Common Financial and Accounting Ratios & Formulas( SOURCE: http://www.accountingscholar.com ) Part 10.1 - Common Financial & Accounting Ratios and Formulas Part 10.2 - Working Capital & Current Ratio Part 10.3 - Acid Test (Quick) Ratio Part 10.4 - Accounts Receivable Turnover Ratio

Accounting ratios are among the most popular and widely used tools of financial analysis because if properly analyzed, they help us identify areas that require further analysis on financial statements of corporations.A ratio can help us uncover conditions and trends that are difficult to find by inspecting individual components making up the ratio. For instance, knowing how much cash a company has in the bank might be a little useful, but working out a ratio to determine how much cash a company has, versus how much short term debt it has coming up is a lot more useful. Accounting ratios help us do just that. In fact, accountants admit that interpreting financial data is the most challenging aspect of ratio analysis. First of all, what is a ratio?

A ratio is a mathematical relation between two quantities expressed as a percentage, a rate or proportion.For example a ratio can derive the answer $900 or can be expressed a 100% or 9:1 or just 9 In this tutorial, we will go over 4 major categories of accounting ratios that are known as the 4 building blocks of financial statement analysis. They are i) liquidity & efficiency ratios ii) solvency ratios iii) profitability ratios and iv)market value ratios.

A) Short Term Solvency or Liquidity Ratios1. Current ratio= Current assets / Current liabilities2. Quick ratio= (Current assets inventory) / Current liabilities3. Cash ratio= Cash / current liabilities4. Net Working Capital= Net working capital / total assets5. Internal measure= Current assets / average daily operating costs

B) Long Term Solvency or Financial Leverage Ratios1. Total debt ratio= (Total assets total equity) / Total assets2. Debt to Equity ratio= Total debt / total equity3. Equity Multiplier= Total assets / total equity4. Long term debt ratio= Long term debt / (Long term debt + total equity)5. Times interest earned= Earnings before Interest & Taxes / Interest6. Cash coverage ratio= (Earnings before Interest & Taxes + Depreciation) / Interest

C) Asset use or turnover ratios1. Inventory turnover= Cost of goods sold / Inventory2. Days sales in Inventory= 365 days / Inventory turnover3. Receivables turnover= Sales / Accounts receivable4. Days sales in receivables= 365 days / Receivables turnover5. Net Working Capital (NWC) turnover= Sales / Net Working Capital6. Fixed asset turnover= Sales / net fixed assets7. Total asset turnover= Sales / total assets

D) Profitability Ratios1. Profit margin= Net income / Sales2. Return on Assets (ROA)= Net income / total assets3. Return on Equity (ROE)= Net income / Total equity4. ROE= (Net Income / Sales) x (Sales / Assets) x (Assets / Equity)

E) Market Value Ratios1. Price to Earnings ratio= Price per share / Earnings per share2. Market-to-book ratio= Market value per share / book value per share

Working Capital & Current Accounting Ratio1. Part 10.1 - Common Financial & Accounting Ratios and Formulas2. Part 10.2 - Working Capital & Current Ratio3. Part 10.3 - Acid Test (Quick) Ratio4. Part 10.4 - Accounts Receivable Turnover Ratio

The amount of current assets less current liabilities is called the working capital, or net working capital. A company needs an adequate amount of working capital on hand to meet its current or short term debts, carry sufficient inventories for resale and take advantage of cash discounts that suppliers might offer.

A company that runs low on working capital is less likely to meet current debt liabilities and obligations. Current assets are those assets that can be readily or easily converted in to cash including cash, accounts receivable, inventories, short term investments, prepaid expenses and other assets that can be readily turned in to cash. Current liabilities on the other hand are those liabilities that are expected to be repaid within 1 year; examples include accounts payable, short term debts such as bank overdraft, accrued expenses such as wages payable, taxes payable and current payments on long term debt, such as bond interest.

To evaluate working capital of a company, we must look beyond the dollar values of current assets & current liabilities and we must consider the relationship between these 2 variables.

The current ratio was designed to help us do just this. The current ratio is meant to describe a companys ability to meet its short term obligations. The formula for current ratio is:

Current Ratio = Current Assets / Current Liabilities

To calculate the current ratio, we will work off a simulated balance sheet of Juakali Corp. as of December 31st, 2004 and 2005 years.

Juakali Corp.Balance SheetAs of December 31st, 2004 and 2005

Assets20042005

Current Assets

- Cash & Short Term Investments$92,124.00$118,256.00

- Accounts Receivable$65,425.00$83,641.00

- Merchandise Inventory$102,335.00$93,222.00

- Prepaid Expenses$4,500.00$3,100.00

Total Current Assets$264,384.00$298,219.00

- Trucks & Equipment$203,654.00$183,542.00

- Other long term assets (Capital)$324,146.00$300,000.00

Total Assets$792,184.00$781,761.00

Liabilities

Current Liabilities

- Accounts Payable$65,231.00$84,521.00

- Accrued Liabilities$6,895.00$7,800.00

- Income Taxes Payable$7,000.00$3,200.00

Total Current Liabilities$79,126.00$95,521.00

- Long Term Debt$325,000.00$357,000.00

Total Liabilities$404,126.00$452,521.00

Shareholder's Equity

- Common Shares$265,000.00$208,000

- Retained Earnings$123,058.00$121,240.00

Total shareholder's equity$388,058.00$329,240.00

Total liabilities & shareholder's equity$792,184.00$781,761.00

The area we are interested in is the Current assets & Current liabilities area.

Assets20042005

Total Current Assets$264,384.00$298,219.00

Total Current Liabilities$79,126.00$95,521.00

Working Capital$185,258.00$202,698.00

Current Ratios

$264,384 / $79,126 .............3.341303743

$298,219 / $95,521 ...........3.122025523

A high current ratio means the company is in a strong liquidity position and should easily be able to pay its suppliers, short term debts and pay its employees salaries, rent expenses, etc.

Sometimes a company can have a very high current ratio, which means they are hoarding cash that could be put to better use such as acquiring value-added investments & companies, equipment or spend on research and development. Since current assets do not generate much additional revenue other than a measly 3% bank interest, an excessive investment in current assets is not preferable for companies.

Most investors like to see a ratio of at least 2 to 1, meaning for every $1 of short term current liability, there is $2 of cash available to pay for it.

A company with a 2 to 1 ratio is also thought to be of a good credit risk in the short term. The type of business a company is in also plays a large role in maintaining a good current ratio. For instance, a service company that has little or no credit and carries no inventories other than suppliers can easily operate on a 1:1 ratio provided it generates cash in time to make its rent and other fixed cost payments. On the other hand, a company selling high priced clothes, perfumes or furniture store requires a higher current ratio of at least 2:1 because of the uncertainty in customer demand, judgement and the economy.

For example, if demand for furniture drops in the economy, the companys inventories will not generate as much cash as expected, which means the current ratio number will be skewed higher because remember, inventories (furniture) are included as current assets.

Therefore, banks and creditors as well as investors prefer to have a ratio of at least 2:1 for such companies.

Acid Test (Quick) Ratio Part 10.1 - Common Financial & Accounting Ratios and Formulas Part 10.2 - Working Capital & Current Ratio Part 10.3 - Acid Test (Quick) Ratio Part 10.4 - Accounts Receivable Turnover Ratio

The way current assets are structured is important in determining the companys short term ability to pay its debts. For instance, cash, cash and equivalents and temporary investments are more liquid than accounts receivable, notes receivable and merchandise inventory. We know that cash and short term investments can be used to pay off debts, pay suppliers, employees wages, etc. However, merchandise inventory and accounts receivable must be converted in to cash before they are any good to the company. Thus, an excessive amount of receivables and inventory weakens a companys ability to pay its current liabilities. One way to test the strength of a companys current assets is to evaluate the acid-test ratio.

The acid-test ratio is also known as the quick ratio and it conducts a more thorough test of a companys ability to pay its short term debts by excluding inventory and prepaid expenses from the calculation. Thus, only quick assets are included in the calculation. The quick assets are cash, cash & equivalents, accounts receivable and notes receivable. Thus, the formula for acid-test ratio is:

Acid-test Ratio = (Cash + Temporary Investments + Accounts Receivables) / Current Liabilities

Assets20042005

Current Assets

- Cash & Short Term Investments$92,124.00$118,256.00

- Accounts Receivable$65,425.00$83,641.00

Total Quick Assets$157,549.00$201,897.00

Total Current Liabilities$79,126.00$95,521.00

Acid-test ratio:

$157,549 / $79,1261.991115436

$201,897 / $95,5212.113639933

Notice that the current ratio in 2004 was 3.34 to 1 and it dropped to 1.99 to 1 in the acid-test ratio, a decline of almost 1.34 points which is significant! This is the reason why the acid-test ratio gives us a much more precise outlook of the companys strength in meeting its short term debt obligations and stay afloat as well as have enough cash on hand to operate effectively. A rule of thumb for evaluating the acid-test ratio is that it must be 1:1 and not less than 1. However, investors prefer this ratio to be as high as possible, even about 1.8 to 1.

