Waterloo SOS AFM 101 Final Fall 2011

Waterloo SOS AFM 101 Final Fall 2011 - AFM 101 Final...

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Unformatted text preview: AFM 101 Final Exam-AID Package Fall 2011 Students Offering Support AFM 101 Final Exam Aid Fall 2011 Prepared by Jenifer Lee December 5th, 2011 Contents 1) 2) 3) 4) 5) Chapter 1-6 material with examples Chapters 7 13 material with examples Article Summaries for Chapter 7-13 articles Extra Practice Problems Extra Practice Problems Solutions AFM 101 Final Exam-AID Package Fall 2011 Chapter 1: Financial Statements and Business Decisions Four Major Financial Statements 1) The Balance Sheet The company's financial position at a point in time Assets (list all assets) Total Assets ABC Co. Balance Sheet December 31, 2009 $XX $XX XX XX XX Liabilities (list all liabilities) Owner's Equity/Shareholder's Equity (list owner's equity components) Total Liabilities and Owner's Equity Assets Economic resources of the company, listed in order of liquidity i.e. what the company owns Liabilities The company's obligations, listed in order of when the liabilities come due i.e. what the company owes Owner's Equity/Shareholder's Equity Two parts: o The amount of financing provided by the owners of the company through share capital o The earnings from the business operations from retained earnings 2) Income Statement How the company operated during the accounting period ABC Co. Income Statement For the Period Ended December 31, 2009 Revenue (List all sources of revenue) $XX Total Revenue XX Expenses (List all Expenses) $XX Total Expenses XX Net Income XX AFM 101 Final Exam-AID Package Fall 2011 Revenue Money received from sale of goods, or providing a service Expenses Resources used up by the entity to run the business and generate revenue 3) Statement of Retained Earnings (Statement of Shareholders' Equity) Used to calculate the ending retained earnings number for the balance sheet ABC Co. Statement of Retained Earnings For the Period Ended December 31, 2009 Beginning Retained Earnings $XX Add Net Income for period XX Subtract Dividends paid to owners XX Ending Retained Earnings XX When net income is earned every year, the company can choose to: o Distribute all (or a portion) to shareholders in the form of dividends o Retain all (or a portion) to continue to run the day to day business Retained Earnings: the accumulation of all net income NOT distributed as dividends since the first year of business 4) Statement of Cash Flows Used to show all inflows and outflows of company cash during the year Used to calculate the cash balance on the balance sheet ABC Co. Statement of Cash Flow For the Period Ended December 31, 2009 Cash flows from Operating Activities (List details) $XX Cash flows from Investing Activities (List details) $XX Cash flows from Financing Activities (List details) $XX Net Increase/Decrease in Cash XX Cash balance beginning of period (Jan 1, 2009) XX Cash Balance end of period (Dec 31, 2009) XX 5) Notes to the Financial Statements Required by accounting standards (GAAP) Further explain the numbers in the financial statements Explain accounting policies used by the management of the company Contain supporting schedules and calculations Additional important non-quantitative disclosures AFM 101 Final Exam-AID Package Fall 2011 Ratio Analysis = Represents the "value" an investor thinks this company is worth Investors will multiply the P/E ratio by the company's net income to determine a price one would pay for the company The higher the P/E ratio, the greater confidence investors have in this company's abilities to generate income Chapter 2: Investing and Financing Decisions and the Balance Sheet The Conceptual Framework The conceptual framework is used to make connections to lead us from the purpose of financial statements to the components and characteristics of Financial Statements and the methods and assumptions management use to create the Financial Statements. Objectives of Financial Reporting (creating financial statements) To provide useful information to external users of the financial statements so they can make business decisions Elements of the financial statements Assets, liabilities, shareholder's equity, revenue, expenses, etc. Qualitative Characteristics of good financial statements Understandability, relevance, reliability, comparability Underlying Assumptions of accounting information Separate entity: each business is accounted for as an individual organization Unit-of-measure: a business accounts for its operations and reports the results using the monetary unit of the country in which it is operating On-Going concern: a business is expected to continue to operate in the foreseeable future; there is nothing to suggest it will go out of business soon Basic Accounting Principles (GAAP) Cost Principle Revenue Recognition Matching Full Disclosure Constraints of financial reporting Cost-benefit: sometimes we want to collect as much information as possible, but we need to view it on a cost-benefit basis; is it worth the costs to collect the extra information? Materiality: information from the financial statements that will affect/influence a user's decision is considered material in nature AFM 101 Final Exam-AID Package Fall 2011 Elements of a Classified Balance Sheet Assets Economic resources arising from past transactions Future benefits (i.e. conversion to cash) can be obtained Current Assets Assets that can generally be "converted" to cash within one year very liquid o Cash and cash equivalents o Short term investments (i.e. shares in other companies, can sell very easily) o Accounts receivable (a promise to pay from a customer or another party) o Note Receivable o Inventory o Prepaid expenses (expenses paid before they are actually used) Non-Current Assets Assets that are generally converted to cash after more than one year o Long term investments o Property, plant, equipment (reported on a net of amortization basis) o Intangible assets (patents, trademarks, licenses, franchises) o Goodwill Liabilities Debts and obligations owed to other parties, which will be paid off using assets in the future Current Liabilities Obligations that will be paid within one year o Accounts Payable o Accrued liabilities (i.e. unearned revenue) o Current portion of long-term debt Long Term Liabilities Obligations that will take longer than a year to pay off o Long term debt o Mortgage payable o Bonds payable Shareholder's Equity Share Capital Money received from the company issuing its own shares, purchased by the shareholders of the company A form of "equity financing", also known as raising money through equity Retained Earnings The accumulation of net income not distributed as dividends since the company began operations Dividends are paid out of retained earnings and distributed to the shareholders as a return on their investment in the company AFM 101 Final Exam-AID Package Fall 2011 Example of a Classified Balance Sheet Ratio Analysis - - = Measures how much debt has been used to finance the company (versus financing through the owners/shareholders of the company Companies need to pay back debt before they can pay dividends to owners, so a high debt-to-equity ratio means there is a higher risk that a company may not be able to meet its financial obligations E.g. the D/E ratio of the above balance sheet is: 481,000 / 289,000 = 1.66 AFM 101 Final Exam-AID Package Fall 2011 Business Transactions and Journal Entries Business Transactions Whenever a transaction occurs, it changes the financial position of the company, so the transaction must be recorded External events: exchanges of assets and liabilities between the business and other parties Internal events: adjustments, unforeseeable events, they do not involve external parties but must still be recorded as the transactions affect the financial position of the company Double Entry Accounting Every time a transaction occurs, at least two accounts are affected The total debits = total credits in a transaction The fundamental accounting equation remains in balance after each transaction An increase to an asset account is a debit entry An increase to a liability account is a credit entry An increase to a shareholder's account is a credit entry Since dividends decrease shareholder's equity, thus an increase to dividends is a debit entry Debits are always on the left side of a transaction entry Credits are always on the right side of a transaction entry Whenever a transaction occurs record in General Journal All transactions are posted to general ledger accounts, or we use t-accounts for simplicity. The ending balances to each t-account form the balances on the Balance Sheet. AFM 101 Final Exam-AID Package Fall 2011 Chapter 3: Operating Decisions and the Income Statement The Operating Cycle The cycle of activities that goes from paying suppliers for goods and materials to generating inventory to selling the inventory to customers to collecting the cash from customers (for a manufacturing/merchandising company) At the end of every operating cycle, a set of "year-end" financial statements are made This supports the periodicity assumption: the operations of a company are reported in specified periods (usually a year) Elements of an Income Statement Revenue/Sales Results of selling a good or providing a service A company can have more than one source of revenue; if this is the case, then the revenue section should have more detailed line items Cost of Goods Sold The cost to the company for obtaining the product to sell Gross Profit Revenue Cost of Goods Sold Operating Expenses The expenses incurred to operating the business o Salaries expense o Utilities expense o Administrative expenses o Rent expense o Insurance expense o Amortization expense Operating Income Subtotal of operating revenues- operating expenses Other Expenses Other expenses incurred that do not directly relate to the daily operations of the business o Interest Expense o Investing Expenses Earnings Before Income Tax Operating Income other expenses Income Tax Expense Calculated by tax professionals, often calculated from a percentage Net Income Net Income = Earnings before income tax-income tax expense AFM 101 Final Exam-AID Package Fall 2011 Earnings Per Share = Required to be disclosed on the bottom of the income statement Accrual vs. Cash Basis of Accounting GAAP specifies the Accrual basis of accounting, where revenue is only recorded when it's "earned" and expenses are recorded when "incurred" This timing can be quite different from the Cash basis of accounting, where revenue is recorded when cash is received and expenses are recorded when cash is paid Revenue Recognition Principle Revenue should be recognized on the income statement when the following 3 criterion are satisfied: o Earnings process is complete or almost complete: the company providing the good or service must have completed its services o An exchange of transaction: the customer must have already paid or have promised to pay in the near future (price agreed upon by both parties) o Collection of payment is reasonably assured: if the customer has agreed to pay in the near future, then there is a low risk of default Matching Principle Expenses should be recorded in the same period as the revenue it helped to earn All expenses of a company either directly or indirectly contribute to the company's abilities to earn revenue; thus, expenses should be recorded when they are used up **Note: Even if revenue isn't recognized or expenses haven't been incurred, we still need to record any business transaction as a journal entry (it just won't affect a revenue or expense account yet; that's what adjusting entries are for in chapter 4) ** Comparison of Accrual vs. Cash Basis of Accounting Cash is paid before expense is incurred th On September 30 ABC Co just made a $3,000 cash payment for the next 6 months of rent Cash Basis Accrual Basis Rent Expense 3,000 Prepaid Rent (Asset) 3,000 Cash 3,000 Cash 3,000 Cash is received before revenue is earned th On Nov 25 TIX Co, a ticketing service agency received $5,000 worth of payments from customers for a Broadway show later in the year Cash Basis Accrual Basis Cash 5,000 Cash 5,000 Revenue 5,000 Unearned Revenue (L) 5,000 Expenses are incurred before cash is paid AFM 101 Final Exam-AID Package Fall 2011 The company received a $500 hydro bill on December 31 , they didn't make the payment until the next fiscal period Cash Basis Accrual Basis NO ENTRY Utilities Expense 500 Utilities Payable (L) 500 Revenue is earned before cash is received You own a lawn-mowing business and you've mowed $200 worth of lawns, yet your clients have promised to pay within the next week Cash Basis Accrual Basis NO ENTRY Accounts Receivable (A) 200 Revenue 200 ***More adjusting entries in Chapter 4 Ratio Analysis = Average Total Assets = [last year's total assets + this year's total assets] / 2 Measures how much sales is generated for every $1 of assets A high ratio is favourable = Measures management's effectiveness at utilizing assets to generate income A high ratio is favourable st Chapter 4: Adjustments, Financial Statements and the Quality of Earnings Unadjusted Trial Balance A list of ALL of the company's accounts, used for internal purposes Contains both balance sheet and income statement accounts The total columns for debits and credits must be equal After closing entries, all revenue and expense accounts will have zero balances, leaving only balance sheet accounts AFM 101 Final Exam-AID Package Fall 2011 ABC Co. Trial Balance December 31, 2009 Debit Credit Cash XX Accounts Receivable XX Inventory XX .... .... Accounts Payable XX Income Tax Payable XX Accrued Liabilities XX .... .... Share Capital XX Retained Earnings XX Revenue XX Other Revenue XX Cost of Goods Sold XX Salaries Expense XX Rent Expense XX .... .... Totals XX XX Adjusting Entries Throughout the normal course of business, we record all transactions as journal entries Adjusting entries transfer amounts to different accounts, allowing us to properly recognize revenue and record expenses Adjusting entries NEVER affect cash At the end of the business cycle, we record entries to close revenue and expense accounts, and prepare the final financial statements Types of Adjusting Entries Deferred Revenue (unearned revenue) Cash was received before revenue is earned During operations, when cash was received DR Cash CR Unearned Revenue (Liability) AFM 101 Final Exam-AID Package Fall 2011 Adjusting entry, when revenue is earned DR Unearned Revenue (erases the liability account) CR Revenue (recognizes the revenue) st E.g. On Jan 1 , ABC Co signed a contract stating they will provide 2 months of services. They received $1,200 payment up front. st Jan 1 During Operations DR Cash 1,200 CR Unearned Revenue 1,200 st Jan 31 Adjusting Entry DR Unearned Revenue 600 CR Revenue 600 First month of revenue is earned th Feb 28 Adjusting