1. Review of
Financial Reporting & Analysis
• Rose Stubberfield

3. Our Approach Tonight
• We have only two hours.
– Giddy up
• The emphasis is on review.
• You should know this material, but not at the
depth you need to understand.
• Assume you know how the financial statements
articulate.
• Review the balance sheet, then the income
statement … you are on your own for cash flows.

4. Asset Definition
1. Probable future economic benefit
2. Obtained or controlled by the entity
3. As a result of past transactions
Current vs. Non-Current
- based on year or operating cycle, which
ever is longer.

5. Cash and Cash Equivalents
• Cash, of course.
• Equivalents include money market
instruments such as ST CDs, high quality
commercial paper, Treasuries, money market
funds that mature in three months or less.

6. Investments in Debt Securities
Three Categories
- Held to Maturity
 Requires ability and intent
- Available for Sale
 Cash Management
- Trading
 Intent to sell in the near term

7. Accounting for Debt Securities
Accounting & Valuation
- Held to Maturity
 Interest revenue, gain/loss on sale
 Reported on balance sheet at amortized cost
- Available for Sale
 Interest revenue, gain/loss on sale
 Fair value … with Unrealized Holding G/L to Comprehensive
Income (i.e., equity)
- Trading
 Interest Revenue, gain/loss on sale
 Fair value … with Unrealized Holding G/L to Current Income
(i.e., Income Statement, then Retained Earnings)

8. Investments in Equity Securities
Accounting is based on level of influence
- Minority, Passive (less than 20% ownership)
 Fair Value Method
- Minority, Active (20% - 50% ownership)
 Equity Method
- Majority, Active (more than 50% ownership)
 Consolidation Method

9. Accounting for Equity Securities
Accounting for Minority, Passive Investments
- Available for Sale
 Dividend Income, gain/loss on sale to Income Statement
 Fair value … with Unrealized Holding G/L to Comprehensive
Income (i.e., equity)
- Trading
 Dividend Income, gain/loss on sale to Income Statement
 Fair value … with Unrealized Holding G/L to Current Income
(i.e., Income Statement, then Retained Earnings)

10. Accounting for Equity Securities
Accounting for Minority, Active Investments
Record purchase at cost. Single line acquisition
If purchase price exceeds proportionate share of
investee’s book value, identify fair values of
underlying assets & liabilities.
Recognize proportionate share of investee’s income as an
increase in the Investment
Recognize proportionate share of investee’s dividends as
reduction in Investment

11. Valuation
Fair Value Method
Annual Adjustment
Trading – Unrealized Holding G/L in current income
Available for Sale – Unrealized Holding G/L in
Comprehensive Income (i.e., equity)
Equity Method
Annual Adjustment
Proportional Share of Income = Income
Proportional Share of income less Dividends = Investment
Adjustment

12. Valuation
The Fair Value Option
• Held-to-maturity
• Available-for-sale
• Equity method
Report unrealized gains and losses through the
income statement (not though comprehensive
income)
Brand-new and not many takers yet.

13. Consolidations
Basic Idea:
The Parent company along with its Subsidiaries are a
single economic unit.
Combine the financial results for Parent & all
Subsidiaries, then
–
Eliminate Intercompany Payables
– Eliminate Intercompany Sales
– Eliminate double-counting of Investment
– Eliminate double-counting of Income

14. Consolidations
– non-controlling Interests
Non-controlling Interest - (aka Minority Interests)
Occurs when the Parent does not own 100% of the
subsidiary. The percentage of ownership not controlled
by the Parent.
For the Balance Sheet, Non-controlling Interests represent
the percent of net assets (assets less liabilities of the
subsidiary). Appears between Liabilities & Equities
For the Income Statement, Non-controlling Interest is the
percentage of subsidiary income held by the minority
shareholders.

