Financial Statement Concepts and Financial Reporting

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Activity: Financial Accounting and Financial Statements Assignment

By completing this assignment, you will achieve financial reporting literacy, previously defined as the ability to interpret general-purpose financial statements in connection in making business decisions, including those related to a business’ strategy, operations, investments, and finances.

Please use the file entitled Topic3Template for this assignment.

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Instructions: Complete the each of following seven tabs in this MS Excel Workbook using the information contained in them: – Post the Journal Entries (to record the transactions of FirstRate Company during the final week of its fiscal year ended [FYE] Dec. 31, 20X5) to the consolidated Trial Balance of the company as of December 31, 20X5 – Consolidated Balance Sheet of the company as of December 31, 20X5 – Consolidated Income Statement, including comprehensive income, of the company for its FYE December 31, 20X5 – Statement of Cash Flows (SCF) Support Schedule, which provides information useful for preparing the SCF – Consolidated Statement of Cash Flows (SCF) of the company for its FYE December 31, 20X5 – Consolidated Statement of Changes in Shareholders' Equity of the company for its FYE December 31, 20X5 Complete the assignment by working "from left to right." That is, first, complete the Trial Balance, followed by the Balance Sheet, then the Income Statemet tab, etc. The background paper, Financial Statement Concepts and Financial Reporting , provides useful guidance for completing this assignment. The facilitator will grade this assignment, assigning up to 100 points for it as follows: Maximum – Trial Balance 15 – Balance sheet 20 – Income Statement 20 – Cash Flow Statement (SCF) and SCF Support Schedule 30 – Statement of Changes in Stockholders' Equity Total points Earned points 15 100 - FirstRate Company and subsidiaries General Journal (U.S. dollars in thousands) (Assumes company does NOT use special journals, such as sales journal, purchases journal, cash journal, or payroll journal) Date General ledger accounts / Explanation Debit Credit Dec. 31, 20X5 Dr. Accounts receivable, gross Cr. 800 Sales revenue (gross) 800 Explanation: To record credit sales for the last few days of 20X5 Dec. 31, 20X5 Dr. Cost of goods sold (COGS) - other Cr. 600 Inventory, at lower of cost or market 600 Explanation: To record cost of sales for the last few days of 20X5 Dec. 31, 20X5 Dr. Cash and cash equivalents Cr. 700 Accounts receivable, gross 700 Explanation: To record collections of accounts receivables for the last week of 20X5 Dec. 31, 20X5 Dr. Allowance for uncollectible accounts receivable Cr. 200 Accounts receivable, gross 200 Explanation: To record write-off of AR outstanding more than 6 months as of Dec. 28, 20X5 Dec. 31, 20X5 Dr. Selling and administrative expenses - other Cr. 200 Cash and cash equivalents 200 Explanation: To record payment of employee 20X5 bonuses, declared by board on Dec. 28, 20X5 Dec. 31, 20X5 Dr. Inventory, at lower of cost or market Cr. 500 Accounts payable 500 Explanation: To record purchases of raw materials during last week of 20X5 on credit (terms net 30 days) Total debits and credits 3,000 3,000 Post the am of these adj entries (JEs balance (in workbook ta BEFORE pr complete th tabs in the w (Complete a this workbo Post the amount of each of these adjusting journal entries (JEs) to the trial balance (in the next workbook tab). Do this BEFORE proceeding to complete the remaining tabs in the workbook. (Complete all 6 tabs in this workbook.) 17S8W2 FirstRate Company and subsidiaries Trial Balance Fiscal Year 20X5 (U.S. dollars in thousands) General ledger (GL) account Cash and cash equivalents Investment securities available for sale (market value) Debit Debit Accounts receivable, gross Debit Allowance for uncollectible accounts receivable Credit FYE Dec. 31, FYTD Dec. 20X4 24, 20X5 2,100 20,200 78,000 JEs Final Week of 20X5 Debits FYE Dec. 31, (Credits) 600 (2,700) 20X5 600 21,700 (3,800) 137,600 160,100 160,100 292,500 266,700 266,700 Credit (129,700) (105,200) (105,200) Accounts payable Credit (81,600) (96,700) (96,700) Accrued income taxes payable Credit (2,300) (1,800) (1,800) Dividends payable on common stock Bank note payable - current portion Bank note payable - noncurrent portion Accrued interest payable 6% Preferred stock, at par value Common stock, at par value Additional paid-in capital (APIC) Treasury stock Accum. other comprehensive income (loss) Retained earnings - beginning of year Credit (19,800) (16,000) (16,000) Credit (89,800) (113,900) (113,900) Credit (52,700) (55,400) (55,400) Credit (2,500) (3,100) (3,100) Credit (20,000) (20,000) (20,000) Credit (42,700) (42,700) (42,700) Credit Debit (8,300) 1,100 Debit Post JEs separately (individually) Debit 94,600 (3,800) Debit Debit Accumulated depreciation on PP&E Debit 21,700 94,600 18S8W1 Inventory, at lower of cost or market Property, plant, and equipment, at cost (8,300) (8,300) 1,100 Enter numbers or formulas in shaded worksheet cells only, leaving the remainder of this worksheet tab unchanged. In the preceding JE workbook tab, there are only 6 debits and 6 credits; so, most cells in the shaded (JE debit and credit) columns of this workbook tab will remain blank (empty). 1,100 Dr (Cr) 200 (1,300) (1,300) Credit (82,500) (79,600) (79,600) FYE Dec. FYTD Dec. JEs Final Week of 31, 20X4 24, 20X5 Debits 600 Error 2,100 20,200 78,000 Credit 94,600 160,100 Error 266,700 Credit (129,700) (105,200) Credit (81,600) (96,700) Credit (2,300) (1,800) Credit (19,800) (16,000) Credit (89,800) (113,900) Credit (52,700) (2,500) (3,100) (20,000) (20,000) Credit (42,700) (42,700) Credit Credit (8,300) 1,100 600 94,600 (3,800) Error ###### ###### ###### Error ###### (1,800) ###### ###### (55,400) Credit Credit FYE Dec. 31, Error Error Error 137,600 292,500 Dr (Cr) Error 21,700 Error (3,800) Debit Debit Debit Use care not to overwrite formulas in some worksheet cells, provided (2,700) (Credits) 21,700 18S8W1 "Post" the amounts of each adjusting journal entry (JE) in the preceding workbook tab to the appropriate GL account and debit (credit) column in this trial balance workbook tab. Complete this workbook tab BEFORE proceeding to complete the remaining tabs in the workbook. ###### (3,100) ###### ###### (8,300) (8,300) 1,100 1,100 200 (1,300) (1,300) (82,500) (79,600) ###### Dividends declared on preferred stock - current year Debit 1,200 1,200 1,200 Debit 1,200 1,200 1,200 Dividends declared on common stock - current year Debit 19,800 16,000 16,000 Debit 19,800 16,000 16,000 Sales revenue (gross) Credit (674,200) (742,300) (742,300) Credit (674,200) (742,300) Error ###### Sales returns and allowances Debit 12,800 16,300 16,300 Debit 12,800 16,300 16,300 Cost of goods sold (COGS) - depreciation Debit 11,400 10,000 10,000 Debit 11,400 10,000 10,000 Cost of goods sold (COGS) - other Debit 469,400 523,600 523,600 Debit 469,400 523,600 Error ###### Selling and administrative expenses - depreciation Debit 600 500 500 Debit 600 500 Selling and administrative expenses - other Debit 109,200 122,900 122,900 Debit 109,200 122,900 Debit 23,800 24,000 24,000 Debit 9,900 12,300 12,300 Debit 23,800 24,000 Other operating expenses Research and development (R&D) expenses Debit 9,900 12,300 Gain on disposal of PP&E Credit - Debit - Debit 9,900 12,500 7,100 Income tax provision Debit 9,100 Loss from discontinued oper., (before tax effect) Debit - Extraordinary loss (before tax effect) Debit Total debits (credits) Net balance of nominal (or, temporary) accounts 17F8W2 (1,100) 7,100 - (14,200) Credit - 12,500 - (18,100) 24,000 12,300 (1,100) Loss on disposal of PP&E Interest on bank note - - - ###### (1,100) (1,100) Debit - - - Debit 9,900 12,500 12,500 7,100 Debit 9,100 7,100 - Debit - - - Debit - - (18,100) The background paper defines nominal (or, temporary) accounts. Computing the net balance of these accounts in final 20X5 column of this tab provides a helpful check figure for use in completing the income statement tab of this workbook. 500 Error - (14,200) - - - A45 FirstRate Company and subsidiaries 17F8W2 FirstRate Company and subsidiaries Consolidated Income Statement 17F8W2 Consolidated Income Statement Fiscal year ended December 31, 20X5 Fiscal year ended December 31, 20X5 (U.S. dollars in thousands, except per share amounts) (U.S. dollars in thousands, except per share amounts) Sales revenue (net of returns and allowances) Sales revenue (net of returns and allowances) Complete this workbook tab using the completed trial balance tab. It may be be useful to review the illustrative income statement in the background paper, Financial Statement Concepts and Financial Reporting. Operating expenses: Enter numbers, formulas, or labels, as appropriate, in shaded worksheet cells only, leaving the remainder of this worksheet tab unchanged. Other operating expenses Total operating expenses Operating income To ensure maximum credit for your work, use formulas whenever possible. This will help enable the faciliator 's understanding of your reasoning, which may justify "partial credit" for inaccurate results. Non-operating items: Non-operating rev enues and gains: Non-operating expense and losses: Error Error Error Operating expenses: Error Error Other operating expenses Total operating expenses Operating income Error Error Error Non-operating items: Non-operating rev enues and gains: Non-operating expense and losses: Interest on bank note Interest on bank note Income before income taxes Income before income taxes Net income Net income Error Error Error Earnings per share: Error Earnings per share: Net income Weighted average number of common shares outstanding Comprehensiv e income: Net income ######## Weighted average number of common shares outstanding Error 42,563,000 Comprehensiv e income: Net income Net income Other comprehensiv e income: Other comprehensiv e income: Comprehensive income Comprehensive income Error Error Error B1 FirstRate Company and subsidiaries 17F8W2 FirstRate Company and subsidiaries Consolidated Balance Sheet Consolidated Balance Sheet December 31, 20X5 December 31, 20X5 (U.S. dollars in thousands) (U.S. dollars in thousands) Assets: Assets: Current assets: Replace this text with an appropriate asset label $ 600 Total current assets Property, plant, and equipment, net Complete this workbook tab using the completed trial balance tab. It may be be useful to review the illustrative balance sheet in the background paper, Financial Statement Concepts and Financial Reporting. Enter numbers, formulas, or labels, as appropriate, in shaded worksheet cells only, leaving the remainder of this worksheet tab unchanged. To ensure maximum credit for your work, use formulas whenever possible. This will help enable the faciliator 's understanding of your reasoning, which may justify "partial credit" for inaccurate results. Current assets: Replace this text with an appropriate asset label $ 600 Error Error Error Error Total current assets Error Error Error Property, plant, and equipment, net Error Total assets Total assets Error Liabilities: Liabilities: Current liabilities: Current liabilities: Error Error Error Error Error Total current liabilities Error Bank note payable - noncurrent portion Error Total liabilities Total liabilities Error Stockholders' equity: Total current liabilities Stockholders' equity: Bank note payable - noncurrent portion Error Error Error Error Error Error Total stockholders' equity Total stockholders' equity Error Total liabilities and stockholders' equity Total liabilities and stockholders' equity Error Hint: the balance of retained earnings in your completed balance sheet should include more than the balance of the "RE - beginning of year" account. See the Background Paper for a discussion of financial statement articulation. Check: Is your balance sheet "in balance"? (If you're $3,000 out-of-balance, it may be because you haven't taken the hint above properly into account! B1 FirstRate Company and subsidiaries