) and par value per share becomes one half what it was. 100,000 issued becomes 100,000 2 = 200,000 issued. 90,000 outstanding becomes 90,000 2 = 180,000 outstanding. 10,000 treasury shares become 10,000 2 = 20,000 treasury shares. Increasing the number of shares authorized requires separate shareholder approval, but this usually occurs along with the action to split the stock. Total Equity is unchanged, no assets transferred from corporation. For a stock split, individual equity accounts are also unchanged. Ratio analysis o Dividend yield = dividends / market price per share. This represents the percentage return a firm’s current dividend provides to an investor buying the firm’s stock at the market price. It is only an incomplete measure of return because an investor also earns a yield based on future stock price changes. A low yield can mean a company is conserving cash to fund growth projects that will result in great increases in the price of the firm’s stock; although it can also mean the firm is experiencing financial difficulty. A high yield can indicate good performance (good cash flow), but can also mean a lack of investment opportunities. Plus a high yield can result from a depressed stock price, i.e., an expectation of poor future performance. Dividend payout = dividends / earnings (met income). Represents the proportion of earnings paid out to stockholders. Ratio analysis o Dividend payout ratio = dividends / net income. Ratio may vary greatly from year to year becomes firms usually have a policy of keeping dividend payments steady, but net income is more difficult to keep steady. Nevertheless, a low payout ratio is usually an indication of a firm with many growth opportunities, while a high payout ratio is an indication of a firm with fewer growth opportunities. Corporation's stock issuance is called an initial public offering (IPO) for the very first sale of stock by firm to public. Corporation's stock issuance is called a seasoned new issue for subsequent issuance of stock to public by firm. Stock Options (from right after issuance of common stock section) o These options are costly to the firm. Incurs chance that will have to sell shares in future at less than market value. o The fair value of this cost to the firm is captured as executive compensation expense. o Ratios analyzing debt claims against corporation vs. equity claims. High debt can be dangerous because payments must be made or company becomes subject to legal action. Equity Ratio = Total Stockholders Equity / Total Assets. Debt Ratio = Total Liabilities / Total Assets. Debt Equity Ratio = Total Liabilities / Total Stockholders Equity. o If stock price greatly exceeds earnings (net income) then stock price may be in danger of falling. Price Earnings = Market price per share of stock / Earnings per share. Earnings per share (EPS) = Net Income less preferred dividends / Avg. # shares outstanding. o Other aspects of preferred stock: Convertible preferred stock may be returned to the corporation in return for a predetermined amount of common stock, at the preferred stockholder’s discretion. Redeemable preferred may be returned to the corporation in return for a stated sum of money, at the preferred stockholder's discretion. Callable preferred stock can be bought back by the issuing corporation at the issuing corporation’s discretion at the call price. Call premium is the amount by which call price exceeds preferred stock’s par value. Chapter 12 – Introductory Accounting An accounting statement reporting on cash flow is important o A firm’s cash flow is the difference between the cash it receives and the cash it pays out in a given period of time. Cash flow is called positive when a firm’s cash receipts exceed its cash payments. o Positive net income does not necessarily imply positive cash flow, at least in the short term, nor do losses always imply negative cash flow. Revenue and expense may be recognized before or after the associated cash flow. o Yet knowing a firm’s cash flow is important to managers. Managers need to manage cash flow as well as profits. Cash is needed to pay a firm’s suppliers, employees, and creditors. o No cash - no firm. Cash is also needed to grow the business, take advantage of investment opportunities, to expand, to replace worn out assets, and to pay dividends to owners. o Knowing cash flow is important to investors when trying to determine the value of companies. Knowing cash flow provides investors with information on: How managers have acquired the cash necessary to run the firm. I.e., whether the firm is generating sufficient cash flow internally to take advantage of investment opportunities, to pay dividends, to replace worn equipment, to pay suppliers, etc, or whether it is seeking capital infusions from investors (operating cash flows vs. financing cash flows). How well managers are managing working capital, e.g., accounts receivable and inventory levels. How much management is investing in productive capacity (investing cash flows). The timing of a firm's cash flows. Two companies with the same profits can have different cash flows. and Cash received today is worth more than cash received tomorrow (Invest $1 today, get > $1 tomorrow). Cash for accounting purposes includes physical cash on hand, bank accounts and cash equivalents. o Cash equivalents, as discussed in chapter 6, are assets of 1) stable value that are quickly and 2) easily converted into cash at will without significant cost. Cash equivalents must be: Highly liquid, i.e., readily and cheaply convertible into a known amount of cash. Short term (maturing in three months or less). o So that there is insignificant risk of changes in value because of interest rate changes. Treasury bills and commercial paper are examples of cash equivalents. o Cash for accounting purposes thereby includes assets readily accepted in exchange for goods and services, as well as assets easily converted into assets readily accepted in exchange for goods and services, with little loss of value. Receivables and Inventory are not cash or cash equivalents. They are unlikely to be accepted as direct payment. They are not convertible into cash at will without significant cost. Statement of Cash Flows o The Statement of Cash Flows explains the changes in a firm’s cash balance from the beginning of an accounting period to the end of that period. It details a firm’s cash flows, providing information relevant to questions such as "Is the company generating sufficient cash to survive or is it borrowing or selling off assets to obtain cash?". Changes in cash (and cash equivalents) are reported in three categories o Cash flows from investing activities are related to the purchase and disposal of long lived productive