15. Consolidating
Foreign Subsidiaries
Companies often have international subsidiaries that must be
consolidated with the Parent’s financial statements.
Typically, the subsidiaries accounts are maintained with local
currency (and, sometimes, local GAAP). The amounts on the
foreign subsidiaries financial statements must be translated
in U.S. dollars.
To translate a foreign subsidiary’s financial statements into
U.S. dollars, conversion is made with both Historical
Exchange Rates (those which existed at the time a
transaction occurred) and Current Exchange Rates
(Exchange rates which exist as of the balance sheet date)

16. Consolidating
Foreign Subsidiaries
The use of different exchange rates means the resulting
financial statements will not balance.
To force the statements to balance, an account called
“Translation Adjustment” is used.
Two approaches are used depending on the independence of
the subsidiary from the Parent company.
- Self-contained: All-current method (local currency is functional)
- Extension of US Parent: Monetary-Nonmonetary method (US dollar
is functional currency)
Subsidiaries in countries with hyperinflation (100+%) use the
U.S. dollar as the functional currency.

17. Accounts Receivable
Involves the application of two concepts –
Definition of an Asset & Matching
Definition of an asset:
- Probable future economic benefit
- Obtained or controlled by the entity
- As a result of past transactions
What is the cost of extending credit?
- Bad debts.

18. Accounts Receivable
Acct Rec.
Beg. Bal.
End Bal.
Allowance for Bad Debts
Beg. Bal.
End Bal.
Sales
Collections
Write-Offs Write-Offs
Bad Debt
Expense
Net Account Receivable
What I can
Collect
What I
expect to
Collect

19. Accounts Receivable Example
Year 1
Sales $1,500,000
December 31, Year 1
Accounts Receivable $175,000
Allowance for Bad Debts (10,000)
Accounts Receivable, net $165,000
Based on
Analysis
Goes to the
Balance Sheet

20. Accounts Receivable Example
December 31, Year 1
Bad Debt Expense $10,000
Allowance for Bad Debts $10,000
This entry applies the two important concepts:
- matching expenses with the related revenues
- recording the asset at its net realizable value (NRV)

21. Accounts Receivable Example
Year 2
Sales $5,000,000
Identified and wrote-off as uncollectible $21,500 of
accounts receivable.
Allowance for Bad Debts $21,500
Accounts Receivable $21,500
Note, No impact
of Net A/R

22. Accounts Receivable Example
Year 2
December 31, Year 2
Accounts Receivable $330,000
Allowance for Bad Debts (25,000)
Accounts Receivable, net $305,000
Based on
Analysis
Goes to the
Balance Sheet

23. Accounts Receivable Example
December 31, Year 2
Bad Debt Expense $36,500
Allowance for Bad Debts $36,500
Allowance for Bad Debts
10,000 Beg. Balance
25,000 End Balance
Write-Offs 21,500 36,500 Bad Debt Exp.

24. Inventory – Basic Approach
Beg. Inventory
+ Purchases
Cost of Goods Available for Sale
Sold
Cost of Goods Sold
(Income Statement)
Not Sold
End. Inventory
(Balance Sheet)

25. Inventory – Costing Methods
Beg. Inventory 300 units @ $10 per unit
Purchase 100 units @ $12 per unit
Sale 200 units @ $30 per unit
Purchase 600 units @ $14 per unit
Purchase 200 units @ $15 per unit
Sale 600 units @ $30 per unit
End Inventory 400 units
LIFO – Periodic
Cost of Goods Sold $11,400
Ending Inventory $ 4,200
LIFO – Perpetual
Cost of Goods Sold $10,800
Ending Inventory $ 4,800

26. Inventory – Costing Methods
Cost of Goods Sold
FIFO Periodic $ 9,800
FIFO Perpetual 9,800
LIFO Periodic $11,400
LIFO Perpetual 10,800
W/A Periodic$10,400
W/A Perpetual 10,200
Ending Inventory
FIFO Periodic $ 5,800
FIFO Perpetual 5,800
LIFO Periodic $ 4,200
LIFO Perpetual 4,800
W/A Periodic$ 5,200
W/A Perpetual 5,400

27. Inventory – Valuation (LCM)
• After determining FIFO/LIFO/W-A Ending
Inventory, must compare to market valuation.
– Follows the definition of an asset
• Report on the balance sheet, the lower of cost or
market. Write-downs of inventory from cost to
market are included in cost of goods sold.
– Can establish a reserve account for obsolesce.

