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Transcript of Part 3 B – 1 V3.0 THE IIA’S CIA LEARNING SYSTEM TM Section Topics 1.Basic concepts and...
Part 3 B – 1V3.0
THE IIA’S CIA LEARNING SYSTEMTM
www.LearnCia.com
Section Topics
1. Basic concepts and underlying principles of financial accounting
2. Intermediate concepts of financial accounting
3. Advanced concepts of financial accounting
4. Financial statement analysis
5. Cost of capital evaluation
6. Types of debt and equity
7. Financial instruments
8. Cash management
9. Valuation models
10.Business development life cycles
Part 3, Section B, Introduction
Part 3 B – 2V3.0
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Financial Audit Risks
Financial Statement
Account Balance
Payroll
A/P
A/R
Financial statements
Rank risk and impact (COSO)
High
Low
Material misstatements?
Inherent risk
Control risk
Detection risk
Part 3, Section B, Introduction
Part 3 B – 3V3.0
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Factors Affecting Risk
• Degree of impact on financial statement• Account characteristics• Business process characteristics• Fraud potential• Organizational characteristics• Types of transactions (i.e., routine, non-
routine, estimated)
Part 3, Section B, Introduction
Part 3 B – 4V3.0
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Financial Audit Risks
Financial Statement
Account Balance
Payroll
A/P
A/R
Financial statements
Rank risk and impact (COSO)
High
Low
Material misstatements?
Inherent risk
Control risk
Detection risk
• Existence or occurrence
• Completeness• Rights and
obligations• Valuation or
allocation• Presentation and
disclosure
Mitigation
Part 3, Section B, Introduction
Part 3 B – 5V3.0
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Common Accounting TermsFill in the blanksAccounting Term Definition
Listing all of an entity’s financial transactions
Residual ownership interest in assets after deducting liabilities
Allocate acquisition costs of intangible assets to periods of benefit
Summary of profitability of an enterprise over a period of time
Recording or representing fair value when value has depleted faster than calculated amortization or depreciation
Amortize
Equity
General ledger
Income statement
Impairment
Part 3, Section B, Introduction
Part 3 B – 6V3.0
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United States:• FASB sets standards.• GAAP
– Recognition principles.
– Disclosure principles.
International:• IASB sets standards.• IFRS
– Harmony among countries’ regulations.
– Develop future standards and review current standards.
– Reduce number of allowed alternative treatments.
Accounting Standards
Standards result from many compromises.
Part 3, Section B, Topic 1
Part 3 B – 7V3.0
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• External financial reporting: not end in itself– Specific (not macroeconomic) data– Includes estimates and judgments– Primarily historical– Not to be used as sole source of data– Has procurement cost
• Data on economic resources (assets) and claims to resources (liabilities and equity)
• Assess amount, timing, and uncertainty of future cash flows
Objectives of Financial Reporting
Part 3, Section B, Topic 1
Part 3 B – 8V3.0
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Underlying GAAP Accounting Concepts
Part 3, Section B, Topic 1
Qualities of InputConstraints on
PreparersAssumptions Principles
RelevanceReliabilityComparabilityConsistency
Cost/benefitMaterialityIndustry practicesConservatism
Economic entityGoing concernMonetary unitPeriodic reporting
Historical costRevenue recognitionMatchingFull disclosure
Part 3 B – 9V3.0
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Accounting Qualities
Primary qualities
Secondary qualities
User-specific qualities
Materiality constraint
Comparability Consistency
Relevance Reliability
Decision usefulness
Understandability
Decision makers
Financial data
Predictive valueFeedback value
Timeliness
VerifiabilityNeutrality
Representational faithfulness
Benefits greater than cost constraint
Reasonably informedReasonable diligence
Part 3, Section B, Topic 1
Part 3 B – 10V3.0
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Revenue Recognition Principle
Realized (or realizable = liquid) Earned
Service substantially performed
Transaction Recognized
Journal entry
Cash or claim to cash received
Part 3, Section B, Topic 1
Part 3 B – 11V3.0
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When practical, recognize expenses in period when corresponding revenues were recognized.
Matching Principle
March
Product costs expensed
Shoes sold
January
Shoes produced
Period costs expensed
Costs generated
February
Revenue generated
Part 3, Section B, Topic 1
Part 3 B – 12V3.0
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Which of the following is true?A. Assets being liquidated are valued at fair value.B. Future value computations assume that compound
interest is applied.C. If most assets were valued at current value, it
would be harder to manipulate financial statements.
D. Future payments required by contractual agreement are valued at historical cost.
Answer: B; Future Value = Present Value (1 + Interest Rate)Number of Periods
Discussion Question
Part 3, Section B, Topic 1
Part 3 B – 13V3.0
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How much cash would you receive initially if you issued a three-year US $100,000 zero-interest-bearing note receivable when market rates were 6%?
Answer: US $100,000 0.83962 = US $83,962; to verify, future value of US $83,962 1.19102 = $100,000.
Discussion Question
Present Value of 1
Periods 3% 4% 5% 6%
3 .91514 .88900 .86384 .83962
Future value of 1
3 1.09273 1.12486 1.15763 1.19102
Part 3, Section B, Topic 1
Part 3 B – 14V3.0
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Cash basis:
• Not GAAP or IFRS
• Recognizes revenue when cash received
• Recognizes expenses when cash paid
Accrual basis:
• GAAP and IFRS
• Recognizes transactions as they occur
• Recognizes revenue when realized or realizable and earned
Accrual vs. Cash Basis Accounting
Part 3, Section B, Topic 1
Accepted Norm
Part 3 B – 15V3.0
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Sum of all debits must equal sum of all credits.
Dual-Entry Accounting
CreditDebit
AssetsExpenses
LiabilitiesRevenuesCapital stockRetained earnings
Part 3, Section B, Topic 1
Part 3 B – 16V3.0
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What is the journal entry and T-account format for plant machinery that is sold for cash in excess of its net book value? What is the type of each account? Is each increasing or decreasing?
Answer: CashAccumulated depreciation–machinery
MachineryGain on sale of machinery
Discussion Question
Dr. Cr.
Cash
Accumulated depreciation–machinery
Machinery
Gain on sale of machinery
(Asset) (Asset)
(Revenue)(Asset disposal)
Part 3, Section B, Topic 1
Part 3 B – 17V3.0
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T-Account with Beginning and Ending Balances (1 of 2)
Cost of goods sold (COGS) $82,400
Finished goods $82,400
Accounts receivable $85,000
Cash $10,000
Sales returns and allowances $5,000
Sales $100,000
To record 1,000 units sold at $100/unit. All amounts are in US dollars.
Beginning Account Balance + Account Additions in Period = Ending Account Balance + Account Deductions in Period
Journal entry
Part 3, Section B, Topic 1
Part 3 B – 18V3.0
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Finished Goods*
BXfer-in
from WIP
$900,000
E
$1,100,000
$1,917,600
$82,400
Accounts Receivable
B
E
$300,000
$100,000
$385,000
Sales $10,000$5,000
Cash receiptsSales ret. & allow.