Accounts Receivable Turnover Ratio Part 10.1 - Common Financial & Accounting Ratios and Formulas Part 10.2 - Working Capital & Current Ratio Part 10.3 - Acid Test (Quick) Ratio Part 10.4 - Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio measures how frequently a company converts its receivables in to cash. We know that accounts receivable is a current asset; however it may not be liquid enough if the debtors are in a bad financial position and cannot pay their dues. If this happens, then this means the companys current assets will be grossly overvalued because it is not expecting to collect a majority of its receivables (these will have to be written off from AR). The accounts receivable turnover ratio is calculated as follows:

Accounts Receivable Turnover = Net Sales / Average Accounts Receivable

The net sales number is derived from the income statement; however a better number to report on the numerator would be Credit sales. However, most companies do not record credit sales, thus this information is not available. In the denominator, the average accounts receivable also includes short-term notes receivables from customers.

Average accounts receivable are estimated by averaging the beginning and ending receivable balances for the period. If this data is not available, then an average of quarterly or monthly receivables can be used. Also some companies prefer to simplify things by substituting the ending accounts receivable balance as the average balance, and thus not having to worry about calculating the beginning balance.

Juakali Corp.Comparative Income StatementAs of December 31st, 2004

Assets2004

Sales$236,589.00

Less: Cost of Goods Sold$56,900.00

Gross Profit$179,689.00

Expenses:$102,335.00

- Advertising & Marketing Expense$21,630.00

- General & Admin expense$54,550.00

- Research & Development$20,000.00

- Amortization expense$6,521.00

- Loss (gain) on foreign exchange$2,000.00

Total Expenses$104,701.00

Income from Continuing Operations$74,988.00

- Interest Income$9,750.00

Less: Interest Expense$4,000.00

Income from Continuing Operations before taxes$80,738.00

- Income Taxes$28,000.00

Net Income$52,738.00

To calculate the accounts receivable turnover ratio, we need to reference the income statement to derive the Net sales number. Thus, here is the AR turnover ratio calculation:To calculate the accounts receivable turnover ratio, we need to reference the income statement to derive the Net sales number. Thus, here is the AR turnover ratio calculation:

Accounts Receivable Turnover = Net Sales / Average Accounts Receivable Accounts Receivable Turnover = $236,589 / ( ($65,425 + $83,641) / 2) Accounts Receivable Turnover = $236,589 / $74,533 Accounts Receivable Turnover = 3.174

This number means Juakali Corp. collects all its average accounts receivable 3.174 times in a year; the higher this number, the better it is for the company and its investors. A high AR turnover ratio is warranted because this means the company is not having problems collecting its receivables, thus it does not need as many employees for making collection calls and chasing the customers. However to get a true picture of whether this ratio is good, always compare it with how companies within that industry are doing.

Part 7.1Assets, Liabilities & Shareholder's Equity Introduction - Advantages & Disadvantages of Shareholder's Equity - Taxation & Control Issues, Limited Liability, Capital Accumulation & Transfer of Shares/Ownership Part 7.2Difference between Private & Public Corporations, Classes of Common Shares & Share Capital Part 7.3Explanation of Common & Preferred Shares - Par Value & No Par Value Shares, Fundamentals of Share Equity Concepts Part 7.4Authorized Share Capital, Journal Entries for Issuance of Non Par Value Shares, Journal Entries for Shares Sold on Subscription Basis Part 7.5Non-Cash Sales of Share Capital, Proportional & Incremental Methods of Share Issuance & Accounting Part 7.6Costs of Share Issues & Accounting for Retirement of Shares & Corresponding Rules Part 7.7Conversion of Shares & Accounting for Treasury Stocks - Buying & Selling Treasury Stocks & Its Effects on Shareholder's Equity - Contributed Capital Part 7.8Explanation of Retained Earnings - Dividends & Dividend Dates & Cash Dividends - Recording Journal Entries for Declaration of Dividends Part 7.9Cumulative Dividends on Preferred Shares - Increases & Decreases of Contributed Capital & Types of Dividends - Stock, Liquidating, Scrip Dividends

Chapter 7.1 Assets, Liabilities & Shareholder's Equity Introduction Advantages & Disadvantages of Shareholder's Equity Taxation & Control Issues, Limited Liability, Capital Accumulation & Transfer of Shares/Ownership

The definition of Shareholder's equity is the difference between the assets and the liabilities of an entity is called Shareholders Equity. The term Equity is a very important meaning in it. The way we describe in a simplest form is there is no asset, no equity. If you remember the accounting equation that we all have studied that Assets Liabilities = Equities. Also, we all know the abbreviation, ALPER, which makes easier to remember the foundation of accounting. ALPER stands for:

ALPER stands for: A = Assets L = Liabilities P = Proprietorship / Equity E = Expenses R = Revenue

All the above mentioned are the pillars of the accounting. And equity is among one of them.

Advantages & Disadvantages:The corporate entity has advantages and disadvantages as compared to sole proprietor or partnership entities. Now, lets take a look advantages first:

Limited LiabilityIn the corporate entity world, every shareholder has a limited liability as per the ratio of shares. In the event of dissolution or insolvency, the shareholders loose their amount invested only. The creditors of the corporation has no authority to challenge the personal assets of the shareholders. But, creditors might ask for personal guarantees against the loans and other financial arrangements from each shareholder or a director.

Capital AccumulationThe corporate entities may have an option of capital accumulation. In this event, the companies may invest the funds in the large portfolios to maintain the companys cash flows and demands for upgradations as per the needs. Most of the companies invest in the open market and big chip companies so that they can earn good profits which reduces their demand to obtain the loans from the financial institutions.

Transfer of Shares / OwnershipThe share capital can be transferred after following the corporate requirement. This is the most attractive part in the corporate environment where you can transfer your ownership.

Issue of sharesA very interesting attitude of the corporate companies is to issue shares to the public where public becomes a part of the management as per the ratio of theor investments. It gives an opportunity to a company to expands their productivity and meet the demand / supply demands.

Voting RightsAll the shareholders have right to vote. They can select the CEO and directors by doing a voting. This gives every body an independence to select their CEO or directors.Now lets talk about the disadvantages of the corporate forms whereas:

Higher Taxation:The corporate entities pay tax on the profits or equity and shareholders pay tax on the dividends which they get from the corporate entity. So, here, if you think, a shareholder is absorbing a burden of double-taxation. However, in the case of private corporation, CCPC (Canadian controlled private corporations, get lower tax rate which is good in compare to the corporate entities. But the private companies have to proof that they qualify for the reduced tax rules. Otherwise, the the combined effect of corporate tax and individual tax will exceed the rate of the tax bracket that would be assessed to the owners of sole proprietors or partnerships.

In the event where entity incurs losses, a sole proprietor or a partner may claim those losses which offset with their income. But in corporate world, the losses may be accumulated and carry forward until they are completely utilized. So, in the corporate entities, no immediate tax benefit.

Controlling issuesThis is the hurdle if a large number of shares have been bought by a family or a group. Why is that? The reason is very simple. The more shares of the corporation you possess, more influence you have. So, if the major shares of the company is with a specific group, this will increase the influence of the group of people and will affect the decision of the corporate matters.

Financial & Legal Costs:The financial and legal costs are always higher for the corporations in comparing with the partnership and sole proprietorship entities.

Chapter 7.2 Difference between Private & Public Corporations, Classes of Common Shares & Share Capital

Federal and provincial Governments control the operations of the corporation. A corporation can be formed either by federally or provincially. There is no difference forming a company under federally or provincially. The businesses can perform their activities within Canada or internationally by incorporating through federally or provincially. Federally incorporated companies can be prestigious if business activities are conducted outside the country.

Survey:As per the survey by Financial Reporting in Canada 2000, it has been noted that about half of the 200 Canadian public companies are incorporated federally.

Private Companies:The corporate entities may be private or public. Here are some important characteristics of private companies which are as follows:

be traded publicly. The private companies have a shareholders agreement. The shareholder agreement describes the ways in which a shareholder can transfer the shares as well as other rights and obligations. The shareholder agreement provides first opportunity to acquire any shares offered for sale. The private companies have a limited number of shareholders. The maximum number of shareholders are restricted to 50 by the provincial securities act. The shares cannot

The majority of the corporation in Canada are private. Private companies are highly prominent among even the largest corporations in Canada.

