Comprehensive Income and Other Comprehensive Income
The statement of shareholders’ equity describes the investments by owners and distributions to owners in a period and helps the stockholders assess whether the company is performing up to par (Wahlen et al., 2017). However, the statement does not represent the gains and losses from non-owners’ sources. Examples of the non-owners’ sources of income (or loss) are changes in the unrealized gain (or loss) from marketable securities the company holds for sale, foreign currency, pension liability, and “value changes in futures contracts that are hedged positions” (Kenton, 2021). The Accumulated Other Comprehensive Income bridges this gap.
“Accumulated Other Comprehensive Income/(Loss) represents cumulative unrealized gains and losses from the recognition and valuation of certain assets or liabilities” (Wahlen et al., 2017). In the case of Peyton Approved, the company must recognize the unrealized loss on the marketable securities it owns and pension expenses it pays to provide a complete picture of its’ current financial standing. Peyton Approved must record the unrealized loss of $265,000 on its’ marketable securities. When traditional income and income from non-owners are combined, it creates a Statement of Comprehensive Income.
Stockholder Equity
As mentioned in the previous section regarding stockholder equity, it is also called Shareholders’ Equity. It is thoroughly discussed in the Statement of Stockholders’ Equity, but the word itself refers to the “remaining amount of assets available to shareholders after all liabilities have been paid” (Hayes, 2021). Based on the preliminary balance sheet for the company, it has equity of $11,668,540.46. This equity is based on 5,000 preferred stocks at $100 par value, 1,750,000 common stock shares at par value $1, and retained earnings of $9,418,540.46.
The company states that it would like to add two storefront locations and launch a new marketing campaign. The company expects the expansion will require an additional $1,000,000 of capital and considers the following financing options: issuing 10% par-convertible preferred stock, issuing 8% of convertible bonds, or issuing $500,000 each of preferred stocks and bonds. Issuing either par-convertible preferred stocks, bonds, or a mixture of both, will increase the stockholders’ equity by another million, making the shareholders’ equity to $12,668,540.46
Retained Earnings Per Share
Retained earnings itself is the “historical profits earned by a company, minus any dividends it paid in the past” (Fernando, 2021). The company can decide whether to pay dividends, but it goes out of this account when it does. Companies must have a positive and even high number of retained earnings to expand business operations or fund share buybacks to thwart company takeovers.
The issuance of preferred stock impacts earnings per share (EPS). The earnings per share goes lower as the number of outstanding shares increases. Additionally, preferred stock dividends are paid out first and subtracted from the net income to compute the earnings per share (EPS). This change in equity structure may worry shareholders and discourage potential shareholders. Based on the preliminary balance sheet for 2017, Peyton Approved’s EPS is $5.34. This number has been derived by using the balance in Retained Earnings, subtracting the Preferred Stock by 10%, then dividing the result by the number of outstanding shares. It does not consider the potentially dilutive stocks, but as a rule of thumb, the lower the EPS, the less attractive it is to investors and shareholders.
Preferred Stock or Debt
Debt, however, gives the company an ongoing responsibility, but it does not change the current equity structure nor lower earnings per share (EPS). Unlike preferred stocks, the company must pay according to its’ debt contracts. It is usually through monthly payments with interest. However, “interest paid or accrued on your business loan is tax-deductible in most cases” (Payne, 2021). On the other hand, preferred shares “do not actually offer the issuing company a direct tax benefit” (Langager, 2019).
Current Tax Structure
Peyton Approved uses MACRS for tax purposes and a straight-line method for financial reporting. Temporary differences occur because of these two tax structures and need to be adjusted. “When a change in the income tax laws or rates occurs, a corporation adjusts the deferred tax liabilities and assets for the effect of the change. It adjusts the balance of each deferred tax liability and asset as of the beginning of the year in which the change is made, and includes the resulting tax effect in the income tax expense related to its income from continuing operations.” (Wahlen, 2017). Peyton Approved recognizes taxes at 25% of pretax income: 20% to Federal and 5% to State. If this were to change, it would impact its bottom line.
For example, the company had recently adjusted income taxes of $1,500 to the correct effective rate of 25% permanent difference. The company also had to expense $52,325.25 in Deferred tax expense for timing difference on book vs. MARCS depreciation. Expenses directly affect the company’s shareholders’ equity, but other transactions have offset the effect of these transactions. However, the company must carefully treat the current tax structure since it affects its financial statements and ratios.
Capital Lease
A capital lease is “considered a purchase of an asset…entitling a renter to the temporary use of an asset…and is treated…as if it were actually owned by the lessee and is recorded on the balance sheet as such” (Hayes, 2021). That said, on December 31, Peyton Company rented six ovens on a capital lease. There is a rent expense of $20,000, while the lease states that it runs for six years with an implicit interest rate of 5%. After six years, the company will own them.