$82,400
COGS
Cash
Sales
Sales Ret. & Allow
$100,000
$5,000$10,000
Key B = Beginning balanceE = Ending balanceXfer-in = Transferred in
T-Account with Beginning and Ending Balances (2 of 2)
T-account
* $900,000 + $1,100,000 = $1,917,600 + $82,400
Part 3, Section B, Topic 1
Part 3 B – 19V3.0
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Reinforcing Activity 3-5Part 3, Section B, Topic 1
Basic Concepts of Financial Accounting
Part 3, Section B, Topic 1
Part 3 B – 20V3.0
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The Accounting Cycle
Part 3, Section B, Topic 1
A. Identification and analysis
B. Recording in journal
C. Posting to
general ledger
D. Trial balance and
working papers
E. Adjusting entries and
adjusted trial balance
F. Closing accounts and
post-close trial balance
G. Preparing external
financial statements
H. Reversing
Part 3 B – 21V3.0
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In the adjusting entries portion of the accounting cycle,which of the following would be true of the adjustment foran accrued expense? (Select all that apply.)I. Debit asset account, interest receivable.II. Debit expense account, interest expense.III. Credit liability account, interest payable.IV. Credit revenue account, interest revenue.V. Each entry decreases the appropriate account.
Answer: II and III. Both entries increase the appropriate account.
Discussion Question
Part 3, Section B, Topic 1
Part 3 B – 22V3.0
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Tests interrelationships by grouping transactions through the journals to the general ledger
Segmented Audit Cycles—Revenues Cycle
$100
Cash
$90
Bad Debt Expense
Sales
Cash sale$100
Credit sale$200 B
A
Cash Discounts Taken
$20C
Sales Ret. & Allow.
$20C
Accounts Receivable
B $1,000
$1,030
$20 Cash receipts$20
E$200 Sales ret. & allow.
Charge-off uncoll.$50B
A
C
D
E
$50 B
Allowance for Uncollectible Accounts
Estimated bad debt expense$800
$90$840
D
Part 3, Section B, Topic 1
Part 3 B – 23V3.0
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Segmented Audit Cycles—Expenditures Cycle
Purchase Returns and Allowances
$40
Selling and Administrative Expense Control Accounts
$70H To subsidiary accts., e.g., taxes
Manufacturing Expense Control Accounts
$150G To subsidiary accts., e.g., taxes
C
Purchase Discounts
$20 B
Manufacturing expenses
Selling & admin. expenses
Purchase Accts., e.g., Raw Materials
$120D
Accounts Payable
Cash disbursements$100
$20
$120Purchases: Raw materials
$500$40
PP&E
Prepaid insurance$10
A
PP&E
$500E
$100
Cash
A
$150
$70
$10
Prepaid Expenses
F
Purch. ret. & allow.B
Purchase discountC
D
E
F
G
H
Part 3, Section B, Topic 1
Part 3 B – 24V3.0
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An auditor for the production or conversion and inventory cycle notices that actual direct labor (DL) costs were 140% higher than applied DL. This amount was charged to cost of goods sold, and management noted that it was due to approved overtime. What should the auditor do?
Sample answer: Due to the size of the variance, the auditor should question whether the DL spending variance should be considered material. If so, it would need to be prorated among raw materials, WIP, and finished goods.
Discussion Question
Part 3, Section B, Topic 1
Part 3 B – 25V3.0
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External Financial Statements
Income Statement
Shareholders’ Equity
Balance Sheet
Statement of
Cash Flows
Part 3, Section B, Topic 1
Part 3 B – 26V3.0
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Summary of profitability over a period of time
Income Statement
RevenuesRevenues
ExpensesExpenses
GainsGains
LossesLosses
Income (Revenues + Gains)Income (Revenues + Gains)
Expenses (Expenses + Losses)Expenses (Expenses + Losses)
GAAP IFRS
Primary operations Secondary operations (not including investments by or distributions to owners)
All operations
Part 3, Section B, Topic 1
Part 3 B – 27V3.0
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Single-Step Income Statement—Steel, Inc., Y6
Revenues Revenues from wholly-owned operations US $1,854,715
Income from joint ventures 4,201
Interest income 1,929
Other gains 58,281
Pre-acquisition interests, net of tax 184
Total revenues 1,919,310
Expenses Cost of goods sold 1,526,990
Selling, general and administrative 156,862
Other expense 3,585
Income tax expense 86,871
Minority interests, net of tax 1,934
Total expenses 1,776,242
Net Income $143,068
Part 3, Section B, Topic 1
Part 3 B – 28V3.0
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Multistep Income Statement (1 of 2)—Steel, Inc., Y6Revenues US $1,854,715
Operating expenses:
Cost of goods sold 1,526,990
Selling, general, and administrative 156,862
Income from wholly-owned operations 170,863
Operating income from joint ventures 4,201
Operating income 175,064
Other income (expense):
Interest income 1,929
Interest expense (3,498)
Gain on divestiture of joint ventures 56,856
Gain (loss) on sale of assets 1,425
Other income (expense) (87)
Total other income (expense) 56,625
Income before income taxes, minority interests, and pre-acquisition interests $231,689
Part 3, Section B, Topic 1
Part 3 B – 29V3.0
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Multistep Income Statement (2 of 2)—Steel, Inc., Y6
Income before income taxes, minority interests and pre-acquisition interests
US $231,689
Income tax expense (86,871)
Income before minority interests and pre-acquisition interests 144,818
Minority interests, net of tax (1,934)
Pre-acquisition interests, net of tax 184
Net income $143,068
Net income per share—basic $4.68
Net income per share—diluted $4.65
See Notes to Consolidated Financial Statements
Part 3, Section B, Topic 1
Part 3 B – 30V3.0
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Additional Income Statement Items
Net sales
– Cost of goods sold
Gross profit on sales
– Operating expenses
Operating income
+/ – Other gains and losses
Earnings before taxes
– Tax expense
Income from continuing operations
+/ – Discontinued operations
+/ – Extraordinary items
+/ – Changes in accounting principle
Net income
Must be clearly distinguishable; separately report gain/loss from continuing operations and from
disposal.
Both unusual in nature and infrequent in occurrence.
Separately disclose effect on net income of change; must justify
change unless externally required.
Part 3, Section B, Topic 1
Part 3 B – 31V3.0
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Statement of Comprehensive Income—Steel, Inc., Y6
Income tax expense US $(86,871)
Income before minority interests and pre-acquisition interests 144,818
Minority interests, net of tax (1,934)
Pre-acquisition interests, net of tax 184
Net income 143,068
Other comprehensive income
Foreign currency translation adjustment, net of tax 1,845
Comprehensive income $144,913
Net income per share—basic* $4.68
Net income per share—diluted* $4.65
* It is not necessary to report EPS related to comprehensive income.