28. Inventory – LIFO Layers
As inventory levels increase, a LIFO layer is added.
Can result in very old costs embedded in inventory.
100 units at $10 per unit
40 units at $13 per unit
20 units at $17 per unit
15 units at $20 per unit

29. Inventory – LIFO Liquidations
Assume current costs are now $25 per unit.
Delay purchases to “dip” into the LIFO layers …
Instead of CGS at $25 per unit, now it is $20, then
$17, then $13 and eventually, $10 per unit
100 units at $10 per unit
40 units at $13 per unit
20 units at $17 per unit
15 units at $20 per unit

30. Inventory – LIFO Liquidations
LIFO Liquidations come at a very high cost –
taxes!!
LIFO Conformity rule states that if you use LIFO
accounting for your tax return, you use it for your
financial statements as well.
It costs real money to dip into your LIFO Layers.

31. Inventory – Comparability
1. BIF + P – CGSF = EIF
2. BIL + P – CGSL = EIL
3. P = CGSL + EIL – BIL
Substitute 3 into 1
4. BIF + (CGSL + EIL – BIL) – CGSF = EIF
Rearrange …
CGSF = CGSL - [(EIF - EIL) – (BIF - BIL)]
CGSF = CGSL – (LIFO ReserveE – LIFO
ReserveB)
CGSF = CGSL – Change in LIFO Reserve

32. Inventory – Comparability
LIFO FIFO
CGS Higher Lower
Income before taxes Lower Higher
Income taxes Lower Higher
Net Income Lower Higher
Cash Flow Higher Lower
Inventory Balance Lower Higher
Assume rising inventory costs and stable or
Increasing inventory levels.

33. Inventory - Summary
Inventory
Beg. Bal.
End. Bal.
Purchases
Cost of Goods Sold
Obsolescence

34. Long-Lived Assets
– Major Issues
Multi-period assets whose costs are matched to the
revenues they help generate.
• Smooths the impact on income
Impairment Issues
Based on the definition of an asset
Great opportunities to shift expenses from one period
to another.
Costs Expense
(Asset)
Capitalize
Allocate

35. Long-lived Assets
Long-lived Asset Acc. Depreciation
Beg. Bal.
End Bal.
Acquisitions
Disposals
Impairments
Beg. Bal.
End Bal.
Depreciation
Expense
Disposals
Impairments

36. Long-lived Assets – Acquisitions
Acquisition Cost – All the costs necessary to ready the asset
for its intended use.
Specialized machinery for a manufacturer.
Invoice price
Taxes
Delivery charges
Speeding ticket during delivery
Installation costs (including repouring floor)
Repair work for damage during installation
Setup costs (labor and materials)

37. Long-lived Assets
– Depreciation
Depreciation – Allocating the cost of the asset over the period
of benefit.
Accounting depreciation ≠ Economic Depreciation
Depreciable amount = Acquisition Cost less Residual Value
Cost - $1,000,000
Residual Value - $250,000
Depreciable Amount - $750,000
The amount to be expensed over the estimated useful life of
the asset.

38. Long-lived Assets
– Depreciation Methods
Straight-Line: Simple and most pervasive.
Other methods:
Sum-of-the-years digits Units of production
Declining balance MACRS (tax return only)
Depreciation Expense Book Value

39. Long-lived Assets
– Betterments vs. Repairs
Betterment – Costs incurred after the asset has
been placed in service. A betterment extends the
asset’s useful life, increases the asset’s productive
capacity, or increases the asset’s productive
efficiency. Capitalize costs incurred.
Repairs – No increase in economic benefit or
increased service potential. Expense costs as
incurred.

40. Long-lived Assets
– Disposals & Exchanges
Disposal – Compare the asset’s book value to the
value received from the sale. The difference is
either a gain or loss.
Exchange – One productive asset (e.g., inventory)
for another asset (e.g., equipment).
General rule: The new asset is recorded as the Fair
market value (FMV) of the asset exchanged.
Exceptions for exchanges of similar assets or where
FMV is not ascertainable.

41. Long-lived Assets
– Change in market Value
Revaluation – Not with U.S. GAAP. However, IFRS
and other countries allow revaluation up to
market value.
Impairments – Decline in market value of an asset.
There are different kinds of tests for different
kinds of long-lived assets.