As per the survey, by Financial Post, half of the list of the 500 largest companies are private.Although, the private companies cannot trade their securities in the open market. But they do have an access to additional share capital through private placement.

Private Placements:The private placement is a process where the corporation offers shares to an individual or institutional investors. The securities Act in the various provinces stipulates that if an investor invests capital of at least a certain amount, the investor is considered to be a good investor and the issuance of the shares in a private placements are not included in the maximum count of 50 shareholders permitted to a private corporation.

Also, the private companies may adopt differential disclosure, with unanimous shareholder consent. Even the shares that are normally non-voting must agree to differential disclosure. The policy can be replaced if the cost is higher than the benefits derived. The policy may be replaced with a more simple alternative.

Public Companies:The public companies can be defined whose securities either debt or equities are traded on stock exchange. These companies may be incorporated under federally or provincially. The public companies follow some statutory requirements by GAAP. They also have a requirements like audits and other interim financial reporting etc.

Share Capital:The share capital is an amount to be invested or proportion invested in the company.

Example:

Mr. A has invested $100,000 in DDD Company. The DDD company will issue a $100,000 share certificate to Mr. A as a share capital owned by Mr. A

The share capital can be transferred to any one without the consent of the corporation in which the investment has been made.

Example:Mr. A, now wants to transfer his shares under his wifes name. Mr. A can transfer all or part of his shares under his wifes name without the permission of the corporation.

Now, we have some different classes of shares issue to the public.

Classes of the Shares:A corporation may be authorized to issue several classes of shares. Following are the important and common classes of shares:

Common Shares Preferred Shares

Chapter 7.3Explanation of Common & Preferred Shares - Par Value & No Par Value Shares, Fundamentals of Share Equity Concepts

Common Shares:At least one class of shares has the right to vote, and receives the dividend in the assets if the company is liquidated or dissolved. This class of share normally is described as the Common Shares. The voting rights include the power to vote for the members of the board of directors, who administer the matters of the company. The common shares may be given additional rights in the corporations articles of incorporation.

Example:The right to purchase shares on a pro rata, or proportionate, basis cab be awarded to common shareholders. This right is designed to protect the proportionate interest of each shareholder.The common shareholders are entitled to dividends only as declared, and they are at risk if the management of the company chooses to reduce or eliminate a dividend.

Preferred Shares:The preferred shares are so designated because they confer certain preferences, or differences, over common shares. Preferred shares are not always titled preferred and may have a variety of names. For example, Class A shares.

The most common feature of the preferred shares is a priority claim on dividends, usually at a stated rate or amount. The dividend rate on preferred shares must be specified, usually as a dollar amount per share, such as $1.20 per share. This preference does not guarantee a dividend but means that, when the board of directors does declare a dividend, preferred shareholders must get their $1.20 preferred dividend before common shareholders receive any dividends.

In exchange for the dividend preference, the preferred shareholder often sacrifices voting rights and the right to dividends beyond the stated rate or amount.

Some companies issue a class of common shares that has no voting rights or limited voting rights. This type of share is generally called restricted shares or special shares.

Example:Samad Khan & Company has two types of common shares, variable voting and limited voting. The limited voting shares have one vote each, while the variable voting shares had in 2007, 23 votes each.

Difference Between Par Value & Non-Par Value Shares:Par Value Shares:The Par Value Shares have a designated dollar amount per share, as stated in the articles of incorporation and as printed on the face of the share certificates. Par value shares may be either common or preferred.

If the par value shares are sold below the par/ face value, it is called discount. Par value shares sold above the par / face value is called premium. When par value shares are issued at a premium, the par value is assigned to the share account, and any excess to the premium on share capital account, a component of contributed capital. The pat value are usually set very low, and thus a major portion of the proceeds on issuance is classified as the premium.

No-Par Shares:These types of shares do not carry a designated or assigned value per share. This allow for all consideration received on sale of the securities to be classified in the share capital account, and it avoids the need to divide the consideration into two essentially artificial components, par value and excess over par.

Fundamental of Share Equity Concepts:The fundamental concepts that underlie the accounting and reporting of shareholders equity may be: Separate Legal Entity Sources of Shareholders Equity Contributed capital from Shareholders Retained Earnings Cost based Accounting No impact on Income

Chapter 7.4Authorized Share Capital, Journal Entries for Issuance of Non Par Value Shares, Journal Entries for Shares Sold on Subscription Basis

This represents the maximum number of shares that can be legally issued. In Canada, under the Canada Business Corporation Act, a corporation can issue unlimited number of shares. Also, the corporation may choose to place a limit on authorized shares. This limit must be stated in the articles of incorporation, which can be changed at the later date.

EXAMPLE OF SHAREHOLDERS EQUITY SECTIONCENTRAL MINARA BANK(In Millions $)

Shareholder's Equity20082007

Capital Stock

- Preferred$1,047$1,020

- Common$2,000$3,000

Retained Earnings$5,032$4,100

Ending Shareholder's Equity$8,079$8,120

Accounting For Share Capital at Issuance:If a corporation has more than one class of share, separate accounts should be maintained for each class. If there is only one share class, an account title share capital usually is used.

Non-Par Value Shares Issues for Cash:When share are issued, a share specifying the number of shares represented, is prepared for each shareholder..

For example, 1,000 common shares were issued at no-par for cash $10.20 per share would be recorded as follows:December 31st, 2009

Account NameDebitCredit

Dr. Cash$10,200

Cr. Common Shares$10,200

To record the issuance of 1000 common no par value shares @ $10.20 each.

Explanation:We debited cash by $10,200 (1,000 shares X $10.20) and credited the Common Share account by $10,200. Remember the concept i.e. (Debit and Credit must be equal).

Shares Sold on a Subscription BasisProspective shareholders sign a contract to purchase a specified number of shares on credit. The payment gets due at one or more specified future dates. These contractual agreements are known as stock subscriptions, and shares involved are called subscribed share capital. The shares are not typically issued until the entire subscription amount is received.Lets assume that 1,200 no-par common shares are subscribed for at $10 by Mr. A.

December 31st, 2009

Account NameDebitCredit

Dr. Stock Subscription Receivable$12,000

Cr. Common Shares$12,000

To record the issuance of 1200 common shares @ $10.20 each (on a subscription basis).

The receivable will be paid in four $3,000 instalments. Now, assume that after the 4th instalment has been paid and the entry of which will be as:

December 31st, 2010

Account NameDebitCredit

Dr. Cash$12,000

Cr. Stock Subscription Receivable$12,000

To record the collection of cash for 1200 shares sold on a subscription basis.

Payment Not Received:If a subscriber unable to pay the remaining instalments, some problems may arise. In this scenario, the corporation has to decide whether;

1) return all payment to the subscriber;2) issue the shares for payment already received; or3) keep the all payment

The above two options are in favor to the subscriber where no loss is falling on the shoulders of the subscriber. But on the other hand, option three has disadvantages where corporation is keeping all the money and paying no consideration. The third option is not generally enforceable.

Chapter 7.5Non-Cash Sales of Share Capital, Proportional & Incremental Methods of Share Issuance & Accounting

If a corporation issues shares for non-cash assets or services or to settle debt, the transaction should be recorded at fair value. But keeping in mind that that there are two fair values present, the fair value of the asset received and the fair value of the shares issued. Now, you will think, which one we should use? The answer is the cost assigned to asset received is the fair value of the consideration given.

Example:Salees Corporation privately placed 150,000 preferred shares and 500,000 common shares, primarily in exchange for real estate. Suppose the value of the land was $620,000 assessed. And the value of shares were assessed as $650,000.January 1st, 2009

Account NameDebitCredit

Dr. Land$620,000

Cr. Capital Stock$620,000

Entry to record acquistion of land worth $620k in exchange for issuance of Capital stock.

Basket Sale of Share Capital:When a corporation sells more than one class of shares for one lump-sum amount is called basket sale. In addition, a corporation may issue two or more classes of its share capital in exchange for non-cash consideration.

When two or more classes of securities are sold and issued for a single lump sum, the total proceeds must be allocated logically among the several classes of securities. Two method are used in such scenarios:

1) the Proportional Method 2) the Incremental Method

In the proportional method, the lump sum received is allocated proportionately among the classes of shares on the basis of the relative market value of each security. In the incremental method, the market value of one security is used as basis for that security and the remainder of the lump sum is allocated to the 0ther class of security. If there is no market value for any of the issued securities, proceed may be allocated arbitrarily.