Net Income + Other Comprehensive Income = Comprehensive Income
Part 3, Section B, Topic 1
Part 3 B – 32V3.0
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• What organization owns and owes and where money originated at a moment in time
• Assets = Liabilities + Equity• Current vs. noncurrent (or long-term)
– Listed from most to least liquid
• Equity– Investments by owners (contributed capital)– Undistributed earnings (retained earnings)– Distributions to owners (dividends)
Balance Sheet
Part 3, Section B, Topic 1
Part 3 B – 33V3.0
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Balance Sheet—Steel, Inc., August 31, Y6
ASSETS LIABILITIES & SHAREHOLDERS’ EQUITY
Current assets: USD Current liabilities: USD
Cash and cash equivalents $25,356 Current portion of L/T debt $100
Restricted cash 7,725 A/P 70,608
A/R – allow. for doubtful accts. 121,319 Other current liabilities 80,404
A/R from related parties 19 Total current liabilities 151,112
Inventories 263,583 Deferred income taxes 9,916
Deferred income taxes 7,285 L/T debt, less current portion 102,829
Prepaid expenses and other 15,105 Other L/T liabilities 46,742
Total current assets 440,392 Shareholders’ equity:
PP&E, net 312,907 Common stock, par 30,779
Other assets: APIC 137,281
Goodwill 266,675 Retained earnings 564,165
Intangibles 11,092 Foreign currency trans. adj. 1,874
Other assets 13,632 Total shareholders’ equity 734,099
Total assets $1,044,698 Total liabilities and equity $1,044,698
Part 3, Section B, Topic 1
A snapshot of performance at one point in time
Part 3 B – 34V3.0
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Statement of Shareholders’ Equity
Prior period balances
+/– change in (∆) net income (loss), dividends, and stock issuances/repurchases
= ending balancesExamples:
∆ Retained earnings Cash dividend
– US $5,000
∆ Preferred stock– 100 preferred shares repurchased
for US $15/share (market price)Treasury stock
– US $1,500
∆ Common stock
1,000 shares issued@ US $1 par value
Receive US $10,000
∆ Par value
+ US $1,000
∆ Additional paid-in capital
+ US $9,000
– US $1,500
Cash outlay Net income
+ US $100,000
Part 3, Section B, Topic 1
Part 3 B – 35V3.0
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Steel, Inc., started a period with US $350,000 in retained earnings. They had US $500,000 in revenues and US $400,000 in expenses and had a US $425,000 balance in retained earnings at the end of the period. How much was the cash dividend paid during this period?
Answer: US $350,000 + (US $500,000 – US $400,000) – X = US $425,000US $450,000 – X = US $425,000 X = US $25,000
Discussion Question
Part 3, Section B, Topic 1
Part 3 B – 36V3.0
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Statement of Shareholders’ Equity—Steel, Inc., Y6
(All amounts in USD) Common Stock,* $1 Par
Additional Paid-In Capital
Retained Earnings
Accum. Other Comp. Income
Total
Balance, Aug. 31, Y5 $30,476 $125,845 $423,178 $29 $579,528
Net income 143,068 143,068
For. currency trans. adj. 1,845 1,845
Common stock issued 303 4,296 4,599
Stock based compensation expense 3,060 3,060
Tax benefits from stock options exercised 4,080 4,080
Cash dividends paid (2,081) (2,081)
Balance, Aug. 31, Y6 $30,779 $137,281 $564,165 $1,874 $734,099
*Simplified statement combines Class A and Class B shares.
Part 3, Section B, Topic 1
Part 3 B – 37V3.0
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Cash levels at beginning and end of period• Net cash flows from operations, investing, financing
Statement of Cash Flows
Net income
+ Noncash expenses: depreciation, amortization, etc.
+ Paper losses from investing/financing – Paper gains from investing/financing
+ Net decrease in current noncash assets or – Net increase in current noncash assets
+ Net increase in current liabilities – Net decrease in current liabilities
+ Amortization of discounts on bonds – Amortization of premiums on bonds
= Net cash flows from operations
Part 3, Section B, Topic 1
Used to reconcile income statement and balance sheet
Part 3 B – 38V3.0
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Statement of Cash Flows—Steel, Inc., Y6Net income US $143,068
Noncash items included in income (16,380)
Changes in assets and liabilities (21,473)
Net cash provided by operating activities 105,215
Capital expenditures (86,583)
Acquisitions, net of cash acquired (77,237)
Other changes in investing activities (33,967)
Net cash used in investing activities (197,787)
Dividends declared and paid (2,081)
Other changes in financing activities 98,927
Net cash provided (used) by financing activities 96,846
Effect of exchange rate changes on cash 437
Net increase in cash and cash equivalents 4,711
Cash and cash equivalents at beginning of period 20,645
Cash and cash equivalents at end of period $25,356
Operating activities
Net changes
Investing activities
Financing activities
Part 3, Section B, Topic 1
Part 3 B – 39V3.0
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Statement InterrelationshipsSteel Inc. Statement of Operations, Aug. 31, Y6
Revenues Total revenues US $1,919,310
Expenses Cost of goods sold 1,526,990
Other expenses 249,252
Total expenses 1,776,242
Net income US $143,068
Steel Inc. Balance Sheet, Aug. 31 Y6
Current assets: USD
Cash, S/T investments $25,356
Other 415,036
Total current assets 440,392
Noncurrent assets 604,306
Total assets $1,044,698
Current liabilities: 151,112
L/T liabilities 159,487
Common stock, par A 22,793
Common stock, par B 7,986
APIC 137,281
Retained earnings 564,165
Foreign currency trans. adj. 1,874
Total shareholders’ equity $734,099
Total liabilities and equity $1,044,698
Shareholders’ Equity Par A Par B APIC Ret. Earn. AOCI Total
Balance, Aug. 31, Y5 $22,490 $7,986 $125,845 $423,178 $29 $579,528
Net income 143,068 143,068
For. currency trans. adj. 1,845 1,845
Common stock issued 303 4,296 4,599
Stock compensation 3,060 3,060
Tax benefits (options) 4,080 4,080
Cash dividends paid (2,081) (2,081)
Balance, Aug. 31, Y6 $22,793 $7,986 $137,281 $564,165 $1,874 $734,099
Steel Inc. Statement of Cash Flows, Aug. 31, Y6
Net income US $143,068
Net cash provided by operating activities 105,215
Net cash used in investing activities (197,787)
Excess tax benefit from stock options exercised 4,080
Dividends declared and paid (2,081)
Other changes in financing activities (see book for details) 94,847
Net cash provided (used) by financing activities 96,846
Effect of exchange rate changes on cash 437
Net increase in cash and cash equivalents 4,711
Cash and cash equivalents at beginning of period 20,645
Cash and cash equivalents at end of period US $25,356
Part 3, Section B, Topic 1
Part 3 B – 40V3.0
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Which of the following applies more to theincome statement than the balance sheet?
A. Evaluating if inventory levels are sufficient
B. Evaluating capital structure
C. Evaluating liquidity
D. Evaluating creditworthiness
Answer: D. The income statement shows net profits from primary activities, a key creditworthiness indicator.
Discussion Question
Part 3, Section B, Topic 1
Part 3 B – 41V3.0
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Identify the proper statement with its use.
Answers:
Discussion Question
1. Includes primary short-term measure of success
2. Includes primary long-term measure of success
3. Helps determine financial flexibility
4. Helps form a picture of an organization’s prospects and priorities
Statement of cash flows
Income statement
Balance sheet
Statement of shareholders’ equity
Part 3, Section B, Topic 1
Part 3 B – 42V3.0
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An integral part of the financial statements• Contingent liabilities• Subsequent events• Contractual obligations• Accounting policies and valuation methods• Change in accounting policies• Capital stock disclosures• Others: Credit claims, deferred taxes, lease
information, off-balance-sheet arrangements, etc.
Disclosures/Footnotes
Part 3, Section B, Topic 1
Part 3 B – 43V3.0
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• Income statement includes judgments and estimates (audit risk) and varied accounting methods.
• Balance sheet omits qualitative, nonfinancial measures.
• Statement of cash flows can be complex: direct vs. indirect, plus inclusion of allowances, noncash transactions, etc.
• Voluntary accounting method changes can distort reported net income.
Limitations of the Statements
Part 3, Section B, Topic 1
Part 3 B – 44V3.0
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• Standard 1210.A.2• SAS No. 99:
– Be professionally skeptical.– Communicate with management.– Randomize audit tests.– Investigate management overrides of controls.