Entry DR Unearned Revenue 600 CR Revenue 600 Second month of revenue is earned **Note: because we were told the contract was for 2 months of services, we are able to adjust at the end of every month; usually, we would recognize the revenue and erase the liability for the entire amount when revenue was deemed earned. Deferred Expense (Prepaid Expenses) Cash is paid for expenses to be incurred in the future (specified amount of time) Includes prepaid rent, prepaid insurance Adjustments are made at the end of every month when expenses are incurred During operations, when payment was made DR Prepaid Expenses (Current Asset) CR Cash Adjusting entry, when expenses are incurred DR Expense CR Prepaid Expenses (decline in the value of the asset as expenses are incurred) th E.g. On April 30 , ABC Co paid for 8 months worth of insurance for $2,400 th April 30 When payment was made DR Prepaid Insurance 2,400 CR Cash 2,400 st May 31 Adjusting Entry DR Rent Expense 300 CR Prepaid Insurance 300 First month of rent expense th June 30 Adjusting Entry DR Rent Expense 300 AFM 101 Final Exam-AID Package Fall 2011 CR Prepaid Insurance 300 Second month of rent expense **Same entries made for months 3 8 Accrued Revenue (receivables) Revenue is earned before payment is received from customer During operations, when service was performed/product was sold DR Accounts Receivable (customer has yet to pay) CR Revenue Adjusting entry, when cash is received DR Cash CR Accounts Receivable (erases the receivable) E.g. On Mar 1 , ABC Co provided services worth $500, the customer subsequently paid on Apr 24 st Mar 1 When service was performed DR Accounts Receivable 500 CR Revenue 500 th Apr 24 Adjusting Entry DR Cash 500 CR Accounts Receivable 500 Payment is received from customer Accrued Expenses (Payables) Expenses are incurred before the company makes a payment During operations, when expenses were incurred DR Expense CR Accounts Payable (company has yet to pay) Adjusting entry, when cash is paid DR Accounts Payable (erases the payable) CR Cash E.g. The company pays their employees on a bi-weekly basis. Total salaries expense for each period is $20,000. nd st The next payday is Jan 2 . Dec 31 is the company's year end. st Dec 31 Adjusting entry to accrue for expenses at year end DR Salaries Expense 16,000 CR Salaries Payable 16,000 Expenses must be accrued at year end, but the company has not paid anything yet nd Jan 2 Entry to record payment of salaries DR Salaries Payable 16,000 (to erase payable) DR Salaries Expense 4,000 CR Cash 20,000 Payment is made st th AFM 101 Final Exam-AID Package Fall 2011 Amortization The matching principle states that a company needs to match expenses to the revenue it helped generate Capital assets (machinery, equipment, plant, etc.) are used to help the company generate revenue Thus, portions of the assets' costs are allocated as amortization expense The cost principle states that assets must be listed on the balance sheet at their historical cost (i.e. purchase price) Therefore, the amortization expense is accumulated in a contra asset account: accumulated amortization On the balance sheet, the capital assets are presented in the non-current assets section at their net value: Equipment 15,000 Less: Accumulated Amortization Equipment 5,000 10,000 The amount of amortization expense each year: [ - } = st E.g. On April 1 , ABC Co purchased equipment for 80,000 on account. It was assumed this equipment would have a salvage value of 8,000 and a useful life of 9 years. Record the journal entry on purchase date and the requirement adjusting entry at year end. Annual Amortization Expense = [80,000 8,000] / 9 = 8,000 Amortization expense for this year (9 months) = 8,000 * 9 / 12 = 6,000 Journal Entry to record amortization expense: Amortization Expense 6,000 Accumulated Amortization Equipment 6,000 Accrued Interest on Bonds or Notes Payable Companies borrow money by issuing bonds or notes to third parties (creditors) Before they pay back the amount borrowed, companies need to pay interest on the amount borrowed Since interest payment days do not usually correspond with year end dates, accrued interest must be recorded at each year end E.g. On April 1 , ABC Co issued a $10,000 bond paying 6% interest semi annually; interest is paid every September th st 30 and March 31 st April 1 Company issues the bond (incurs the liability) Cash 10,000 Bond Payable 10,000 th Sept 30 First interest payment Interest Expense 300 Cash 300 Every 6 months, the company needs to pay 0.06 * 10,000 * 0.5 = $300 st December 31 Year end, need to adjust for the interest expense incurred (but not paid) Interest Expense 150 Interest Payable 150 st AFM 101 Final Exam-AID Package Fall 2011 March 31 Second interest payment Interest Expense 150 Interest Payable 150 Cash 300 Closing Entries Relationship between the Balance Sheet and Income Statement: o Net Income each year adds to the Retained Earnings account on the Balance Sheet At the end of each operating cycle, we need to transfer the net income earned during the period to Retained Earnings o This is done through closing entries Temporary (Nominal) Accounts Revenue, Expense accounts Close out to retained earnings at end of fiscal period Start with $0 balance at beginning of fiscal period Permanent (Real) Accounts Accounts on the Balance Sheet (they have a beginning balance at the start of each operating period) ***We close Temporary Accounts and do not close Permanent Accounts The Closing Entry Process Step 1: Close Revenue Accounts Sales Revenue XX Rent Revenue XX ... Income Summary XX The Income Summary is another temporary account that we use only in the closing entry process. This account itself gets closed out to retained earnings. Step 2: Close Expense Accounts Income Summary XX Rent Expense XX Salaries Expense XX Interest Expense XX ... Step 3: Close Income Summary Account If there was a net income Income Summary XX Retained Earnings XX ** Retained earnings increased (credit entry) st AFM 101 Final Exam-AID Package Fall 2011 If there was a net loss Retained Earnings XX Income Summary ** Retained earnings decreased (debit entry) Ratio Analysis XX = ( - ) Measures how much income is generated for each dollar of sales i.e. For every $1 of sales, how much does the company get to retain? A higher net profit margin is more favourable = ! Average Shareholder's Equity = [Beginning SH Equity + Ending SH Equity] / 2 Measures how much income is generated for each dollar of shareholder's equity (or the shareholder's investment in the company) A higher ratio is more favourable Chapter 5: Reporting and Interpreting Cash Flows The Need for a Cash Flow Statement Due to the accrual basis of accounting: o Cash received Revenue o Cash paid Expenses Knowing how much cash is available for use in the company is very important o If a company wants to purchase items or expand operations, cash is needed A company can have lots of assets on their Balance Sheet, but if none of them can be converted to cash easily, then the company will have difficulty continuing operations The Cash Flow Statement Separated into 3 sections: o Operating o Investing o Financing Summarizes the inflows and outflows of cash We can determine the ending cash balance on our Balance Sheet by adding the inflows and outflows of cash to the beginning cash balance o Cash (Beginning) +/- Increase or Decrease of Cash = Cash (Ending) AFM 101 Final Exam-AID Package Fall 2011 Cash Flows from Operating Activities Cash inflows and outflows relating to the day to day operations of the business Cash inflows: (money received from) o Making sales o Receiving dividend or interest revenue Cash outflows: (money paid for) o Operating expenses (salaries, utilities, rent) o Interest expense, income tax expense Cash Flows from Investing Activities Cash inflows and outflows relating to the purchase or sale of capital assets or the purchase or sale of investments in other companies Cash inflows (money received from) o Sale of plant, property, or equipment o Sale of investments Cash outflows (money paid for) o Purchase of plant, property, or equipment o Purchase of investments Note: the cash flows are categorized as investing activities when it relates to the initial purchase or final sale of investment in other activities. If we receive interest of dividend revenue on the investment, that cash flow is considered an operating activity Cash Flows from Financing Activities Cash inflows and outflows related to external parties (owners and creditors) in order to finance (or generate cash) for the company Cash inflows (money received from) o Issuing shares of your own company (money is received from shareholders) o Issuing debt or notes payables (money is received from debt-holders or creditors) Cash outflows (money paid for) o Buying back your own shares from existing shareholders o Paying back the debt or note payable to debt-holders or creditors o Paying dividends to existing shareholders Accounts and Types of Activities (General Guideline) A = Current Assets L + Current Liabilities SE Sinancing operating Non Current Assets operating Long Term Liabilities investing Sinancing Very general guideline for each transaction affecting cash flows Identify the accounts that are affected o Current assets or current liabilities operating o Non-current asset (i.e. plant, property, equipment, or long term investments) investing o Long term liabilities or Shareholder's Equity (i.e. long term debt or bonds, commons shares) financing AFM 101 Final Exam-AID Package Fall 2011 Examples Receiving interest on investments held A: operating Balance Sheet account affected (other than cash): None so this example does not follow the `general guideline' Sale of a piece of land and related building A: investing Balance Sheet account affected: Land, Building Investing in common stock in another company A: investing Balance Sheet account affected: Investments (assume long term asset, but could be current asset as well) Cash payment of a Note Payable A: financing Balance Sheet account affected: Note Payable (assume long term liability, but could be short term liability as well) Purchasing a new supply of inventory A: operating Balance Sheet account affected: Inventory Issuing Common Shares to new shareholders A: financing Balance Sheet account affected: Common Shares Paying dividends to shareholders A: financing Balance Sheet account affected: Dividends (which affects retained earnings) Issuing a bond to generate cash for a company A: financing Balance Sheet account affected: Bond Payable Two Methods to Prepare Cash Flows from Operations section 1) Direct method record all the actual movements of cash that occurred in the period 2) Indirect method start with net income and adjust for any non-cash items or items that will be accounted for in the investing or financing sections Both methods give the same cash flow from operations number Indirect Method: Operating Cash Flows Net Income - Increases in current assets + Increases in current liabilities + Non cash expenses, losses - Non cash revenues, gains = Cash Flow from Operations We want to get from Net Income to Net Cash Flows Revenue Cash Received - Expenses - Cash Paid = Net Income = Net Cash Flows AFM 101 Final Exam-AID Package Fall 2011 So therefore, we need to make adjustments for differences between revenue and cash received and expenses and cash paid You will be given a balance sheet showing balances for this year and the previous year Current Assets Subtract increases in current assets (A/R, Inventory, Prepaids, etc.) Add decreases in current assets Why? Illustrate with A/R We know: Beginning A/R + Revenue Cash Collected = Ending A/R If there was an increase in A/R then: Revenue Cash Collected > 0 Revenue > Cash Collected Thus our cash collected was less than actual revenue, and we should subtract this difference (i.e. the increase in A/R) from net income to account for the actual cash collected If there was a decrease in A/R then: Revenue Cash Collected < 0 Revenue < Cash Collected Thus our cash collected was more than actual revenue, and we should add this difference (i.e. the increase in A/R) to net income to account for the actual cash collected Current Liabilities Add increases in current liabilities (A/P, Interest Payable, Income Tax Payable, etc.) Subtract decreases in current liabilities Why? Illustrate with A/P We know: Beginning A/P + Expenses Cash Paid = Ending A/P If there was an increase in A/P then: Expenses Cash Paid > 0 Expense > Cash Paid Thus our expenses were greater than the cash paid. Since we subtract expenses to arrive at net income and our cash flow was less than expenses, we should add the difference back to net income to account for the actual cash paid. If there was an decrease in A/P then: Expenses Cash Paid < 0 Expense < Cash Paid Thus our expenses were less than the cash paid. Since we subtract expenses to arrive at net income and our cash flow was more than expenses, we should subtract the difference from net income to account for the actual cash paid. Non-cash expenses and losses Add expense amounts on the income statement that do not affect cash o Depreciation expense, future income tax expense Add losses on sale of assets or investments o Accounted for in the investing section Add losses on repayment of long term debt or bonds o Accounted for in the financing section Since these expenses do not affect cash and the losses are accounted for in other sections of the cash flow statement, we need to add these amounts back so the net effect on net income is zero. AFM 101 Final Exam-AID Package Fall 2011 Non-cash revenues and gains Subtract revenue amounts on the income statement that do not affect cash Subtract gains on sale of assets or investments o Accounted for in the investing section Subtract gains on redemption of long term debt or bonds o Accounted for in the financing section Since these revenues do not affect cash and the gains are accounted for in other sections of the cash flow statement, we need to subtract these amounts so the net effect on net income is zero. Example: Prepare the statement of cash flows for SOS Limited for 2009 using the indirect method. Cash Accounts receivable Inventories Prepaid expenses Equipment Accumulated amortization, equipment Amortization expense, equipment Land Accounts payable Interest payable Notes payable Bonds payable Mortgage payable Capital stock The following information relates to activities for SOS Limited for 2009. a) Net income for the year ended December 31, 2009, was $22,500. b) The company borrowed $20,000 on a long-term note from the bank. Interest is payable annually and the interest expense of $3,000 is included in net income. c) An additional piece of land was purchased on November 30, 2009. The seller of the land accepted a mortgage as full payment. d) During the year, a piece of equipment was sold for $15,000, paid in cash. Any gain or loss on the sale was