42. Long-lived Assets
– Acquired Intangibles
Acquired Business
Identifiable IntangiblesTangible Assets Other Balance Sheet
Marketing related Contract relatedTechnology relatedCustomer related
• Trademarks
• Trade names
• Marketing materials
• Style guide (unique
color, shape or
package design)
• Mastheads
• Domain names
• Distributor
relationships
• Retailer relationships
• Order or production
backlog
• Contractual and non-
contractual customer
relationships
• Trade secrets, such
as secret formulas,
processes or recipes
• Patented and un-
patented technology
• Computer software
• Databases
• Supply contracts
• Advertising,
management & service
contracts
• Licensing & royalty
agreements
• Lease agreements
• Construction permits
• Franchise agreements
• Non-compete
agreements

43. Goodwill
Goodwill arises when the purchase price paid for
another business exceeds the fair market value of
the acquired net assets of that business.
$10 million
$5 million
$3 million
$1 million - Goodwill
- Excess net asset FMV over BV
- Net asset book value
Consideration
transferred
Allocation
$1 million - Identifiable Intangibles

44. Long-lived Assets
– Intangibles Amortization
Depends on the type of intangible asset it is.
•Limited Life intangible assets
– Amortize straight-line over estimated economic life.
•Indefinitive Life intangible assets
– Assets that the firm intends to maintain for an
unknown period of time.
– No amortization.
•Goodwill
– No amortization.

45. Long-lived Assets
– Impairments
Property, Plant & Equipment and Limited Life Intangible
Assets (Category 1)
Two Step Impairment Test:
Step one: Compare future estimated
undiscounted cash flows to book value. If cash
flows are less than book value, the asset is
impaired.
Step two: Write the asset down to either fair
market value (FMV) or discounted future cash
flows & recognize the impairment loss.

46. Long-lived Assets
– Impairments
Indefinite-Life Intangible Assets (other than Goodwill)
(Category 2)
One Step Impairment Test:
Step one: Write the asset down to either fair
market value (FMV) or discounted future cash
flows if below book value.

47. Long-lived Assets
– Impairments
Goodwill (Category 3)
Two Step Impairment Test:
Step one: Compare the fair value of the reporting
unit to its book value including goodwill If fair
value is below book value, then go to step two.
Step two: Determine the implied fair value of
goodwill by comparing the fair value of the
reporting to the fair value of net identifiable
assets. Write goodwill down if needed.

48. Long-lived Assets
– Impairments
The FASB added a new Step Zero for Intangibles
and Goodwill.
– Step zero is an optional, qualitative assessment.
– If determined that it is more likely than not
(i.e., a greater than 50% likelihood) that the
fair value of a reporting unit exceeds its
carrying value, then no further work required.

49. Liabilities – Major Issues
Fixed Payment
Dates & Amts.
Fixed Payment
Amts, Est. Dates
Est. Date
& Amount
Advances
& Unexecuted
Agreements
Mutually
Executed
Contracts
Contingent
Obligations
Note Payable
Interest Pay.
Bonds Pay.
Accounts Pay.
Taxes Pay.
Warranties
Payable
Rental Fees
Subscriptions
Insurance
Purchase
Employment
Commitments
Pending
Lawsuits
Off BS
Instruments
Recognized as Accounting Liabilities
Generally Not Recognized
as Accounting Liability

50. Liabilities – Basic Definition
1. Probable future economic sacrifice,
2. The obligation belongs to the firm, and
3. Is the result of past transactions.
Parallels the definition of an asset.

51. Liabilities – Current
• Accounts payable
• Wages, salaries, and other payroll items
• Short-term notes and Interest payable
• Warranties – Matching concept.
• Estimate the warranty liability at the time of
sale and record the expense.
• Reduce the liability based on actual costs
incurred.