Fraud in Financial Statements
Type of risk
Pervasiveness Risk attributes Significance (materiality)
Likelihood of material misstatement
Part 3, Section B, Topic 1
Part 3 B – 45V3.0
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If sales revenue and the customer base for a firm haveremained stable but inventory and gross margin haveincreased significantly, which of the following couldexplain this?A. Production efficiency has increased.B. Sales price per unit has increased.C. Inventory was deliberately overstated.D. All of the above.
Answer: D. Further investigation could help narrow the possible reasons for this change.
Discussion Question
Part 3, Section B, Topic 1
Part 3 B – 46V3.0
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Falsified reporting: Usually overstating/understating assets/liabilities or revenues/expenses
Fraudulent Financial Reporting
Manipulation of accounting records and supporting documents
Omission of events
Intentional misapplication of accounting
principles
Part 3, Section B, Topic 1
Part 3 B – 47V3.0
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Fraudulent Financial ReportingRed Flags
• Fictitious revenues
• Improper asset valuation
• Concealed liabilities
• Improper disclosures
Part 3, Section B, Topic 1
Part 3 B – 48V3.0
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• Government bonds• Industrial revenue bonds• Corporate bonds• Debenture bonds• First mortgage/mortgage
bonds• Callable bonds• Subordinate bonds• Serial bonds• Term bonds• Income bonds
Bond features:• Restrictive covenants• Sinking fund requirements• Call provisions• Stock warrants
Types of Bonds
Part 3, Section B, Topic 2
Part 3 B – 49V3.0
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What’s the yield-to-maturity (YTM) of a three-year US $100,000 note receivable bearing annual interest at 6% when the current market rate for a similar investment is 5%? Is this a discount or a premium?
Answer: US $100,000 0.06 = US $6,000 interest payment. Market rate is used for PV of both principal and interest. YTM = (US $100,000 .86384) + (US $6,000 2.72325) = US $86,384 + US $16,340 = US $102,724, a premium.
Discussion Question
Present Value of 1
Periods 3% 4% 5% 6%
3 .91514 .88900 .86384 .83962
Present Value of an Ordinary Annuity of 1
3 2.82861 2.77509 2.72325 2.67301
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Par, discount, or premium Amortization
Discounts and Premiums on Bonds
YTM Discount Premium Already Amortized
(Example from prior slide) Y1 $102,724
Carrying Value of Bonds Effective Interest Rate
Y1 $102,724 0.05 $5
Carrying Value of Bonds
Bond Interest Expense
,136
Bond Interest Expense Interest Paid in Period
Y1 $5,136 $6,000 ($864) Premium
Y2 Carrying Value $102,724 $864 $101,860
Bond Amortization Amount
Market (Effective) Rate
Stated Bond Rate
6%
7%
5%
Discount
Premium 6%
Par 6%
6%
Note: All amounts in US dollars.
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Fraud risk, e.g.,
• Overstating by recording false receivables• Understating by improperly recognizing
receivables in later period
Revenue Recognition Misuses
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• Repurchase agreement• Misuses
– Trade loading/channel stuffing.– High ratio of returns: either delay recognition until
warranties expire or record returns as they occur.
• Recognize at sale only if:– Sales aren’t on consignment.– Prices easily determined.– Theft or loss cannot revoke obligation to pay.– Not a transfer payment.– Returns can be estimated.
Point-of-Sale Recognition
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Installment sales method• Used when title transfers at final payment.• At sale, recognize revenue up to cost of goods sold
plus direct expenses, e.g., selling and administrative.• Gross profit deferred until cash collected.
Cost recovery method• No basis for estimating collectibility.• Defers all profit recognition until collections exceed
cost of goods sold.
Revenue Recognition After Delivery
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Using the percentage-of-completion method, how much revenue should be recognized in June for a construction project that has incurred $100 in to-date costs, should cost $400 in total, and has collected $200 in total revenue, of which $25 was already recognized? (All amounts in thousands of US dollars.)
Discussion Question
Cost - to - Cost Percent Complete
To - Date Costs Incurred $100 0.25Most Recent Total Cost Estimate $400
To - Date Revenue to Recognize
Cost - to - Cost Percent Complete Total Re venue
0.25 $200 $50
Cur
rent Period's Portion of Revenue
To - Date Revenue to Recognize - Pr ior Period
Revenue Recognized $50 - $25 $25
Part 3, Section B, Topic 2
Answer:
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A lease has the following terms. Under US GAAP, is this an operating lease or a capital lease?• Lessor retains title at the end of the lease.• Lease has no bargain purchase option.• Lease term spans 6 years; estimated remaining life
is 10 years.• Present value of the lease payments is $80,000; current market value is $100,000.
Answer: Operating lease. None of the four capital lease criteria are satisfied: III would need to be 75% or more; IV would need to be 90% or more.
Discussion Question
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Defined contribution plans• Promise required annual
contribution.• Annual pension expense =
required contribution.• Actual benefits depend on
market returns.
Defined benefit plans• Promise specific level of
retirement benefits.• Minimum pension liability =
actuarial present value of expected minimum payments at retirement.
• Accumulated benefit obligation = service cost +/– actual return on plan assets.
• If accumulated benefit obligation > fair value of plan assets, record liability.
Pensions
Service cost measured by vested benefit obligation, accumulated benefit obligation, or projected benefit obligation (best).
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Assets with no physical substance (but not financialinstruments)• Subject to interpretation or estimation, e.g., cost or
expense recognition issues• Purchased vs. internally created• Examples
– Copyrights– Patents– Trade names or trademarks– Contracts– Leases– Customer intangibles– Goodwill
Intangibles
®
©™
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Limited life(e.g., extraction rights)
Valuation of Intangibles
Indefinite life(e.g., goodwill, brand)
Amortized over period
Fair value tested annually
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• Allocates cost of tangible assets over periods of expected use.
• Land is not depreciated.• Depreciable base = cost less salvage value.• Service life accounts for wear plus obsolescence.• Example: Machine A, with original cost of $50,000,
salvage value of $5,000, service life of 3 years or 5,000 units produced.
Depreciation
-
Depreciable Base $45,000 $15,000/YearEstimated Service Life 3 Years
Straight Line Depreciation per Period
Note: All amounts are in US dollars.
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Example: Machine A, with original cost of $50,000, salvage value of $5,000, service life of 3 years or 5,000 units produced If Machine A made 2,000 units in Year 2, what would be the year’s depreciation using the activity method?
Answer:
Discussion Question
Depreciable Base Units in Period Total Estimated Units in Service Life$45,000 2,000 units
$18,0005,000 units
Activity Depreciation per Period
Note: All amounts are in US dollars.
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Example: Machine A, with original cost of $50,000, salvage value of $5,000, service life of 3 years or 5,000 units produced
For Machine A, calculate depreciation and end-of-year book value for all years using a 200% declining balance.
Answer: Straight line of 1/3 x 2 = 2/3 or 66.7%
Discussion Question
Year Beginning of Year Asset Book Value
Rate Depreciation Charge
End-of-Year Book Value
1 $50,000 66.7% $33,350 $16,650
2 $16,650 66.7% $11,106 $5,544
3 $5,544 66.7% $544 * $5,000
*Depreciation of $3,698 reduced in Y3 to reflect salvage value.
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• Contingent liabilities– A loss contingency that
is recorded.– Amount of loss can be
estimated reasonably.– Probable a liability will
likely exist on or before financial statement date.