included in net income. A new piece of equipment costing $28,000 was purchased in June. The purchase price was paid in cash. e) Dividends of $6,000 were paid in cash. f) Capital stock was issued in exchange for the retirement of $7,000 of long-term notes payable. g) A portion of the bonds matured during 2009 and the company paid cash to redeem these bonds 2008 $10,000 17,000 14,000 3,500 50,000 19,000 11,000 80,000 13,000 550 31,000 50,000 40,000 210,000 2009 $20,200 21,000 18,400 1,000 65,000 27,000 14,000 120,000 19,000 1,150 44,000 30,000 40,000 217,000 AFM 101 Final Exam-AID Package Fall 2011 Solution First, identify the changes in current asset and current liability accounts for the cash flow from operating activities section and any non-cash expenses and revenues: 2008 2009 Cash Accounts receivable Inventories Prepaid expenses Equipment Accumulated amortization, equipment Amortization expense, equipment Land Accounts payable Interest payable Notes payable Bonds payable Mortgage payable Capital stock $10,000 17,000 14,000 3,500 50,000 19,000 11,000 80,000 13,000 550 31,000 50,000 40,000 210,000 $20,200 21,000 18,400 1,000 65,000 27,000 14,000 120,000 19,000 1,150 44,000 30,000 40,000 217,000 4,000 4,400 (2,500) 6,000 600 Cash flows from operating activities Net Income 22,500 Adjustments: Increase in A/R (4,000) Increase in Inventory (4,400) Decrease in Prepaid 2,500 Increase in A/P 6,000 Increase in Interest Payable 600 Amortization Expense 14,000 Next, use the additional information to start constructing the cash flows from investing activities section: An additional piece of land was purchased on November 30, 2009. The seller of the land accepted a mortgage as full payment. No effect on cash, but should be disclosed as a non cash investing activity During the year, a piece of equipment was sold for $15,000, paid in cash. Any gain or loss on the sale was included in net income. A new piece of equipment costing $28,000 was purchased in June. The purchase price was paid in cash. Cash received for sale of equipment: 15,000 Cash paid for new equipment: 28,000 AFM 101 Final Exam-AID Package Fall 2011 Cash flows from investing activities Cash paid for purchase of new equipment (28,000) Cash received for sale of equipment 15,000 Net Cash Flows from Investing Activities (13,000) Next, since there was a sale of equipment, we need to figure out the gain or loss and back that out of net income in the operating activities section Equipment Account: Beginning Balance + Cost of Purchases Cost of Equipment Sold = Ending Balance **Here, the historical cost of any equipment sold is removed from the equipment account Using the balances provided, we see that 50,000 + 28,000 Cost of Equipment Sold = 65,000 Cost of Equipment Sold = 13,000 To determine the gain or loss on sale of asset, we need the Net Book Value of the equipment that was sold. Net Book Value = Cost of equipment Accumulated Amortization (of that equipment) Accumulated Amortization Account: Beginning Balance + Amortization Expense of the Year Accumulated Amortization amount for any equipment that was sold = Ending Balance 19,000 + 14,000 Accumulated Amortization for equipment sold = 27,000 Accumulated Amortization for equipment sold = 6,000 Therefore Net Book Value of equipment sold = 13,000 6,000 = 7,000 Gain on Equipment Sold = Sale Price Net Book Value = 15,000 7,000 = 8,000 Thus this gain needs to be subtracted from net income in the operating activities section Our finished operating and investing sections: Cash flows from operating activities Net Income 22,500 Adjustments: Increase in A/R (4,000) Increase in Inventory (4,400) Decrease in Prepaid 2,500 Increase in A/P 6,000 Increase in Interest Payable 600 Amortization Expense 14,000 Gain on Sale of Equipment (8,000) Net Cash Flows from Operating Activities 29,200 Cash flows from investing activities Cash paid for purchase of new equipment (28,000) Cash received for sale of equipment 15,000 Net Cash Flows from Investing Activities (13,000) AFM 101 Final Exam-AID Package Fall 2011 Next, use the additional information to start constructing the cash flows from financing activities section: The company borrowed $20,000 on a long-term note from the bank. Interest is payable annually and the interest expense of $3,000 is included in net income. Cash received from borrowing of 20,000 Dividends of $6,000 were paid in cash. Cash paid for dividends of 6,000 Capital stock was issued in exchange for the retirement of $7,000 of long-term notes payable. Not a cash item, should be disclosed as a non cash financing activity A portion of the bonds matured during 2009 and the company paid cash to redeem these bonds. Looking at the B/S, bonds payable decreased by 20,000 so $20,000 was paid to redeem these bonds Adding the financing section, we have our finished statement of cash flows: Cash flows from operating activities Net Income 22,500 Adjustments: Increase in A/R (4,000) Increase in Inventory (4,400) Decrease in Prepaid 2,500 Increase in A/P 6,000 Increase in Interest Payable 600 Amortization Expense 14,000 Gain on Sale of Equipment (8,000) Net Cash Flows from Operating Activities 29,200 Cash flows from investing activities Cash paid for purchase of new equipment (28,000) Cash received for sale of equipment 15,000 Net Cash Flows from Investing Activities (13,000) Cash flows from financing activities Cash received from issuance of N/P 20,000 Cash paid for dividends (6,000) Cash paid for redemption of bonds (20,000) Net Cash Flows from Financing Activities (6,000) Net Increase in Cash 10,200 Cash (Begin) 10,000 Cash (End) 20,200 The ending cash balance of $20,200 matches with the cash balance on the balance sheet for 2009. AFM 101 Final Exam-AID Package Fall 2011 Ratio Analysis Quality of Income = [Cash Flow from Operating Activities] / Net Income Measures portion of income generated in cash A higher ratio indicates greater ability to finance operating activities from cash inflows, and less likely to be using aggressive accounting Capital Acquisitions Ratio = [Cash Flow from Operating Activities] / Cash paid for PPE Measures the ability of company to pay for Property, Plant, and Equipment (PPE) using operating cash flows The alternative way for company to buy PPE is to borrow money via debt or equity Preferable to have Ratio above 1: greater ability to finance growth/ expansion with internal funds Chapter 6: Interpreting and Communicating Accounting Information Players in the Accounting Communication Process Remember the end goal: companies want to produce reliable financial statements for the public to view Along the way, many questions arise: o How is management going to record their accounting information? o Who is going to ensure the information is accurate and appropriate? o Who decides what set of principles or rules govern how companies can report their financial information Regulators Financial information reported by public companies is subject to strict rules and standards These standards are set by different organizations on different levels (provincial, national, etc.) Regulators work to create a set of standards regarding how to report financial information to create consistency and comparability for all companies Management (CEO, CFO, Senior Executives) These are the people running the business Top management chooses which accounting methods to use when recording their financial information The methods must still comply with standards set by the regulators, but in lots of situations, a choice can be made between which method to use Board of Directors The board is supposed to be independent from management and is the "voice" for the shareholders of the company They are responsible for ensuring the integrity of the accounting records (no fraud, theft, scandals) However, it's very common to have the CEO, CFO also on the Board, which creates perceived independence issues External Auditors Independent third parties that come to companies to ensure their financial statements comply with standards They spend weeks gathering evidence provided by management in order to produce an auditor's report AFM 101 Final Exam-AID Package Fall 2011 The auditor's report will state whether the company is in compliance with accounting standards The auditor's report will be a part of the company's annual report The annual report displays company goals, vision, mission, product lines, and of course, the set of financial information that has been audited by external auditors Auditors do not make any opinions on the financial wealth of the company; they are merely there to ensure accounting records are in compliance with standards Financial Analysts Financial Analysts use information available to the public to analyze the financial health of a company They make recommendations on whether to buy, sell, or hold the company's shares Communicating Useful Information Financial statements are made public in order to provide information to the users of the statements It is up to management to provide information that is actually useful to both internal and external parties Qualitative Characteristics of useful information Decision Usefulness Relevance Faithful Representation Predictive Value ConSirmatory Value Complete Neutral Free from Material Error ***Decision usefulness leads to comparability, verifiability, timeliness and understandability Relevance: Information that can influence a decision; it has predictive and/or confirmatory value o Material Amounts: Are amounts that are large enough to influence the user's decisions Faithful Representation: suggests that information provided in financial statements must reflect the substance of the underlying transactions Comparability: Of accounting information across businesses is enhanced when similar accounting methods have been applied Verifiability: information is verifiable if independent accountants can agree on the nature and amount of the transaction Timeliness: Information enhances both its predictive and confirmatory values Understandability: Is the quality of information that enables users to comprehend its meaning Constraints of Accounting Management Cost Constraint: Suggests that information should be produced only if the perceived benefits of increased decision usefulness exceed the expected costs of providing that information AFM 101 Final Exam-AID Package Fall 2011 Standard settlers such as the Account Standards Board of Canada require companies to disclose specific information, known as mandatory disclosure o Other cases, the company's managers may decide that voluntary disclosure of information about specific aspects of the company's operations would be beneficial to users Prudence: Suggests that care should be take not to overstate assets and revenues or understate liabilities and expenses o Chapter 7: Sales, Receivables, and Cash Revenue Revenue Recognition Principle - revenue is recognized when: 1) Earnings process is substantially complete 2) A transaction has taken place, consideration is received or receivable 3) If consideration is receivable, there is reasonable assurance that amount will be collected When is Revenue Recognized? Free on Board Destination: title passes from the seller to purchaser when the purchaser has received the goods. Seller can record revenue when the goods have been delivered. Free on Board Shipping Point: title passes from the seller to purchaser when the goods leave the shipping dock. Seller can record revenue when the goods have left the shipping dock. How Much Revenue should we record? On the income statement, we report net sales Sales Revenue Less: Sales Returns & Allowances Credit Card Discounts Sales Discounts = Net Sales 1. Sales Returns & Allowances A contra-revenue account (debit balance) Represents the products returned by customers 2. Sales Discounts A contra-revenue account (debit balance) Represents the discount given to customers Eg: "2/10, n/30" = 2% discount if you pay within 10 days, and the net amount is due in 30 days 3. Credit Card Discounts Fee charged by credit card company by providing the ability for customers to pay with credit Calculated as a percentage of gross revenue Either a selling expense or contra-revenue AFM 101 Final Exam-AID Package Fall 2011 Other Revenue Recognition Methods Installment Method When a high level of uncertainty concerning the collectability of the sales price, the company will recognize revenue only when cash is collected from the customer Often used for very expensive items, such as real estate, or high tech items Percentage of Completion Method: Method where revenue is recognized based on a percentage of work performed in the period Used when a business delivers a good or service over a long period The amount of work completed during the period is usually measured by the % of the total cost that was incurred in the period Matches revenues to expenses, preferred by management because revenues and expenses are spread out over the life of the good/service Completed Contract Method: Method where revenues and costs are recognized only after the project is fully completed If a company is working on a project, its income statement will show $0 revenues and $0 costs until the final year Comparison of Methods: Percentage of Completion method is preferred by management because it shows the progress made every period Completed Contract method may be misleading because it does not show any revenues or expense until completion only use when there is substantial doubt about ability to finish contract, and the costs and revenues the total expenses, revenues and income using both methods over the life on the contract are the same, only the timing is different Receivables Accounting for Bad Debts Companies selling on credit make a tradeoff between increasing sales and potentially uncollectible accounts To avoid overstating A/R and net income, companies need to: o Estimate how much of A/R will not get collected o This amount is expensed as "bad debt expense" in the current period Allowance for Doubtful Accounts (AFDA): a contra asset account to A/R that accumulates the estimated bad debt expense On the Balance sheet, the A/R is presented as a net number Accounts Receivable $XX Less: Allowance for Doubtful Accounts XX XX AFM 101 Final Exam-AID Package Fall 2011 Accounting for bad debts: estimating bad debt expense for the period (2 methods) 1) Percentage of Sales (on credit): Gives you the bad debt expense amount for the income statement Bad debt expense is based on credit sales, and historical rate of % of sales that aren't collected Bad debt expense = total credit sales x bad debt rate 2) Aging of A/R: Gives you the amount for AFDA on the balance sheet Groups A/R into categories by due date Apply a percentage to each category and sum to get to the AFDA ending balance Based on balances of A/R, and the percentage that will not be paid Amount uncollectible = balance of A/R * bad debt = balance of the AFDA Use T accounts to