52. Bonds– Early retirement
Example:
The $100,000 bond is two years from maturing.
Originally issued at a market rate of 8%, now
trades in the market at 12%.
Journal Entry
Bonds Payable $103,630
Cash $ 96,535
Gain on early retirement 7,095
Reported in the Income
Statement

53. Contingent Liabilities
When is a liability a liability? If there is
uncertainty regarding the outcome of an event
(e.g., litigation, possible assessments,
expropriation of assets).
Disclosure or Recognize?
Two Criteria for Accruing a Liability:
- “Probable”
- “Reasonably estimated”

54. Liabilities
– Capital Leases Requirements
Must meet one of the four criteria:
1. The lease transfers the ownership to the lessee at the end
of the lease term.
2. The lease contains an option to purchase substantially less
than the expected fair market value at the end of the lease
term.
3. The lease term is equal to 75% or more of the estimated
remaining economic life.
4. At the beginning of the lease term, the present value of the
minimum lease payments equals or exceeds 90% of the fair
market value of the leased asset

55. Liabilities – Operating Leases
No entry at lease inception - executory contract
Lease Payment Journal Entry
Rent Expense $ xx
Cash $ xx
No asset nor liability recognized on the balance
sheet.
Footnote disclosures are substantial including
description and payment schedule.

56. Liabilities – Capital Leases
At Lease Inception
Leased Asset $ xx
Lease Liability $ xx
Present value of
Minimum Lease
Payments
Second GP
Amortize the leased asset over the life of the lease.
Amortization Expense $ xx
Leased Asset $ xx
Lease payments follow Long-Debt GP
Interest Expense $ xx
Lease Liability $ xx
Cash $ x
Difference

57. Leases
Managerial considerations
– On Balance sheet or off?
• Are investors really fooled?
– Cash flows
• Operating leases – Operating cash flows
• Capital leases – Investing cash flows
• Performance metrics

58. Pensions
– Defined Contribution Plans
Defined Contribution Plans are the dominate
pension vehicle.
•Transfers ownership of risks to employees
•Easy accounting:
Pension Expense $ XX
Cash $ XX

59. Pensions
– Defined Benefit Plans
Rose in popularity following WWII.
•Employer bear risks of funds market returns
•Conceptual Underpinnings
– Matching concept
– Record expenses in period of benefit
– Record liability
•Management Incentives
– Management prefers not to report a liability
 Cost of Credit
 Share price impact

60. Pensions
– Defined Benefit Plans
Three Concepts
Vested benefits
- Legal issue with respect to employee right. If they
leave the firm prior to achieving retirement conditions
(e.g., age, years of service).
Accumulated Benefit Obligation (ABO)
- Vest & non-vested benefits
- Non-vested benefits are estimated
- “Actuarial” net present value of benefits earned to date
at today’s pay levels.

61. Pensions
– Defined Benefit Plans
Three Concepts
Projected Benefit Obligation (PBO)
- PBO equals …
 “Actuarial” net present value
of benefits earned to date
projected at future pay rates
- The real liability conceptually
• Best estimate of future payments

62. Pensions
– Defined Benefit Plans
Three Elements of Pension Accounting
Record liability for deferred cash flows
- Increase for interest recognized over time
- Decrease for cash payments
Record asset for invested funds
- Recognize earnings on invested funds
- Increase cash contributions to fund
- Decrease for payments made to retirees
Record expense for “service cost”
- NPV of incremental benefit earned for current year services

63. Pensions
– Defined Benefit Plans
Violations of FASB Conceptual Framework
Off-set Revenues and Expenses
Annual pension expense = Net of …
 Interest expense
 Service Cost expense
 Investment Returns
Off-set Asset & Liabilities
Net Pension asset or Liability on Balance Sheet
The Plan is said to be either “over-funded” or “under-
funded”

64. Pensions
– Components of Pension Exp.
1. Service Cost – Increase in PBO because employees have worked
another year.
2. Interest Cost – The PBO is the discounted present value of expected
benefits to be paid to employees. As the payment date gets closer,
interest cost must be recognized (2nd
general principle of long-term
debt)
3. Expected Return on Plan Assets – The off-sets pension costs and
makes pension expense smaller. The expected return is used rather
than the actual return to avoid the effects of the stock market’s
volatility.
4. Prior Year Service Cost – Adjustments to PBO for additional
benefits granted to employees … “sweeteners.”
5. Amortization of Excessive Plan Gains & Losses – Due to changes in
Fund earnings experience or PBO assumptions.