Consolidated SCF Support Schedules (NOT for inclusion in U.S. GAAP-GPFS) Fiscal year ended December 31, 20X5 Column C (U.S. dollars in thousands) December 31, 20X5 Working capital assets: Accounts receivable, net of allowance $ 90,900 Increase (decrease) 20X4 $ 75,300 $ 15,600 Use of cash Row 8 Inventory, at lower of cost or market Row 9 Error In Cell Working capital liabilities: Row 10 Accounts payable Row 11 Error In Cell Complete this workboo completed balance Row 12 Error In Cell sh and trial balance tabs. Row 13 Error In Cell It may be be useful to Row 14 cash flow statement a prepare it in the backg Row 15 Statement Concepts a Row 16 Enter numbers, formu Row 17 appropriate, in shaded leaving the remainder Row 18 unchanged. Row 19 To ensure maximum c Row 20 formulas whenever po Row 21 enable the faciliator 's Row 22 reasoning, which may Row 23 inaccurate results. Accrued income taxes payable Source of cash Accrued interest payable Net working capital $ 90,900 $ 75,300 $ 15,600 Net use of cash Non-working capital asset accounts Property, plant, and equipment (PP&E), at cost Balance at beginning of period, reported in December 31, 20X4 balance sheet $ Increase: Acquisitions of PP&E during 20X5 292,500 9,200 Decrease: Original cost of equipment sold in 20X5 (fully depreciated at date of disposal) (35,000) Balance at end of period, reported in December 31, 20X5 balance sheet $ 266,700 $ 129,700 Row 24 10,500 Row 25 (35,000) Row 26 105,200 Row 27 Accumulated depreciation (of PP&E) Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: Depreciation of PP&E for 20X5 Decrease: Accumulated depreciation on equipment sold in 20X5 Balance at end of period, reported in December 31, 20X5 balance sheet $ Row 28 Non-working capital liability accounts Row 29 Dividends payable on common stock Row 30 Balance at beginning of period, reported in December 31, 20X4 balance sheet $ 19,800 Increase: Dividends declared on common stock on December 15, 20X5 Row 31 Row 32 Decrease: Dividends paid during FYE December 31, 20X5 (19,800) Balance at end of period, reported in December 31, 20X5 balance sheet Row 33 Row 34 Row 35 Non-current Bank note payable Current portion Balance at beg. of period, reported in Dec. 31, 20X4 balance sheet Increase: Additional borrowings during 20X5 ("plugged" from remaining info) 89,800 portion 52,700 Row 36 Total 142,500 Row 37 (142,500) Row 38 Decrease: None (FirstRate made no repayments during 20X5) - Row 39 Balance at end of period, reported in Dec. 31, 20X5 balance sheet - Row 40 Row 41 Stockholders' equity accounts Row 42 Preferred stock, par value $100 per share Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: None Decrease: None Row 43 20,000 Row 44 - Row 45 (20,000) Row 46 Balance at end of period, reported in December 31, 20X5 balance sheet Row 47 Common stock, par value $1 per share Row 48 Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: NO shares issued in 20X5, at par value Decrease: NA - see Treasury Stock, below 42,700 Row 49 - Row 50 (42,700) Row 51 Balance at end of period, reported in December 31, 20X5 balance sheet Row 52 Additional paid-in capital (APIC) Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: NO shares issued in 20X5 Decrease: None (not applicable) Row 53 8,300 Row 54 - Row 55 (8,300) Row 56 Balance at end of period, reported in December 31, 20X5 balance sheet Row 57 Treasury stock Row 58 Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: NO shares repurchased in 20X5 Decrease: None (NO treasury shares re-sold in 20X5) 1,100 Row 59 (1,100) Row 60 - Row 61 Balance at end of period, reported in December 31, 20X5 balance sheet Row 62 Retained earnings Row 63 Balance at beginning of period, reported in December 31, 20X4 balance sheet 79,600 Row 64 Increase: Net income for FYE December 31, 20X5, as reported in the income statement 14,200 Row 65 Decrease: Preferred dividends declared (and paid) in 20X5 Decrease: Common stock dividends declared (refer to analysis of dividends payable, above) Row 66 (17,200) Row 67 76,600 Determination of Supplemental Disclosures of Interest and Income Taxes Paid Row 68 Row 69 Row 70 Accrued interest payable Row 71 Balance at end of period, reported in December 31, 20X5 balance sheet Balance at beginning of period, reported in December 31, 20X4 balance sheet 2,500 Increase: Interest on bank note, as reported in the income statement Decrease: Interest paid during 20X5 (inferred, or "plugged," from remaining info) Row 72 Row 73 (2,500) Row 74 Balance at end of period, reported in December 31, 20X5 balance sheet Row 75 Accrued income taxes payable Row 76 Balance at beginning of period, reported in December 31, 20X4 balance sheet 2,300 Increase: Income tax provision (i.e., income tax expense) reported in the income statement: Decrease: Income taxes paid during 20X5 (inferred, or "plugged," from remaining info) Balance at end of period, reported in December 31, 20X5 balance sheet Row 77 Row 78 (2,300) Row 79 Row 80 Column D Column E Column F December 31, 20X5 Working capital assets: Accounts receivable, net of allowance Error In Cell Error In Cell Error In Cell $ Inventory, at lower of cost or market 90,900 Increase (dec 20X4 $ 75,300 $ 15,600 Error Error Error Accounts payable Error Error Error Accrued income taxes payable Error Error Error Accrued interest payable Error Error Error Working capital liabilities: Error In workbook tabCell usingError the In Cell Error In Cell anceError sheet, income statement, In Cell Error In Cell Error In Cell ce tabs. Error In Cell Error In Cell seful to review the illustrative Error Cell ErrorofInhow Cellto ement andInexplanation e background paper, Financial ncepts and Financial Reporting. Net working capital $ 90,900 $ 75,300 $ 15,600 Non-working capital asset accounts formulas, or labels, as shaded worksheet cells only, mainder of this worksheet tab Property, plant, and equipment (PP&E), at cost Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: Acquisitions of PP&E during 20X5 ximum credit for your work, use ever possible. This will help liator 's understanding of your ich may justify "partial credit" for ults. Decrease: Original cost of equipment sold in 20X5 (fully depreciated at date of disposal) Balance at end of period, reported in December 31, 20X5 balance sheet Accumulated depreciation (of PP&E) Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: Depreciation of PP&E for 20X5 Decrease: Accumulated depreciation on equipment sold in 20X5 Balance at end of period, reported in December 31, 20X5 balance sheet Non-working capital liability accounts Dividends payable on common stock Balance at beginning of period, reported in December 31, 20X4 balance sheet Error In Cell Increase: Dividends declared on common stock on December 15, 20X5 Decrease: Dividends paid during FYE December 31, 20X5 Error In Cell Balance at end of period, reported in December 31, 20X5 balance sheet Bank note payable Balance at beg. of period, reported in Dec. 31, 20X4 balance sheet Error In Cell Current Non-current portion portion 89,800 52,700 Increase: Additional borrowings during 20X5 ("plugged" from remaining info) Decrease: None (FirstRate made no repayments during 20X5) Error In Cell Error In Cell Error In Cell Balance at end of period, reported in Dec. 31, 20X5 balance sheet Stockholders' equity accounts Preferred stock, par value $100 per share Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: None Error In Cell Decrease: None Error In Cell Balance at end of period, reported in December 31, 20X5 balance sheet Common stock, par value $1 per share Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: NO shares issued in 20X5, at par value Error In Cell Decrease: NA - see Treasury Stock, below Error Error Error In Cell Balance at end of period, reported in December 31, 20X5 balance sheet Additional paid-in capital (APIC) Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: NO shares issued in 20X5 Error In Cell Decrease: None (not applicable) Error In Cell Balance at end of period, reported in December 31, 20X5 balance sheet Treasury stock Balance at beginning of period, reported in December 31, 20X4 balance sheet Error In Cell Increase: NO shares repurchased in 20X5 Decrease: None (NO treasury shares re-sold in 20X5) Error In Cell Balance at end of period, reported in December 31, 20X5 balance sheet Retained earnings Balance at beginning of period, reported in December 31, 20X4 balance sheet Increase: Net income for FYE December 31, 20X5, as reported in the income statement Error In Cell Decrease: Preferred dividends declared (and paid) in 20X5 Error In Cell Decrease: Common stock dividends declared (refer to analysis of dividends payable, above) Balance at end of period, reported in December 31, 20X5 balance sheet Determination of Supplemental Disclosures of Interest and Income Taxes Paid Accrued interest payable Balance at beginning of period, reported in December 31, 20X4 balance sheet Error In Cell Increase: Interest on bank note, as reported in the income statement Error In Cell Decrease: Interest paid during 20X5 (inferred, or "plugged," from remaining info) Error In Cell Balance at end of period, reported in December 31, 20X5 balance sheet Accrued income taxes payable Balance at beginning of period, reported in December 31, 20X4 balance sheet Error In Cell Increase: Income tax provision (i.e., income tax expense) reported in the income statement: Error In Cell Decrease: Income taxes paid during 20X5 (inferred, or "plugged," from remaining info) Error In Cell Balance at end of period, reported in December 31, 20X5 balance sheet se (decrease) Use of cash Error Error Error Source of cash Net use of cash $ 292,500 9,200 (35,000) $ 266,700 $ 129,700 10,500 (35,000) $ $ 105,200 19,800 Error (19,800) Error Total 142,500 (142,500) - 20,000 (20,000) Error 42,700 (42,700) Error 8,300 (8,300) Error 1,100 (1,100) - 79,600 14,200 Error (17,200) 76,600 2,500 Error (2,500) Error 2,300 Error (2,300) Error G66 FirstRate Company and subsidiaries Consolidated Statement of Cash Flows Fiscal year ended December 31, 20X5 Column B (U.S. dollars in thousands) Net income Row 6 Adj ustments to reconcile net income to cash flows prov ided by operating activ ities: Error In Cell Complete this workbook tab using Row 7 Net income Error Adj ustments to reconcile net income to cash flows prov ided by operating activ ities: the completed cash flow support and8trial Error balance tabs. It may be Row In Cell Depreciation of property, plant, and equipment be useful to review the illustrative Gain on disposal of equipment Row 9 flowError In Celland cash statement Loss on sale of equipment explanation of how to prepare it in Row the10 background paper, Financial Changes in working capital accounts: Statement Concepts and Row 11 Depreciation of property, plant, and equipment Error Gain on disposal of equipment Error Loss on sale of equipment Changes in working capital accounts: Financial Reporting. Decrease (increase) in accounts receivable, net Row 12 Decrease (increase) in inventory labels, appropriate, Row 13 asError In Cell in shaded Error In Cell Enter numbers, formulas, or worksheet cells only, leaving the Decrease (increase) in accounts receivable, net Error Decrease (increase) in inventory Error Increase (decrease) in accounts payable Row remainder 14 Error of this In Cell worksheet tab Increase (decrease) in accounts payable Error Increase (decrease) in accrued income taxes payable Row 15 Increase (decrease) in accrued income taxes payable Error unchanged. Error In Cell To ensure maximum credit for your useIn formulas Row 16work, Error Cell whenever possible. This will help enable faciliator 's Row 17 the Error In understanding of Cell your reasoning, which may justify "partial credit" Row for 18 inaccurate results. Increase (decrease) in accrued interest payable Net cash provided by (used in) operating activities Cash flows from inv esting activ ities: Increase (decrease) in accrued interest payable Error Net cash provided by (used in) operating activities Error Cash flows from inv esting activ ities: Proceeds on sale of equipment Row 19 Error In Cell Proceeds on sale of equipment Error