find the bad debt expense Journal Entry to record bad debt expense DR Bad Debt Expense XX CR Allowance for Doubtful Accounts XX Comparison of the two methods: - Both allowed by GAAP - Percentage of Credit Sales focuses on Income Statement valuation (matches bad debt expense to sales) - Aging of A/R focuses on Balance Sheet valuation (estimates the net realizable value of AR) Accounting for bad debts: writing off specified uncollectible accounts Sometimes, company decides some specific A/R accounts will no longer be collected We must remove these A/R from our balance sheet. DR AFDA $100,000 CR Accounts Receivable $100,000 Writing off the account has no effect on the Income Statement accounts (the bad debt was already recorded in the period of the sale) The net A/R balance is still the same (decrease in A/R offset by a decrease in Allowance for Doubtful Accounts) Accounting for bad debts: recovery of accounts previously written off If a customer of an A/R account actually pays and we had already written them off, we need to reinstate the A/R balance Set up the A/R previously written off DR A/R $100,000 CR AFDA $100,000 Record the collection of the A/R DR Cash $100,000 CR A/R $100,000 AFM 101 Final Exam-AID Package Fall 2011 Example Sailor Company estimates that its annual bad debts are approximately 4% of credit sales. At the beginning of the year, the AFDA had a credit balance of $100. During the year, the $200 of A/R from Moon Inc. was written off. Also during the year, $300 of A/R previously written off was collected. Sailor had the following balances at year-end prior to recording adjusting entries: Credit Sales $16,000 Accounts Receivable $30,000 a) Following the completion of an aging analysis, $1,100 of the A/R is estimated to be uncollectible. Record the journal entries involved with reporting bad debt. b) What would be the journal entry to record bad debt if the % of credit sales method was used? Solution a) The AFDA account starts off with a balance of 100 (Cr). If $200 were written off, then we would debit AFDA by $200. If $300 of previously written off A/R was collected, then we would credit AFDA by $300. The balance in AFDA is now $200 (Cr). Since the aging of A/R method to record bad debt expense requires the ending AFDA balance to be $1,100 (Cr), bad debt expense for the period would be $900. Thus the journal entry is: Bad Debt Expense 900 AFDA 900 b) Bad debt expense is 4% of total credit sales ($16,000). Thus the journal entry to record bad debt is: Bad Debt Expense 640 AFDA 640 Cash Cash is a risky asset easily stolen Effective internal controls of cash should have two components 1) Separation of Duties: maintaining accounting records and handling of cash 2) Proper policies and procedures - Cash budgets - Listing of cash receipts - Approval of cash payments - Bank reconciliations Bank reconciliation At fiscal year end, the cash amount on the trial balance will not equal the amount of cash on the bank statement provided by the bank These two amounts also do not equal the correct ending cash balance for the Balance Sheet A bank reconciliation highlights the amounts that need to be adjusted so we obtain the correct cash balance Ensures accuracy of book's cash balance Differences in the book's and the bank's cash balance may be due to: 1. Transactions recorded by the bank, but not yet recorded by the company - bank charges, service charges subtract from company's books - NSF cheques (a bad cheque deposited with non-sufficient funds) subtract from company's books AFM 101 Final Exam-AID Package Fall 2011 Transactions recorded in the company's books, but not yet been recorded by the bank Deposits in Transit (deposits received by the company, but not yet processed by the bank) add to the bank balance - Outstanding cheques (cheques written by the company but not cleared by the bank yet) deduct from bank balance 3. Errors in recording transactions Preparation of A Bank Reconciliation Ending Cash Balance per Bank $XX Add: Deposits in Transit Amounts withdrawn from your bank account by mistake Deduct: Outstanding Cheques Amounts deposited into your bank account by mistake Correct Ending Cash Balance $XX Ending Cash Balance per Books $XX Add: Interest earned on bank account Bank collected a A/R or N/R for you (Bank Credit Memo) Errors in writing cheques - you meant to write a cheque for $156 but actually wrote $165 Deduct: NSF Cheques Bank service charges (Bank Debit Memo) Bank paid a A/P or N/P for you Errors in writing cheques - you meant to write a cheque for $165 but actually wrote $156 Correct Ending Cash Balance $XX Example The bank statement set to Witt Merr Corp., shows a balance of cash at July 31 of $5,000.17. The Witt Merr Corp., shows a ledger bank balance of $4,262.83. The following reconciling items are noted: 1) A deposit was made after bank hours on July 31 of $410.90 2) Four cheques totaling $717.75 have not yet been cash by the bank 3) Bank Credit Memo: proceeds from collection of an N/R from J. David for $500 4) Bank Credit Memo: interest earned for month of July of $24.74 5) Bank Debit Memo: $17.00 fee charged by the bank 6) Bank Debit Memo: NSF cheque: J.B. Ball for $50.25 7) Cheque No. 875 issued for the amount of $85 was erroneously recorded in the journal as $58. The cheque was paid by the bank and recorded in the bank statement as $85 2. - - Collections by bank, Interest paid by the bank to the company add to company's books AFM 101 Final Exam-AID Package Fall 2011 Solution Bank Reconciliation Balance per Bank Statement Add: Late Deposit Less: Outstanding cheques Adjusted Cash Balance Balance per Company Records Add: N/R collected Interest Earned Less: NSF Cheque Bank Service Fee Error in Cheque Adjusted Cash Balance Journal Entries to update company's books Cash 500.00 N/R J. David 500.00 Cash 24.74 Interest Revenue 24.74 Accounts Receivable J.B. Ball 50.25 Cash 50.25 To reinstate A/R to be still collected after NSF cheque Bank Service Expense 17.00 Cash 17.00 Accounts Payable 27.00 Cash 27.00 To correct A/P incorrectly recorded 5,000.17 410.90 (717.75) 4,693.32 4,262.83 500.00 24.74 (50.25) (17.00) (27.00) 4,693.32 AFM 101 Final Exam-AID Package Fall 2011 Chapter 8: Inventory and Cost of Goods Sold Inventory Tangible property either held for sale or used to produce goods and services for sale Current asset: usually used/converted to cash within a year 3 Types of Inventory 1) Merchandise Inventory - Purchased & already-complete products held for resale Beginning Inventory + Purchases = Cost of Goods Available for Sale - Ending Inventory = Cost of Goods Sold 2) Manufacturing Inventory Inventory held by companies that produce the goods internally Raw Materials Inventory items acquired to be used in the production of goods Work in Process Inventory goods in the process of being manufactured, but not yet completed Finished Goods Inventory- completed manufactured goods, ready for sale Beginning Finished Goods Inventory + Cost of Goods Manufactured (materials, labour, overhead) = Cost of Goods Available for Sale - Ending Finished Goods Inventory = Cost of Goods Sold 3) Supplies Inventory - Supplies used in daily operations - As supplies are used up, they are expensed and the supplies asset is reduced - Methods of Recording Inventory Perpetual Inventory System Keeps track of every purchase and sale, the number of units and the cost Can determine the amount of ending inventory and the COGS at any time Periodic Inventory System Physical inventory count is required at end period in order to update inventory records All purchases made during the year accumulate in the Purchases account (instead of being debited directly to Inventory, like in the perpetual system) Need to make a schedule of cost of goods sold in order to compute COGS at year end Cheaper and more simple ***Both systems give the same ending inventory and COGS AFM 101 Final Exam-AID Package Fall 2011 Inventory Valuation Methods How do we decide what is the cost of the inventory that is being sold if we're purchasing different batches of inventory at different times and prices from suppliers? 1) Specific Identification Identifies the cost of each specific item that is sold, or in ending inventory Not practical when there are many similar or identical items Only used when goods are unique and expensive e.g. paintings, jewelry, houses 2) FIFO (First In, First Out) The oldest units sitting in inventory are being sold first Cost of Goods Sold contains the oldest units Ending Inventory contains the most recent units 3) Weighted Average Use the average of total cost of goods available for sale Average cost = cost of goods available for sale # of units available for sale Which inventory valuation method to use? Should choose the best method that best reflects the physical flow of goods. The ending inventory in units is the same in all methods: the cost is different The cost of goods sold and the cost of ending inventory are different The cost of purchases is the same in all four methods Note: when the cost of inventory is increasing, FIFO method will have lower COGS and higher EI compared to the weighted average method, which tends to smooth out fluctuations in inventory costs Note: LIFO (Last in, First Out) Last-in, First-out (LIFO) is no longer allowed in Canada; however, it is commonly used in the United States Allocates most recent units to COGS, and the oldest units to ending inventory On IS, gives more realistic measurement of current cost of items sold, but on BS, ending inventory does not reflect cost of inventory recently acquired Valuation of Inventory Inventory is initially recorded at cost Inventory is valued at the lower of cost and net realizable value Net realizable value (NRV) is the estimated selling price less the estimated disposal costs A more conservative approach doesn't overstate the ending inventory AFM 101 Final Exam-AID Package Fall 2011 Example The records of Shorter Company reflected the following for the month of February: Date Feb. 1 Feb. 2 Feb. 5 Feb. 12 Feb. 15 Feb. 23 Feb.28 Transaction Beginning inventory Purchase Sale (selling price $12/unit) Purchase Sale (selling price $13/unit) Purchase Ending inventory Number of Units 600 500 700 600 700 900 ? Unit Cost $3 $4 $5 $6 Shorter Company uses a periodic inventory system. Compute the following under FIFO and Average Cost: Revenue, Cost of Goods Sold, Gross Margin, Ending Inventory Redo the question assuming weighted average costing method and perpetual inventory Example FIFO Revenue = 700 @ $12/unit + 700 @ $13/unit = $17,500 COGS = 600 @ $3/unit + 500 @ $4/unit + 300 @ $5/unit = $5,300 (total units sold = 1,400) Gross Margin = Revenue COGS = 17,500 5,300 = $12,200 Cost of Ending Inventory = 300 @ $5/unit + 900 @ $6/unit = $6,900 Weighted Average Revenue = 700 @ $12/unit + 700 @ $13/unit = $17,500 Total units in beginning inventory and purchased during year = 600 + 500 + 600 + 900 = 2,600 Total cost of inventory and purchases = 600@$3 + 500@$4 + 600@$5 + 900@$6 = 12,200 Average cost per unit = 12,200 / 2,600 = $4.69 Cost of Goods sold = 1,400 units @ $4.69 = $6,566 Gross Margin = Revenue COGS = 17,500 6566 = $10,934 Cost of Ending Inventory = 1,200 units left * 4.69 = $5,628 Cost of goods available for sale = 600 * $3 + 500 * $4 + 600 * 5 + 900 * $6 = $12,200 (same across methods) Number of units available for sale = 2,600 units (same across methods) Note: when the cost of inventory is increasing, FIFO method will have lower COGS and higher EI compared to the weighted average method, which tends to smooth out fluctuations in inventory costs. AFM 101 Final Exam-AID Package Fall 2011 Perpetual Weighted Average Revenue = 700 @ $12/unit + 700 @ $13/unit = $17,500 th Cost of Inventory Sold at Feb 5 : Average Cost per Unit = [600@3 + 500@4] / 1,100 units = $3.45/unit th Cost of Goods Sold for Feb 5 Sale = $3.4545 * 700 = 2,418 th Inventory Remaining at Feb 5 : 400 units @ 3.4545 = 1,382 th Cost of Inventory Sold at Feb 15 : Average Cost per Unit = [400@3.4545 + 600@5] / 1,000 units = $4.382/unit th Cost of Goods Sold for Feb 5 Sale = $4.382 * 700 = 3,067 th Inventory Remaining at Feb 5 : 300 units @ 4.382 = 1,315 th Ending Inventory at Feb 28 300 units @ 4.382 + 900 units @ 6 = 6,715 Cost of Goods sold = 2,418 + 3.067 = $5,485 Gross Margin = Revenue COGS = 17,500 5,485 = $12,015 Ending Inventory = 6,715 Chapter 9: Plant Property & Equipment, Natural Resources, and Intangibles Long-term assets: tangible or intangible resources used in operations over several years Plant, Property & Equipment: tangible assets with physical substance Record at acquisition cost = purchase price + costs incurred to make asset ready for use taxes, installation costs, legal costs, transportation costs For self-constructed assets, includes the cost of constructing the asset, ie: labour, materials, overhead, interest expense incurred during construction Examples - land, building, fixtures equipment, natural resources Various ways to acquire a long term asset Cash Debt (issue bonds, borrow money) Equity (issuing shares) Construction (self-constructed assets) Basket Purchase buying two or more assets in a single transaction for a lump sum o Allocate total purchase price to individual assets acquired, based on % of the appraised value or market value AFM 101 Final Exam-AID Package Fall 2011 Costs incurred after acquisition of asset: Over the lifespan of the capital asset, a company will make additional expenditures, which may be recorded as an expense or an asset Ordinary repairs and maintenance Expense DR Expense CR Cash Extraordinary repairs and maintenance (betterments) capitalize DR Asset CR Cash Example Piggy Limited made a lump sum purchase of an office building, including the land and some fixtures, for cash of $160,000. The tax assessments for the past year reflected the following: Land, $25,000; Building, $60,000; and Fixtures, $15,000. Record the purchase. Solution Total assessed value = $25,000 + $60,000 + $15,000 = $100,000 Allocate the cost of $160,000 among the assets acquired: Land ($25,000/ $100,000) * $160,000 40,000 Building ($60,000 / $100,000) * $160,000 96,000 Fixtures ($15,000 / $100,000) * $160,000 24,000 Cash 160,000 Amortization Matching principle states we need to match expense with the revenue it helped generate The use of capital assets generate revenue therefore there should be corresponding expenses Land is NOT amortized, it has unlimited lifespan Amortization is the systematic allocation of the acquisition cost of an asset against the revenues it helps generate each period It's important to note, amortization expense is not an expenditure (no cash outflow) Journal Entry to record amortization expense: DR: Amortization Expense CR: Accumulated Amortization Assets are stated at their Net Book Value (NBV) NBV = Cost Accumulated Amortization Methods of Amortization 1) Straight line Amortization expense = ( cost residual value ) estimated useful life Estimated useful life: