This chapter identifies the different sources of paid-in capital and how to present them on a balance sheet, and explains accounting for a cash dividend, a stock dividend, a stock split, and a retained earnings appropriation. It covers acquiring and reissuing treasury stock, discontinued operations and extraordinary items, prior period adjustments, and earnings per share.
Sources of paid-in capital
Paid-in capital comes from more than the sale of common and preferred stock at par or stated value; it can also arise from amounts received above par, from donations to the corporation, and from other capital transactions, and each source is presented separately in the paid-in capital section of the balance sheet. Together with retained earnings, these accounts make up total stockholders’ equity.
Dividends, stock splits, and treasury stock
A cash dividend reduces both cash and retained earnings once declared, while a stock dividend distributes additional shares and transfers an amount from retained earnings to paid-in capital without changing total stockholders’ equity; a stock split, by contrast, only increases the number of shares outstanding and reduces par value per share, leaving all equity accounts unchanged. Treasury stock, a corporation’s own shares reacquired but not retired, reduces total stockholders’ equity when purchased and is accounted for separately from unissued shares.
Unusual items and analyzing results
Discontinued operations, extraordinary items, and changes in accounting principle each receive specific, separate treatment in the financial statements so a reader can distinguish continuing operating performance from one-time or accounting-driven effects, and prior period adjustments correct errors from earlier years directly through retained earnings rather than through current income. Analysts use earnings per share and the price-earnings ratio to relate a corporation’s profitability and market price to its shares outstanding.
This chapter discusses the nature of standard costs and how they are set, and the advantages and disadvantages of using a standard cost system alongside budgets. It explains how to calculate the six cost variances and determine whether each is favorable or unfavorable, and prepare the journal entries that record them.
Standards, budgets, and their trade-offs
A standard cost represents what a unit of product should cost under efficient operating conditions, set in advance for materials, labor, and overhead, and it works alongside a company’s budgets to plan and control operations. Using standard costs offers advantages such as simplifying inventory valuation and highlighting inefficiencies quickly, but it also carries disadvantages, including the cost of setting and revising standards and the risk that outdated standards mislead managers about current performance.
Computing and recording the six variances
Comparing actual costs to standard costs produces six variances covering materials, labor, and overhead, each of which can be favorable, when actual cost is less than standard, or unfavorable, when it is more. The chapter shows how to calculate each variance and prepare the journal entries needed to record it, isolating the difference between actual and standard cost directly in the accounts rather than leaving it buried in a single actual-cost figure.
Investigating and disposing of variances
Not every variance is worth investigating, so managers apply selection guidelines, generally based on the size of the variance and whether it appears to be a recurring or one-time deviation, to decide where to spend their limited investigative time. Once a period ends, the accumulated variances must also be disposed of in the accounting records, using either a theoretical approach that allocates them to inventory and cost of goods sold or a more practical approach that closes them directly to cost of goods sold.
This chapter defines capital budgeting and explains the effects of poor capital-budgeting decisions, and shows how to determine net cash inflows after taxes for an asset addition and an asset replacement. It covers evaluating projects using the payback period, the unadjusted rate of return, the net present value, and the profitability index.
What capital budgeting decides
Capital budgeting is the process of planning and evaluating long-range decisions that commit a company’s resources for several years, such as whether to add a new asset or replace an existing one, and poor decisions in this area can be costly and difficult to reverse. The starting point for any capital-budgeting evaluation is determining the net cash inflows, after taxes, that a project is expected to generate over its life, since these cash flows, not accounting income, drive the analysis.
Payback period and unadjusted rate of return
The payback period measures how long it takes a project’s net cash inflows to recover the original investment, favoring projects that return cash sooner, while the unadjusted rate of return relates a project’s average annual income to the investment required, without regard to when in the project’s life that income arrives. Both methods are simple to apply but, unlike the methods that follow, neither accounts for the time value of money.
Net present value, profitability index, and working capital
The net present value method and the closely related profitability index discount a project’s expected future cash inflows back to their present value using a required rate of return, allowing projects of different sizes and timing to be compared on a consistent basis; the time-adjusted rate of return instead finds the discount rate at which a project’s net present value equals zero. Because many projects also require an investment in working capital, evaluators must include that investment, and its eventual recovery, in the cash flows being analyzed.
This chapter introduces budgeting for planning and control, defining a budget as a plan showing a company’s objectives and how management intends to acquire and use resources to reach them. It covers the master and responsibility budgets, the human factors that make budgeting effective, and building an operating budget from a sales forecast.
What a budget is for
A budget formalizes management’s plans in quantitative terms, forcing all levels of management to think ahead, anticipate results, and take corrective action before problems occur. Several kinds of budgets serve different purposes, including the master budget, responsibility budgets tied to individual managers, the capital budget for longer-term asset spending, and the planned operating and financial budgets that together project a company’s income statement and balance sheet.
Making budgeting work
A budget succeeds only when top management visibly supports it and when the employees who must live within it participate in setting its goals, since people are more likely to strive toward targets they helped set. Results must be communicated promptly and clearly so employees can adjust their performance, the budget itself must stay flexible enough to be restated if the assumptions behind it change, and managers must follow up continuously rather than treating the budget as fixed once approved.
Building the operating budget
Managers typically begin a planned operating budget in units rather than dollars, forecasting sales units for the year and then, based on that sales forecast and the company’s inventory policy, the units that must be produced. Dollar figures are introduced afterward: expected selling prices and costs are analyzed, a schedule forecasts cost of goods sold, and a separate budget covers selling and administrative expenses, supported by further schedules as needed.
This chapter explains the purposes and uses of the statement of cash flows and where items appear on it, and describes how to calculate operating cash flows under the direct and indirect methods. It covers preparing the statement across operating, investing, and financing activities, and analyzing results with cash flow per share and margin.
Purpose and content of the statement of cash flows
The statement of cash flows reports the cash a company generated and used during a period, classified into operating, investing, and financing activities, and reconciles the change in cash from the beginning to the end of that period. It supplements the income statement and balance sheet by showing where cash actually came from and where it went, which matters because a profitable company can still face a cash shortage if its earnings are not backed by cash.
The direct and indirect methods
Cash flows from operating activities can be calculated under the direct method, which lists actual cash receipts and payments such as cash collected from customers and cash paid to suppliers, or under the indirect method, which starts from net income and adjusts it for noncash items and changes in working capital accounts to arrive at the same operating cash flow figure. Both methods produce identical totals for investing and financing activities; they differ only in how the operating section is presented.
Analyzing cash flow results
Once prepared, a statement of cash flows can be analyzed using ratios such as cash flow per share of common stock, cash flow margin, which relates operating cash flow to sales, and cash flow liquidity ratios, which compare cash resources to current obligations. Applied to a real company’s statement, these measures help assess whether reported earnings are supported by actual cash generation rather than by accounting estimates alone.