Examples:

A) Proportional Method:The common shares were selling at $40 per share and the preferred at $20. Assume the total cash received is $48,000. Because reliable market values are available for both share classes, the proportional method is preferable as a basis for allocating the lump-sum amount as follows:

Proportional Allocation

Market value of common (1,000 shares X $40)$40,000 = 4/5 of total

Market value of preferred (500 shares X $20)10,000 = 1/5

Total Market Value$50,000 = 5/5

Allocation of the lump-sum sale price of $48,000

Common ($48,000 X 4/5)$38,400

Preferred ($48,000 X 1/5)$9,600

Total$48,000

January 1st, 2009

Account NameDebitCredit

Dr. Cash$48,000

Cr. No-Par Common Shares (1000 shares)$38,400

Cr. No-Par Preferred Shares (500 shares)$9,600

To record the issuance of 1000 common shares at $38,400 & 500 preferred shares at $9,600

B) Incremental MethodThe common shares were selling at $40; a market for the preferred has not been established. Because there is no market for the preferred shares, the market value of the common ($40,000) must be used as a basis for the following entry:January 1st, 2009

Account NameDebitCredit

Dr. Cash$48,000

Cr. No-Par Common Shares (1000 shares)$40,000

Cr. No-Par Preferred Shares (500 shares)$8,000

To record the issuance of 1000 common shares at $40,000 & 500 preferred shares at $8,000

Arbitrary Allocation:When there is no established market for either class of shares, neither the proportional method nor the incremental method of allocation can be used. In this case, an arbitrary allocation is used. In the absence of any other any other logical basis, a temporary allocation may be made by the board of directors. If a market value is established for one of the securities in the near future, a correcting entry based on such value would be made.

When the issue involves only a mix of equity, the arbitrariness of an allocation does not really matter; the classification of the proceeds between different classes of shares does not affect anyones rights or interests.

Chapter 7.6Costs of Share Issues & Accounting for Retirement of Shares & Corresponding Rules

Share Issue Costs:The expenditures include registration fees, underwriter commissions, legal and accounting fees, printing costs, clerical costs and promotional costs are called Shares issue Costs.

Two methods of accounting for share issue costs are found in practice:

1) Offset method 2) Retained Earnings Method

Both methods are found in practice.

Retirement of Shares:Some preferred shares are retractable, which means that, at the option of the shareholder, and at a contractually arranged price, a company is required to buy back its shares. Other preferred shares are callable, or redeemable, which means that there are specific buy-back provisions, at the option of the company. In these transactions, the company deals directly with the shareholder. However, a company can buy back any of its shares, preferred or common, at any time, if they are offered for sales. Such a sales can be a private transaction, or a public transaction.

Reasons for Shares Retirement:

- Increase Earning Per Share- Provide cash flow to shareholders in lieu of dividends- Acquire shares when they appear to be undervalued- Buy out one or more particular shareholders and to thwart takeover bids- Reduce future dividends payments by reducing the shares outstanding

Retirement Accounting Rules:

When shares are purchased and immediately retired, all capital items relating to the specific shares are removed from the accounts. If cumulative preferred shares are retired and there are dividends in arrears, such dividends are paid and charged to retained earnings in the normal manner. Where the reacquisition cost of the acquired shares is different from the average original issuance price, the cost be allocated as follows for non-par shares:

When the reacquisition cost is lower than the average price per share issued to date, the cost should be charged;a) first, to share capital, at the average price per issued share; and thenb) any remaining amount, to a separate contributed capital account.

When the reacquisition cost is higher than the average price per share issued to date, the cost should be charged in this sequence:a) first, to share capital, at the average price per issued share;b) second, to any contributed capital that was created by earlier cancellation or resale transactions in the same class of shares; and thenc) any remaining amount, to retained earnings.

Example:Lets assume that Fresco has 200,000 no-par common shares outstanding, and that there is $1 million in the common share account, which yields an average issuance price per share of $5. The contributed capital account from previous retirement transactions of common shares has a $7,200 credit balance. The corporation acquired and retired 10,000 shares at a price of $6.25 per share. The shareholder who sold these shares back to Fresco had originally paid $4 per share. The transaction would be recorded as:

January 10th, 2009

Account NameDebitCredit

Dr. Common Shares ([{$1,000,000 / $200,000} X 10,000 shares$50,000

Dr. Contributed capital, common share retirement$7,200

Dr. Retained earnings ($62,500 - $50,000 - $7,200)$5,300

Cr. Cash (10,000 X $6.25)$62,500

The first step in constructing this journal entry is to compare the cost to retire the shares ($62,500) with the average initial issuance price to date ($50,000). The specific issue price of these shares ($4) is irrelevant. The corporation paid $12,500 more to retire these shares than the average original proceeds. The $12,500 is debited first to contributed capital from prior share retirements until that account is exhausted.

This account may never have a debit balance. Retained earnings is debited for the balance. The effect of this transaction is to reduce paid-in capital by $57,200, retained earnings by $5,300 and total shareholders equity by $62,500. Assets are reduced by $62,500.

If the shares were reacquired for $4.25 per share, the entry to record the transaction would be:

January 10th, 2009

Account NameDebitCredit

Dr. Common Shares [($1,000,000 / 200,000) X 10,000$50,000

Cr. Contributed capital, common share retirement ($50,000 - $42,500)$7,500

Cr. Cash (10,000 X $4.25)$42,500

Chapter 7.7Conversion of Shares & Accounting for Treasury Stocks - Buying & Selling Treasury Stocks & Its Effects on Shareholder's Equity - Contributed Capital

Shares of any class may include the provision that they may be converted, at particular times and /or in particular quantities, into shares of another class.

Example:Preferred shares may be convertible into common shares. Conversions are accounted for at book value, with an equal decrease to one share class and increase to another.If 20,000 preferred shares, issued for an average of $36.70 per share, were to convert per the terms of their share certificates to 60,000 common shares (that is, 3-for-1):

January 1st, 2009

Account NameDebitCredit

Dr. Preferred shares (20,000 X $36.70)$734,000

Cr. Common Shares$734,000

Entry to record conversion of 20,000 preferred shares to common shares @ $36.70 per share.

Treasury Stocks:A firm may also buy its own shares and hold them for eventual resale. These shares are called treasury stocks.

Accounting for the Treasury Stocks:When a company buys treasury stocks, the cost of the shares acquired is debited to a treasury stock account which appears a deduction at the end of the shareholders equity section. When the shares are resold, the treasury stock account is credited for the cost, and the difference, which is the gain or loss, affects various equity accounts. The gain or loss is not reported on the income statements. A firm cannot improve reported earnings by engaging in capital transactions with their own shareholders. The balance in the treasury stock account is logically shown as a deduction from the total of shareholders equity.Accounting Method:This method of accounting for treasury stock is called the single-transaction method. The treatment is the same as that used for share retirement. An example will illustrate the sequence of entries.

a) Record initial sale and Issuance of 10,000 Common Shares at $26 per share

June 30th, 2009

Account NameDebitCredit

Dr. Cash (10,000 shares X $26)$260,000

Cr. Common shares (10,000 shares)$260,000

Entry to record the initial sale and issuance of 10,000 common shares at $26 per share

b) Record the acquisition of 2,000 common treasury shares at $28 per share

June 30th, 2009

Account NameDebitCredit

Dr. Treasury stock, common (2,000 shares X $28)$56,000

Cr. Cash$56,000

Entry to record the acquisition of 2,000 common treasury shares at $28 per share

Note: The cash price paid is always the amount debited to the treasury stock account.

c) Record sale of 500 treasury shares at $30 per share (above cost)

June 30th, 2009

Account NameDebitCredit

Dr. Cash (500 shares X $30)$15,000

Cr. Treasury stock, common (500 shares at cost, $28)$14,000

Cr. Contributed capital from Treasury stock transaction$1,000

Entry to record sale of 500 treasury shares at $30 per share (above cost)

Note: Had this sale been at cost ($28 per share), no amount would have been entered in the contributed capital account. If treasury shares are bought in a series of acquisitions at different prices, weighted average cost is used on disposition.

d) Record the sale of another 500 treasury shares at $19 per share (below cost)June 30th, 2009

Account NameDebitCredit

Dr. Cash (500 shares X $19)$9,500

Dr. Contributed Capital from treasury stock transactions$1,000

Dr. Retained Earnings$3,500

Cr. Treasury stock, common (500 shares at cost, $28)$14,000

Entry to record the sale of another 500 treasury shares at $19 per share (below cost)

Assuming entries (1) through (4) above, and a beginning balance in retained earnings of $40,000, the balance sheet would reflect the following:Shareholders Equity

-- Contributed capital

Common shares, 10,000 shares issued, of which 1,000 are held as treasury stock$260,000

Retained earnings ($40,000 - $3,500)$36,500

Total contributed capital and retained earnings$296,500

Less: Treasury stock, 1,000 shares at cost$28,000

Total shareholders equity$268,500

Chapter 7.8Explanation of Retained Earnings - Dividends & Dividend Dates & Cash Dividends - Recording Journal Entries for Declaration of Dividends

Retained earnings represent accumulated net income or net loss (including all gains and losses), error corrections, and retroactive changes in accounting policy, if any, less accumulated cash dividends, property dividends, stock dividends, and other amounts transferred to contributed capital accounts. If the accumulated losses and distributions of retained earnings exceed the accumulated gains, a deficit will exist.