expected service life of an asset to the company, (not the total economic life to all potential users) Residual/Salvage value: estimated amount to be recovered when the asset is disposed Amortization expense is a constant amount each year AFM 101 Final Exam-AID Package Fall 2011 2) 3) Declining Balance Amortization expense is a percentage of the net book value each year More amortization in early years, less in later years Amortization rate = 1 / estimated useful life of the asset Amortization expense = net book value x amortization rate Sometimes an acceleration rate is also applied Double-declining method acceleration rate is 200% Amortization Expense = net book value x 2 / estimated life Other acceleration rates are common: e.g. 150% Amortization Expense = net book value x 1.5 / estimated life If we amortize below the residual value, we plug the amortization expense in the last year so the net book value equals the residual value Units of Production Allocates cost of asset to amortization expense based on usage Rate per unit = (cost residual value) total estimated output Amortization expense = Rate per unit * Actual production units Amortization expense each period varies directly with production or use Common with natural resource industry Choice of Amortization Method - All 3 methods are acceptable by GAAP - Choose method based on how the asset actually generates revenues, and how it wears out, in order to accurately match expenses to revenues - Eg: asset generates same utility every year straight line - Eg: asset wears out with each usage, and ability to generate revenues declines with each usage units of production - Eg: asset produces more revenue in early years when it is more efficient when new, and wears out over time declining balance - Tax purposes: companies in Canada must follow the Capital Cost Allowance (CCA) system, which is an accelerated amortization method, with different maximum CCA rates for different types of assets Example Keener Company acquired a machine on January 1, 2009, at a cost of $3,000. The machine had an estimated useful life of five years and an estimated residual value of $500. Keener Company estimates that the machine can be used to produce 10,000 units over its lifetime. Actual production was 2,000 units in 2009 and 1,000 units in 2010. The fiscal year end is December 31. Required: Determine the Amortization Expense for 2010 and the Accumulated Amortization balance at December 31, 2010, under the three methods of amortization: (a) Straight-line (b) Units-of-production AFM 101 Final Exam-AID Package Fall 2011 (c) Declining-balance at 150% acceleration rate Solution Straight-line ($3,000 500) / 5 years = $500 / year Amortization Expense for 2010 = $500 Accumulated amortization at Dec 31, 2010 = 2 * $500 = $1,000 Units-of-production ($3,000 500) / 10,000 units = $0.25 / unit 2010 Amortization expense = 1,000 units * $0.25 / unit = $250 Accumulated amortization = (1,000 + 2,000 units) * $0.25 / unit = $750 Declining-balance: Rate = 1.5 / 5 years = 0.3 2009 Amortization expense: $3,000 * 0.3 = $900 Net Book Value at Dec 31, 2009 = 3,000 900 = 2,100 2010 Amortization expense = 2,100 * 0.3 = $630 Accumulated amortization = $900+ $630 = $1,530 Changes in Estimates Management estimates of useful life and salvage value may not be accurate, and thus, may need to be revised at a later date Changes in estimates are applied to future years, and no changes are made to past years' amortization expenses Disposal Of Asset Record amortization expense not yet recorded to disposal date DR Amortization Expense CR Accumulated Amortization Entry to record disposal/sale of asset Reverse accumulated amortization account Record gain or loss from disposal DR Accumulated Amortization DR Accumulated Amortization DR Loss on Asset CR Gain on Asset CR Asset CR Asset If net book value < proceeds from sale of the asset gain on sale If net book value > proceeds from sale of the asset loss on sale Example Trunks Corporation purchased a robot on Jan 2, 2004 by paying cash of $500,000. The robot has an estimated residual value of $20,000 and an expected useful life of 10 years. At the beginning of 2007, the management of Trunks Corporation concluded that the total useful life of the robot will be 19 years rather than 10, and that the residual value will be zero. On June 30, 2009 management sold the robot for $300,000 Trunks Corporation uses the straight-line method for amortization. Record journal entries for each transaction. AFM 101 Final Exam-AID Package Fall 2011 Solution Jan 2, 2004 to record purchase Robot 500,000 Cash 500,000 Straight line amortization expense = (500,000 20,000) / 10 = 48,000 / year Journal entry made on Dec 31 2004, 2005, 2006 Amortization Expense 48,000 Accumulated Amortization Robot 48,000 Revision of useful life, need to recalculate yearly amortization expense Net Book Value on Jan 1, 2007 = 500,000 48,000*3 = 356,000 Remaining Useful life (revised) = 16 Straight line amortization expense = (356,000 20,000) / 16 = 21,000 / year Journal entry made on Dec 31 2007, 2008 Amortization Expense 21,000 Accumulated Amortization Robot 21,000 June 30, 2009 sale of robot. First update amortization expense from Dec 31, 2008 Amortization Expense 10,500 Accumulated Amortization Robot 10,500 Calculate Net Book Value of robot on June 30, 2009 Net Book Value = 500,000 48,000*3 21,000*2 10,500 = 303,500 Proceeds received from sale of robot = 300,000 Therefore loss of 3,500 on sale Journal entry to record sale Accumulated Amortization Robot 196,500 Loss on Sale 3,500 Cash 300,000 Robot 500,000 Natural Resources Assets held by companies working in industries dealing with natural resources are used up, or depleted Depletion is very similar to amortization in which the acquisition cost of the asset (e.g. a mine) is allocated to depletion expense using a systematic allocation Usually, the method used for depletion is units of production Intangibles Assets with value due to certain rights and privileges given to the owner Recorded at cost only if purchased (versus developed internally) Intangibles with definite lives are amortized over the life of the asset (straight line) Intangibles with indefinite lives are only checked for impairment on an annual basis and not amortized on a regular basis Examples of intangible assets o Trademarks, patents, copyrights (usually have definite useful lives) AFM 101 Final Exam-AID Package Fall 2011 o o Leaseholds and leasehold improvements Goodwill: the difference between the purchase price of a company and the fair market value of all its assets and liabilities The "extra" price paid for purchasing a company Not amortized, checked for impairment on a regular basis Impairment The historical cost principle states assets must be recorded on the books at cost, or acquisition cost However, if evidence that the asset's book value > fair value, then impairment occurred and the asset must be written down to fair value Fair value: the amount at which an asset can be bought or sold in the market The journal entry to write down assets is: DR Impairment Loss (income statement account) CR Asset Chapter 10: Current Liabilities Capital Structure Refers to the balance between equity and debt; how the company finances its assets Equity Financing obtaining funding for the company from contributions of the owners/ shareholders, issuing shares Debt Financing obtaining funding for the company from short term or long term borrowing o Advantages: potential of greater return to owners, no dividends need to be paid, interest on debt is tax-deductible o Disadvantages: interest charges increase risk, and must be paid (whereas dividends don't have to be paid) Financial Leverage Ratio = Average total assets/Average shareholders' equity o Measures how the firm is financed, through debt or equity o The greater the debt, the higher the ratio and the higher the risk Current Liabilities Obligations that must be paid within a year or the operating cycle Accounts Payable Accrued liabilities o Income Tax Payable o Wages Payable o Deferred Revenue Notes payable we need to also calculate interest payable Current portion of long-term debt Employee Deductions o Income Tax Withheld (to be forwarded to the government) o CPP Payable o EI Payable AFM 101 Final Exam-AID Package Fall 2011 Liquidity refers to the ability to pay off debts as they mature/become due Current Ratio = Measures amount of current assets available to meet current liabilities A ratio above 1 good; company has liquidity: able to pay off current liabilities But, a ratio much greater than 1 inefficient use of resources Working Capital = If positive: current assets exceed current liabilities, and company can pay off its current liabilities A measure of liquidity, but in absolute terms, so we need to adjust for size larger companies should have more working capital than smaller ones Contingent Liabilities Represents likely or probable obligations that will arise in the future There are 3 ways to treat these liabilities: record on Balance Sheet, disclose in notes, do nothing If the event that creates a contingent liability is likely to occur and the amount owed is estimable record as a liability on the balance sheet If the event is likely to occur and but the amount owed is not estimable disclose in notes only If the event is unlikely to occur no action needed If the occurrence of the event is not determinable disclose in notes only Chapter 11: Long Term Liabilities Bonds A formal debt contract issued by companies (borrower) to raise money, a long term liability for the company Bonds are purchased by other parties (lender) either at par, at a premium, or at a discount Bond contracts state o Face value: the principal amount to be repaid to the other party at the end of the contract period o Coupon rate: a percentage of the principal to be paid as interest to the other party. Interest can be paid annually, semi-annually, monthly, etc. The percentage stated in the contract is an annual percentage. The amount of interest paid per period is fixed. o Maturity date: when the bond matures, and the principal is repaid to the lender. Bonds are usually held for long periods, some up to 30 years. Special types of bonds: o Secured bonds: assets are pledged to guarantee repayment (eg: real estate, stocks) o Debentures: unsecured bonds with no pledged assets o Callable bonds: give issuer right to call and retire debt prior to maturity o Convertible bonds: gives bondholder the option to convert bonds into other securities of the issuer (ie: common stock) AFM 101 Final Exam-AID Package Fall 2011 Bond Transactions 3 types of transactions occur At time 0, lender pays the company an amount to purchase the bond Company pays coupon payments to the lender at specified time periods through the life of the bond At maturity, company pays last coupon payment along with the principal or face value back to the lender Issuance of Bonds The price the bond is issued at depends on the current market interest rate We calculate the price of the bond at time zero by discounting or determining the present value of all future cash payments o Price of bond = Present value of all coupon payments + present value of principal Present Value of Principal Present Value of a single sum n PV= P / (1 + i ) P = Principal PV = Present Value i = the market interest rate per period (note not necessarily an annual rate) n= the number of compounding periods Or use PV tables with i and n Present Value of an ordinary annuity 1- PVA = coupon * 1 (1 + i) n i Coupon = Coupon Payment received each period PVA = Present Value of annuity i = the market interest rate per period n= the number of compounding periods Or use PVA tables with i and n Example Given: Face value of bond issue: $100,000 Term of issue: 5 years Stated coupon rate: 9% per year Market rate of interest: 11% Determine the issue price of the bonds AFM 101 Final Exam-AID Package Fall 2011 Solution Price of bond = Present value of all coupon payments + present value of principal Present value of the principal PV = 100,000 = 59,345 1.115 Or use PV tables with i = 0.11, n = 5 from table: 0.5935 PV = 100,000 * 0.5935 = 59,350 Present value of the coupon payments Coupon paid per coupon period = 0.09 * 100,000 = $9,000 1 1- 5 PVA = 9, 000( 1.11 ) = 33, 263 0.11 Or use PVA tables with i = 0.11, n = 5 from table: 3.6959 PVA = 9,000 * 3.6959 = 33,263 Price of bond = 59,345 + 33,263 = $92,608 Example Given: Face value of bond issue: $100,000 Term of issue: 5 years Stated coupon rate: 10%, paid quarterly Market rate of interest: 8% Determine the issue price of the bonds Solution Price of bond = Present value of all coupon payments + present value of principal In this example, n = 20 periods Coupon paid per period = 100,000 * 0.1 * 0.25 = 2,500 Market rate of interest per coupon period = 2% Present value of the principal PV = 100,000 = 67,297 1.02 20 Or use PV tables with i = 0.02, n = 20 from table: 0.6730 PV = 100,000 * 0.6730 = 67,300 Present value of the coupon payments AFM 101 Final Exam-AID Package Fall 2011 1 1- 1.02 20 ) = 40,879 Coupon paid per coupon period = 100,000 * 0.1 * 0.25 = 2,500 PVA = 2,500( 0.02 Or use PVA tables with i = 0.02, n = 20 from table: 16.3514 PVA = 2,500 *16.3514 = 40,879 Price of bond = 67,297 + 40,879 = $108,176 Recording the Issuance of Bonds The price of the bond usually does not equal the face value of the bond, this is due to differences between the coupon rate and the market interest rate If the coupon rate < market interest rate, bonds are issued at a discount o Lender party receives fixed coupon payments, but could have invested their money in the market at a higher rate. Therefore these bonds are at a discount. If the coupon rate > market interest rate, bonds are issued at a premium o Lender party receives fixed coupon payments, but could have invested their money in the market at a lower rate. Therefore these bonds are at a premium. The company will record the discount or premium in a separate account when initially recording the bond issuance From our previous two examples: Cash 92,608 Cash 108,176 Discount on B/P 7,392 Premium on B/P 8,176 Bond Payable 100,000 Bond Payable 100,000 The book value of the Bond Payable is the face value + premium OR face value discount Discount on B/P is a contra liability account (with debit balance), decreases the liability Premium on B/P has a credit balance, increases the liability Amortization of Discount or Premium Throughout the life of the bond, we need to amortize the discount or premium until its value is zero when the bond matures Recall amortizing capital assets has journal entry Amortization Expense Accumulated Amortization The expense account we use to amortize discount or premium is Interest Expense Amortizing the discount (we want to decrease Discount on Bond Payable, therefore we need to credit the account and debit interest expense) Interest Expense Discount on Bond Payable