Acquisitions of property, plant, and equipment Row 20 Error In Cell Acquisitions of property, plant, and equipment Error Row 21 Error In Cell Net cash provided by (used in) investing activities Error Net cash provided by (used in) investing activities Cash flows from financing activ ities: Row 22 Cash flows from financing activ ities: Net proceeds from issuance of common stock Row 23 Net proceeds from issuance of common stock Repurchases of common stock Row 24 Repurchases of common stock Redemption of preferred stock Row 25 Redemption of preferred stock Payment of dividends on preferred stock Row 26 Error In Cell Payment of dividends on preferred stock Error Payment of dividends on common stock Row 27 Error In Cell Payment of dividends on common stock Error Proceeds from borrowings under bank note agreement Row 28 Error In Cell Proceeds from borrowings under bank note agreement Error Net cash provided by (used in) financing activities Net increase (decrease) in cash and cash equivalents Row 30 Error In Cell Row 31 Error In Cell Cash and cash equivalents, January 1, 20X5 Row 32 Error In Cell Cash and cash equivalents, December 31, 20X5 Row 33 Row 34 Row 35 Error In Cell Supplemental disclosures: 17F8W2 Net cash provided by (used in) financing activities Net increase (decrease) in cash and cash equivalents Error Error Cash and cash equivalents, January 1, 20X5 Error Cash and cash equivalents, December 31, 20X5 Error Supplemental disclosures: Row 36 Error In Cell Error Row 37 Error In Cell Error B38 FirstRate Company and subsidiaries Statement of Changes in Stockholders’ Equity Fiscal year ended December 31, 20X5 (U.S. dollars in thousands) 17S8W2 Balance at January 1, 20X5 Preferred stock Common stock Additional paid-in capital Treasury stock Accum. other comprehens ive income Retained earnings Total stockholde rs' equity $ - Complete this workbook tab using the completed trial balance tab. It may be be useful to review the illustrative statement of changes in shareholders' equity in the background paper, Financial Statement Concepts and Financial Reporting. Column B Column C Column D 17S8W2 Enter7numbers, formulas, or In Cell Error In Cell Balance at January 1, 20X5 Row In Cellin Error labels, as Error appropriate, shaded worksheet cells only, leaving the Row 8 remainder of this worksheet tab Preferred stock redeemed unchanged. Row 9 To ensure maximum credit for Row your10 work, use formulas Common stock repurchased Row 11 the faciliator 's enable Net income Common stock issued whenever possible. This will help understanding of your reasoning, which Row 12may justify "partial credit" for inaccurate results. Other comprehensive income (loss) Dividends on common stock Dividends on preferred stock Balance at December 31, 20X5 Row 13 17F8W2 Row 14 $ - Row 15 Preferre d stock Error Common stock Error Additional paid-in capital Error Treasury stock Error Accum. other compreh ensive Error Retained earnings Error Total stockhol ders' equity $ - Preferred stock redeemed Common stock repurchased Net income Common stock issued Error Other comprehensive income (loss) Error Error Dividends on common stock Error Error Dividends on preferred stock Error In Cell Error In Cell Error In Cell Balance at December 31, 20X5 Error Error Error Error Error Error Error Error Error $ ~ - A6 Background Paper: Financial Statement Concepts and Financial Reporting College of Business and Economics Master of Business Administration MBA C604 Accounting and Finance Concepts for Managers Contents Topic 3  Introduction and Purpose  General-Purpose Financial Statements  Regulatory Structure of Financial Reporting by U.S. Public Companies  Objective of Financial Reporting  The Accounting Information System and the Accounting Cycle  Events and Transactions Recognized in the Accounting Information System  Accrual Basis Accounting  Content and Meaning of General-Purpose Financial Statements — Balance Sheet (or Statement of Financial Condition) — Income (or Operating) Statement and Statement of Comprehensive Income — Cash Flow Statement — Statement of Changes in Stockholders’ Equity — Footnote Disclosures  Financial Statement Articulation  Definitions of Financial Statement Elements  Desired Qualitative Characteristics of Accounting Information  Basic Assumptions and Principles of, and Constraint on, Financial Reporting Topic 4  Limitations on the Usefulness of Financial Statements — — — — Trade-offs between Relevance and Representational Faithfulness due to Articulation and Conservatism Definitions of Financial Statement Elements and Measurement Uncertainty Political Influence and Accountings Principles that Fail to Reflect Economic Reality Management Judgment: Accounting Policy Choices, Accounting Estimates, and Earnings Management  Earnings Management: Cosmetic and Real — Earnings Management Incentives — Earnings Management Indicators — Earnings Quality and Effects of Earnings Management  Ethical Dimensions of Financial Reporting 1 Introduction and Purpose As a student in this course, you previously completed a financial accounting principles course (as well as a managerial accounting principles course). Your financial accounting principles course introduced you to: — General-purpose financial statements, — Accrual accounting as the basis for such financial statements, and — The essential accounting systems and processes that businesses maintain to support their financial reporting The users of these reports include managers and external parties, such as investors and creditors. Of course, this foundational accounting skill and knowledge is necessary for students pursuing careers as accounting, auditing, and finance professionals. However, as an effective manager of a business’ marketing, operations, or other functions, you need the skill of financial reporting literacy. The purpose of this background paper is to help you build on your foundational skills by acquiring this literacy. Financial reporting literacy means that a manager is able to interpret general-purpose financial statements in connection with making business decisions, including those related to a business’ strategy, operations, investments, and finances. In making such business decisions, managers who have financial reporting literacy appreciate the limitations of general-purpose financial statements. To acquire financial reporting literacy, managers must examine:        The objective and basic regulatory framework of financial reporting The content and meaning of general-purpose financial statements, including the elements comprising them, and how they articulate with each other The desired qualitative characteristics of accounting information The basic assumptions, principles, and constraint underlying financial reporting The limitations on the usefulness of financial statements resulting from trade-offs made necessary by the present accounting model, political influences, and the need for managers’ judgment The importance of earnings quality to the usefulness of financial statements and how earnings management affects this quality, and The ethical dimensions of financial reporting policies and practices, including managers’ incentives to engage in earnings management 2 Topic 3 General-Purpose Financial Statements Generally Accepted Accounting Principles in the U.S. (U.S. GAAP) has long required that businesses preparing general-purpose financial statements for external (non-manager) users include each of the following basic statements and disclosures: Balance Sheet (or Statement of Financial Condition) Assets Liabilities Stockholders’ equity Income (or Operating) Statement Sales Cost of sales Gross profit Cash Flow Statement Cash flows provided by operating activities Net income Adjustments to reconcile net income to cash flows provided by operating activities: Statement of Changes in Stockholders’ Equity1 Preferred stock Common stock Treasury stock APIC AOCI Retained earnings Balance, Jan. 1 Common stock issued Comprehensive income Footnotes Summary of Significant Accounting Policies . . . Composition of Inventory . . . Commitments and Contingencies . . . ______ 1 Throughout this course, unless stated otherwise, assume that the organizational form of businesses is a corporation organized under the state laws in which the business is domiciled. Recall from your foundation courses in financial accounting principles and business finance that financial statements label owners’ equity interests in a corporation stockholders’ equity or shareholders’ equity, and stockholders’ interest in the corporation take the form of shares of capital stock, more commonly referred to as common stock. 3 Regulatory Structure of Financial Reporting by U.S. Public Companies Since 1973, the Financial Accounting Standards Board (the FASB) has had primary responsibility for establishing U.S. GAAP. In the case of public companies – those having debt and equity securities traded on U.S. securities exchanges (such as the NYSE and NASDAQ) – the FASB obtained this authority from the U.S. Securities Exchange Commission (the SEC). This is because the Securities Exchange Act of 1934 (the 1934 Act) created the SEC and empowered it to establish U.S. GAAP. The SEC largely delegated this authority to the FASB (and its predecessor standard-setters) since its inception in 1934. However, the SEC continues to oversee the FASB and has occasionally overridden the FASB’s accounting policy decisions, as set forth in the FASB’s Statements of Financial Accounting Standards. The SEC also regulates companies’ issuance of debt and equity securities that investors trade on U.S. exchanges (or by inter-state mail), the exchanges themselves, and certain activities of various market participants. These market participants include (among others) investment advisors, mutual funds, securities brokers and dealers, investment bankers, and independent auditors of public companies’ financial statements. The SEC refers to public companies as registrants. Regulations of the SEC require registrants to issue periodic reports that include general-purpose financial statements:  Annual Report on Form 10-K. Public companies must file these reports within 60 days of their fiscal year end and include financial statements audited by an independent auditor. These audited financial statements must include: — Balance sheets as of the two most recent fiscal year-end dates, presented in comparative form — Income statements, cash flow statements, and statements of changes in stockholders’ equity for the three most recent fiscal years, each presented in comparative form for all years included, and — Footnote disclosures of information necessary to amplify, explain, or supplement the content of the basic financial statements.  Quarterly Reports on Form 10-Q. Public companies must file these reports within 40 days of their fiscal quarter end, for each of the first three fiscal quarters of the companies’ fiscal year. The purpose of these reports is to update the information included in the most recently filed report on Form 10-K. The Form 10Q includes unaudited, interim general-purpose financial statements. These financial statements must include: — Balance sheets of the most recent quarter end and the most recent fiscal year end dates, presented in comparative form — Income statements for the most recent fiscal quarter and fiscal year-to-date, and for the comparable periods of the previous fiscal year, presented in comparative form for all such periods, and — Cash flow statements for the most recent fiscal year-to-date and for the comparable period of the previous fiscal year, presented in comparative form. SEC regulations require public companies to obtain a review (but not an audit) of their interim, quarterly financial statements, included in Forms 10-Q filed with the SEC. A review is much more limited in scope than an independent audit. (The A605 course examines this point in detail.)  