65. Accounting for Dividends
Stock Dividend
Small (less than 20 – 25% of outstanding stock)
Retained Earnings $ FMV
Common Stock $ Par
Additional Paid-In Capital Difference
Large (more than 20 – 25% of outstanding stock)
Retained Earnings $ Par
Common Stock $ Par

66. Accounting for Dividends
Stock Split
Just like a stock dividend, increases the number of shares
outstanding … without impacting Retained Earnings.
No entry is record. Par value and shares outstanding are
adjusted to reflect the split.
PhilDrakeCo has 1,000,000 shares of $10 par common stock.
Following a 2 for 1 stock split, there are 2,000,000 shares outstanding
with a par value of $5.

67. Treasury Stock
Purchase 10,000 shares of PhilDrakeCo at $11 per share.
Treasury Stock $ 110,000
Cash $ 110,000
Reissue Above Cost - $15 per share
Cash $ 150,000
Treasury Stock $ 110,000
Paid-In Capital – TS 40,000
Reissue Below Cost - $5 per share
Cash $ 50,000
Paid-In Capital – TS 60,000
Treasury Stock $ 110,000
Contra-Equity

68. Convertible Securities
Convertible securities (debt and preferred stock) is the
underlying security with an option to convert the security
into common stock. Terms of conversion are typically fixed
(i.e., 50 shares common stock for each $1,000 bond).
For debt, the conversion feature reduces the interest rate
due to the investor … lowers cost of borrowing.
When the security is converted, no gain or loss is
recognized. Thus, the conversion is done at the convertible
security’s book value.

69. Revenue Recognition
The Securities and Exchange Commission (SEC) has
issued authoritative statements in Staff Accounting
Bulletin (SAB) 104.
Revenue, generally, is realized or realizable and earned when all of
the following criteria are meet:
1. There is persuasive evidence that an arrangement exists,
2. Delivery has occurred or services have been rendered*,
3. The seller’s price to the buyer is fixed or determinable, and
4. Collectability is reasonable assured.
* Risk of loss is transfer or no future performance required

70. Research & Development
• Companies engage in R&D with the expectation
of producing profitable future goods and
services. However, there is the risk that these
expenditures will have no value for the firm.
• The resulting assets typically have values
unrelated to the R&D costs.
• Expensed as incurred. Lacks the probable future
economic benefit criteria of an asset.
• Creditors generally do not lend on R&D projects.

71. Restructuring Activities
Most firms experience some type of restructuring.
It is a natural evolution of business.
Restructuring can include employee layoffs, lease
terminations, asset write-downs, moving locations,
closing operations and other reorganizations.
Following the commitment to a formal plan of
restructuring, recognize a liability & expense.

72. Restructuring Activities
Provides management with a tool for earnings
management. The Big Bath Theory.
As the restructuring unfolds, the liability & expense
are updated for the new information.
This creates an incentive to front-load expenses.
Strangely, restructuring costs imposed by a merger
as expensed as incurred. No liability is established
due to past abuses.

73. Accounting for Income Taxes
GAAP
FASB, SEC
Tax law
Congress

74. Book Income
Taxable Income
≠
Timing
differences
Permanent
differences
A timing difference results when a revenue (gain) or expense (loss) enters book income in one period
but affects taxable income in a different (earlier or later) period.
The basics
A permanent difference results when a revenue (gain) or
expense (loss) enters book income but never recognized
in taxable income or vise versa.

75. Temporary Differences
Event
Book
Income
Tax
Income
Def. Tax
Asset
Def. Tax
Liability
Installment Sales Revenue Today Income Later
Product Warranties Expense Today Deduction Later
Bad Debt Expense Expense Today Deduction Later
Rent Rec’d in Advance Revenue Later Income Today
Depreciation Expense Straight-Line Accelerated
Prepaid Expenses Expense Later Deduction
Today
Deferred Tax Liability when Future Taxable Income > Future Book Income
Deferred Tax Asset when Future Taxable Income < Future Book Income
X
X
X
X
X
X

76. Permanent Differences
• Permanent differences will not reverse in the
future. Thus, book and tax will never equalize.
• Common permanent differences:
– Fines and Penalties
– Meals and Entertainment
– Political Contributions
– Officers Life Insurance
– Tax-exempt Interest
• Permanent differences are ignored for
financial accounting purposes.