Amortizing the premium (we want to decrease Premium on Bond Payable, therefore we need to debit the account and debit interest expense) Premium on Bond Payable Interest Expense AFM 101 Final Exam-AID Package Fall 2011 Amortization occurs on every coupon payment date To determine the amount to amortize each period, there are two methods Straight Line = Example Recall previous example Length = 5 years Face value = 100,000 Coupon rate = 9%, paid annually Discount on B/P = 7,392 (we calculated this) Record the journal entries for each coupon paying date Solution Amount amortized each coupon period = 7,392 / 5 = 1,478.40 Record the payment of the coupon Interest Expense 9,000 Cash 9,000 Record the amortization of the discount Interest Expense 1,478.40 Discount on B/P 1,478.40 Effective Interest Total interest expense = effective interest rate per period * net book value of bond Total interest paid is constant each period (coupon payment) The amount amortized is the difference between the total interest expense and interest paid An effective interest table should be created for each question Recall net book value of bond = principal + premium or principle discount Example Given: Face value of bond issue: $100,000 Term of issue: 5 years Stated coupon rate: 10%, paid quarterly Market rate of interest: 8% Premium on B/P: 8,176 (we calculated this from the issue price) Issued on Jan 1, 2007, coupon payable every March 30, Jun 30, Sept 30, Dec 31 Create an effective interest table for the first 8 coupon paying dates and record journal entries for the first two coupon paying dates AFM 101 Final Exam-AID Package Fall 2011 Solution Date Interest Payment Interest Expense Jan 1, 2007 --- --- Mar 30, 2007 2,500 2,164 Jun 30, 2007 2,500 2,157 Sept 30, 2007 2,500 2,150 Dec 31, 2007 2,500 2,143 Mar 30, 2008 2,500 2,136 Jun 30, 2008 2,500 2,129 Sept 30, 2008 2,500 2,121 Dec 31, 2008 2,500 2,114 At Jan 1, 2007 Principal = 100,000 Premium on B/P = 8,176 Net Book Value = Principal + Premium = 108,176 Total interest expense on Mar 30, 2007 = NBV * 2% = 108,176 * 0.02 = 2,164 Interest paid (coupon paid) = 100,000 * 2.5% = 2,500 Therefore amortization of premium = 2,500 2,164 = 336 Premium on B/P at Mar 30, 2007 = 8,176 336 = 7,840 NBV at March 30, 2007 = 100,000 + 7,840 = 107,840 Total interest expense on Jun 30, 2007 = NBV * 2% = 107,840 * 0.02 = 2,157 Interest paid (coupon paid) = 100,000 * 2.5% = 2,500 Therefore amortization of premium = 2,500 2,157 = 343 Premium on B/P at Mar 30, 2007 = 7,840 343 = 7,497 NBV at June 30, 2007 = 100,000 + 7,497= 107,497 Total interest expense on Sept 30, 2007 = NBV * 2% = 107,497 * 0.02 = 2,150 Interest paid (coupon paid) = 100,000 * 2.5% = 2,500 Therefore amortization of premium = 2,500 2,150 = 350 Premium on B/P at Mar 30, 2007 = 7,497 350 = 7,147 NBV at June 30, 2007 = 100,000 + 7,147= 107,147 Continue this calculation for all coupon paying period Journal Entries: At Jan 1, 2007 when bond is purchased Cash 108,176 Premium on B/P 8,176 Bond Payable 100,000 Amortization of Discount or Premium --- 336 343 350 357 364 371 379 386 Book Value 108,176 107,840 107,497 107,147 106,790 106,426 106,055 105,676 105,290 AFM 101 Final Exam-AID Package Fall 2011 At Mar 30, 2007 at coupon paying date Interest Expense 2,500 Cash 2,500 Premium on B/P 336 Interest Expense 336 **Total interest expense on March 30 = 2,500 336 = 2,164, which matches with the effective interest method At June 30, 2007 at coupon paying date Interest Expense 2,500 Cash 2,500 Premium on B/P 343 Interest Expense 343 **Total interest expense on June 30 = 2,500 343 = 2,157, which matches with the effective interest method Zero Coupon Bonds No coupon payments, only repayment of principle at maturity Price paid by lender at issue = present value of principle (single sum) Always results in a Discount on Bond Payable Account Discount is amortized to Interest Expense at end of every year (or compounding period) Example $40,000 zero coupon bond issued on Jan 1, 2008 with market interest rate 8%, compounded semi annually, matures in 2 years Record all journal entries, use effective interest amortization Solution Price of Bond = 40,000 / (1.04)^4 = $34,192 (or use PV tables with n = 4 i = 4%) Jan 1, 2008 Cash 4,192 Discount on B/P 5,808 Bond Payable 40,000 AFM 101 Final Exam-AID Package Fall 2011 Interest Expense on June 30, 2008 = NBV of Bond * 4% June 30, 2008 Interest Expense 1,368 Discount on B/P 1,368 Discount on B/P balance on June 30, 2008 = 5,808 1,368 = 4,440 NBV of Bond on June 30, 2008 = 40,000 4,440 = 35,560 Interest Expense on Dec 31, 2008 = NBV of Bond * 4% Dec 31, 2008 Interest Expense 1,422 Discount on B/P 1,422 Discount on B/P balance on Dec 31, 2008 = 4,440 1,422 = 3,018 NBV of Bond on Dec 31, 2008 = 40,000 3,018 = 36,982 Interest Expense on June 30, 2009 = NBV of Bond * 4% June 30, 2009 Interest Expense 1,479 Discount on B/P 1,479 Discount on B/P balance on June 30, 2009 = 3,018 1,479 =1,539 NBV of Bond on June 30, 2008 = 40,000 1,539 = 38,461 Interest Expense on Dec 31, 2009 = NBV of Bond * 4% Dec 31, 2009 Interest Expense 1,539 Discount on B/P 1,539 Discount on B/P balance on Dec 31, 2009= 1,539 1,539 = 0 NBV of Bond on Dec 31, 2009 = 40,000 0 = 40,000 Repayment of Bond on Dec 31, 2009 Dec 31, 2009 Bond Payable 40,000 Cash 40,000 Callable Bonds/Early Retirement of Bonds Callable bonds: company has the right to repay back the principle before bond matures (and doesn't have to pay the future coupon payments) Redemption value: amount paid by the company to the other parties to repay the principle earlier than maturity o Usually not equal to face value/principle amount If redemption value > net book value of bond o Gain on redemption of Bonds Payable If redemption value < net book value of bond o Loss on redemption of Bonds Payable AFM 101 Final Exam-AID Package Fall 2011 Example Bond is issued on Jan 1, 2008. Redeemed for $53,000 on June 30, 2009 Principle: 50,000 Premium on Bond Payable: 2,000, amortized using straight line Maturity: 5 years Coupon: 4%, paid semi-annually Record all journal entries up to date of redemption of bonds Solution Jan 1, 2008 Cash 52,000 Premium on B/P 2,000 Bond Payable 50,000 June 30, 2008 Interest Expense 1,000 Cash 1,000 Premium on B/P 200 Interest Expense 200 Amortization of discount Dec 31, 2008 Interest Expense 1,000 Cash 1,000 Premium on B/P 200 Interest Expense 200 Amortization of discount June 30, 2009 Interest Expense 1,000 Cash 1,000 Premium on B/P 200 Interest Expense 200 Net Book Value of Bond Payable on June 30, 2009 Bond Payable 50,000 Premium on B/P 1,400 Net Book Value 51,400 Bond is redeemed for 53,000 on June 30, 2009 Bond Payable 50,000 Premium on B/P 1,400 Loss on Redemption of Bond 1,600 Cash 53,000 AFM 101 Final Exam-AID Package Fall 2011 Bonds and Cash Flows - Issuance of bonds financing inflow - Repayment of principal financing outflow - Payment of bond interest operating outflow - Amortization of bond discount operating: add to net income - Amortization of bond premium operating: subtract from net income Other Long-term Liabilities Employee liabilities: pension plans benefits given to employees after retirement - Defined contribution plan employer will contribute a fixed amount each month to the plan, and the amount employees will collect is not guaranteed, and depends on the performance of the investments in the plan - Defined benefit plan employees are guaranteed a fixed amount at retirement, and the company must contribute enough money to ensure that employees receive the promised pension Leases: renting an asset for use in operations (2 types) - Operating lease a lease of short term duration, recorded as an expense, and no asset nor liability is recorded - ii) Capital lease where an asset is rented for substantially all of its useful life; company records the asset, and also the liability for the lease obligation Covenants: ratio requirements built into lending agreements to protect the lender (i.e. current ratio above 2 must be maintained) Chapter 12: Shareholder's Equity Shareholder's Equity Section - Share Capital (may be separated into more than 1 class) - Retained Earnings Why Own Shares? 1) Voting power (unless shares are non-voting) 2) Dividends 3) Residual Claims (rights to leftover assets when company dissolves) Common Shares Every corporation has common shares Voting rights Upon bankruptcy, common shareholders have residual (last) claim on the assets (after other classes of shares) Preferred Shares No voting rights Paid a fixed dividend rate per share Dividends can be cumulative or non cumulative Cumulative: if company declares dividends in current year, preferred shareholders will get paid dividends from all prior years when dividends were not declared AFM 101 Final Exam-AID Package Fall 2011 Non cumulative: if company declares dividends in current year, preferred shareholders will receive the dividend rate per preferred share held Paid dividends before common shareholders Less risky than common shares Issuance of Shares IPO Initial Public Offering - the first sale of a company's shares to the public SEO Seasoned equity offering an additional sale of new shares to the public after the IPO Shares may be issued for cash, or in exchange for assets or services, or for employee compensation Journal entry to record issuance of shares DR: Cash CR: Common Shares Dividends Distribution of earnings back to the shareholders Declaration Date - The date dividends are declared DR Dividends CR Dividends Payable Date of Record - All shareholders owning shares on this date will receive dividends Payment Date - Dividends are distributed DR Dividends Payable CR Cash Preferred shares Current dividend preference preferred share dividends are paid before common share dividends Cumulative dividend preference if all or part of the preferred dividend was not paid in previous years, it must be paid before any common dividends can be paid in the current year Example Durian Inc. has the following share capital: Common shares, 100,000 shares authorized, 20,000 shares outstanding Preferred shares, $41,000 shares authorized, 3,500 shares outstanding The company declared a cash dividend of $55,000 in 2009. No dividends were declared or paid during 2008. Dividends were paid on preferred and common shares in 2007. Compute the amount of cash that would be paid to each stockholder group in 2009 under the assumption that a) preferred shares are cumulative and b) preferred shares are non-cumulative Solution Preferred shares are cumulative Cash dividends paid to preferred shareholders = 3,500 shares * $4/share * 2 years = 28,000 AFM 101 Final Exam-AID Package Fall 2011 Cash dividends paid to common shareholders = 55,000 28,000 = 27,000 Preferred shares are non-cumulative Cash dividends paid to preferred shareholders = 3,500 shares * $4/share * 1 year = 14,000 Cash dividends paid to common shareholders = 55,000 14,000 = 41,000 Not required in solution, for illustrative purposes only: Journal entries under assumption of cumulative preferred shares: Entry when dividend is declared, and not yet paid: Retained earnings 55,000 Dividends payable preferred shares 28,000 Dividends payable common shares 27,000 Entry when dividend is paid: Dividends payable preferred shares 28,000 Dividends payable common shares 27,000 Cash 55,000 Stock Dividends Distribution of additional shares of a corporation's share capital to its shareholders Paid based on pro-rata basis "10% stock dividend" No cash involved, no net effect on total shareholders' equity When declared: DR: Retained earnings CR: Stock dividends to be issued When `paid': DR: Stock dividends to be issued CR: Common shares Stock Splits 2 for 1 stock split: Company doubles the amount of total shares outstanding Value per share is halved No journal entry required Can go the other way: 1 for 2 stock splits mean company halves the number of shares outstanding Used by company to control the trading price of their shares Repurchase of Shares A company may buy back its own shares because: i) it has excess cash and wants to return it to shareholders ii) management wants to maintain control of the company, and make it harder for another party to take over AFM 101 Final Exam-AID Package Fall 2011 Motivation for Stock Splits and Stock Dividends When the share price gets too high, there is a concern that the average investors will not be able to buy the shares, because they are required to trade in round lots, and a round lot of expensive shares may not be affordable to the average investor As a result, use stock dividends and splits to lower the price per share The market value of the corporation doesn't change, but the total number of shares and the price per share changes Corporations A separate legal entity Advantages: Limited liability: owner's liability is only limited to the contributions of the owner, ie: initial investment in shares, and not liable for personal assets Easier to raise capital by issuing bonds and shares Separation of owners and managers Perpetual lifespan of corporation Easier to transfer ownership by trading shares Disadvantages: Agency problem: Managers are separate from owners, and have less incentive to make decisions to maximize value Potential loss of control Double taxation More costly to start (incorporation, legal and registration fees) More complexity in ownership and management structure Chapter 13: Analyzing Financial Statements The Investment Decision Current and potential investors are single largest groups Analysts: information intermediaries who interpret audited financial information and advise their clients to whether they should buy, hold, or sell shares o Reach different decisions o Good understanding of financial statements and relevance and faithful representation o Analysts' differing opinions affect their predictions o Look at other factors: global, economic, and industry factors o Managements ability to adapt its business plans in response to the uncertainties and risk associated o Economic Factors Overall health of economy has direct impact on performance of business Dramatic downturn in 2007 -> reduced demand for g & s -> bankrupt large organizations o Industry Factors Make sure you understand what each ratio means Ratios need to be compared against a benchmark (ie: companies in the same industry), or against prior years Refer to Extra Practice Problems Also refer to ratios from Chapters 1 6 of the text in Midterm Exam Aid AFM 101 Final Exam-AID Package Fall 2011 Might have major impact in industry but minor impact outside the industry A major drought impacts food-related industries, but none on electronics Individual Company Factors Visit companies, buy products, read about it in the business press Also important to understand business strategy Business Strategy -> operating decisions -> transactions ->financial statements Return on Equity (ROE) o profit drivers or profit levers describe the three ways that management can improve