Because it is a capital lease, the full lease obligation will be reflected on the company’s balance sheet. However, a capital lease may also provide tax benefits. For example, “the full amount of equipment purchases can be written off if an equipment lease is set up. Even if you do not pay the entire amount for the equipment in that year, you can deduct the entire amount on your taxes for the year” (Cabrera, 2018). The purchase price of the six ovens is $106,589.54 or $17,765 per oven, and with interest, that number becomes $120,000 and $20,000 per oven.
While capital leases have advantages, these leases may make the company less favorable to lenders, as certain agreements of some leases may restrict borrowing or tie the company down to obligations. If possible, management may consider operating leases, as these leases do not affect the balance sheet and may keep the debt-to-equity ratios low (Tardi, 2021).
Postretirement Plans
Peyton Approved has recently revised its postretirement plan to provide health insurance to retired employees. Providing this additional service to its’ retired employees shows appreciation and will attract more employees in the future. However, the expenses will be higher with more benefits. Currently, the company has an accrued pension liability of $107,041.70, and with the change, it increased with an additional liability of $43,718.91. These numbers are based on the 60 employees employed by the company and may increase as the number of employees and accrued expenses related to health insurance grow. Postretirement plans are considered liabilities, affecting the company’s balance sheet and financial ratios, especially the debt-related ratios. In the short term, the company is expected to pay the pension liabilities like regular liabilities.
In the long term, the company may run into financial problems. For example, creditors may be discouraged from lending the company money because of the liabilities incurred from postretirement plans. Additionally, the high debt-to-equity ratios may discourage potential investors in short- and long-term situations. Costs of healthcare and living may increase in the future, but with the company tied to the obligation, it may worsen its’ financial situation.
Current Performance
To evaluate a company’s performance, one must use relevant financial ratios. These ratios are derived from a company’s financial statements. The ratios are divided into four categories: profitability, liquidity, solvency, and valuation (Elmerraji, 2022). Profitability is an important aspect, as it checks for earning power, and comprises gross margin, return on assets (ROA), and more.
In this company’s case, it has a gross margin of 68% (Gross profit of $22,962,050.80 divided by sales of $34,005,952.95). For each dollar, the company retains $0.68. Liquidity measures whether a company can repay its debts. The company’s current ratio is 3.79 (current assets of $15,847,105 divided by current liabilities of $4,179,472.80). This number indicates how capable the company is of paying its’ responsibilities. Many more ratios can be used to determine a company’s performance, but with these ratios alone, one can see that this company is performing well. Below is a table of relevant ratios:
Ratio Analysis
Current Ratio 3.791652
Quick Ratio 2.053248
Debt-to-Assets 42%
Gross Margin 68%
Net Margin 36%
Sales-to-Assets 1.748014
Return-on-Assets 85%
Return-on-Investment 1.472128
Inventory Turnover 6.371784
Inventory Turn-Days 56.49909
Accounts Receivable Turnover 4.794638
Accounts Receivable Turn-Days 75.08387
Accounts Payable Turnover 7.101216
Average Payment Period 50.69554
New Credit Policies
In the table above this section, the last four rows focus on the accounts receivable and the accounts payable. According to Akers from Small Business Chron (2012), the accounts receivable ratio determines how long a company takes to collect its payment. In the Peyton Approved Company’s case, the accounts receivable turnover is 4.79 with turnover days of 75. Meanwhile, the “accounts payable turnover shows how many times a company pays off its accounts payable during a period” (Murphy, 2020). This ratio shows that the company can pay its suppliers and other creditors.
Credit policies protect creditors from the risk of loss from extending credit to customers that cannot pay and may come in forms such as collateral and the sort (Bragg, 2021). In addition, it affects the company’s accounts receivable and payable accounts. New credit policies may change these numbers. For example, a positive change may lower these numbers, signaling that the company collects its receivables and pays its’ payables more often and in shorter days. An unfavorable change may increase these numbers, signaling fewer times the company collects its’ receivables and pays its payables.
Retrospective and Prospective Approaches
Accounting errors and changes can happen for any business. However, accountants must correct these errors immediately after they find them. There are two methods to correct an error: retrospective and prospective. Additionally, GAAP recognizes three types of accounting changes: accounting principles, accounting estimates, and changes in a reporting entity (Wahlen et al., 2017). There is one more category, which is the errors.
The retrospective approach requires “that any previously issued financial statements reported for comparative purposes be revised to reflect the impact of the accounting change” (Wahlen et al., 2017). Meanwhile, the prospective approach requires no changes to previously issued financial statements but instead accounts for the current and future changes.