assets, patents, investments in the securities of other companies or other income producing assets. Outflows Buy plant property and equipment, patents, etc. Buy a bond of another firm or lend money. Buy stock of another firm. Inflows Sell plant property and equipment. Sell a bond of another firm or collect on a loan. Sell previously purchased stock of another firm. Net Cash inflow (outflow) from investing activities is the difference between the above inflows and outflows, the direction depending on which is larger. Under GAAP, Interest and Dividends received are not investing activities cash flows just as income earned on PP&E is not an investing activity cash flow. However, under IFRS, Interest and Dividends received can be classified as either investing or operating activities. o Cash flows from financing activities are related to obtaining funds from investors and paying those funds back, i.e., issuing and redeeming claims against the corporation. Inflows Issue debt (notes, bonds, mortgage), or borrow. Issue stock. Outflows Pay off debt. Repurchase stock (treasury stock purchase or stock redemption). Pay dividends on the company’s outstanding stock. Net Cash inflow (outflow) from financing activities is the difference between the above inflows and outflows, the direction depending on which is larger. o Distinguishing between investing and financing activities Investing activities involve a cash outflow first, buy then sell another firm’s stock. Financing activities involve a cash inflow first, issue debt then pay it off. Important: paying dividends is considered a financing activity outflow while paying interest is considered an operating activities cash flow. Corporation makes a decision to retain earnings to finance operations. Interest payments, however, are not voluntary like dividends are, and are an expense of the business and part of operating cash flows. However, under IFRS, Interest and Dividends paid can be classified as either financing or operating activities. o Cash flows from operating activities relate directly to revenue and expenses reported on the income statement. Includes cash flows associated with income from investment activities and expenses from financing activities (Under GAAP). But dividends paid are not considered an expense of financing activities. They are considered a financing activities cash flow themselves. Inflows Cash receipts from product sales to customers (PPE). Interest received (Bond investment). Dividends received (Stock investment). Outflows Cash disbursements, including taxes, associated with the expense of making and selling the firms products or services (PPE). Interest Paid (Bond issued). o Directly relates to an expense reported on the income statement. Dividends paid on the stock that the firm has issued are NOT considered operating activity cash outflows under GAAP. Payment is voluntary; firm chooses not to pay dividends so as to finance operations. Net Cash inflow (outflow) from operating activities is the difference between the above inflows and outflows, direction depending on which is larger. o For our purposes, the total of the net cash flow from operating, investing and financing activities must equal the net increase or decrease in a firm’s cash during the associated period. This total of the net cash flow from the three activities is the firm’s overall net cash flow for the accounting period in reality, other items, such as currency translation changes, will be needed to reconcile between the total of the net cash flow from the three activities and the change in the firm’s cash position. o Cash flow from operating activities is the only long run, sustainable source of cash. In the long run, investors and creditors will not invest in a company that does not demonstrate the ability to generate sufficient cash flow from operations to pay them their required returns and assets can’t be sold off forever. The operating activities section is therefore considered the most important of the three sections as it shows the ability of the firm to generate cash internally through operations and through the management of working capital. Cash flow from operations o Cash flow from operations may be reported using either the indirect method or the direct method. The indirect method is used by most (99%) U.S. companies because the direct method is more expensive to implement. Direct method is officially preferred under IFRS and GAAP, although indirect method is acceptable. FASB and IASB have considered requiring the direct method, but there has been significant resistance from preparers. o Both the direct and indirect methods yield the same net operating cash flow. The direct and indirect methods are simply alternative ways to arrive at the same number. And the investing and financing sections will always be presented in the same manner regardless of the alternative chosen to report operating cash flows. o The indirect method starts with net income and adjusts for deferrals and accruals as well as income and expense accounts that do not involve cash. The indirect method reconciles a firm's reported net income to the firm's total net operating cash flow. Total net operating cash flow = operating inflows less operating outflows. Although firms using the indirect method must disclose interest paid and income taxes paid. o The direct method reports cash receipts and cash disbursements. The direct method adjusts the elements of the income statement to separate cash inflows and outflows. Although firms using the direct method must reconcile net income to cash flow in the notes to the financial statements. Indirect method of presenting Cash Flows from Operating Activities Cash flow from operating activities will be presented as follows: o Net Income (for loses, start with a negative) Minus Income, Gains or Expense Reductions that have zero effect on Operating Activities cash flow. Plus Expenses or Losses that have zero effect on Operating Activities cash flow. Minus changes in those assets associated with transactions affecting only cash flow from operations. Plus changes in those liabilities associated with transactions affecting only cash flow from operations. o Net Cash Flows provided by operating activities Net Income Less gains on sale of PP&E and on early redemption of debt Less bond premium amortization Plus losses on sale of PP&E and on early redemption of debt Plus bond discount amortization Plus depreciation expense Less change in A/R | Less change in prepaids | Less change inventory | Plus change A/P | Plus change Unearned Revenue | (Change means ending Plus change Int. Payable | balance less beginning Plus change Taxes Payable | balance) Plus change Accrued Liabilities | Equals Net cash provided by operations