ROE o Product differentiation: unique benefits o Cost advantage: operate efficiently Financial Statement Analysis 1. Time Series Analysis: information for a single company is compared over time 2. Comparison with Similar Companies: financial results are often affect by industry and economic-wide factors, finding comparable companies is often very difficult Ratio and Percentage Analyses Condenses large volumes of raw financial information and helps decision makers identify significant relationships and make meaningful comparisons between companies Component Percentages o Express each item on a financial statement as a percentage of a single base amount o E.g. to compute the component percentage for the income statement the base amount is net sales revenue Analysts use only those that are relevant to the analysis Research and development costs as a percentage of sales is not commonly used, but it is useful when analyzing companies that depend on new products, such as pharmaceutical or technological firms We average the beginning and ending balances because statement of financial position is an instant in time and income statement relates to a specified period Test of Profitability Return on Equity (ROE) Return on Equity = Profit Average Shareholders' Equity Profit to the investment made by owners Return on Assets (ROA) Return on Assets = Profit +Interest Expense (net of tax) Average Total Assets Compares profit to total assets used to earn that profit Management's ability to utilize assets effectively because it is not affected by the way in which the assets were financed Financial Leverage Percentage Advantage of disadvantage that occurs when a company's return on equity differs from its return on assets (ROE - ROA) Proportional of assets acquired with funds supplied by owners Leverage is positive when the rate of return on a company's assets exceeds the average after-tax interest rate on its borrowed funds AFM 101 Final Exam-AID Package Fall 2011 o The company borrows at one rate and earns a higher rate on investment The difference benefits the owners It is available to shareholders This is the primary reason why companies obtain a significant amount of their resources from creditors rather than from the sale of shares Investing effectively (increase ROE) or borrowing effectively (paying low rate of interest) Negative financial leverage means that ROE has decreased relative to ROA or that ROA has increased relative to ROE If ROE decreases if profitability decreases, or company issues more shares Earnings per Share Earnings per Share = Profit Available to Common Shareholders Avrg # of Common Shares Outstanding Return on investment that is based on the number of shares outstanding instead of the dollar amounts Quality of Earnings Quality of Earnings = Cash Flows from Operating Activities Profit Use of some accounting procedures can result in higher earnings reports o Short estimated lives for non-current assets will report lower earnings than will a similar company that uses longer estimated lives Higher-quality earnings because each dollar of profit is supported by at least one dollar of cash flow Profit includes both cash and non-cash components (accruals of revenues and expenses) Ratio of below 1 means that accruals represent a significant portion of profit Profit Margin Profit Margin = Income (before Extraordinary Items) Net Sales Revenue Percentage of each sales dollar It does not consider the amount of resources employed (total investment) to earn profit Fixed Asset Turnover Fixed Asset Turnover = Net Sales Avrg Net Fixed Sales Compares sales volume with a company's investment in fixed assets (PPE) Measures their ability to effectively utilized fixed assets to generate revenue Tests of Liquidity Tests of Liquidity: Are ratios that measure company's ability to meet its currently maturing obligations Tests of liquidity focus on the relationship between current assets and current liabilities Important in evaluating a company's short-term financial strength AFM 101 Final Exam-AID Package Fall 2011 Cash Ratio Cash Ratio: One measure of the adequacy of available cash Even a profitable business will fail without sufficient cash Cash ratio should not be too high because holding excess cash usually is uneconomical and it is better to invest cash into productive assets or reduce debt = + Current Ratio Current Ratio: Measures the relationship between current assets and current liabilities at a specific date Measures the cushion of working capital that companies maintain to allow the inevitable unevenness in the flow of fund through the working capital accounts = To properly use the current ratio, analysts must understand the nature of the company's business o Many manufacturing companies have developed sophisticated systems to minimize the amount of inventory they must hold for instance, just in time inventory, which is designed in a way that inventory arrive just as needed Analysts consider a current ratio of 2 to be financial conservative There is concern when the company's current ratio is too high compared to other companies because this indicates that the firm is operating inefficiently when it ties up too much money in receivables or inventory Quick Ratio (Acid Test) Quick Ratio: Compares quick assets, defined as cash and near-cash assets to current liabilities Is a more stringent test of short-term liquidity than the current ratio Quick assets include cash, short-term investments, and trades receivables Inventories are omitted from quick assets because of the uncertainty of the timing of cash flows from their sales Measure of the safety margin that is available to meet a company's current liabilities = Receivable Turnover Ratio Trades receivables are closely related to both short-term liquidity and operating efficiency Reflects how many times the trades receivables were record, collected and then new receivables recorded again during the period Expresses the relationship of the average balance in the trade receivables transactions that created those receivables Measures the effectiveness of the company's credit-granting and collection activities High ratio indicates effective collection, but a very high ratio could indicate that the company is overly stringent in its credit policy that could result in a loss of sales and profit On the other hand a low ratio indicates the firm is granting credit to credit risks and making inefficient collection efforts = AFM 101 Final Exam-AID Package Fall 2011 = The receivables turnover ratio is often converted to a time basis known as the average age of trades receivables Effectiveness of credit and collection activities is sometimes judged by the rule that the average collection period should not exceed 1.5 times the credit terms Inventory Turnover Ratio Measures both liquidity and operating efficiency Reflects the relationship of inventory to the volume of sales during the period = If the ratio is too high, it may be an indication that sales were lost because the desired items were not in stock Turnover ratios vary from one industry to the next The turnover ratio is often converted to a time basis called the average days' supply in inventory ! = Payables Turnover Ratio Payables Turnover: Evaluates the company's effectiveness in managing payables to trade creditors = Purchases= Cost of Sales + Ending Inventory Beginning Inventory Reflects how many times the trades payables were recorded, paid and then new payables recorded again during the period Expresses the relationship of the average balance in trades payables to the purchase transactions that created those payables Low ratio raises questions concerning a company's liquidity or aggressive cash management by conserving cash with slow payments to trade suppliers, the company minimizes the amount of money it must borrow and the related interest The payables turnover ratio is often converted to a time basis known as the average age of payables = Using Ratios to Analyze the Operating Cycle Analysts are interested in the operating cycle because it helps them evaluate a company's cash needs and is a good indicator of management efficiency Operating cycle for most companies involves three distinct phases: acquisition of inventory, sale of inventory and collection of cash from customers Three ratios that are helpful in determining a company's operating cycle: payables turnover ratio, inventory turnover ratio and receivables turnover AFM 101 Final Exam-AID Package Fall 2011 Tests of Solvency Tests of Solvency: Are ratios that measure a company's ability to meet its long-term obligations Times Interest Earned Ratio Compares profit that a company generate during one period to its interest expense for the same period Represent a margin of protection for the creditors = Cash Coverage Ratio Compares the cash generated with the cash obligations of the period Concerned about a company's ability to make required interest payments = ( ) Debt-to-Equity Ratio Expresses a company's debt as a proportion of its shareholder's equity Debt is risky for a company because of specific interest payments must be made even if the company has not earned sufficient profit Dividends are always the discretion of the firm - - = ! Market Tests Market Tests: Are ratios that tend to measure the market worth of the common share Price Earnings Measures the relationship between the current market price per share and its earnings per share Reflects the stock market's assessment of the company's future business performance High ratio indicates that the market expects earnings to grow rapidly Sometimes the components of the P/E ratio are inverted, giving the capitalization rate, a rate at which the stock market apparently is capitalizing the current earnings The share price is related to the present value of the company's future earnings There are risks of a high ratio because if the company does not meet its level of expected earnings, the negative impact on the share price can be dramatic Dividend Yield Measures the relationship between the dividend per share paid to shareholders and the current market price per share Investors may accept low dividend yields if they expect that the price of company's shares will increase while they own it = Interpreting Ratios and Other Analytical Considerations Except for earnings per share, the computation of financial ratios has not been standardized by the account profession or security analysts, thus users of financial statements should compute the various ratios in accordance with their decision objectives AFM 101 Final Exam-AID Package Fall 2011 The important first step in analyzing financial statements is a review of the company's accounting policies, which are disclosed in a note to the financial statements Other Financial Information Rapid Growth: Growth in total sales volume does not always indicate that a company is successful Uneconomical Expansion: Some growth-oriented companies open stores in less than desirable locations if good locations cannot be found o These poor locations can cause the company's average productivity to decline o One measure of productivity in the retail industry is sales volume per square foot for selling space Subjective Factors: Remember that vital information about a company is not contained in the annual report Information in an Efficient Market Efficient Markets: Are securities markets in which prices fully reflect all publicly available information Considerable research has been performed on the way in which stock markets react to new information Much of this evidence supports the view that the markets react very quickly to new information in an unbiased manner Investors have a large financial incentive to discover new information about a company and trade quickly based on that information The research on efficient markets has important implication for financial analysis It is not beneficial to study old information (6 months prior) in an effort to identify an undervalued stock A company cannot manipulate the price of its stock by manipulating its accounting policy Market should be able to differentiate between a company with increasing earnings because of improved productivity and one that has increased its earnings by changing from prudent to liberal accounting policies Article Summaries Is Target Corp.'s Credit Too Generous? Expansion of the card business in the current tough environment could lead to higher-than-expected bad loans The card business had been responsible for a large part of the retailer's overall earnings growth Fears that Target has lent too much at a time when a slowing economy makes it harder for borrowers to repay Target has made a choice to significantly increase its credit-card loans because it identified more borrowers that it felt comfortable lending to Target has a proven track record of managing its credit business Investors may be wary of investing in Target because it may look less attractive to buyers since it is grappling with problems in its credit-card operations Bad debts may be higher than expected due to the turn of the economy How Much is Your Revenue, Really? Current accounting standards are not good enough as there a growing number of bundled revenues For example, smartphone bundle with 2 year contract, under one transaction How do you recognize bundled transactions? o Have to deal with this in multiple steps: 1. Identify the contract with the customer 2. Identify goods and services to be dealt with AFM 101 Final Exam-AID Package Fall 2011 3. Determining the overall transaction then allocate this price over various periods and over various items 4. Identify the price of each item independently, compare it to the bundle price, allocate the bundle price over the various components 5. Recognize revenue as each component/obligation takes place Weak Links in the Food (Supply) Chain Gives a number of examples of companies that would try to reduce inventory costs and cost of sales in order to generate greater profits A number of companies were encountering costs in inventory and trying to manage those costs First example was pizza company in the US and how they would try to manage cost of sales and inventory costs in order to maintain their profits in spite of rising material costs and rising fuel costs Talks about what they were trying to do about costs in their supply chain Also talks about a supermarket and how they were trying to reduce costs with inventory Could save money by combining delivery of grocery goods in bunches Nestle is trying to change production processes Gap Gets Squeezes by Spiral of Costs Mentions how the clothing company Gap deals with rising labour costs and material costs and as a result they were looking at a 20% increase in their costs Do not seem to be dealing with it very well since their profit dropped Selling prices are low because of excess supply, therefore not about to maintain profit Competitors are better at managing inventory