Current Reports on Form 8-K. Public companies must file these reports within four business days of the occurrence of certain events that the SEC has deemed sufficiently important to affect financial statement users’ judgments and decisions about the company. The SEC’s instructions for completing reports on Form 8-K includes an extensive list of reportable events, a sample of which includes: — The registrant has changed its independent auditor — Information comes to light that indicates users should no longer rely on previously issued financial statements, or a related audit report, or completed interim review 4 — The registrant has issued an “earnings release” reporting summarized results of operations and financial condition — The registrant has determined that it has experienced material impairment in the realizable (recoverable) value of significant operating assets — A director or principal officer has departed the registrant, or there has been an election of directors or appointment of principal officers — The registrant has amended it code of ethics, or waived a provision of its code of ethics — An exchange has notified the registrant that it is delisting its securities or the registrant has failed to satisfy a rule or standard for continued listing — The registrant has materially modified the rights of security holders — There has been a change in control of the registrant — The registrant has entered into bankruptcy or receivership — The registrant has entered into a definitive agreement relating to a material acquisition or disposition of assets The principal regulations of the SEC affecting financial reporting by public companies are Regulation S-X (affecting the form and content of general-purpose financial statements) and Regulation S-K (affecting the form and content of other financial information and disclosures included in reports filed with the SEC, but not within the financial statements that comprise a part of these reports). Outside the U.S., in recent years, many countries have adopted International Financial Reporting Standards (IFRS), established by the International Accounting Standards Board (the IASB), as the basis for financial reporting by companies domiciled within their borders and therefore subject to securities and business regulations in those countries. The FASB and the IASB are engaged in a long-running effort to “harmonize” their respective accounting standards with the ultimate goal of complete “convergence” of their respective standards. In that regard, in 2008, the SEC adopted a rule that will eventually, and gradually, require registrants to prepare their financial statements (included in reports filed with the SEC) using IFRS. While there are both significant and minor differences between present U.S. GAAP and IFRS, the basic financial reporting concepts and principles examined in this course are largely unaffected by the transition from existing U.S. GAAP to the eventual, “converged” IFRS. (The A608 course examines IFRS in detail.) 5 Learning Objective 3 Objective of Financial Reporting The U.S. Congress passed the Securities Act of 1933 (the 1933 Act) and the 1934 Act in response to the market abuses that contributed to the stock market “crash” of 1929. Recall that the 1929 “crash” was a material contributing factor in the Great Depression of the early 1930s. One of Congress’ objectives in adopting these statutes was to improve the quality and transparency of financial reporting as a means to protect the integrity and enhance the efficiency of the securities markets. The securities markets include principally the national securities exchanges. Consistent with this legislative objective, the FASB determined that the objective of general-purpose financial statements is to provide financial information about a business that is useful for making capital allocation decisions by   Equity investors and Creditors, such as — Banks — Insurance and finance companies, and — Investors in bonds and other debt securities In addition to current and potential investors and creditors (collectively, the capital markets), financial statement user groups include (among others) — — — — — Managers of public companies (financial statement issuers) Employees and unions Customers and suppliers Government agencies with oversight responsibility (such as the SEC, FCC, FRB, and FTC), and Environmental and social interest groups 6 The Accounting Information System and the Accounting Cycle The Topic 1-2 background paper defines the accounting information system within a business as the collection of people, policies, procedures, information technology, and processes that identifies, classifies, processes, summarizes, and distributes economic and financial information to the various financial statement user groups. Check your understanding of the accounting information system (examined in detail in your financial accounting principles course) by reviewing the essential steps of the accounting cycle and the related basic terminology (identified in bold type) below: Steps in the Accounting Cycle 1. Enter transactions and events of the period in the appropriate accounting journal (such as the cash receipts journal, purchases journal, cash disbursements journal, sales journal, and general journal). These entries, also called journal entries, use the double-entry rules that employ the customary debits (left) and credits (right), which businesses maintain in equality. 2. Post from the various journals to the accounts, including — Real (or permanent) accounts such as cash, accounts receivable, accounts payable, and equipment, and — Nominal (or temporary) accounts such as sales, purchases, and salaries Collectively, the accounts comprise the general ledger. 3. Prepare an unadjusted trial balance from the general ledger 4. Prepare adjusting journal entries and post these to the general ledger 5. Prepare an adjusted trial balance from the general ledger after posting adjusting journal entries 6. Prepare the financial statements from the adjusted trial balance. These include the balance sheet, income statement, statement of comprehensive income, and statement of changes in stockholders’ equity. 7. Prepare closing journal entries and post these to the general ledger 8. Prepare a post-closing trial balance from the general ledger after posting the closing journal entries A business will normally perform all these steps at the end of each of its fiscal years. 7 Learning Objective 1 Events and Transactions Recognized in the Accounting Information System Under U.S. GAAP, businesses do not recognize (that is, record) in their accounting information systems every transaction and event. For example, even though they may have important effects on the business, companies do not recognize in their financial statements: — — — — Increases in customer credit limits Extension of customer payment terms Modifications to personnel policies, or Adoption of business strategies or dividend policies Transactions and events that businesses do recognize in their accounting information systems may be either external or internal in nature:  Internal transactions and events occur within a business. These include, for example: — Consumption of plant and equipment in the process of producing goods for sale — Transfers of raw materials into production, and — Application of labor and other conversion costs to the production of goods for sale  External transactions and events occur between a business and other parties or its environment. These include, for example: — Purchases or sales of goods and services — A customer’s refusal or inability to pay amounts owed to the business — A change in an interest rate affecting the value of fixed-rate securities in which the business holds an investment, and — The introduction by a competitor of technology superior to that used by a business in its products, indicating the business’ product inventory is now obsolete Transactions and events that businesses recognize in the accounting information systems must result in items meeting the definition of financial statement element, as this background paper discusses, below. 8 Accrual Basis Accounting Throughout your financial accounting principles course, you examined the application of accrual basis accounting to each major business cycle 2, such as: — — — — Revenue cycle – sales, shipping, billing, and collections Acquisition cycle – purchasing, receiving, and disbursements Conversion (production) cycle, and Payroll cycle Financial statements prepared using the accrual basis of accounting are more relevant (useful for financial statement users) than those prepared using cash basis (“check book”) accounting. This background paper reviews the basic principles of financial reporting, below. Together, two of these principles – the revenue recognition principle and the matching principle – form the basis of accrual accounting that has been the foundation of the financial reporting model used in the U.S. for more than a century (and has become the basis of financial reporting in virtually all economically developed, market-based economies). _____ 2 The application of accrual basis accounting is too voluminous and varied for a summary review that would be helpful to you, here. If you need a refresher on basic accrual accounting concepts, crack open your dusty, ol’ financial accounting text and spend a couple of hours reviewing the accounting for: — Sales “on credit” (accounts receivable) and purchases of goods and services “on credit” (accounts payable) — Acquisitions and depreciation of PP&E — Unpaid-but-incurred expenses, such as interest on borrowing between interest payment dates, employee services between payroll distribution dates, services rendered but not yet billed (as in the case of legal and accounting services) — Customers’ payments received before the seller has fully earned them (as in the case of prepaid subscription fees), and — Businesses’ advance payments for goods and services that relate to current and future periods (as in case of annual insurance premiums paid at the beginning of the policy year, “bulk” purchases office supplies, and pre-paid advertising space for use over the next (say) six months) If you got rid of your financial accounting principles text long ago (shame on you!), you can probably access comparable material – for free – by doing a bit of research on the Internet (e.g., Google, U-Tube, Wikipedia, Investopedia, etc.) 9 Under the accrual basis of accounting, businesses recognize revenues and expenses in their income statements according to these two principles, rather than based on the timing of cash receipts or expenditures: Revenue Recognition Principle Businesses (sellers) recognize revenueA from the exchange of goods or services, based on completed transactions, once it is both;  Earned – The seller has delivered the goods or provided the service, and  Realizable – The seller receives a collectible accounts receivable, even if it has not yet realized (collected) the selling price in cash As a result, a seller may not recognize revenue before it has delivered goods or provided services, even if the buyer has already paid the selling price “in advance.” On the other hand, the seller may recognize revenue from goods delivered or services provided before it receives the selling price in cash. Matching Principle  Whenever reasonable and practical, businesses recognize costs incurred as expensesA in the income statement in the same period in which they recognize the revenueA to which those costs contributed.  Whenever not reasonable and practical to match costs with revenues, businesses recognize costs as expensesA — In the income statement of the period in which they incur them, even if they have not yet paid them in cash, or — In the income statements of multiple periods beyond the period in which the business made the related cash expenditure using a depreciation or amortization method (as in the case of equipment and certain software development costs) A This background paper defines each of the financial statement elements, including revenues and expenses, below Recall that accounting accruals are either short-term or long-term in nature:   Short-term accruals include principally working capital assets and liabilities (examined further below), such as accounts receivable, inventory, and accounts payable; and Long-term accruals relate principally to the cost of assets that businesses allocate over multiple accounting periods benefitting from their services, such as plant and equipment. In the case of plant and equipment, accountants refer to this “inter-temporal cost allocation” as depreciation. 