GSBA 510 Lecture Notes PDF

08/26/24: Class 1 - Class Introduction, Financial Accounting & Business Decisions (Ch. 1) Class Introduction - Process of looking at transactions, deciding their financial impact and recording that → then preparing financial statements that you issue to your shareholders - Accounting...

08/26/24: Class 1 - Class Introduction, Financial Accounting & Business Decisions (Ch. 1) Class Introduction - Process of looking at transactions, deciding their financial impact and recording that → then preparing financial statements that you issue to your shareholders - Accounting is “the language of business” (a scorecard) → summarizes what a business is doing in a financial/quantitative sense CHAPTER 1 Forms of Business Organizations 1. Sole proprietorship - A business owned by one person - The most common form of business 2. Partnership - A voluntary association of two or more persons for the purpose of conducting a business 3. Corporation - A separate legal entity - The owners of the corporation are the stockholders - The dominant organizational type Sole Proprietorship - Advantages - Easiest to form - Tax advantages (single taxation) - Owner can control - Disadvantages - Unlimited liability - Difficult to transfer ownership (key person problem) and raise capital - Variants - DBAs Partnerships - Advantages - Relatively easy to form - Tax advantage (single taxation) - Broader skill set - Disadvantages - Unlimited liability (GPs: Joint and Several) - Difficult to transfer ownership and raise capital - Variants - LPs and LLPs Corporation - Advantages  - Easiest to raise capital - Easiest to transfer ownership - Protection for the stockholders against personal liability - Disadvantages - Business taxed and owners taxed (double taxation) - Hard to establish and is costly - Expensive to be a publicly traded company - Variants - LLCs and Sub-S Select the correct answer – Each of the following is an attribute of a corporation except a) Easiest to transfer ownership b) Double taxation c) Owners have unlimited liability d) Easiest to raise capital Business Activities - Three types of business activities reflected in financial statements 1. Operating 2. Investing (you need to invest in the assets your company needs to succeed) 3. Financing - Fourth type of business activity 4. Planning Business Activities - Operating - The day-to-day activities of producing and selling a product or providing a service - The reason the company exists Business Activities - Investing - A company needs to purchase resources in order to run its day-to-day operations - Investing activities involve both the acquisition and disposition of items such as land, buildings, and equipment - Money needed to make an investment in such items can be obtained from either financing activities or from cash accumulated from running the business profitably - A lot of this will be PPE (property, plant, and equipment) but it could also include patents, other types of intellectual property, etc Business Activities - Financing - A company needs to acquire money in order to support its operations - Debt financing - Borrowing money from creditors - Equity financing - Selling stock to investors Select the correct answer – Which of the following is an example of a financing activity? a) Acquisition of land. b) Borrowing money from a bank. c) Producing and selling a product. d) Disposition of old equipment. Accounting Information - Definition of Accounting: - Process of measuring the economic activity of a business in terms of dollars, and then communicating those results to users - Users are classified based on whether they are external (stockholders, government regulators, the bank, SEC, etc) or internal (management, HR, finance, etc) to the entity being reported upon Accounting Information and Its Use - Financial Accounting Information - For External Users - Results of operating activities - Income statement (shows accruals, income and expenses) - Financial position - Balance sheet (assets, liabilities, shareholders’ equity) - Cash flows - Statement of cash flows (what happened to our cash, how liquid are our assets) - External Users (examples) - Investors need information that is useful in valuing the company, such as its profitability - Creditors need information on the company’s credit worthiness, such as its ability to repay its loans - Many other users, such as labor unions need to know the company’s ability to raise the pay of its members (auditors, legal professionals, etc) - Managerial Accounting Information - For Internal Users - Used for internal decision-making - Examples: pricing products and budgets - Typically proprietary in nature - Only shared internally - Internal Users (examples) - Management needs to know the profitability of each division - The finance department needs to know if there is enough cash to pay its short-term expenses  - Human resources needs to know the effect of a four percent raise for all employees Ethics and Accounting - Ethics deals with the values, rules, and justifications that govern one’s way of life - Written code of ethics help guide the behavior of employees - Accounting organizations such as the American Institute of Certified Public Accountants have a professional code of ethics - Unethical behavior can result in misleading financial statements - Sarbanes-Oxley Act of 2002 was written to help deter unethical behavior (the CEO and CFO have to certify the financial statements and if they’re fraudulent, it is considering a criminal offense) after Enron fraudulent accounting activity - Required companies to set up a system of internal controls and have those controls audited → your accounting system has to be set up to produce accurate information; there needs to be control in place so there is no space for people to act unethically - Questionable financial reporting can be deemed as “becoming aggressive” to then committing “accounting fraud” → investors need to have accurate and truthful financial data and information The Accounting Process - The Accounting Process: Accounting is the process of measuring economic activity of an entity in monetary terms and communicating the results to users - The measurement process must: 1. Identify the relevant economic activity 2. Quantify these activities 3. Record the results - The communication process: 4. Prepares financial reports to meet users’ needs (follow the accounting standards that exist for comparability) 5. Helps interpret the results for users - The process is first at the transaction level and then we need to summarize what