so can manage their profit Real Estate Worries some GE Analysts Analysts argue that general electric was not writing down assets to recognize impairment GE responds by saying that declines in value of assets are temporary and these declines will reverse and thus, no write down is necessary There is judgement to determine impairment, market value is not crystal clear Inconsistencies amongst others firms on write downs and impairments The challenge is determining when an asset write down is appropriate Pension Plans are Getting Fresh Attention Two types: Defined contribution and defined benefits pension plans Defined Contribution: The contribution is defined by a type of formula (i.e. salary), contribution by the employee to the employer Trustee manages the contribution in the pension plan If the trustee can manage these funds properly, through investments, etc. and the trustee is successful, the employee gets a large pension, if the trustee is not, employee gets a small pension Do not know what kind of pension you will receive Risk is borne by the employee Defined Benefit: Pension that employee receives is a function of some formula, benefit is defined o Employee is aware of the amount in pension plan based on salary and number of years work are contributing factors o Responsibility of the employer to ensure that enough money is placed into the pension plan, if the trustee invested well, the employer puts less money in the plan o Risk is borne by the employer AFM 101 Final Exam-AID Package Fall 2011 Difficulties with Pensions o Interest rates are low, when payments are discounted, the present value is a large number o Very difficult to earn a high rate of return on investments (bond interests are not good, stocks are risky), people are living longer How Leases Play a Shadowy Role in Accounting Article mentions how many company's in the US have many assets are listing their capital leases are recorded as an operating lease Structuring the capital lease to appear as a operating lease 90% rule: take the present value of the lease payments and adding them up and comparing it to the fair value of the asset today, if the value of the present value payments is less than 90% of the fair value, then the lease is considered an operating lease Want to keep debt off balance sheet and it makes debt look smaller, thus more attractive to investors Backdating Likely more Widespread Backdating refers to looking back (now: Dec 2) and finding the lowest share price in that period (Oct 15), then presently set the exercise price equal to the lowest price, write off the stock option using the lowest price at a previous date (Oct 15) Many companies have backdated and only a portion have been caught Example of how some companies bent the rules in order to give their top managers a bigger profit on their stock option, governance fell down in these firms This is CHEATING! LinkedIn IPO Soars, Feeding Web Boom Underpricing of 109% occurred for the LinkedIn shares If you happened to invest in the IPO, you would have gained a lot of profit Factors influencing underpricing: First internet firm to have an IPO, Role of supply and demand LinkedIn only had 7 million shares available for trade (less than 10% of the equity within the firm vs Google who had 20 million) Yahoo, Google and Internet Math Compared revenue numbers of Yahoo and Google, but found that they account for their revenue using different methods They were changing their revenues drastically by each quarter In order to understand what a company's financial statements are telling you, cannot look at the statements, need to read then notes to read what it says about the accounting method used when preparing the statements Why You Shouldn't By those Earnings Surprises Deals with earnings analysis For larger companies, they are followed by multiple analysts and each quarter when they company announces earnings per share, they will make prediction of what they think it will be Consensus analyst forecasts is the median of the analyst forecasts When company announces earnings per share, in majority of the cases the actual EPS is more than the consensus analyst forecasts 68% of companies had EPS greater than forecast Companies feed information to analysts who gradually changes forecast AFM 101 Final Exam-AID Package Fall 2011 Extra Practice Problems Problem 1 Albert Company agreed to build a bowling complex for Pins R Us for a price of $2,000,000. The project is expected to take three years to complete. Albert estimated that the total cost of the project would be $1,600,000. During the first year, construction costs amount to $600,000. If Albert uses the percentage-of-completion method, the amount of revenue recognized for the first year will be Problem 2 Red Company received the following October 31, 2009, bank statement: Transactions Balance Balance, September 30 $18,000 Deposits recorded during October $40,000 58,000 Customer note collected for Red Company 2,520 60,520 (including $120 interest) Cheques cleared during October (38,300) 22,220 NSF cheque (given to Red Company by (100) 22,120 a customer) Bank service charges (15) 22,105 Balance, October 31 $22,105 The cash account (in Red Company's ledger) reflected the following for October: September 30 balance $20,500 October cash deposits 41,000 October cheques written (38,600) October 31 balance $22,900 The September 30 bank reconciliation showed outstanding cheques of $500 and deposits in transit of $3,000. Prepare the bank reconciliation using the following table: Problem 3 Martinelli Company recently purchased a truck. The price negotiated with the dealer was $85,000. Martinelli also paid sales tax of $6,000 on the purchase, shipping and preparation costs of $950, and insurance for the first year of operation of $2,000. For the truck, what amount should be debited to the asset account Vehicles? Problem 4 The records of Piccalo Company showed the following about a machine on January 1, 20H: Purchased 1/1/20E for $35,000 Accumulated amortization at January 1, 20H, $26,400 On July 1, 20H, the machine was sold for $7,000. Amortization for the first six months of 20H was $1,467. The gain or loss on disposal would be Problem 5 Chipmunks Corporation issued 3,000, 10 year bonds at 103 on November 1, 2009, which results in an effective interest rate of 8%. The bonds have a $1,000 face value and a 9% stated interest rate. Interest is payable annually on October 31. The company uses the straight-line amortization method. Record the payment of interest on October 31, 2010. AFM 101 Final Exam-AID Package Fall 2011 Problem 6 Alvin Simon &Theodore Corporation issued $5,000,000, 8 percent, 10 year bonds dated May 1, 2009. Interest is paid semi-annually on October 31 and April 30. The market rate of interest was 6 percent. Record the sale of the bonds on May 1, 2005. Problem 7 TomTom Limited issued $1,000,000, 10 percent, 10 year bonds dated July 1, 2009. Interest is paid semi-annually on June 30 and December 31. The issue price was $1,135,903 based on a market interest rate of 8 percent. The company uses the effective interest rate method of amortization. Complete the following table and complete journal entries for the first 2 years until Dec 31, 2010 Date Interest Payment Interest Expense Amortization of Book Value Discount or Premium July 1, 2009 --- --- --- $1,135,903 Dec 31, 2009 July 1, 2010 Dec 31, 2010 Problem 8 A review of the financial records for Murray Company revealed the following information for 2009: Cash dividend on preferred shares $1,800 Amortization of premium on bonds payable 1,650 Cash balance, January 1, 2009 12,250 Amortization expense for equipment 7,000 Net income 26,000 Stock dividend on common shares 4,200 Expenditure for the purchase of equipment 10,000 Net decrease in accounts payable 1,100 Net decrease in accounts receivable 1,900 Purchase of office equipment in exchange for note payable 2,700 Cash received from sale of delivery truck 4,800 (net book value $6,000) Prepare the statement of cash flows for Murray Company for 2009 using the indirect method. Problem 9 The following information was taken from the financial statements of David Company for the years 2009 and 2008 (amounts in thousands): Income Statement Net operating revenues Cost of goods sold Gross profit Selling, administrative and general expenses Other operating charges Operating income Other revenues (expenses) including interest expense of $337 ($277) in 2005 (2004) 2009 $ 21,000 6,500 13,500 8,000 750 4,250 1000 2008 $ 17,000 5,500 11,500 7,350 150 4,000 600 AFM 101 Final Exam-AID Package Fall 2011 Income before taxes Income tax expense (tax rate 36.3% (32.0%) in 2005 (2004)) Net income Balance Sheet Cash and cash equivalents Marketable securities Trade accounts receivables, net of allowance for doubtful accounts of $101 ($89) in 2005 (2004) Inventories Prepaid expenses and other assets Total current assets Total investment assets Property, plant and equipment, net of accumulated amortization of $3,126 ($2,887) in 2005 (2004) Goodwill and other intangible assets Total assets Current liabilities Long-term debt Other liabilities and deferred taxes Total liabilities Total stockholders' equity Total liabilities and stockholders' equity Required: Calculate the following ratios for 2009: A) Times interest earned ratio B) Accounts receivable turnover ratio C) Return on assets D) Debt to equity ratio E) Current ratio F) Return on equity 5,250 1,906 $3,344 $ 1,700 210 1,798 1,100 1,650 6,458 9,500 4,267 2,000 $20,225 7,000 1,200 800 9,000 11,225 $20,225 4,600 1,472 $3,128 $ 1,600 200 1,666 900 2,000 6,366 7,000 3,669 1000 $18,035 5,000 1,000 1,600 7,600 10,435 $18,035 AFM 101 Final Exam-AID Package Fall 2011 Extra Practice Problems Solutions Solution 1 Percentage deemed complete = 600,000 / 1,600,000 = 0.375 Therefore recognize 0.375 * 2,000,000 = 750,000 of revenue Solution 2 Red Company Bank Reconciliation October 31, 2009 Company's Books Bank Statement Ending cash balance per books $22,900 Ending cash balance per bank statement $22,105 Additions Additions Collection of customer note 2,520 Deposits in transit 4,000 ($41,000 + 3,000 40,000) Deductions Deductions NSF cheque (100) Outstanding cheques (800) Bank service charges (15) ($38,600 + 500 38,300) Ending correct cash balance $25,305 Ending correct cash balance $25,305 Solution 3 Vehicle cost = 85,000 + 6,000 (taxes) + 950 (shipping, etc.) = 91,950 Insurance should be expensed since it is an ordinary expenditure and likely to be incurred every year during the life of the vehicle. Solution 4 Accumulated amortization at July 1, 20H = 26,400 + 1,467 = 27,867 Net Book Value at Jul1, 20H = 35,000 27,867 = 7,133 Proceeds received from sale = 7,000 Since proceeds < NBV, a loss was incurred Loss on sale = 7,133 7,000 = 133 Solution 5 Issue price = 3,000 * $1,000 * 1.03% = $3,090,000 Total premium = $3,090,000 3,000,000 = $90,000 Amortization = $90,000 / 10 years = $9,000 / year Interest Expense $261,000 Premium on Bonds Payable 9,000 Cash ($3,000,000 * 9%) $270,000 AFM 101 Final Exam-AID Package Fall 2011 Solution 6 Present value of principal = $5,000,000 * PV(n=20, i=3%) = $5,000,000 * 0.554 = $2,771,000 Present value of interest = $5,000,000 * 4% * PV(annuity, n=20, i=3%) = $200,000 * 14.877 = $2,975,400 Issue price = $2,771,000 + 2,975,400 = $5,745,400 Cash $5,745,400 Premium on Bonds Payable $745,400 Bonds Payable $5,000,000 Note: if a financial calculator or formulas are used: Present value of principal $2,768,378.77 Present value of interest $2,975,494.97 Issue price $5,743,873.74 Solution 7 Number of periods: 20 Coupon rate per period: 5% Market Interest rate per period: 4% Dec 31, 2009 Interest Expense = 4% * 1,135,903 = 45,436 Interest Payment (coupon is fixed) = 5% * 1,000,000 = 50,000 Premium Amortization = 50,000 45,436 = 4,564 Book Value at Dec 31, 2009 = 1,135,903 amortization of premium = 1,135,903 4,564 = 1,131,339 July 1, 2010 Interest Expense = 4% * 1,131,339 = 45,254 Interest Payment (coupon is fixed) = 5% * 1,000,000 = 50,000 Premium Amortization = 50,000 45,254 = 4,746 Book Value at July 1, 2010 = 1,131,339 amortization of premium = 1,131,339 4,746 = 1,126,593 Dec 31, 2010 Interest Expense = 4% * 1,126,593 = 45,064 Interest Payment (coupon is fixed) = 5% * 1,000,000 = 50,000 Premium Amortization = 50,000 45,064= 4,936 Book Value at Dec 31, 2009 = 1,126,593 amortization of premium = 1,126,593 4,936 = 1,121,657 AFM 101 Final Exam-AID Package Fall 2011 Date Interest Payment Interest Expense Amortization of Discount or Premium --- 4,564 4,746 4,936 Book Value July 1, 2009 --- --- Dec 31, 2009 50,000 45,436 July 1, 2010 50,000 45,254 Dec 31, 2010 50,000 45,064 Journal Entries July 1, 2009 Cash 1,135,903 Premium on Bond Payable 135,903 Bond Payable 1,000,000 Dec 31, 2009 Interest Expense 45,436 Premium on Bond Payable 4,564 Cash 50,000 July 1, 2010 Interest Expense 45,254 Premium on Bond Payable 4,746 Cash 50,000 Dec 31, 2010 Interest Expense 45,064 Premium on Bond Payable 4,936 Cash 50,000 $1,135,903 1,131,339 1,126,593 1,121,657 AFM 101 Final Exam-AID Package Fall 2011 Solution 8 Murray Company Statement of Cash Flows For the Year Ended December 31, 2009 Operating Activities: Net Income Add (deduct) items not affecting cash Amortization of premium on bonds Amortization of equipment Net decrease in accounts payable Net decrease in accounts receivable Loss on sale of truck _________________________ Net cash flow from operating activities Investing Activities: Purchase of equipment Sale of delivery truck _________________________ Net cash flow from investing activities Financing Activities Dividend on preferred shares _________________________ _________________________ Net cash flow from financing activities Net increase in cash Cash balance, January 1, 2006 Cash balance on December 31, 2006 Non-cash Investing and Financing Activities Purchase of office equipment in exchange for note payable ** Note: Stock Dividend does not involve cash. $26,000 __________ (1,650) 7,000 (1,100) 1,900 1,200 __________ ($10,000) 4,800 __________ ($1,800) __________ __________ $33,350 (5,200) (1,800) $26,350 12,250 $38,600 $2,700 AFM 101 Final Exam-AID Package Fall 2011 Solution 9 A) Times interest earned ratio = $3,344 + 337 + 1,906 337 = $5,587 / $337 = 16.58 B) Accounts receivable turnover ratio = $21,000 ($1,798 + 1,666) = $21,000 $1,732 = 12.12 C) Return on assets = $3,344 ($20,225 + 18,035) = $3,344 $19,130 = 17.48% D) Debt to equity ratio = $9,000 $11,225 = 0.80 E) Current ratio = $6,458 $7,000 = 0.92 F) Return on equity = $3,344 ($11,225 + 10,435) = $3,344 $10,830 = 20.88 Works Cited Libby, Libby, Short, Kanaan & Gowing. Financial Accounting. Toronto: McGraw-Hill Ryerson, 2011. Print. ...
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This note was uploaded on 01/18/2012 for the course AFM 101 taught by Professor Kennedy during the Fall '08 term at Waterloo.

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