10 Learning Objective 2 Content and Meaning of General-Purpose Financial Statements Recall from your financial accounting principles course the essential content and meaning of general-purpose financial statements, as summarized below. Balance Sheet (or Statement of Financial Condition) The balance sheet presents the assets, liabilities, and stockholders’ equity elements of a business as of a specified date, most often as of the end of the business’ fiscal year or interim fiscal quarter. Public companies include fiscal yearend and quarter-end financial statements in reports filed with the SEC and otherwise make them available to the public. In addition, most businesses also prepare balance sheets as of each month end during a fiscal year strictly for managers’ use in their on-going decision-making. Your financial accounting principles courses introduced you to the “basic accounting equation” and the concepts of debits (left) and credits (right). Within the basic accounting information system (summarized in this background paper, above) the equality of aggregate debits with aggregate credits ensures that the basic accounting equation remains valid: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY Consistent with the form of the basic accounting equation, businesses present assets on the left side (or top) of the balance sheet, and present liabilities, followed by stockholders’ equity, on the right side (or bottom) of the balance sheet. Critically, a business’ balance sheet contains clear headings that include:  The identity of the reporting entity (including any group of consolidated companies that includes a corporate parent and the subsidiary companies that its controls)  A proper title, and  The date of the statement The following graphic illustrates the form of the balance sheet (or statement of financial condition): 11 FirstRate Company and subsidiaries Consolidated Balance Sheets (or Consolidated Statements of Financial Condition) December 31, 20X1 and 20X0 (U.S. dollars in thousands) 20X1 20X0 20X1 20X0 $45,000 $42,800 3,000 3,300 Dividends payable on common stock 12,000 13,200 3 60,500 56,200 Assets: Liabilities: Current assets 3: Current liabilities 3: Cash and cash equivalents $9,900 $14,300 Investment securities available for sale, at market 20,200 21,200 Accounts payable Accrued income taxes payable Accounts receivable, net allowance 43,300 41,300 Bank note payable – current portion Inventory, at lower of cost or market 91,000 86,600 Accrued interest payable 1,300 1,200 Total current assets 164,400 163,400 Total current liabilities 121,800 116,700 Property, plant, and equipment, at cost 209,600 206,000 Bank note payable – noncurrent portion3 20,100 18,700 94,800 105,300 Total liabilities 141,900 135,400 114,800 100,700 Stockholders’ equity: Preferred stock, par value $100 per share 20,000 20,000 Common stock, par value $10 per share 42,700 42,700 8,300 8,300 (1,100) – (200) 800 67,600 56,900 137,300 128,700 $279,200 $264,100 Less: Accumulated depreciation Property, plant, and equipment, net Additional paid-in capital (APIC) Treasury stock, at cost Accum. other comprehensive income Retained earnings Total stockholders’ equity Total assets A $279,200 $264,100 Total liabilities and stockholders’ equity L+E _____ 3 This background paper examines the classification of assets and liabilities in the balance sheet (as current or noncurrent) below. 12 Assets, liabilities, and stockholders’ equity refer to categories of financial statement elements that businesses report in their balance sheets. (This background paper defines each of the principal financial statement elements, such as assets, in a separate section, below.)  Assets. Recall that balance sheet elements meeting the definition of assets include, for example: — Cash and so-called “cash equivalents” (as described further below) — Investments in marketable debt and equity securities — Trade accounts receivable from customers arising from sales made “on credit” — Amounts owed to the business under notes receivable arising from loans by the business and from extended trade credit arrangements with customers, and — Capitalized costs of resources having future economic utility, such as Inventory (principally, raw materials and finished goods available for sale to customers) Computer software, supplies, and insurance policy premiums paid Plant and equipment (such as, buildings, computer hardware, and vehicles), and Certain intangible assets (such as goodwill, intellectual property rights, and rights arising from licensing or other contractual arrangements)  Liabilities. Balance sheet elements meeting the definition of liabilities include, for example: — Trade accounts payable to suppliers arising from purchases of goods and services “on credit” — Deposits received from customers (to secure their performance under trade credit arrangements) and amounts received from customers for goods that the business has not yet delivered (or for services the business has not provided) — Income and other types of taxes owed to governmental tax authorities — Accrued expenses, such as: Estimated obligations to customers under anticipated warranty claims Accrued compensation payable to employees for regular payroll, commissions, bonuses, and other arrangements Future income taxes owed to governmental tax authorities upon the reversal certain temporary differences in the accounting treatment of income or expenditures under income tax accounting regulations and U.S. GAAP, and Estimated amounts that managers believe the business will probably pay to plaintiffs or other claimants upon the eventual resolution of litigation (in the form of settlements or court judgments) — Dividends declared by the company’s board of directors on its common stock but not yet distributed, and — Principal and accrued interest amounts owed under various borrowing arrangements, such as: Notes or mortgages payable to banks and other financial institutions Bonds payable to investing bondholders, and Future rental payments (as a lessee) under certain lease agreements 13  Equity. Balance sheet elements meeting the definition of stockholders’ equity principally include: — Common stock and related items, such as: Additional paid-in capital (APIC), representing amounts paid to the company by stockholders for the company’s shares of common stock in excess of the shares’ par or stated value, as set forth in the company’s articles of incorporation, and Treasury stock, representing the company’s cost to reacquire shares of its own common stock from stockholders — Preferred (or preference) stock4 issued to preferred stockholders, if any — Retained earnings, representing the cumulative net income of the company, as reported in its income statements, to the extent that the company has not distributed such income to stockholders as dividends, and — Accumulated other comprehensive income (AOCI), representing the cumulative change in the market prices of certain investment securities, derivative financial instruments, and foreign currencies that businesses do not report as gains or losses in their income statements Balance Sheet Classifications. Accountants classify assets and liabilities in the balance sheet generally in terms of their nearness to cash or availability for settling liabilities. A classified balance sheet reports assets and liabilities as current or noncurrent:  Current assets are (a) cash and “cash equivalents” (defined to include most negotiable instruments and highly liquid investments, such as U.S. Treasury Bills, having original maturities of three months or less) and (b) other recognized assets that the business will either: — Consume or convert into cash within one year (or the business’ normal operating cycle, if longer than one year), or — Use to settle current liabilities  Current liabilities are recognized obligations that a business expects to settle or refund (replace with other current liabilities) within one year (or the business’ normal operating cycle, if longer than one year) 5. A business’ operating cycle is the average length of time between when it orders materials for production (in a manufacturing business) to the point that the business collects cash from customers as a result of the sale of goods produced by the business. The graphic below illustrates the concept of the operating cycle: Company receives materials used in producing goods. After delivery of materials, company uses cash to pay for them Materials issued into production. Labor and other conversion costs applied (see Topic 1-2) Finished goods remain in warehouse facility until shipped based on customer orders Company (seller) receives payment for finished goods shipped _____ 4 The F602 course considers preferred stock in the context of determining a business’ appropriate capital structure. Recall from your foundational business finance course that, preferred stock has characteristics of both common stock (equity) and debt. The financial structure and terms of preferred stock vary considerably among companies that use this form of financial capital. In the past two decades, relatively few public companies have used preferred stock as a part of their long-term capital structure. 5 However, a business classifies as noncurrent a liability (such as bonds or bank notes) due within the next year to the extent that it will refinance it upon its maturity with another long-term liability or newly issued equity securities, or defease (retire) it with specifically identified noncurrent assets. The A603 course examines this special rule in detail. 14 Interpreting and Using the Balance Sheet. A business’ balance sheet presents its investments and sources of financing for those investments. Recalling the basic accounting equation, the following graphic illustrates the alternative ways of describing the relationship between these groups of financial statement elements: Left side of balance sheet ASSETS Right side of balance sheet = LIABILITIES + STOCKHOLDERS’ EQUITY or INVESTMENTS = SOURCES OF FINANCING FOR THOSE INVESTMENTS or RESOURCES = CLAIMS ON THOSE RESOURCES Together with the business’ income and cash flow statements, investors, creditors, and managers use the balance sheet of a business to evaluate its:      Liquidity (the nearness of the business’ assets to cash) Solvency or capital structure (the business’ ability to pay its debts as they mature) Profitability and asset utilization (or efficiency) Asset quality, and Financial flexibility Proper classification of balance sheet elements as current (or non-current) assets and liabilities is critical to financial statement users’ analysis of a business’ liquidity. This is because financial statement users commonly examine businesses’ working capital (the balance of current assets less the balance of current liabilities, as reported in businesses’ balance sheets) to evaluate businesses’ liquidity, even though businesses do not show the working capital measurement on their balance sheets. Of course, liquidity is essential to a business’ daily operations. It is cliché, but essentially correct that cash is the lifeblood of a business. Financial flexibility describes businesses’ ability to — Exploit new investment opportunities, and — Withstand adverse changes, such as the effects of an economic downturn on the businesses’ industry, or tightening in the availability of credit. Analysts assess a businesses’ financial flexibility using such measurements as free cash flow and ratios of operating cash flow (OCF) to noncurrent (or total) liabilities. (The Topic 8 background paper and the A602 course discuss financial statement analysis of this kind in detail.) 