W. F. BentzA&MIS Financial Accounting I William F. Bentz Sessions 9 and 10

W. F. BentzA&MIS Statement of Financial Position l the statement of financial position, a primary financial statement, l reporting standards and objectives for contingencies, and l the effect of subsequent events on financial reporting.

W. F. BentzA&MIS Statements of Financial Position (SFP) l Amount and composition of assets, liabilities & equities reported »Classification of assets and liabilities as current or noncurrent »Information about working capital »Information about asset liquidity »Information about the use of leverage »Equity interests of stockholder groups

W. F. BentzA&MIS Current versus Noncurrent l Current assets are those assets that will be converted into cash, used to reduce current liabilities, or consumed (as expenses) in the operation of the business over one year or the operating cycle, whichever is longer.

W. F. BentzA&MIS Current versus Noncurrent l Current liabilities are obligations that will come due or be satisfied within one year or the operating cycle, whichever is longer. l All other liabilities are long-term liabilities.

W. F. BentzA&MIS Working capital (gross) l Working capital represents the liquid assets available to operate a business. Cash, accounts receivable, and marketable securities are short-term sources of purchasing power. Inventories are available for sale or use in the business. Prepaid expenses represents goods and services that have been paid for in advance.

W. F. BentzA&MIS Working capital l Current liabilities are those obligations that must be repaid with current assets or cash flows from operations. Thus, current liabilities represent a drain on the liquid assets available to operate a business.

W. F. BentzA&MIS Net working capital l Net working capital is equal to total current assets minus total current liabilities. Net working capital is the preferred measure of the liquid resources available to operate a business, because it recognizes the obligations--current liabilities--that will require resources within the next operating cycle.

W. F. BentzA&MIS Net working capital l Net working capital is thus an important measure of the solvency and financial flexibility of an enterprise.

W. F. BentzA&MIS Stockholders’ equity l Stockholders’ equity is the total residual interest of equity investors in the assets of the entity »Contributed capital--Investment from the owners (par value + paid-in capital) »Earned capital--Undistributed cumulative earnings of the entity (retained earnings)

W. F. BentzA&MIS Stockholders’ equity l Contributed capital »Par value of common and any preferred stocks »Paid-in capital in excess of par values l Earned capital--The cumulative undistributed earnings of the entity (retained earnings = cumulative income - cumulative dividends)

W. F. BentzA&MIS Stockholders’ equity l Treasury stock consists of the historical cost of common or preferred shares that have been repurchased by the corporation directly from its investors or in the open market. l Reported as a deduction from stockholders’ equity because it represents a reduction in the investment in the firm

W. F. BentzA&MIS Contingencies l A contingency is an issue that is unresolved as of the end of a reporting period, the resolution of which is subject to significant risk and uncertainty.

W. F. BentzA&MIS A contingency l Depends on an external party, event, or conditions for resolution l Is not controllable by the company, i.e. is contingent on conditions of nature or the actions of others l Results from a past transaction, condition, or event

W. F. BentzA&MIS Examples of contingencies l Outcome of a lawsuit regarding patent or copyright dispute l Outcome of a product liability suit l Provision for current income taxes l Outcome of an income tax negotiation or court case concerning prior years

W. F. BentzA&MIS More examples l Provision for uncollectible accounts and notes receivable l Provision for product warranty costs l Estimated useful lives of assets l Estimated value of an acquired company

W. F. BentzA&MIS Recognition - contingent gains l Contingent gains are not recognized in the financial statements l Contingent gain amounts are rarely mentioned in footnote or parenthetical disclosures l There may be some mention by management of an expected contingent gain in the section called MD&A-- Management Discussion & Analysis.

W. F. BentzA&MIS Recognition - contingent gains l Disclosure of prospective contingent gains is apt to be in the form of press releases and presentations to financial analysts. l Consequence: financial reports tend to understate the contingent gains that may be available to an entity. However, most such one-time events are ignored by investors anyway.

W. F. BentzA&MIS Recognition - contingent losses There are three issues to consider when deciding how to report loss contingencies: 1. Issue one is the probability of loss 2. Issue two is the ability of the company to estimate the loss with acceptable accuracy

W. F. BentzA&MIS Recognition - contingent losses 3.Issue three is the materiality of the expected contingent loss.

W. F. BentzA&MIS Losses that must be accrued in the accounts 1.A loss is more probable than not (Pr > 0.5). 2.The probable loss is material in amount. 3.The magnitude of the loss is “reasonably” estimable. Note: In the case of estimates and forecasts, some loss (cost) will occur, so the only remaining issues are materiality and estimableness.

W. F. BentzA&MIS Losses that are not accrued, but are footnoted l Losses that are less probable than not (Pr < 0.5) OR are not reasonably estimable l Losses that are more probable than not (Pr > 0.5), BUT are not reasonably estimable

W. F. BentzA&MIS Losses not disclosed in the financial statements l Losses that are only remotely possible. l Losses that are not specific in nature or are part of the normal risk of being in business

Six possible combinations of estimability & probability.

W. F. BentzA&MIS Contingent losses l Current reporting practice is consistent with the full and prompt disclosure of information that is material to investor decisions. By reporting bad news as soon as it is known, companies hope to earn the confidence of investors and financial analysts. Conservatism argues for the early recognition of losses, while recognizing gains only when realized.

W. F. BentzA&MIS Subsequent events l Sub-se-quent (sub′si kwant), adj. 1. Occurring or coming later or after: subsequent events. The Random House Dictionary of the English Language (2 nd ed.)

W. F. BentzA&MIS Subsequent events l These are events that occur after the end of a fiscal year, but before the audited financial statements for that year have been issued. l Type 1 subsequent events have their origins in the fiscal year just ended and provide confirming or disconfirming information.

W. F. BentzA&MIS Subsequent Events-2 l Type one subsequent events may result in the revision of estimates or other adjustments in light of the information that becomes available after year-end, but before the related statements are issued. When appropriate, the accounts involved are adjusted to reflect the new information.

W. F. BentzA&MIS Subsequent Events-3 l Type two subsequent events do not relate to the year just ended, but they constitute important information that should be disclosed to investors. However, since the information is not based in a prior year, no adjustments are made to the financial statements. Instead, type 2 events are disclosed in the footnotes to the prior year statements.

W. F. BentzA&MIS Statements of Financial Position l Aka balance sheets