• Contingency states:– Probable– Reasonably possible– Remote
• Examples– Lawsuits– Warranties and
guarantees– Premiums and coupons
Contingent Liabilities
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A firm with 50,000 common shares outstanding for the first quarter issues 40,000 more on April 1. The firm has net income of US $350,000 and has paid US $10,000 in common dividends and US $5,000 in preferred dividends. What is its basic earnings per share (EPS)?
Discussion Question
Weighted Average Shares Outstanding
Months Outstanding= Shares Outstanding ×
12 Months3 9
= 50,000 × + 90,000 × = 80,000 Shares12 12
Net Income Preferred DividendsEPS =
Weighted Average Sh
ares Outstanding
US $350,000 US $5,000= = US $4.31 per Share
80,000 Shares
Part 3, Section B, Topic 3
Answer:
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Convertible bonds—if-converted method• Numerator increases: Bond interest expense eliminated,
increasing net income.• Denominator increases: Assumes bonds converted at start of
period or date of issuance (prorated).
Warrants and options—treasury stock method• Denominator increases by net incremental shares:
– Warrants converted at start of period or when issued.
– Proceeds used to repurchase stock, so net income stays same.
– For example, exercise price US $10; stock price US $20. 2 warrants exercised for 2 shares and US $20, which is used to repurchase 1 share, leaving 1 net incremental share.
EPS with a Complex Capital Structure
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• A distribution of profits, not an expense.
• Audit registrar and disbursement process.
• Dividend policy: retained earnings vs. dividends.
• At date of declaration, dividend becomes a liability.
• Types– Cash dividends– Liquidating dividends– Property dividends– Stock dividends
Dividends
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At the beginning of next year, a firm’s effective tax rate is scheduled to increase significantly. Which of the following would be most likely to require scrutiny as a potential source of fraud in the current year’s financial statements and taxable income?
A. Unusually large deferred tax assets
B. Unusually large deferred tax liabilities
C. Differing amounts for taxable income and reported pretaxfinancial income
Answer: A. Deferred tax assets would increase the current year’s tax and reduce future taxes when the tax rate would be higher.
Discussion Question
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Equity Security Investments
Ownership level Recorded at Valuation Unrealized gains/losses
Passive interest: < 20%
Cost Fair value method: Report unrealized net gain/loss of similar securities in portfolio
• If available-for-sale, record in other comprehensive income and separate component of stockholders’ equity
• If trading, record as part of net income
Significant influence: 20% to 50%
Cost adjusted by investor’s share of investee’s net income/dividends
Equity method: Proportional share of investee’s net income/loss, dividends
Not recognized
Controlling interest: > 50%
Fair market value Consolidated financial statements
Not recognized
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• Companies form partnerships and mergers to increase their influence over a market or over a company with a purchasing interest.
• Types of practices– Partnerships– Business combinations and mergers– Special purpose entities (SPEs)
Partnerships, Combinations, and Consolidations
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• Required under GAAP and IFRS.• Records assets and liabilities at fair value (FMV),
excess of cost over FMV is goodwill.• Excess of market over book value is depreciated/
amortized for applicable assets.• Acquired retained earnings not recognized. • Investee earnings after acquisition are included.
Purchase Accounting
Indirect acquisition costs
Expensed
Direct acquisition costs
Capitalized
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Present results of operations and financial position asif entities were a single company.
Steps in consolidation:1. Determine ownership percentage and minority interests
of each subsidiary.2. Book value of subsidiary = investee’s net assets x
ownership percentage. Allocate purchase price vs. book value differences to underlying asset and liability accounts—requires estimates!
3. Record eliminating entries to reverse intercompany transactions and balances.
4. Issue consolidated statements.
Consolidated Financial Statements
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A UK firm has accounts payable with US clients, and it wants to minimize exchange rate risk. The US interest rates are currently higher than the UK rates. What should the firm do?A. Buy a forward exchange contract for USD now.B. Wait and buy on the spot market.C. Buy on the spot market now.
Answer: A. US currency is trading at a discount now, so a forward contract would be a valid fair value hedge.
Discussion Question
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Remeasurement• If subsidiary uses parent’s
reporting currency as functional currency.
• Uses historical exchange rates from time of transactions.
• Temporal method remeasures balance sheet accounts other than cash, claims to cash, and their associated expenses.
Translation• If subsidiary uses local
country’s currency as functional currency.
• Current rate method translates all assets and liabilities using the exchange rate as of the balance sheet date.
• Paid-in capital accounts use historical transaction date rates.
Remeasurement or Translation
Both methods translate income statement amounts using average exchange rates.
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Financial ratios:
• Quantitatively relate two or more numbers mathematically for comparison as a percentage or number of times or days.
• Help auditors find irregularities.
• Gain relevance when compared to competitors’ ratios or to firm’s historical data, but this requires making the sources reasonably comparable through:– Benchmarking.– Common-size financial statements.– Adjustments for inflation, historical cost, accounting
method.
Use of Ratios in Analysis
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Common-Size Financial Statements—HorizontalASSETS % Change Difference Year 6 Year 5
Current assets: USD USD USD
Cash, S/T investments 22.82% $4,711 $25,356 $20,645
Restricted cash — 7,225 7,725 —
A/R – allow. for doubtful accts. 137.41% 70,218 121,319 51,101
A/R from related parties (91.59%) (207) 19 226
Inventories 148.22% 157,394 263,583 106,189
Deferred income taxes 124.36% 4,038 7,285 3,247
Prepaid expenses and other (2.58%) (400) 15,105 15,505
Total current assets 123.65% 243,479 440,392 196,913
PP&E, net 87.48% 146,006 312,907 166,901
Other assets:
Investment in/adv. to joint venture (95.19%) (175,292) 8,859 184,151
Goodwill 76.19% 115,321 266,675 151,354
Intangibles 319.52% 8,448 11,092 2,644
Other assets (36.32%) (2,722) 4,773 7,495
Total assets 47.25% $335,240 $1,044,698 $709,458
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Common-Size Financial Statements—Vertical
Revenues Revenues from wholly owned operations US $1,854,715 96.63%
Income from joint ventures 4,201 0.22%
Interest income 1,929 0.10%
Other gains 58,281 3.04%
Pre-acquisition interests, net of tax 184 0.01%
Total revenues 1,919,310 100.00%
Expenses Cost of goods sold 1,526,990 79.56%
Selling, general and administrative 156,862 8.17%
Other expense 3,585 0.19%
Income tax expense 86,871 4.53%
Minority interests, net of tax 1,934 0.10%
Total expenses 1,776,242 92.55%
Net income US $143,068 7.45%
Base value
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• Analytical procedures can detect:– Differences that aren’t expected.– Absence of expected differences.– Potential errors.– Potential irregularities or illegal acts.– Other unusual or nonrecurring
transactions.
• Include nonfinancial data in analysis.• Ratios helpful before and during audit.
Auditor’s Financial Statement Analysis
Part 3, Section B, Topic 4
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Which of the following investments would be preferable assuming that investors want to minimize risk but still receive a positive return?
Answer: Firm B, because operating leverage is lower but financial leverage index is still positive.
Discussion Question
(all amounts in thousands of USD) Firm A Firm B
Total costs $3,400 $1,600
Fixed costs $2,100 $600
Return on common equity (ROCE) 0.258 0.282
Return on assets (ROA) 0.193 0.269
Fixed CostOperating Leverage =
Total Cost
$2,100 $600A = = 0.62 B = = 0.38
$3,400 $1,600
ROCEFinancial Leverage Index =
ROA
0.258 0.292A = = 1.34 B = = 1.09
0.193 0.269
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• Show ability to pay short-term obligations without undue hardship.