15 Income (or Operating) Statement The income statement presents the revenues, expenses, gains, and losses (financial statement elements) of a business for a specified period, most often for the fiscal year or interim fiscal quarter of the business. As indicated above, public companies include fiscal year and quarterly interim financial statements in publicly available reports filed with the SEC. In addition, most businesses also prepare income statements at each month end (and for the corresponding year-to-date period) during a fiscal year strictly for managers’ use. An expanded version of the basic accounting equation captures the essential relationship between (or articulation6 of) the income statement, which reports net income of the current period, and the balance sheet: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY where STOCKHOLDERS’ EQUITY = PERMANENT EQUITY + NET INCOME OF CURRENT PERIOD and PERMANENT EQUITY = PREFERRED + COMMON + APIC – TREASURY + STOCK STOCK AOCI STOCK (IF ANY) + RETAINED EARNINGS AS OF BEGINNING OF PERIOD A – DIVIDENDS OF CURRENT PERIOD and NET INCOME = REVENUES + GAINS – EXPENSES – LOSSES, EACH FOR THE CURRENT PERIOD A As defined above retained earnings represents the cumulative net income of the company, as reported in its income statements, to the extent that the company has not distributed such income to stockholders as dividends. The following graphic illustrates the form of the multiple-step income statement (or operating statement). Critically, a business’ income statement contains clear headings that include:  The identity of the reporting entity  A proper title, and  The period of activity that the statement reports _____ 6 This background paper examines the articulation of financial statements, below. 16 FirstRate Company and subsidiaries Consolidated Income Statement (or Consolidated Operating Statement) Fiscal year ended December 31, 20X1 (U.S. dollars in thousands, except per share amounts) Sales revenue (net of returns or allowances) $519,700 Cost of goods (or services) sold 363,800 Gross profit 155,900 Operating expenses: Selling and administrative expenses 78,000 Research and development expenses 26,000 Other operating expenses 5,200 Total operating expenses 109,200 Operating income 46,700 Non-operating items: Non-operating revenues and gains A – B Non-operating expense and losses : Loss on disposal of equipment Interest on bank note 900 5,400 Income from continuing operations before income taxes 40,400 Taxes on income from continuing operations 13,500 Income from continuing operations 26,900 Income (loss) from discontinued operations, net related income tax benefit of $1,000 (2,000) Income before extraordinary items 24,900 Extraordinary gain (loss), net of related income tax benefit of $500 (1,000) Net income $23,900 Earnings per share: Income from continuing operations $0.63 Income (or loss) from discontinued operations, net of tax benefit (0.04) Income before extraordinary items 0.59 Extraordinary gain (or loss), net of tax of tax benefit (0.03) Net income $0.56 Weighted average number of common shares outstanding during the year 42,463,000 17 A Non-operating revenues and gains include, for example: — Interest from investments in debt securities and dividends from certain marketable equity securities — Gains on disposition of investment securities, and — Gains on sales of PP&E B Non-operating expenses and losses include, for example: — Interest on debt, such on notes, mortgages, and bonds payable and certain lease obligations — Provision of an allowance for a decline in inventory’s market value below its original cost — Write-downs of inventory or long-lived operating assets (such as PP&E) to recognize “permanent” impairment in their recoverable value, and — Losses on investment securities or dispositions of PP&E Intermediate subtotals. Compared to net income, intermediate subtotals (shaded elements in the illustrative income statement, above) are frequently of equal or greater importance to financial statement users as indicators of a business’ earnings quality or sustainability, particularly when users examine the period-to-period trend of such intermediate totals. The Topic 8 background paper examines this point further in connection with financial ratio analysis. Note the following important principles implicit in this income statement format (bold type indicates key income statement terminology):  Irregular items and the “modified all-inclusive income concept.” All income statement elements presented below income from continuing operations are irregular items. The content and format of the income statement illustrated above represents what the FASB calls the “modified all-inclusive income concept.” The modification here relates to the concept of “other comprehensive income,” described below.  Non-operating expenses and losses. Non-operating expenses and losses represent items that are either unusual or infrequent in nature, but not both. These are not irregular items and consequently included in income from continuing operations. In contrast, extraordinary items are (by definition) both unusual and infrequent in nature and reported as irregular items. Non-operating expenses include any interest expense on company borrowings even though such costs are commonplace. Non-operating expenses also include any write-downs representing anticipated losses on the disposition of inventory; businesses should not include such losses in COGS because they have not yet sold the related products.  Intraperiod income tax allocation. U.S. GAAP requires businesses to use intraperiod income tax allocation. This means that businesses must present (a) income statements elements above income from continuing operations without any related income tax effects and (b) income from continuing operations and each irregular item along with its proportionate share of the business’ total income tax expense. Thus, intraperiod income tax allocation emphasizes the irregular nature of each such item and the “of a piece” nature (“the whole”) of income from continuing operations.  EPS presentation requirements. Companies must present EPS amounts for net income, each irregular item, and the intervening subtotals. This permits a more complete analysis and understanding of this widely used measurement. Under U.S. GAAP, companies present no other statistical measures (such as the effective tax rate, current ratio, solvency ratio, etc.) on the face of the financial statements, including the income statement. Recall from your financial accounting principles course that companies compute basic EPS by dividing the relevant income statement amount (such as income from continuing operations) by the average number of shares of common stock outstanding (excluding any preferred stock outstanding) during the period corresponding to income statement period. 18 Accounting Changes. Businesses do not report the effects of accounting changes – including changes in accounting principles, changes in accounting estimates, and corrections of material accounting errors – as irregular items. Instead, U.S. GAAP requires businesses to account for such items prospectively (changes in estimates), retrospectively (changes in accounting principles), or by restatement of previously issued financial statements (corrections of errors). The A602, A603, and A605 courses examine accounting changes under U.S. GAAP. Comprehensive Income. Businesses generally include in the income statement and the determination of net income all revenues, gains, expenses, and losses recognized during the accounting period. Since 1998, U.S. GAAP has required businesses to report comprehensive income, in addition to net income. Comprehensive income is net income increased by other items of comprehensive income (OCI). The FASB defined OCI to include only a limited number of specific items. Items of OCI relate to changes in the market prices of certain investment securities, derivative financial instruments, and foreign currencies that businesses do not report as gains or losses in their income statements. Perhaps the most frequently appearing item of OCI is the unrealized gain (or loss) a business experiences on debt and equity securities that it holds as investments “available for sale” in the event the business needs additional cash for operating purposes (working capital), plant expansion, or any other purpose. The FASB permits businesses two alternative methods of presenting elements of OCI and comprehensive income: — In the income statement, immediately below net income (as illustrated below), or — As a separate statement of comprehensive income that begins with net income FirstRate Company and subsidiaries Consolidated Income Statement and Statement of Comprehensive Income Fiscal year ended December 31, 20X1 (U.S. dollars in thousands, except per share amounts) Sales revenue (net of returns or allowances) $519,700 Cost of goods (or services) sold : : Net income 363,800 : : $23,900 Other comprehensive income: Unrealized loss on investments available for sale (1,000) Other comprehensive income (loss) (1,000) Comprehensive income $22,900 As indicated above, the FASB defined OCI to include only a limited number of specific items, such as — Unrealized holding gains (or losses) experienced on debt and equity securities that companies continue to hold as investments “available for sale” — Unrealized gains or losses on certain derivative instruments used to hedge anticipated cash transactions — Unrealized gains or losses resulting from translation of the financial statements of consolidated foreign subsidiaries operating in a foreign “functional” currency 19 Note that underlying each of these items of OCI are market prices that fluctuate with changes in — Economic conditions, — Interest rates (effectively, the market prices for the “rental” of money) — Currency exchange rates (effectively, the market prices for foreign currencies, priced in terms of the U.S. dollar), and — Prices of debt and equity securities, commodities, and derivative financial instruments (such as interest rate or currency swaps, interest rate futures, and commodity options) These are so-called “exogenous” factors that a business’ managers have no ability to control, and may have very limited, near-term effects on a business’ on-going operations. 20 Cash Flow Statement The statement of cash flows (SCF) provides information about a business’ cash receipts and payments for a specified period, most often for the fiscal year-to-date of the business. As indicated above, public companies include fiscal year and interim period (fiscal year-to-date) SCFs in publicly available reports filed with the SEC. In addition, many businesses also prepare SCFs at each month-end (and for the corresponding year-to-date period) during a fiscal year strictly for managers’ use. In preparing the SCF, U.S. GAAP requires that businesses classify cash flow information as operating, investing, and financing in nature, presenting such information in this order, beginning with operating cash flow (OCF). Investors, creditors, and managers use the SCF to:   Obtain an understanding of a business’ sources and uses of cash, and Evaluate a business’ earnings quality, as set forth in its income statement. For example, a business may report significant and growing earnings over several periods, but have declining or even negative OCF during the same period. Such a relationship between income and OCF is rarely sustainable over many periods and consequently may foretell (or confirm present) financial difficulty for the business. By analyzing OCF and earnings quality, users may learn much about a business’ financial flexibility (defined above). This background paper examines earnings quality below, in connection with Topic 4. (The A602 and A605 courses also examine earnings quality). Therefore, the proper classification of cash flows in the SCF as operating, investing, and financing in nature is critical to users’ assessment of a business’ liquidity and earnings quality. To acquire financial reporting literacy, you must understand the relationship between each of these categories of cash flows, the balance sheet, and the income statement. To acquire this understanding, you will practice preparing the SCF, even though you previously studied the SCF in your financial accounting principles