Decrease (Debits)

- Net loss- Error correction- Effect of a change in accounting policy- Cash and other dividends- Stock dividends- Share retirement and treasury stock transactions- Share issue costs

Increase (Credits)

- Net Income- Removal of deficit in a financial reorganization- Unrealized appreciation of investments valued at market

Reporting Retained Earning:The statement of retained earnings may include the following:

- beginning balance of retained earnings- restatement of beginning balance for error corrections- restatement of beginning balance for retroactively applied accounting changes- net income or loss for the period- dividends declared for the period- appropriations and restrictions- adjustments made pursuant to a financial reorganization- adjustment s resulting from some share retirements- ending balance of retained earnings

Dividends:

Nature of Dividends:A dividend is a distribution of earnings to shareholders in the form of assets or shares.

Relevant Dividend Dates:Prior to payment, dividends must be formally declared by the board of directors of the corporation. Subsequent to the declaration date, there are three other dates relating to dividends that are important for the investing community.

Date of Declaration:On the declaration date, the corporations board of directors formally announces the dividend declaration.

Date of Record:The date of the record is the date on which the list of shareholders of record is prepared.

EX-Dividend Date:The Ex-dividend date is the day following the date of record.

Date of Payment:The date of payment follows the declaration date by four to six weeks.

Legality of Dividends:The requirement that there be retained earnings or certain elements of contributed capital before dividends can be declared.

- Dividends may not be paid from legal capital- Retained earnings available for dividends unless there is a contractual or statutory restriction.

Cash Dividend:Cash dividends are the usual form of distributions to shareholders. Before a cash dividend can be paid to common shareholders, appropriate preference dividends, if any, must be paid.

Example:Lets assume that the board of directors of BA company, at its meeting on January 2009, declared a dividend of $0.50 per common share, payable 20 March 2009, to shareholders of record on 1 March 2009. We assume that 10,000 no-par common shares are outstanding.

January 31st, 2009

Account NameDebitCredit

Dr. Retained earnings* - 10,000 shares X $0.50$5,000

Cr. Cash dividend payable$5,000

Entry to record payable of dividends on March 20th, 2009 at $0.50 per common share.

* Or cash dividends declared, which is later closed to retained earnings.

January 31st, 2009

Account NameDebitCredit

Dr. Cash Dividend Payable$5,000

Cr. Cash$5,000

Entry to record actual payment of cash dividends declared on March 1st, 2009 to shareholders.

The cash dividends payable is reported on the balance sheet as a current liability if the duration of the dividend liability is current; otherwise it is a long-term liability.

Chapter 7.9Cumulative Dividends on Preferred Shares - Increases & Decreases of Contributed Capital & Types of Dividends - Stock, Liquidating, Scrip Dividends

Cumulative preferred shares provide that dividends not declared in a given year accumulate at the specified rate on such shares. This accumulated amount must be paid in full if and when dividends are declared in a later year before any dividends can be paid on the common.

If the cumulative preference dividends are not declared in a given year, they are said to have been passed and are called dividends in arrears on the cumulative preferred shares.

Participating Dividends on Preferred Shares:Participating preferred shares provide that the preferred shareholders participate above the stated preferential rate on a pro rata basis in dividend declarations with the common shareholders.

First, preferred shareholders receive their preference rate. Second, the common shareholders receive a specified matching dividend. Then, if the total declared dividend is larger than these two amounts, the excess id divided on a pro rata basis between the two share classes.

Shares may be partially participating or fully participating. If partially participating, preferred shares may participate in dividend declaration in excess of their preference rate, but the participation is capped at a certain level.

Property Dividends & Spin-Offs:Corporations occasionally pay dividends with non-cash assets. Such dividends are called property dividends or dividends in kind.

Liquidating Dividends:Liquidating dividends are distributions that are a return of the amount received when shares were issued, rather than assets acquired through earnings. Liquidating dividends are appropriate when there is no intention or opportunity to conserve resources for asset replacement.

Scrip Dividend:A corporation that has a temporary cash shortage might declare a dividend to maintain a continuing dividend policy by issuing a scrip dividend. A scrip dividend (also called a liability dividend) occurs when the board of directors declares a dividend and issues promissory notes, called scrips, to the shareholders.

Stock Dividends:A stock dividend is proportional distribution to shareholders of additional common or preferred shares of the corporation. A stock dividend does not change the assets, liabilities, or total shareholders equity of the issuing corporation. It does not change the proportionate ownership of any shareholder. It simply increase the number if shares outstanding.

Special Stock Dividends:A special stock dividend is a dividend in a share class different from the class held by the recipients, such as a stock dividend consisting of preferred shares issued to common shareholders.In this case the market value of the dividend should be capitalized.

Stock SplitsA stock split is a change in the number of shares outstanding with no change in the recorded capital accounts. A stock split usually increases the number of shares outstanding by a significant amount, such as doubling or tripling the number of outstanding shares.

In contrast reverse sock split decreases the number of shares. It results in a proportional reduction in the number of shares issued and outstanding and an increase in the average book value per share.

Additional Contributed Capital:Transactions that may change additional contributed capital are:

Increase:- receipt of donated assets- retirement of shares at a price less than average issue price to date- issue of par value shares at a price or assigned value higher than par- treasury stocks transactions, shares reissued above cost

Decrease:- retirement of shares at a price greater than average issue price to date, when previous contributed capital has been recorded- treasury stock transactions, shares issued below cost, when previous contributed capital has been recorded- financial restructuring

Part 11.1Summary of Qualitative Characteristics of GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Part 11.2How and When to Recognize Revenues & Expenses in Accrual Accounting Part 11.3Functions in the Purchasing Process and how to Segregate Purchasing Duties Part 11.4Three Steps to Determining and Applying Materiality Part 11.5Assertions of Management about Economic Events in the Business Part 11.6Bank Accounting - Types of Bank Accounts, Cash Receipts & Disbursements, Disclosures Required for Cash Accounting Part 11.7Objectives of Internal Controls set by Management Part 11.8How to Test Internal Controls of an Organization Part 11.9Positive Accounting Theory (PAT) Part 11.11Accounting Information - Complex Commodity & Information Asymmetry

Part 11.1Summary of Qualitative Characteristics of GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)Understandability a basic level of understandability is assumed to assist both the preparer and users of financial information

Relevance if information has the ability to make a difference in a decision scenario, it is relevant predictive value:Help prevent financial impact of past, present and future event. Feedback value Helps confirm or correct minor expectations

Reliability information is reliable if it can be depended upon verifiable representational faithfulness neutral conservative

Comparability when different firms use the same accounting principles

Consistency when firms use the same account principles and methods from year to year

Economic (Business) Entity Concept personal transactions of owners/shareholders recorded separately from business entity's transactions economic entity not necessarily legal entity

Objectivity (Reliability) accounting information must be capable of third party verification free from bias supported by evidence (source documents)

Historical Cost (Cost Principle) assets and services acquired are recorded at original cost, and not subsequently changed to market/appraised value (value upwards).

Going Concern Assumption assumes a business will continue as a viable operations indefinitely financial statements are prepared on assumptions that company will expect in the foreseeable future.

Monetary Unit Principle monetary unit is stable; transaction is as recorded, not adjusted for inflation.

Time Period (Periodicity) life of a business entity can be broken up into distinctive periods (years, months, quarters) and report financial performance by period

Matching Principles expenses are incurred to generate revenue and these expenses must be matched with the revenue earned in the same period.

Revenue Realization (Revenue Recognition) Principle revenue is recognized as earned when a product sold or a service is provided Not contingent on when cash is received.

Full Disclosure Principles all relevant facts useful to interpreting financial statements must be disclosed (either in notes or body of statement).