• The higher the ratio, the stronger the liquidity.
• Current ratio: If too high, too much invested in low-yield short-term assets.
• Cash ratio: More conservative, most short-term measure.
• Quick ratio: Compared to cash ratio, shows effect of inventory on liquidity.
Liquidity/Short-Term Debt Ratios
Current AssetsCurrent Ratio =
Current Liabilities
Cash and Marketable SecuritiesCash Ratio =
Current Liabilities
Cash, Cash Equiv., ReceivablesQuick Ratio =
Current Liabilities
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In comparison to an industry debt ratio benchmark of 0.6, a firm has 0.8. The debt-to-equity ratio benchmark is 0.37, and the firm has 0.44. Which of the following is true relative to the benchmarks?
A. The firm has low financial leverage.
B. The debt ratio implies that few liabilities exist.
C.The debt-to-equity ratio implies that debt levels shouldbe reduced for equity financing.
Answer: C. The benchmark of 0.37 uses less debt in its equity financing than the firm does.
Discussion Question
Part 3, Section B, Topic 4
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If the gross profit margin, the operating profit margin, and the net profit margin all declined proportionally from the prior year, which of the following is most likely the cause?A. Increased cost of goods soldB. Increased selling, general, and administrative
expensesC. Increased sales priceD. Increased tax rate
Answer: A. Since all ratios decreased, the cost of goods sold must have increased or the sales price must have decreased.
Discussion Question
Part 3, Section B, Topic 4
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• “Return” and “investment” can be defined many ways.
• ROA’s net income should consist only of income from continuing operations.
• DuPont ROI shows how profits are a function of both markup over cost and efficiency of asset usage.
Return on Investment (ROI) Ratios
Net IncomeReturn on Assets (ROA) =
Average Total Assets
Net Income Preferred DividendsReturn on Common Equity (ROCE) =
Average Common Equity
DuPont ROI = Profit Margin × Total Asset Turnover
Net Inco=
me Sales ×
Sales Average Total Assets
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What is the DuPont return on equity (ROE) for a firm that has $200 in net income, $900 in average total assets, $2,000 in sales, $1,000 in total assets, and $800 in total equity?
Discussion Question
DuPont ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
Net Income Sales Total Assets= × ×
Sales Average Total Assets Total Equity
$200 $2,000 $1,000= × × = 0.1 × 2.22 × 1.25
$2,000 $900 $800 = 0.278
Note: All amounts in thousands of US dollars.
Part 3, Section B, Topic 4
Answer:
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• Average A/R turnover
• Average days’ A/R
Average A/R Turnover and Average Days’ A/R
Net Credit SalesA/R Turnover =
Average A/R
365Receivables Collection Period =
A/R Turnover Ratio
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In Year 6, average inventory turnover for Steel, Inc., was 8.26 times, and its inventory processing period was 44.2 days. If in Year 7, the ratios were 5.09 times and 71.7 days, which of the following could be true? (Select all that apply.)
I. Cost of goods sold increased.
II. Inventory is becoming obsolete.
III. Competitors are gaining market share.
Answer: Either II or III could cause a large rise in inventory levels.
Discussion Question
Part 3, Section B, Topic 4
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• Accounts payable (A/P) turnover
• Accounts payable payment period
Accounts Payable (A/P) Turnover and Accounts Payable Payment Period
Cost of Goods SoldA/P Turnover =
Average A/P
365A/P Payment Period =
A/P Turnover Ratio
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A growing firm is assessing current working capital requirements. It has the following averages: 58 days to convert raw materials into goods and sell them, 32 days to collect on A/R, and 15 days to pay for raw materials. What is its cash conversion cycle?
A. 11 days
B. 41 days
C. 75 days
D. 90 days
Answer: C. 58 + 32 – 15 = 75 days
Discussion Question
Part 3, Section B, Topic 4
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A firm has a high fixed assets turnover ratio. What conclusion can a financial analyst draw from this?A. The firm may be overcapitalized.B. Someone may be stealing inventory.C. The firm may be undercapitalized.D. The company is profitable.
Answer: C. A high ratio could mean that the firm can’t afford to buy enough assets.
Discussion Question
Part 3, Section B, Topic 4
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Shows percentage of stock value returned as dividends in period
Dividend Yield
Dividends per Common ShareDividend Yield =
Market Price per Common Share
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Reinforcing Activity 3-6Part 3, Section B, Topic 4
Financial Statement Analysis
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• Projects with no readily available market value.• Set minimum return rate, and if RI is positive,
investors will get their return and excess can go to retained earnings.
• Evaluations using ROI only can lead to rejection of profitable projects; RI helps focus on long-term gains and total monetary value of gains.
Residual Income (RI)
RI = Income Minimum Return Rate Investment
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Comparison Between Ratios
SalesA/R
Profits
Finished Goods InventoryInventory Turnover Ratios
Overall Inventory=+
+
A/R Turnover Ratio + A/R Aging Schedule = Receivables Outstanding
Current AssetsCurrent Ratio =
Current Liabilities Working Capital =
Current Assets Current Liabilities
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• Should be augmented with other data.• Beware of “window dressing.”• Industry averages = mediocre goals.• Competitors highly diversified.• International: language, currency.
Limitations of Ratios
“Same” ratio and financials, different assumptions
Different results
US $170,863Return on Assets (ROA) = = 0.195
US $1,044,698 US $709,4582
US $143,068= = 0.202
US $709,458
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Capital structure ratio• Low = able to pay debts without reliance on
long-term debt
Analysis of Capital Investments
Average Long-Term Debt
Capital Structure Ratio = Long-Term Debt Shareholders' Equity
Part 3, Section B, Topic 5
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What is the current asset value of an investment that costs an organization $1,000 in Year 1 and is expected to earn returns of $400 in Year 1, $500 in Year 2, and $600 in Year 3 and has a required return of 10%?
Discussion Question
n
t = 1
1 2 3
Cash Flow for PeriodCurrent Asset Value =
1 Required Rate of Return
$400 $500 $600= $1,000
1 0.1 1 0.1 1 0.1
= $1,000 $363.64 $413.22 $450.79 = $227.65
Period
Note: All amounts in thousands of US dollars.
Part 3, Section B, Topic 5
Answer:
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Cost of debt
Cost of equity• Efficient markets theory: stock prices
automatically and immediately react to financial and other publicly available data.– Weak, semistrong, strong forms.– Accounting tricks won’t fool market overall.
Cost of Debt and Cost of Equity
Cost of Debt = Yield-to-Maturity (YTM) 1 Tax Rate
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• Cost of preferred stock
• Cost of common stock– For stock with constant dividends, divide dividend
by required rate of return to get stock value.
Cost of Stock
Preferred Dividend
Cost of Preferred Stock = Share Price Flotation Costs
Current Dividend 1 gShare Price of Stock =
Required Return g
Expected Dividend = Current Dividend 1 g
Where g = dividend growth rate
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Capital asset pricing model
• Beta (β)– 0, item, such as a T-bill, is not affected by the market.– 0.5, for every increase (decrease) of 2, the security changes 1.– 1.0, an average security.– 2.0, for every increase (decrease) of 1, security changes 2.
• Risk-free return: benchmark no-risk government security (e.g., in US, a T-bill).
• Portfolio return: e.g., Standard & Poor’s.