course. Cash Flow Category  Operating cash flows (OCF) Relationship to balance sheet or income statement Corresponds with:   Activities presented in the income statement, and Changes during the period in working capital assets and liabilities presented in the balance sheet: — Working capital assets generally includes all current asset elements, except investments in debt and marketable equity securities and cash and cash equivalents – the element whose change during the period the SCF explains. — Working capital liabilities generally includes all current liability elements except: Dividends payable (on the company’s common or preferred stock), and The current portion of any borrowings, such as notes, mortgages, and bonds payable and capital lease obligations (so-called “funded debt”)  Investing cash flows Corresponds with changes during the period in all assets, other than working capital assets, as presented in the balance sheet (such as investments and PP&E)  Financing cash flows Corresponds with changes during the period in:  All liabilities other than working capital liabilities, (such as “funded debt”), and  Stockholders’ equity elements each as presented in the balance sheet 21 The following graphic illustrates the form of the SCF using the indirect method for presenting OCF, as discussed below. Critically, a business’ SCF contains clear headings that include:  The identity of the reporting entity  A proper title, and  The period of activity that the statement reports FirstRate Company and subsidiaries Consolidated Statement of Cash Flows Fiscal year ended December 31, 20X1 (U.S. dollars in thousands) Net income Adjustments to reconcile net income to cash flows provided by operating activities: Depreciation of property, plant, and equipment Amortization of limited-life intangibles Loss (gain) on sale of equipment Impairment loss on long-lived assets [such as intangibles, PP&E] Changes in working capital accounts: Increase in accounts receivable, net Increase in inventory Increase in accounts payable Decrease in accrued income taxes payable Increase in accrued interest payable Net cash provided by (used in) operating activities Cash flows from investing activities: Proceeds on sale of equipment Acquisitions of property, plant, and equipment Net cash provided by (used in) investing activities Cash flows from financing activities: Net proceeds from issuance of common stock Repurchases of common stock Redemption of preferred stock Payment of dividends on preferred stock Payment of dividends on common stock Proceeds from borrowings under bank note agreement Repayments of borrowings under bank note agreement $23,900 10,500 – 900 – (2,000) (4,400) 2,200 (300) 100 30,900 2,100 (27,600) (25,500) – (1,100) – (1,200) (13,200) 5,700 – Net cash provided by (used in) financing activities (9,800) Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, January 1, 20X1 Cash and cash equivalents, December 31, 20X1 (4,400) 14,300 $9,900 Supplemental disclosures: Cash paid in 20X1 for interest Cash paid in 20X1 for income taxes $5,300 12,300 22 Preparing the SCF Using the Indirect Method. Businesses prepare their balance sheets and income statements directly from trial balance listings of general ledger accounts and their corresponding balances, as summarized above and examined in detail in your financial accounting principles course. In contrast, businesses prepare their SCFs using, in large part, information obtained from these other statements, rather than directly from the underlying accounting records (such as trial balances and the general ledger). The reason for this difference in financial statement preparation methodologies is that businesses maintain their accounting records using the accrual method of accounting, rather than the cash method. (This background paper reviewed accrual basis accounting, above.) Although the general ledger – maintained using the accrual method – facilitates preparation of the balance sheet and income statement, it does not directly enable preparation of the SCF. In order to prepare the SCF for the current accounting period, accountants begin by gathering:    Balance sheets of the business as of the end of the current period and as of the beginning of the current period (i.e., the end of the previous period). The accountant will analyze: — Significant changes in all non-working capital asset accounts (such as PP&E) and all non-working capital liability accounts (such as bonds payable), and — Changes in each stockholders’ equity account, such as common stock and retained earnings. Income statements of the business for the current period. The accountant will identify: — Non-cash charges against and credits to income during the period Non-cash charges include, for example, depreciation of PP&E, amortization of certain recognized intangible assets, and losses on the write-downs of inventory and other long-lived assets such as PP&E Non-cash credits include the business’ share of earnings in certain investee companies to the extent the investee has not distributed those earnings to the business as dividends — Any gains or losses that relate to investing or financing activities, such as sales of PP&E or investment securities Selected transaction data from the business’s general ledger. For this purpose, the accountant obtains information relating to particular types of operating, investing, and financing transactions. When complete, the SCF must explain the net change during the period in total cash and cash equivalents. Accountants readily determine this net change by computing the net increase or decrease in this element from the balance sheets of the business as of the end of the current period and as of the beginning of the current period (i.e., the end of the previous period). After gathering the required information, the accountant must determine whether the business will present OCF in the SCF using the direct (operating statement) method or the indirect (reconciliation) method. U.S. GAAP permits businesses to choose either type of presentation. A significant majority of public companies use the indirect method because it is easier and less costly to implement than the direct method. In any event, U.S. GAAP requires that businesses selecting the direct method also provide a supplemental schedule that provides the same information that the indirect method provides. Many analysts prefer the indirect method because it facilitates their evaluation of a business’ earnings quality. In this course, use the indirect method in all assignments or other course activities. Supplemental Cash Flow Disclosures. U.S. GAAP requires that businesses choosing the indirect method of presentation of OCF in their SCF also disclose the amounts of cash paid for interest and cash paid for income taxes during the reported period. (This is information that businesses adopting the direct method report directly in the OCF section of the SCF.) 23 Illustration of Methodology for Preparing SCF using Indirect Method Using the illustrative consolidated balance sheets and income statement of FirstRate Company and subsidiaries, presented above, an explanation of the methodology for preparing the SCF of FirstRate for the fiscal year ended (FYE) December 31, 20X1, above, follows:  A FirstRate accountant obtained the following transaction data – relating to the company’s operating, investing, and financing activities – from FirstRate’s general ledger, general journal, and other accounting records for the fiscal year ended (FYE) December 31, 20X1: — In March 20X1, FirstRate sold equipment with an original cost of $24,000,000 and accumulated depreciation of $21,000,000 for proceeds of $2,100,000. — FirstRate made no repayments during FY 20X1 under the bank note agreement. — On September 1, 20X1, FirstRate repurchased 137,500 shares of its outstanding common stock for net cost of $8 per share. — In January 20X1, FirstRate paid dividends totaling $13,200,000 on its common stock that its board declared in December 20X0. On December 1, 20X1, FirstRate declared dividends on its common stock totaling $12,000,000 and paid them on January 15, 20X2 to stockholders of record on January 1, 20X2. — In July 20X1, FirstRate declared and paid the regular annual dividend on its 6% preferred stock.  FirstRate’s accountant prepared the following schedule using the company’s end-of-year balance sheet and beginning-of-year (end-of-prior-year) balance sheet to identify its working capital assets, working capital liabilities, and the changes in each of these elements during FY 20X1. She used this information to help prepare the OCF section of the SCF under the indirect (reconciliation) method: (U.S. dollars in thousands) December 31, Working capital assets: 20X1 20X0 Increase (decrease) Accounts receivable, net allowance $43,300 $41,300 $2,000 Use of cash Inventory, at lower of cost or market 91,000 86,600 4,400 Use of cash 45,000 42,800 2,200 Source of cash Accrued income taxes payable 3,000 3,300 Accrued interest payable 1,300 1,200 100 Source of cash $85,000 $80,600 $4,400 Net use of cash Working capital liabilities: Accounts payable Net working capital (300) Use of cash With regard to the increases or decreases in working capital assets and liabilities in the table above, recall the following concepts from your financial accounting principles course: — Working capital assets. An increase in working capital assets represents a use of cash. A decrease in working capital assets represents a source of cash. Stated differently, increases in working capital assets require the use of cash to finance (fund) such increases, while decreases in working capital assets provide (“free up”) cash for other purposes. — Working capital liabilities. An increase in working capital liabilities represents a source of cash. A decrease in working capital liabilities represents a use of cash. Stated differently, increases in working capital liabilities provide (“free up”) cash for other purposes, while decreases in working capital liabilities require the use of cash to liquidate (settle) the related liabilities. 24  FirstRate’s accountant identified a non-cash charge recorded during FY 20X1 for depreciation of PP&E totaling $10,500,000, as determined below.  FirstRate’s accountant also identified the $900,000 loss on the sale of equipment, a category of PP&E. (The sale of PP&E is an investing activity.) The complete journal entry included: debit cash (proceeds of sale), $2,100,000; debit loss on sale of equipment, $900,000; debit accumulated depreciation of equipment, $21,000,000; and credit equipment (original cost), $24,000,000  FirstRate’s accountant analyzed the changes during FY20X1 in the following balance sheet elements: — Non-working capital asset accounts, — Non-working capital liability accounts, and — Stockholders’ equity accounts using the company’s end-of-year balance sheet, beginning-of-year (end-of-prior-year) balance sheet, and the transaction data above: (U.S. dollars in thousands) Non-working capital asset accounts Property, plant, and equipment (PP&E), at cost Balance at beginning of period, reported in December 31, 20X0 balance sheet $206,000 Increase: Acquisitions of PP&E during 20X1 (inferred, or “plugged,” from remaining info) 27,600 Decrease: Original cost of equipment sold in March 20X1 (24,000) Balance at end of period, reported in December 31, 20X1 balance sheet $209,600 Accumulated depreciation (of PP&E) Balance at beginning of period, reported in December 31, 20X0 balance sheet $105,300 Increase: Depreciation of PP&E for 20X1 (inferred, or “plugged,” from remaining info) 10,500 Decrease: Accumulated depreciation on equipment sold in March 20X1 (21,000) Balance at end of period, reported in December 31, 20X1 balance sheet $94,800 Non-working capital liability accounts Dividends payable on common stock Balance at beginning of period, reported in December 31, 20X0 balance sheet Increase: Dividends declared on common stock on December 1, 20X1 $13,200 12,000 Decrease: Dividends paid during FYE December 31, 20X1 (13,200) Balance at end of period, reported in December 31, 20X1 balance sheet $12,000 — Dividends