The company has encountered two errors in recording the ovens to rent expense account and the patent to the miscellaneous expenses. The general treatment for these errors is as follows: the patent expense is corrected by crediting the amount, which is $50,000, to remove it from the miscellaneous expense account. After that, the $50,000 is accounted for properly in the patent account and patent amortization account. The four-step process is discussed in detail in the next section.
Four-Step Process
According to Wahlen et al. (2017), these are what comprises the four-step process in correcting an error:
- Analyze the original erroneous journal entry and determine what accounts and/or amounts were recorded in error.
- Determine the journal entry that should have been recorded.
- Evaluate whether the error has caused additional errors in other accounts.
- Prepare the correcting entry (or entries). Any corrections of the revenues and expenses for prior years are recorded as adjustments to Retained Earnings. (Wahlen et al., 2017).
In the Peyton Approved’s case (step one), the error of $20,000 for six rented ovens was charged to the Rent Expense account, and another error for the patent, which is already explained in the previous section. (step two) The cost for the oven should have been recorded in the lease liability account. (step three) This error does not affect other accounts. (step four) The corrective journal entries were made.
Accounting Standards
Financial statements are crucial because it is how the external stakeholders can assess the company’s performance. Accuracy, comparability, and relevancy are three crucial qualities that should be followed. The information described in the financial statements must be accurate and free from errors. If any errors are found, corrective measures must be disclosed, and the error must be corrected. Financial statements must be comparable to other companies’ financial statements. Finally, the information disclosed must be relevant and valuable to stakeholders.
In that sense, the company follows several accounting standards for reporting. This brief has followed the accounting standards and their effects on the company in the following situations or items:
- Other Comprehensive Income (OCI) and Stockholder’s Equity
- The effects of raising $1 million either through bonds, preferred stocks, or a combination of both on the Earnings-per-Share (EPS)
- Current Tax Structure
- Treatment of Capital Leases
- Pension plans and other postretirement benefits
- Evaluation of company performance through financial ratios
- Effects of New Credit Policies on financial ratios
- Accounting changes and errors and their treatment, either through retrospective and prospective approaches
- Four-step process in correcting an error
References
Akers, H. (2012). Importance of Accounts Receivable Ratio. Small Business - Chron.com. https://smallbusiness.chron.com/importance-accounts-receivable-ratio-52542.html
Bragg, S. (2021, January 11). AccountingTools. AccountingTools. https://www.accountingtools.com/articles/credit-policy-sample.html
Cabrera, E. (2018, October 24). Tax Benefits of Equipment Loans and Equipment Leases. SMB Compass. https://www.smbcompass.com/tax-benefits-equipment-financing/
Elmerraji, J. (2022, January 27). Analyze Investments Quickly With Ratios. Investopedia. https://www.investopedia.com/articles/stocks/06/ratios.asp
Fernando, J. (2021). Retained Earnings. Investopedia. Retrieved from https://www.investopedia.com/terms/r/retainedearnings.asp
Hayes, A. (2021). Stockholders’ Equity. Investopedia. Retrieved from https://www.investopedia.com/terms/s/stockholdersequity.asp
Hayes, A. (2021, August 25). Capital Lease. Investopedia. https://www.investopedia.com/terms/c/capitallease.asp
Kenton, W. (2021). Comprehensive Income. Investopedia. Retrieved from https://www.investopedia.com/terms/c/comprehensiveincome.asp
Langager, C. (2019, October 1). Do Preferred Shares Offer Companies a Tax Advantage? Investopedia. https://www.investopedia.com/ask/answers/06/preferredsharestaxbenefit.asp
Payne, K. (2021). How to write off repayment of a business loan. Bankrate. Retrieved from https://www.bankrate.com/loans/small-business/write-off-repayment-of-business-loan
Tardi, C. (2021, September 5). What Is an Operating Lease? Investopedia. https://www.investopedia.com/terms/o/operatinglease.asp#toc-what-is-an-operating-lease
Wahlen, J., Jones, J., & Pagach, D. (2017). The Balance Sheet and the Statement of Shareholders’ Equity. Cengage.com. https://ng.cengage.com/static/nb/ui/evo/index.html?eISBN=9781337119146&nbId=372031&snapshotId=372031&id=124839367&
Wahlen, J., Jones, J., & Pagach, D. (2017). 18-3b Change in Income Tax Laws or Rates. Cengage.com. https://ng.cengage.com/static/nb/ui/evo/index.html?eISBN=9781337119146&id=124839386&snapshotId=372031&
Wahlen, J., Jones, J., & Pagach, D. (2017). Chapter 22. Accounting for Changes and Errors. Cengage.com. https://ng.cengage.com/static/nb/ui/evo/index.html?eISBN=9781337119146&id=124839390&snapshotId=372031&