77. Accounting for Taxes –
Mechanics
Income tax expense is the “plug” after determining
the tax liability and changes in deferred taxes.
1.Record the tax liability
2.Record the changes in the deferred tax accounts
3.Plug “Income tax expense.”
Unusual occurrence – Income tax expense when
there is a net loss.

78. Deferred Tax Assets
Deferred tax assets must pass the definition on an
asset … “probable future economic benefit”
If there is uncertainty realizing the deferred tax asset
(e.g., history of operating losses/profits, unsettled
circumstances, presence of existing contracts or backlog),
then a valuation allowance (contra asset) must be
establish.
The criteria for the valuation allowance is needed is
whether the it is “more likely than not” that the tax
benefits will be realized.

79. Net Operating Losses
The U.S. income Tax code allows firms reporting operating losses to
offset those losses against past or future tax payments.

80. Valuation Allowance
When a valuation allowance is recognized, there is a
corresponding increase in the income tax expense.
If it subsequently determined that the deferred tax benefit will
be realized, then the entry that established the valuation
allowance is reversed. This results in a decrease in income
tax expense and an increase in net income. Some analysts
call this cookie jar accounting.
Also reveals information about the long-term prospects of a
firm’s profitability. General Motors established a $38.6 billion
valuation allowance in the 3rd
quarter, 2007.

81. Effective v. Marginal Tax Rates
• Effective Tax Rate (ETR)
– Income tax expense divided by pretax book income.
– Provides information as to a firm’s tax management.
• Marginal Tax Rate
– Income tax for the next dollar of taxable income.
– For the U.S. companies, use a marginal federal rate of
35% plus estimated 5% state and local tax rate.
• In conducting incremental analysis and after-tax
effects (e.g., interest costs), use the marginal tax
rate.

82. Foreign Currency Transactions
Amerco, a U.S. company, sells goods to a German customer
at a price of 1 million Euros (€) when the spot exchange rate
is $1.50 per Euro.
If payment were received at the date of sale, Amerco would
convert 1 million Euros into $1,500,000.
Instead, Amerco allows the German customer 30 days to pay.
At the end of 30 days, the euro had depreciated to $1.45 per
Euro and Amerco can convert the 1 million euros into
$1,450,000.
How should Amerco account for the $50,000 decrease in
value?

83. Foreign Currency Transactions
Two-transaction perspective:
- The export sale
- The decision to extend credit
Date of Sale
Accounts Receivable $1,500,000
Sales $1,500,000
Date of Collection
Foreign Exchange Loss $ 50,000
Accounts Receivable $ 50,000
Cash $1,450,000
Accounts Receivable $1,450,000
Goes to
Income Stmt

84. Below the line components
Discontinued Operations & Extraordinary Items
- Reported net of tax
- Separate EPS calculations
Proctor & Gamble

85. Earnings Per Share
Very powerful … highly cited, moves markets,
motivates people, affects M&As.
The most important single financial number.
Simple Capital Structure – No potential common
stock (e.g., NO convertible bonds, convertible preferred stock, stock
warrants, stock options)
EPS =
Net Income − Preferred Dividends
Weighted Average Number of Shares Outstanding

86. Earnings Per Share
Complex Capital Structure:
Dual Structure- Basic EPS, Diluted EPS
For Diluted EPS calculation include only dilutive securities,
exclude antidilutive securities.

87. Impact of Conversions & Options
The “if converted” method:
• Assumes that all convertible
bonds are exchanged for stock at
the beginning of the reporting
period.
• But conversion is unlikely if the
stock price ($75) is substantially
below the conversion price
($100).
• The resulting diluted EPS figure
overstates likely dilution in this
case and thus understates EPS.
The “treasury stock” method:
• Assumes that proceeds received
on exercise of the options ($100
per share) are used to buy back
shares at the average market
price.
• If the average market price is
below the exercise price, the
options are not dilutive for EPS
purposes.
• The resulting diluted EPS figure
understates likely dilution and
overstates diluted EPS.