Consistency Principle accounting practices and methods should be consistent from year to year this assists in making comparisons, trend analysis, and forecasts if change is necessary, the impact of the change must be shown on all statement.

Conservatism when two or more accounting alternatives are equally acceptable, the one with the least favorable impact on assets and income is chosen.

Materiality involves professional judgment refers to the significance of an omission if not significant, no adjustment required if you mess out, it's not material

Benefit/Cost Relationships cost must be compared to benefits to determine desirability of producing information easier to quantify costs vs benefit.

Unit of Measure All information is expressed in $ (or medium of exchange).

Part 11.2How and When to Recognize Revenues & Expenses in Accrual Accounting

What is Information? It is a COMPLEX commodity Investors are demanders/managers the suppliers Should we let the rules of supply and demand determine the amount of information provided (no regulation)? Should there be regulation to protect investors as market forces fail to ensure investors have adequate information? Currently, we have regulation= standard setting But how much regulation is required? How much is too much?

Information impacts not only individual decision making but the efficiency of the market Currently we report most assets and liabilities at historical but there has been movement towards more market values- therefore we have a mixed measurement system. Investors prefer current values as they are more relevant- they provide the best available indication of future firm performance and investment returns. Management prefers not to include unrealized gain/ losses as it increases volatility- and they do not believe this reflect their performance

So as accountants our role is to manage the expectations of many parties- and to have a critical awareness of the impact of financial reporting on investors, managers and the economy. We need to design and implement concepts and standards that best trade off the investor informing and manager performance evaluating roles for accounting information

Information Asymmetry When one party has an information advantage over another.

1. Adverse Selection where by one or more parties have an info advantage over others Occurs because insider of the firm (Managers) know more about the current condition and future prospect of the firm than investors They can exploit this advantage by managing the info released to investors often to increase/maintain the value of the stock options they hold i.e. Enron management were selling their stock and telling employees to hold on to theirs..... Called Adverse as it reduces an investors ability to make good investment decisions and impairs the functioning of Capital markets Example: Insider Trading i.e. Martha Stewart- her friend Sam Walker from Imclone knew that an important cancer drug was rejected by the FDA- this was a huge blow to Imclone and once announced it was expected the share price would drop- Martha wasnt hurt by the decline because she sold her shares before the info became public....therefore information asymmetry!

Clarification: Is all Insider Trading illegal? No-Trades by insiders can be legal if reported to the securities exchange commissions within a predetermined time frame. This way if it is reported to the public, it can be interpreted as a signal Studies show that the buying and selling by insiders is valuable information. When an insider buys or sells, they may know something the public doesnt generally when an exec purchases the co. shares, the co. outperforms the market by approx. 10% over a 12 month period. Conversely when execs sold, co. performed 5-6% below market.

2. Moral Hazard Where one or more parties observe their actions but other parties cannot Caused by separation of ownership/ control Consider, if there were no exams, how hard would you study? How would instructor be able to evaluate effort? This is very popular in insurance industry. If car insurance covered 100% of your car- with no cost to you- what would stop you from not leaving it running with the doors open? If you dont suffer any consequences- why mitigate any loss--- this is why there is a deductible= moral hazard I.e. how do shareholders know management is working hard on their behalf since they cannot observe their behaviour on a day to day basis? Management net income, like insurance deductables, is usually considered a measure of management performance to control moral hazard- first net income is usually used as an input to management compensation contracts and second it can inform the labour market if a manager shirks and he/ she will suffer a loss on income/ reputation.

Part 11.3Functions in the Purchasing Process and how to Segregate Purchasing Duties

1) Requisition An authorized individual makes a request for the required good/Service within his/her authorization limit via a purchase requisition

Each company should have a policy, which requires different levels of authorization for different dollar values of purchases (higher dollar purchases should require higher level of approval).2) Purchasing Purchases are coordinated through the purchasing department to ensure goods are acquired in the right quantities at the lowest possible prices and documented on the Purchase order

3) Receiving Responsible for receiving counting and inspecting goods from venders as documented on the receiving report

4) Invoice Processing AP department processes the invoices by recording the asset/expense/ liability- A/P obligations are recorded when the purchaser receives the goods or services ordered. This department matches the PO to the receiving reports to the invoices for terms, quantities, prices and extensions Disbursements- responsible for preparing and signing cheques to vendors Cheques are signed by a person authorized by management or the board of directors Generally dual signatures on cheques over a certain amount are required Vouchers should be stamped paid so they are not paid twice General Ledger- ensure all purchases, cash disbursements, and payables are properly accumulated/classified in the f/s accounts

Segregation of Duties Segregationneed to separate custody of assets, authorization and recordkeeping of assets (C.A.R. principle)

Key Segregation of Duties in the Purchasing Process

1) Purchasing function should be segregated from requisition and receiving functions Possible error: fictitious or unauthorized purchases may be made resulting in theft of goods and payment for unauthorized purchases

2) Invoice Processing should be segregated from the AP function Possible error: Purchase transactions can be processed at the wrong price/term or payments made for items not received- so overpayment of goods and theft of cash

3) Disbursement function should be segregated from the AP function Possible error: unauthorized cheques supported by fictitious documents may be issued and unauthorized transactions recorded

4) AP function should be segregated from the GL function Possible error: concealment of defalcation which would be detected during the reconciliation of the subsidiary ledger to the GL control account.

Part 11.5Assertions of Management about Economic Events in the Business

Three Steps to Determining and Applying Materiality

What is Materiality?Materiality is an amount that makes a difference to the users- an audit never provides 100% assurance- only reasonable assurance." For instance, if a company has overstated its revenues by $5million when its total revenues are $4 billion, then this $5 million is considered 'immaterial.' However, if the company's total revenues are only $50 million, then this $5 million overstatement is considered 'Material."1) Determine a base and calculate a number.

MATERIALITY GUIDELINES: 5% of income from continuing operations (normalized) 5% of net income before bonus, to 2% of revenues or expenses for non-for profit entities, to 1% of net asset value for the mutual fund industry, or 1% of revenue for the real estate industry.

Note: Materiality is a matter of Professional Judgement so:

When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues but for most for profit enterprises, income from continuing operations is the most appropriate.

Once a preliminary figure is calculated- then consider qualitative items i.e. Misstatements due to fraud/ illegal acts Amounts that may violate contractual covenants Amounts that may affect earnings trends Misstatements that may increase management compensation Amounts that may result in an entity missing its forecast Industry conditions Past number of misstatements

2) During the audit, auditors track the misstatements on the SUE- Summary of Unadjusted Errors

3) Estimate the likely misstatement and compare the total to the preliminary materiality. If the estimate misstatement is less than materiality- then the auditor can generally conclude the financial statements are fairly presented. If the estimate is greater than materiality then the adjustments should be recorded by the client- if the client refuses then the auditor cannot issue a clean audit report Unadjusted amounts from prior years should be carried forward in assessing the misstatement Preliminary materiality may be revised if the auditor feels it is necessary due to information obtained during the audit

Materiality Allocation auditors generally assign a lower level of materiality to each account balance in performing their audit procedures rationale is that several errors could exist within the account that together would result in a material misstatement to the financial statements may also use a lower level of materiality for testing balances that have a higher risk of misstatement (results in more testing) there are a variety of methods used to do this i.e. may say tolerable error for account balances is 10% of materiality.

Part 11.5Assertions of Management about Economic Events in the BusinessManagement is responsible for preparing the financial statements of the organization. Each journal entry & transaction recorded in the books has at least 1 of these assertions applied. The 5 major assertions can be shortened to ECOVP - Existence, Completeness, Ownership, Valuation, Presentation and Disclosure. Below are managements assertions about economic actions and events

Management Assertions Existence or Occurrence used to establish that assets, liabilities and equities actually exist and that revenue and expense transactions actually occurred. Occurence refers to controls surrounding the purchase/sale of any investment must be properly initiated by an authorized individual. Here are some important points to consider: Adequate documentation must support the purchase/sale of each security to ensure the process was properly initiated and approved Commitment of resources to investment activities should be approved by the board of directors or by an executive with board-designated authority Board of directors should establish general policies to guide the entitys investment activities Completeness all transactions and accounts that should be presented in financial reports are included. Completeness refers to adequate controls should exist to ensure that all securities transactions are recorded. Securities ledger should be maintained to record all securities owned by the client ?this sub ledger should be reconciled to the general ledger periodically Regular review procedures should exist to ensure that all dividends and interest earned on investments are recorded regularly by the entitys records Accuracy all account balances have been recorded correctly. Accuracy refers to 3 types of investment holdings that must be accurately recorded in the books. Held to Maturity Securities the entity has the positive intent and ability to hold the investment to maturityreported at amortized cost Held for Trading Securities debt and equity securities that are bought and held for the purpose of selling them in the near termreported at fair value with unrealized gains and losses reported in earnings. Available for Sale Securities debt or equity securities not classified as either of the above, reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders equity called other comprehensive income Cutoff all transactions should be recorded in proper period (purchases, revenue accruals etc) Ownership (rights and obligations) amounts reported as assets of the company represent property rights and amounts reported as liabilities reflect its actual obligations. Valuation ensuring proper application of GAAP especially with respect to assets/ Accuracyused to establish evidence that transactions for all account balances have been recorded correctly in financial records. Presentation and Disclosureensuring accounting principles are properly selected to reflect economic nature of the transactions and applied and whether note disclosures are adequate. Cutoff all transactions recorded in proper period Classification transactions are recorded in the correct accounts.