Cost of Retained Earnings
Expected Return on Security =
Risk-Free Return β Portfolio Return Risk-Free Return
Part 3, Section B, Topic 5
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An organization finances its equity solely through retained earnings, at an internal cost of 12%. Its average cost of all debt interest and fees is 15%. It has a 35% tax rate and a 40% debt to 60% equity weighting. What is its weighted average cost of capital (WACC)?
Discussion Question
Debt Debt Equity EquityWACC = Weight Cost 1 Tax Rate Weight Cost
= 0.4 0.15 1 0.35 0.6 0.12 = 0.111
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Answer:
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Debt versus Equity
Debt Financing Equity Financing
High debt = more difficult financing. High equity reduces financial leverage.
Creditors prefer low debt ratio. Shareholders prefer more leverage.
Debt interest is tax-deductible. Dividends are paid after taxes.
Debt has flotation costs. Retained earnings have no flotation costs, but capital stock does.
Debt financing gives no ownership rights.
Equity financing gives away ownership rights.
Nonpublic companies (no stock or private stock) have fewer disclosures and total control but illiquid stock; owners are personally less diversified.
Publicly traded companies have extensive disclosure requirements and less control but more liquid stock; owners can diversify.
Part 3, Section B, Topic 5
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Ranking by liquidityand default risk • Preservation of
capital primary goal• Base index
– In US, T-bills backed by full faith and credit of government, or no risk
Credit and working capital policies
Types of Debt and Equity
Policy Fixed assets Permanent current assets
Shorter-term assets
Aggressive
Moderate
Conservative
Long-term financing Short-term financing
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• Trade credit• Accrued expenses• Letters of credit (L/Cs)• Money market instruments and mutual funds
– T-bills– Commercial paper (CP)– Bankers’ acceptances (BAs)– Repurchase agreements (repos)
Types of Short-Term Debt
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• Government-backed securities– T-notes– Municipal notes
• Other asset-backed securities– Pledging receivables/factoring– Pledging inventory– Securitization
• Lines of credit
Types of Short-Term Debt (continued)
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Categories of Debt SecuritiesTrading Available-for-Sale Held-to-Maturity
Description Intent to sell soon for profit based on short-term changes
Default category for all securities not falling elsewhere
Positive intent and ability to hold until maturity
Recorded at… Cost Cost Cost
Subsequently valued at…
Fair value (market value not in liquidation)
Fair value Amortized cost (cost +/– amortization of discount/premium)
Discount/ premium
Not amortized Amortized if sold prior to maturity
Amortized as normal
Unrealized holding gains/ losses?
Recognition in net income
Recognition in other comprehensive income and as separate component of shareholders’ equity
No recognition
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• Common stock• Preferred stock• Stock value
– Par value = legal capital– Additional paid-in capital
• Retained earnings
• Authorized• Issued • Outstanding
Types of Equity Securities
Book value
Primary market
Underwriter
Market value
Secondary market
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An organization reacquires 1,000 shares of $1 par value stock for $20/share. (It originally received $10/share.) Later that year, the shares are reissued for $30/share. Which of the following would be the correct entries using the cost method? (All amounts are in US dollars.)
Answer: Repurchase: I, Reissuance: IV
Discussion Question
I. Treasury stock $20,000
Cash $20,000
II. Cash$10,000
Treasury stock $10,000
III. Treasury stock$10,000
Cash $10,000
Retained earnings $20,000
IV. Cash$30,000
Treasury stock $20,000
Additional paid-in capital $10,000Part 3, Section B, Topic 6
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• Contracts requiring one party to pay another party some amount based on an underlying price or value
• Forward-type contracts– Forwards, futures,
swaps
• Option-type contracts– Right, not obligation
• Terminology– Counterparty risk
(settlement risk; credit risk)
– Over-the-counter trading– Exchange-traded
securities– Cap, floor, collar– Put and call– Long and short– Naked short selling
Financial Instruments—Derivatives
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• Management risk• Market risk• Legal risk
• Trader risk• Model risk• Portfolio leverage risk
Derivative Risk
Required to Deliver Required to Accept Delivery
Hedger
Baker
Hedger
Miller
Speculator
Speculator
e.g., Future
e.g., Forward
e.g., Future
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An organization defines speculating and specifically bans the practice. Segregation of duties provides review and approval; otherwise managers have no limits on their derivative investments. Which of the following should an audit focus on? (Select all that apply.)I. Managers could divert derivative profits to personal accounts.II. There could be large potential loss due to trading on the
margin.
III. Derivative selections could be illiquid.IV. Derivatives could be concentrated with a single
counterparty.
Answer: II, III, and IV. These require additional controls. I is less likely due to segregation of duties.
Discussion Question
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• Over-the-counter contract. • Counterparty exposure: Each party required to
perform, but each could still default.• Both limit their potential profits.• Parties usually “cash-settle.”
Forwards
Seller wants to reduce chance of price falling.
Buyer wants to reduce chance of price rising.
Hedger
Baker
Hedger
Miller
Required to Deliver Required to Accept DeliveryForward Contract
Opposite risk profiles
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• Like forwards but traded on an organized futures exchange or its clearinghouse.– Limited number of underlyings– Specified prices and delivery times
• Clearinghouse greatly reduces counterparty risk by acting as counterparty to each side.
• Reversing trade settles prior to delivery.• Party with an interest in the underlying that wants to
mitigate risk is hedger, other is speculator.– Required to deliver = going short– Required to accept delivery = going long
Futures
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1: Go long on bond forward contract (accept bonds in future at price set now). As interest rates rise, price of bond falls.
2: Purchase short futures contract as hedge. Equal risk, opposite profile.
3: Net result: Symmetric payoff profile. Reduces downside potential at cost of upside potential plus fees.
Hedging Bond Purchase with a Bond Future
Interest Rates
Price 3
1
2
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• Over-the-counter exchange of payment streams for specific time period– Payment stream: current
portion owed on liability
• Symmetrical payoff profile
• Counterparty risk– Credit risk limited to
fraction of notional principal
• Interest rate swaps– Coupon swaps– Basis swaps
• Currency swaps• Commodity swaps• Swaptions
Swaps
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ABC and DEF each need to borrow US $10 million. • ABC can borrow at 8% fixed or 6-month LIBOR + 1%. • DEF can borrow at 10% fixed or 6-month LIBOR + 2%.
ABC takes the former deal, DEF the latter. They form a coupon swap and split the comparative advantage at 0.5% each. After 6 months, if LIBOR goes up, will both parties continue to benefit equally from the swap? Explain your answer.
Suggested answer: As the floating rate rises, the party paying the net floating rate will benefit relatively less.
Discussion Question
Net Payment = ( Payment to Lender Payment to Counterparty
Payment from Counterparty)
ABC = ( 8% LIBOR 7.5%) = LIBOR 0.5%
DEF = ( LIBOR 2% 7.5% LIBOR) = 9.5% fixed
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• Buying options is hedging (like buying insurance).
• Hedger has limited downside potential, unlimited upside potential.
• Selling options is speculating (like selling insurance).
• Speculator has limited upside potential, unlimited downside potential.