relate to financing, not operating, activities, even though the company properly classified the dividend payable as a current liability in its balance sheet. — Recall from your financial accounting principles course that companies record a liability for dividends (credit to dividends payable) at the time they declare them, recording an accompanying reduction in (i.e., debit to) retained earnings. Dividends become a legal obligation upon their declaration by a company’s board of directors. When they subsequently pay dividends, companies record a reduction of (debit to) dividends payable, with an offsetting reduction of (credit to) cash. 25 (U.S. dollars in thousands) Non-working capital liability accounts (continued) Current portion Non-current portion Bank note payable Balance at beg. of period, reported in Dec. 31, 20X0 balance sheet $56,200 $18,700 Increase: Additional borrowings during 20X1 (inferred, or “plugged,” from remaining info) Decrease: None (FirstRate made no repayments during 20X1) Balance at end of period, reported in Dec. 31, 20X1 balance sheet $60,500 $20,100 Total $74,900 5,700 – $80,600 Bank notes payable (and any other borrowings) relate entirely to financing, not operating, activities, even though the company properly classified a portion of the note as a current liability. Stockholders’ equity accounts Preferred stock, par value $100 per share Balance at beginning of period, reported in December 31, 20X0 balance sheet Increase: None Decrease: None Balance at end of period, reported in December 31, 20X1 balance sheet $20,000 – – $20,000 Common stock, par value $1 per share Balance at beginning of period, reported in December 31, 20X0 balance sheet Increase: None (no new shares issued during 20X1) Decrease: None (inferred, or “plugged,” from remaining info) Balance at end of period, reported in December 31, 20X1 balance sheet $42,700 – – $42,700 Additional paid-in capital (APIC) Balance at beginning of period, reported in December 31, 20X0 balance sheet Increase: None (no new shares issued in 20X1) Decrease: None (inferred, or “plugged,” from remaining info) Balance at end of period, reported in December 31, 20X1 balance sheet $8,300 – – $8,300 Treasury stock Balance at beginning of period, reported in December 31, 20X0 balance sheet Increase: 137,500 outstanding shares repurchased by company in 20X1 for $8 per share Decrease: None (inferred, or “plugged,” from remaining info) Balance at end of period, reported in December 31, 20X1 balance sheet $– . 1,100 – $1,100 Retained earnings Balance at beginning of period, reported in December 31, 20X0 balance sheet Increase: Net income for FY 20X1, as reported in the income statement Decrease: Common stock dividends declared (refer to analysis of dividends payable, above) Decrease: Preferred stock dividends declared in 20X1 Balance at end of period, reported in December 31, 20X1 balance sheet $56,900 23,900 (12,000) (1,200) $67,600 26 Note that the completed SCF explains the net decrease of $4,400,000 in the balance of cash and cash equivalents during the FY 20X1 from $14,300,000 in the December 31, 20X0 balance sheet to $9,900,000 in the December 31, 20X1 balance sheet. Determining Supplemental Disclosure of Interest and Income Taxes Paid during Reported Period. By analyzing the changes in accrued interest payable and accrued income taxes payable, as reported in the balance sheets, FirstRate’s accountant determined the amounts of interest paid and income taxes paid by the company during the FYE December 31, 20X1: (U.S. dollars in thousands) Accrued interest payable Balance at beginning of period, reported in December 31, 20X0 balance sheet $ 1,200 Increase: Interest on bank note, as reported in the income statement 5,400 Decrease: Interest paid during 20X1 (inferred, or “plugged,” from remaining info) (5,300) Balance at end of period, reported in December 31, 20X1 balance sheet $ 1,300 Accrued income taxes payable Balance at beginning of period, reported in December 31, 20X0 balance sheet $3,300 Increase: Income tax provision (i.e., income tax expense) reported in the income statement: Taxes on income from continuing operations $13,500 Tax benefit related to loss from discontinued operations ($1,000) Tax benefit related to extraordinary loss ($500) 12,000 Decrease: Income taxes paid during 20X1 (inferred, or “plugged,” from remaining info) (12,300) Balance at end of period, reported in December 31, 20X1 balance sheet $3,000 27 Supplemental Disclosure of Non-cash Investing and Financing Activities. U.S. GAAP requires that businesses (using either the direct or the indirect method of presenting OCF) provide information about significant non-cash investing and financing activities during the reported period. Businesses may present these supplemental disclosures either in the footnotes to the financial statements (discussed further below) or immediately below the SCF, as illustrated below. Global Corp. and subsidiaries Consolidated Statement of Cash Flows Fiscal year ended December 31, 20X9 (U.S. dollars in thousands) Net income $52,000 Adjustments to reconcile net income to cash flows provided by operating activities: Depreciation of property, plant, and equipment : 19,500 : Net cash provided by (used in) financing activities 94,200 Net increase in cash and cash equivalents Cash and cash equivalents, January 1, 20X9 8,200 12,500 Cash and cash equivalents, December 31, 20X9 $20,700 Supplemental cash flow information: Cash paid during 20X9 for interest $15,100 Cash paid during 20X9 for income taxes 19,900 Significant non-cash investing and financing activities: Acquisition of equipment under capital lease Conversion of preferred stock to common stock $115,000 34,900 Distribution of stock dividend to common stockholders Exchange of equipment (non-cash portion of transaction) 1,100 22,600 Refinancing of bank note agreement 40,000 28 Statement of Changes in Stockholders’ Equity The statement of changes in stockholders’ equity analyzes the change during a specified period (most often for the fiscal year of a business) in each of the financial statement elements comprising a company’s total stockholders’ equity. This background paper discusses these financial statement elements, above, in connection with its examination of the balance sheet. In addition, as noted above, public companies must include in the financial statements contained in their annual reports on Form 10-K, statements of changes in stockholders’ equity for their three most recently completed fiscal years, presented in comparative form for all such years. Recall, too, the basic accounting equation: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY, where stockholders’ equity is comprised of: — — — — — — Preferred stock, if any Common stock Additional paid-in capital on preferred or common stock (APIC) Accumulated other comprehensive income (AOCI) Retained earnings, and Reduced by the balance of any treasury stock Retained earnings represents the cumulative net income of the company, reduced by cumulative cash (or stock) dividends paid or declared on common and preferred stock. The following graphic illustrates the form of the statement of changes in stockholders’ equity. Critically, a business’ statement of changes in stockholders’ equity contains clear headings that include:  The identity of the reporting entity  A proper title, and  The period of activity that the statement reports FirstRate Company and subsidiaries Statement of Changes in Stockholders’ Equity For the year ended December 31, 20X1 (U.S. dollars in thousands) Preferred stock Balance at January 1, 20X1 $20,000 Common stock $42,700 Additional paid-in capital $8,300 Common stock repurchased Treasury stock – Accum. other comprehensive income $800 Retained earnings $56,900 (1,100) Total stockholders’ equity $128,700 (1,100) Net income 23,900 23,900 Dividends on preferred stock (1,200) (1,200) Dividends on common stock (12,000) (12,000) $67,600 $137,300 Other comprehensive income Balance at December 31, 20X1 (1,000) $20,000 $42,700 $8,300 $(1,100) $(200) 29 Footnote Disclosures U.S. GAAP and regulations of the SEC require that companies provide additional information in their financial statements about the elements reported in their balance sheets and income statements sufficient to permit users to understand and evaluate the company’s financial condition and performance. A company may provide this information parenthetically on the face of balance sheet or (more commonly) in footnotes, whichever is more effective. Such disclosures include, for example:  A summary of the significant accounting policies of a business (the so-called “SOSAP footnote”) that describes, among other accounting policies, a business’: — Policy for recognizing sales revenue — Choice of depreciation methods for PP&E (straight-line or an “accelerated” method), and — Inventory cost flow assumption (“LIFO,” “FIFO,” or another method) adopted  Information about borrowings under bank note or mortgage agreements, bond indentures, or capital leases, including key terms and conditions, such as financial covenants  Components of financial statement elements – assets, liabilities, revenues, and expenses – for example: — PP&E, such as land, buildings, equipment, vehicles, etc., and — Inventory, such as finished goods, work-in-process, raw materials, and supplies  Nature and terms of purchased or licensed intangible assets, such as patents and royalty agreements  Descriptions of items not meeting the definition of liabilities and consequently not reported (recognized) in the business’ balance sheet, but relevant to financial statement users, including: — Unrecognized commitments, such as Long-term, fixed-price vendor supply agreements, and Operating leases — Unrecognized contingencies, such as Pending litigation, and Tax disputes with governmental authorities This background paper provides definitions of financial statement elements, below.  The cost of investment securities classified “available for sale” and reported at their fair value in the balance sheet  Descriptions of significant events affecting the business that occurred subsequent to the date of the financial statements, but before the business issued the financial statements, such as a material business acquisition, plant destruction from an environmental disaster, or refinancing of significant borrowings – each occurring after the reported fiscal year-end of the business  The nature and extent of concentrations of credit risk represented in accounts receivable, such as significant amounts of receivables due from customers operating in the same industry or geographic region and consequently subject to common economic variables, like recession This background paper examines the full disclosure principle further below. 30 Financial Statement Articulation Your financial accounting principles courses explained the links between the balance sheet, income statement, SCF, and statement of changes in stockholders’ equity – that is, how the statements articulate with each other. The principal concept underlying financial statement articulation is “clean surplus,” readily explained below by examining a portion of the previous illustrative statement of changes in stockholders’ equity: FirstRate Company and subsidiaries Statement of Changes in Stockholders’ Equity For the year ended December 31, 20X1 (U.S. dollars in thousands) Preferred stock Balance at January 1, 20X1 $20,000 Common stock $42,700 Additional paid-in capital Treasury stock – $8,300 Common stock repurchased Accum. other comprehensive income $800 Retained earnings $56,900 (1,100) Total stockholders’ equity $128,700 (1,100) Net income 23,900 23,900 Dividends on preferred stock (1,200) (1,200) Dividends on common stock (12,000) (12,000) $67,600 $137,300 Other comprehensive income Balance at December 31, 20X1 (1,000) $20,000 $42,700 $8,300 $(1,100) $(200) In the absence of dividends, net income for a period, as reported in the company’s income statement, explains the change in retained earnings from the beginning-of-period balance sheet to the end-of-period ...
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