Management Assertions fall into 3 Categories:1) Classes of Transaction and events for the period under audit (Income Statement) Occurrence, Completeness, Accuracy, Cut Off, Classification2) Assertions about account balances at the end of the period (Balance Sheet) Existence, Rights and Obligations, Completeness, Valuation and Allocation3) Assertions about Presentation and disclosureOccurrence and rights and obligations, completeness, classification and understandability, accuracy and valuation

Part 11.6Bank Accounting - Types of Bank Accounts, Cash Receipts & Disbursements, Disclosures Required for Cash Accounting

Bank account involves accounting for cash transactions including organization-wide cash receipts, cash disbursements, payroll disbursements, vendor payments, rent payments, employee salary payments, etc. Cash refers to:

Currency on hand Cash on deposit in bank accounts (including certificates of deposit, time deposits and savings accounts) May also include cash equivalents, which are short-term, highly liquid investments that are readily convertible into cash or are so close to maturity that there is little risk of change in their value (e.x. T-bills, commercial paper, money market funds, may also include demand loans)

Why is Cash Critical to Accounting? Virtually all accounting transactions that flow through the organization pass through the cash accountSources of Cash (Cash Receipts) Cash receipts from the sale of goods/services Sale of property, plant and equipment Proceeds from issuing long-term debt or capital stock

Uses of Cash (Cash Disbursements) Purchasing inventory and supplies Payment of payroll expenses Purchase of property, plant and equipment Payment on long-term debt and repurchase of stock

Types of Bank Accounts1) General cash accounts principal cash account used by the organization for cash receipts from the revenue process and cash disbursements from the payroll and purchasing processes

2) Imprest cash accounts contains a stipulated amount of money and the account is used for limited purposes (for example disbursing payroll and dividend cheques).

When used for payroll, the total amount of the net payroll is drawn from the general account and then the individual cheques are drawn from the imprest cash account. The payroll account serves as a clearing account and maintains adequate control over cash).

3) Branch accounts used by companies with branches in multiple locations. Each branch is able to pay local expenses and maintain a banking relationship in the local community. May be in the form of an imprest account with designated amounts transferred based on cash reports submitted to headquarters.

Disclosures required for Cash Accounting Accounting policy for defining cash and cash equivalents Restrictions on cash (funds allocated for a specific purpose by the board of directors) Contractual obligations to maintain compensating balances (debt covenant restrictions) Cash balances restricted by foreign exchange controls Letters of credit Restriction on the use of specific funds of cash for NPOs

Part 11.7Objectives of Internal Controls set by Management

Internal controls are a systems capability to prevent or detect material data processing errors or fraud and provide for correction on a timely basis. Common internal controls include segregation of accounting & operations duties, two signatures on every check, 2 approvals on any recquisitions, etc. The objectives of Internal controls are as follows:

1) Optimize use of Company Resources Prevent unnecessary duplication and waste Possible conflict between safeguarding of assets and providing reliable information and optimizing use of resources

2) Prevent and detecting error and fraud3) Safeguard company's assets Adequate controls necessary to prevent theft, misuse or accidents

4) Maintain reliable control systems Necessary to produce accurate information to carry out operations Information must be timely and reliable

More specifically Management needs to ensure the following: 1) Validity recorded transactions are valid and documented (purchases are supported by purchase orders, receiving documents, and invoices)2) Completeness all valid transactions are recorded and none are omitted (all receiving documents are matched to purchase orders)3) Authorization transactions are authorized according to company policy (purchases greater than $500 must be signed off by department head)4) Accuracy transaction dollar amounts are properly calculated (receipts of inventory are correctly recorded in the accounting system)5) Classification transactions are properly classified in accounts (purchases of assets are correctly capitalized and amortized, purchases of inventory are correctly recorded as inventory)6) Accounting transaction accounting is complete (all purchase orders are captured in the system, are matched to receiving documents and invoices as the goods are received)7) Proper period transactions are recorded in the proper period (goods that have been received and there is no invoice yet received are accrued for at year end)

5 Components of Internal Control

1. Control Environment Management Philosophy and Operating Style BoD, Audit Committee independent, level of involvement Organizational Structure reporting relationships Management Control Methods ability to delegate, supervise, overall budgets, performance evaluation system Assigning of authority and responsibility conflicts of interest Systems development methodology, update of computer files/programs Personnel policies hiring, terminations, training, performance evaluation, compensation Internal audit

2. Entitys Risk Assessment Process How management identifies and responds to risks Should consider internal and external events and circumstances, their significance, likelihood of occurrence, and how they should be managed Risks can arise or change due to the following: Changes in the operating environment i.e. increased competition New personnel New info systems New Technology Rapid Growth New business products/activities Corporate Restructuring International Operations New Accounting Pronouncements

3. Information and Communication Must consider the info system relevant to financial reporting how does the system ensure all transactions are recorded (completeness) valid, accurate and timely with all appropriate disclosures Need to understand how and when all information is captured for both regular and unusual transactions Consider extent of IT and E-Commerce

4. Control Procedures Policies and procedures are required- this ensures people know what they are supposed to do, when and how. Information processing controls are general (controls over the data centre/ server) and application controls (processing of individual transactions) Physical controls- security over assets Segregation of duties- must segregate CAR (Custody/ Authorization/ Recording)

5. Monitoring Controls Assesses the quality of internal controls over time Take corrective action as required

Part 11.8How to Test Internal Controls of an Organization

What are Testing Procedures of Internal Controls for Organizations? Procedures designed to evaluate the effectiveness of the design and operation of internal controls Auditor assesses whether the control has been properly designed to prevent or detect a material misstatement in the financial statements Auditor then assesses the operational effectiveness of the control, which determines whether the control is applied consistently through the period and by whom is it applied

Examples of tests of controls: Inspecting documents/reports for evidence the control has been performed. Example: HR manager signs the payroll as evidence of her/his review before the payroll is finalized and the cheques are issued.

Observation of the application of specific controls. Example: auditor observes the cashier perform sales transactions and notes that the cash register will not open unless a sale has occurred.

Walkthroughs tracing a transaction from its point of origin to its inclusion in the financial statements. Involves several audit procedures: enquiry, observation, inspection. Example: the purchase of a capital asset is traced from the purchase order to the inclusion on the financial statements, ensuring required approvals, categorization of asset, and amortization policies are applied.

Reperformance of the application of the control by the auditor test ensures the integrity of the control. Example: recalculating the sales commissions paid on a sample of sales transactions.

Substantive Tests Two Key Categories of Substantive Tests: Substantive Tests of Transactions test for fraud or errors in individual transactions. Provides evidence on occurrence, completeness and accuracy assertions.

Tests of Account Balances establish whether there are any material misstatements in accounts or disclosures included in the financial statements by concentrating on the details in an account balance. Example sending A/R confirmations to specific customers in the A/R listing to confirm the amounts outstanding.

Substantive Analytical Procedures Substantive analytical procedures include evaluating financial information made by studying plausible relations among financial and non-financial data. Requires knowledge of clients business and industry

Key procedures used include: Trend analysis examines changes in an account balance over time. Example: compare current year budgeted insurance expense to current year actual insurance expense.

Ratio analysis compares balances either across time or to a benchmark, of relationship between financial statement accounts or between an account and non-financial data. Example: compare current year inventory turnover to prior year inventory turnover.

Reasonableness analysis develops a model to form an expectation using financial data, non-financial data or both to test account balances or changes in account balances. Example: calculate average purchase price *number of units sold to estimate cost of goods sold.