Option-Type Contracts
Dec 100 XYZ CALL 10
Asymmetric payoff profiles (buyer’s perspective)
Dec 100 XYZ PUT 10
Share Price
Max. loss
Profit
010
−10
20
100110
908070
Premium Cost
Strike price
Share Price
Max. loss
Profit
010
−10
20120130
11010090
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Managing Liquidity
Liquidity
Synchronizing cash inflow and outflow transactions
Precautionary motive
Speculation
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Cash Receipt Controls
MailedMailedElectronic
Point-of-sale (POS)
POS controls• POS receipts• Manager reconciliation vs.
cash count• Locking deposit envelope• Accounting entries
Mailed payment controls• Lockbox (best)• Check images• Internal processing
– Only specific mail room employees open mail.
– Employee who doesn’t open mail compares remittance advice vs. check totals.
– Controller compares mail room total to bank deposit receipt, journal entries, reported sales.
Electronic payments controls• Improved speed and control• Customer remittance
information sent directly to accounting system
• A/R automatically updated• Funds automatically routed to
correct accounts
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Which of the following steps are used or allowed for physical check processing? For electronic payment processing? (Select all that apply.)
I. Payor issues payment instructions
II. Use of check images for transfer of value
III. Clearing
IV. Communication
V. Settlement
Answer: physical: I, II, III, V; electronic: IV, V
Discussion Question
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Cash Payment Controls
Purchase request
Purchase order (PO) Supplier
Receiving recordInspection
Accounting department
3-way match
Receiving department
Treasurer
Authorize payment Disbursement
PO
Invoice
Manager approval
Goods
Bill of lading
+
Invoice
+
Positive payHole punch for physical forms
Disbursement controls
Master payee file
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A seller offers terms of 1/15 n30. If the buyer would need to borrow from a line of credit at a rate of 16% to pay early, should the buyer pay early or when net is due?
Answer: Pay early.
Discussion Question
Effective Cost of Discount
Discount % 365=
1 Discount % Net Period Discount Period
0.01 3651/15 n30 = = 0.2457
1 0.01 30 15
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Incentive for Offering a Cash Discount
Discount Period Net Period
Discount Period
Net Present Value of Cash Discount = PV PV
Avg. Credit Sale × 1 Discount %Present Value =
Cost of Capital1 + Discount Period ×
365
Present Val
Net Period
Discount Period
Net Period
Avg. Credit Saleue =
Cost of Capital1 + Net Period ×
365
US $50,000 × 1 0.011/15 n30 = = US $49,235
0.1311 + 15 ×
365
US $50,01/15 n30 =
00 = US $49,467
0.1311 + 30 ×
365
NPV = US $49,235 US $49,467 = (US $232)
Terms: 1/15 n30,US $50,000 average credit sale,13.1% cost of capital
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The slides that follow use this example to present various perpetual inventory cost flow methods:• July: No beginning inventory.• July 1: Purchase 8,000 units @ US $10/unit.• July 4: Sell 2,000 units. • July 12: Purchase 12,000 units @ US $12/unit.• July 15: Sell 9,000 units.• July 26: Purchase 4,000 units @ US $14/unit.• Cost of goods available for sale = US $280,000.
Inventory Cost Flow Methods—Perpetual
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• Oldest goods used first• Violates matching principle
• Difficult to manipulate
FIFO Inventory Valuation
Date Transaction Cost Balance Calc. Balance
July 1 Purchase 8,000 $10 = $80,000 8,000 $10 $80,000
July 4 Sale 2,000 $10 = ($20,000) 6,000 $10 $60,000
July 12 Purchase 12,000 $12 = $144,000 (6,000 $10) + (12,000 $12)
$204,000
July 15 Sale (6,000 $10) + (3,000 $12) =
($96,000) 9,000 $12 $108,000
July 26 Purchase 4,000 $14 = $56,000 (9,000 $12) + (4,000 $14) $164,000
Cost of Goods Available for Sale – Ending Inventory = COGS
US $280,000 – $164,000 = $116,000
All amounts in US dollars.
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• Newest goods used first• Not IFRS; is GAAP
• Assuming inflation, undervalues inventory
LIFO Inventory Valuation
Date Transaction Cost Balance Calc. Balance
July 1 Purchase 8,000 $10 = $80,000 8,000 $10 $80,000
July 4 Sale 2,000 $10 = ($20,000) 6,000 $10 $60,000
July 12 Purchase 12,000 $12 = $144,000 (6,000 $10) + (12,000 $12)
$204,000
July 15 Sale 9,000 $12 = ($108,000) (6,000 $10) + (3,000 $12) $96,000
July 26 Purchase 4,000 $14 = $56,000 (6,000 $10) + (3,000 $12)
+ (4,000 $14)
$152,000
Cost of Goods Available for Sale – Ending Inventory = COGS
US $280,000 – $152,000 = $128,000
All amounts in US dollars.
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• Called moving if perpetual• Simple
• Income cannot be manipulated
Moving Average Cost Inventory Valuation
Date Transaction Cost Unit Balance Average Cost Balance
July 1 Purchase 8,000 $10 = $80,000 8,000 $10.00 = $80,000
July 4 Sale 2,000 $10 = ($20,000) 6,000 $10.00 = $60,000
July 12 Purchase 12,000 $12 = $144,000 18,000 $11.3333
* = $204,000
July 15 Sale 9,000 $11.3333 = ($102,000) 9,000 $11.3333
= $102,000
July 26 Purchase 4,000 $14 = $56,000 13,000 $12.1538
** = $158,000
*Average cost = ($60,000 + $144,000)/18,000. **New average cost = ($102,000 + $56,000)/13,000.
Cost of Goods Available for Sale – Ending Inventory = COGS
US $280,000 – $158,000 = $122,000
All amounts in US dollars. Part 3, Section B, Topic 9
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• Each specific item in inventory is tracked separately.
• Special order or low-volume, high-cost goods.
• Manipulate COGS, ending inventory, and net income by selecting from otherwise identical inventory the item with a lower or higher cost.
• Indirect costs not easily specifically identified.
Specific Identification Method
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• Shrinkage• Lower of cost or market (LCM)
– Ceiling: Market cannot be greater than inventory’s net realizable value (NRV).
– Floor: Market cannot be less than NRV less an ordinary profit margin.
– NRV is sales price less cost of completion and transportation or disposal.
– Ceiling helps prevent overstatement.– Floor helps prevent understatement.
Adjusting Inventory
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What is the Year 2 economic value added (EVA) for a firm with a 12% WACC, $300 in net income, $5 in interest expense, and the following other balances?
Discussion Question
Note: All amounts in thousands of US dollars.
Account Y1 End Y2 EndNotes payable $10 $12Current maturities of long-term debt $20 $24Long-term debt $40 $44Shareholders’ equity $1,000 $1,200
EVA = Net Income + Interest Expense Beginning Capital × WACC
Where Beginning Capital = Beginning Balances of
(Notes Payable + Current Maturities of Long-Term Debt
+ Long-Term Debt + Shareholders' Equ
ity)
Y2 = $300 + $5 $10 + $20 + $40 + $1,000 × 0.12 = US $176.60
Part 3, Section B, Topic 9
Answer:
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Reinforcing Activity 3-7Part 3, Section B, Topic 9
Valuation Models
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Business Development Life Cycle
Internal audit focus
Risks
Establish control framework.
Formalize internal controls.
Maintain control integrity; internal controls formalized.
Audits to increase efficiencies and streamline decision processes without loss of control integrity.
• Loose management.
• Strategy omits controls.
Capacity constraints encourage workarounds.
Labor cuts could threaten segregation of duties.
• Entrenched bureaucracy.• Management may
manipulate earnings.• Layoffs threaten control
continuity.
Emergence Growth Maturity Decline
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Questions?
End of Section B
Part 3, Section B