Purposes of Analytical Procedures: 1) To assist auditor in planning the nature, timing and extent of other audit procedures2) As a substantive test to obtain evidence about particular assertions

Steps:a) Develop an expectationsb) Define an acceptable difference based on significance of the account, degree of reliance on the procedure, level of potential disaggregation in the amount being tested and precision of the expectationc) Compare expectation to actual recorded amountd) Investigate differences greater than acceptable difference threshold1) Quantify portion of the difference that can be explained2) Corroborate explanations of unexpected difference by substantiating the information supporting the explanation is reliable3) Evaluation using professional skepticism4) If the desired level of assurance is not obtained from the procedure, perform additional test of details or substantive analytical tests to achieve the required assurance levels

3) As an overall review of the financial statements in the final review stage of the audit

Dual-Purpose Tests Include both tests of controls, which assess errors in the design and application of controls, and substantive tests of transactions, which are concerned with monetary errors.Example: Check for agreement of a sample of purchase invoices to receiving documents and purchase order for approval signatures, product types, price and quantity. Recalculate the total purchase and ensure the purchase is recorded in the correct account (capitalized as an asset, vs expensed as operating expenditure).

Part 11.9Positive Accounting Theory (PAT) Positive Accounting Theory tries to make good predictions of real world events and translate them to accounting transactions. While normative theories tend to recommend what should be done, Positive Theories try to explain and predict Actions such as which accounting policies firms will choose How firms will react to newly proposed accounting standards

Its overall intention is to understand and predict the choice of accounting policies across differing firms. It recognizes that economic consequences exist. Under PAT, firms want to maximize their prospects for survival, so they organize themselves efficiently. Firms are viewed as the accumulation of the contracts they have entered into. In relation to PAT, because there is a need to be efficient, the firm will want to minimize costs associated with contracts. Examples of contract costs are negotiation, renegotiation, and monitoring costs. Contract costs involve accounting variables as contracts can be stipulated in terms of accounting information such as net income, and financial ratios. The firm will choose the accounting policies that best acknowledge the need for minimization of contract costs. PAT recognizes that changing circumstances require managers to have flexibility in choosing accounting policies. This brings forward the problem of opportunistic behavior. This occurs when the actions of management are to better their own personal interests. With this in mind, the optimal set of accounting policies are described as a compromise between fixing accounting policies to minimize contract costs and providing flexibility in times of changing circumstances (considering the effects of opportunistic behavior).

The Three Hypotheses of Positive Accounting Theory Positive Accounting Theory has three hypotheses around which its predictions are organized. 1) Bonus plan hypothesis Managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period. By doing so, they can increase their bonuses for the current year.2) Debt covenant hypothesis The closer a firm is to violating accounting-based debt covenants, the more likely the firm manager is to select accounting procedures that shift reported earnings from future periods to the current period. By increasing current earnings, the company is less likely to violate debt covenants, and management has minimized its constraints in running the company3) Political cost hypothesis The greater the political costs faced by the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods. High profitability can lead to increased political heat, and can lead to new taxes or regulations esp. for large firms which may be held to higher reporting standards

How to Achieve Positive Accounting Theory Changing accounting policies Managing discretionary accruals Timing of adoption of new accounting standards Changing real variables--R&D, advertising, repairs & maintenance SPEs (Enron), capitalize operating expenses (WorldCom)

Part 11.11Accounting Information - Complex Commodity & Information Asymmetry

What is Information?It is a COMPLEX commodity Investors are demanders/managers the suppliers Should we let the rules of supply and demand determine the amount of information provided (no regulation)? Should there be regulation to protect investors as market forces fail to ensure investors have adequate information? Currently, we have regulation= standard setting But how much regulation is required? How much is too much?

Information impacts not only individual decision making but the efficiency of the market Currently we report most assets and liabilities at historical but there has been movement towards more market values- therefore we have a mixed measurement system. Investors prefer current values as they are more relevant- they provide the best available indication of future firm performance and investment returns. Management prefers not to include unrealized gain/ losses as it increases volatility- and they do not believe this reflect their performance So as accountants our role is to manage the expectations of many parties- and to have a critical awareness of the impact of financial reporting on investors, managers and the economy. We need to design and implement concepts and standards that best trade off the investor informing and manager performance evaluating roles for accounting information

Information Asymmetry When one party has an information advantage over another.

1. Adverse Selection where by one or more parties have an info advantage over others Occurs because insider of the firm (Managers) know more about the current condition and future prospect of the firm than investors They can exploit this advantage by managing the info released to investors often to increase/maintain the value of the stock options they hold i.e. Enron management were selling their stock and telling employees to hold on to theirs..... Called Adverse as it reduces an investors ability to make good investment decisions and impairs the functioning of Capital markets

Example: Insider Trading i.e. Martha Stewart- her friend Sam Walker from Imclone knew that an important cancer drug was rejected by the FDA- this was a huge blow to Imclone and once announced it was expected the share price would drop- Martha wasnt hurt by the decline because she sold her shares before the info became public....therefore information asymmetry!

Clarification: Is all Insider Trading illegal? No- Trades by insiders can be legal if reported to the securities exchange commissions within a predetermined time frame. This way if it is reported to the public, it can be interpreted as a signal Studies show that the buying and selling by insiders is valuable information. When an insider buys or sells, they may know something the public doesnt generally when an exec purchases the co. shares, the co. outperforms the market by approx. 10% over a 12 month period. Conversely when execs sold, co. performed 5-6% below market.

2. Moral Hazard Where one or more parties observe their actions but other parties cannot Caused by separation of ownership/ control Consider, if there were no exams, how hard would you study? How would instructor be able to evaluate effort? This is very popular in insurance industry. If car insurance covered 100% of your car- with no cost to you- what would stop you from not leaving it running with the doors open? If you dont suffer any consequences- why mitigate any loss--- this is why there is a deductible= moral hazard I.e. how do shareholders know management is working hard on their behalf since they cannot observe their behaviour on a day to day basis? Management net income, like insurance deductables, is usually considered a measure of management performance to control moral hazard- first net income is usually used as an input to management compensation contracts and second it can inform the labour market if a manager shirks and he/ she will suffer a loss on income/ reputation.

Business & Financial Valuation Formulas In this section, we explain in detail some of the most common financial valuation tools that businessese & investors in the Finance world use to run their businesses, acquire new businesses, issue shares of stock and other Corporate activities.

Economic Value Added (EVA) - How to Calculate Economic Viability of a Corporation Economic Value Added is a performance ratio that determines the true economic profitability of a corporation because it factors in net operating income after taxes & interest minus the opportunity cost of capital deployed to earn that net operating income.

In other words, Economic Value Added shows whether the financial performance of a company exceeds or is below the minimum required rate of return for shareholders or business lenders. Economic Value Added tells investors whether the amount of capital they have invested in to the business is generating them higher return than their minimum, or if it is better to invest the capital elsewhere.

Here is how Economic Value Added (EVA) is used by financial analysts:

1) Economic Value Added is used as a performance evaluation tool of higher level managers, directors, VPs and CEOs of a corporation because the performance of the organization depends on the human resources deployed.

2) Economic Value Added is used at sub-division level & entire organizational level of the business, unlike other methods such as Market Value Added that only focuses on the big picture of a corporation.

3) Economic Value Added factors in to performance evaluation that the operating net income of a corporation must cover both operating costs of the organization as well as the capital costs (opportunity cost of capital). This is unlike other accounting methods such as EBIT or EBITDA or Net Income that look at total revenues generated by the business minus total expenses as a performance evaluation tool.

How to Calculate Economic Value Added Net Sales - Operating Expenses ___________________________ Operating Profit (EBIT)

- Taxes ___________________________ Net Operating Profit After Tax (NOPAT)

- Capital Costs (Total Capital x Cost of Capital) ___________________________Economic Value Added

Economic Value Added can also be used for the following purposes: Determine management bonuses Motivate management to achieve sales objectives & goals Corporate valuation for shareholders, bankers & lenders Performance measurement of Business Capital budgeting & Investing decisions Set organizational objectives & goals

4 Steps to Calculate Economic Value Added

1) Calculate Net Operating Profit after TaxesGross Sales = $1,000,000Operating Expenses = $350,000Depreciation = $100,000Taxes = $150,000Net Operating Income = $1m - $350k - $100k - $150k = $400,000

2) Determine total Capital deployed in the businessTotal Capital = Net Working Capital + Net Fixed Assets Total Capital = $300,000 + $1.2m Total Capital = $1,500,000

3) Calculate Weighted Average Cost of Capital Assume WACC = 12%

4) Calculate Capital cost to NOPAT & Economic Value AddedCapital Costs = Total Capital x Cost of Capital Capital Costs = $1,5