happens after a certain period of time - US publicly traded companies file reports to the SEC quarterly - Wall street investors vs main street investors - The FASB is trying to make accounting understandable to the main street investors as much as the wall street investors are able to (disclosure, information, etc); SEC has a hand in this as well 08/26/24: Class 2 - Chapter 1 Continued & Chapter 2 What are “Generally Accepted Accounting Principles”? - G.A.A.P - The standards, rules and procedures that accountants follow in preparing financial reports - Using a common set of rules allows comparability across companies - GAAP changes over time to accommodate new types of transactions and circumstances - GAAP differs across countries - Efforts are being made to create greater international harmony - 80/90% of IFRS standards are identical to US GAAP but they are not identical - We allow FIFO inventory in US GAAP and IFRS but LIFO is only allowed under US GAAP (reduces taxation) - Impairment (if an asset isn’t worth what it’s booked at, you can reduce the asset and you take a loss) → US GAAP and IFRS handle impairment differently - US GAAP vs IFRS → 60% follow IFRS standards (about 140 countries), US GAAP is 40% because some foreign companies want to be traded in the US exchange and be comparable to US companies - GAAP are not laws themselves although sometimes if you break them, you may be breaking the law Financial Accounting Oversight - What is the US Securities and Exchange Commission (SEC)? - A federal agency whose primary focus is to regulate the interstate sale of stocks and bonds - The only governmental agency - There are also securities organizations/regulators in most nations - Mission: to ensure the smooth functioning of capital markets & to protect investors - With smooth functioning, the economy can grow - How does the SEC know when to step in and investigate a corporation? Division of corporation finance is comprised of accountants, lawyers, etc - Companies will have to file restatements if they made a mistake - The division of enforcement handles cases where the division of corporation finance believes there may be fraudulent activity from a company statement (they work with the FBI, Department of Justice, etc) - Whistleblowers can report to the SEC - US exchange act of 1934 → first US law mandating the disclosure of financial statements and books/records for more transparency - What is the Financial Accounting Standards Board (FASB)?  - A nongovernmental entity in charge of creating US GAAP (but it is funded by the SEC) - FASB has codified how GAAP is organized and communicated - The SEC still has legal authority because of the US Exchange Act of 1934 but they delegated standards/principle setting to the private sector (FASB) → they created an independent body to create standards under the authority of the SEC - When FASB creates regulations … consider the cost/benefit and administrative burden & the SEC needs to agree that a new regulation is the best way to counter fraud than administering a different rule - Practical expediency is the goal - Accounting rules have to track changes in the economy and the overall changes in how people live and make money - What is the Public Company Accounting Oversight Board (PCAOB)? - Creates auditing standards, known as generally accepted auditing standards (GAAS) - Oversees and disciplines the auditing profession - A.org that’s fully funded by the US SEC - Oversight on the auditors; a peer review system existed prior to this and there was a conflict of interest - International Financial Reporting Standards - International Accounting Standards Board (IASB) - Taken the lead role in formulating international accounting principles - International Financial Reporting Standards (IFRS) - Approximately 140 nations or reporting jurisdictions require or permit its use - Helps investors compare companies across different countries Financial Statements - Balance Sheet - Income Statement - Statement of Stockholders’ Equity - Subcomponent of the balance sheet - Statement of Cash Flows - Established later on because companies were positive in net income but went bankrupt because they didn’t have cash - How much is our cash increasing/decreasing each year and in what way? Balance Sheet - Reports the assets, liabilities and stockholders’ equity - Over time or point in time? - Point in time! - What are the three elements?  1. Assets―the firm’s resources 1. Liabilities―the firm’s obligations 2. Stockholders’ equity―the stockholders’ claim on the assets of the firm - The accounting equation: - Assets = Liabilities + Stockholders’ Equity - The “Holy Grail” of Accounting Income Statement - Reports the results of the firm’s operating activities - Over time or point in time? - Over time! - What are the basic elements? 1. Revenues―increases in resources from operating activities 2. Expenses―decreases in resources from generating revenues - Revenues – Expenses = Net Income Statement of Stockholders’ Equity - Reports the events causing an increase or decrease in a company’s stockholders’ equity during a given period of time - Consists of two parts: 1. Contributed capital from stockholders in exchange for shares 2. Earned capital or Retained Earnings is the cumulative earnings, less the dividends that have been distributed to the shareholders - Some companies have a separate statement of retained earnings, but most include retained earnings as part of the statement of stockholders’ equity Statement of Cash Flows - Reports a company’s cash inflows and outflows during a given period of time 1. Cash flow from operations reports the cash spent on operating expenses and cash received from the sale of goods or services - Sort of comparable to operating income 2. Cash flow from investing includes the cash payments and receipts when a company buys and sells long-term assets that it uses in its operations 3. Cash flow from financing reports the issuance and repurchase of company stock and the cash borrowed from and repaid to creditors - Liabilities and equities - All about the fundraising/financing Relations Among the Statements (Articulation → financial statements are intertwined) a. Net income from the income statement is used to compute ending retained earnings on the statement of retained earnings b. Ending common stock, retained earnings, and total equity from the statement of stockholders’ equity is shown on the balance sheet c. The ending cash balance on the statement of cash flows is shown on the balance sheet Relations Among the Statements Pt. 2 a. The beginning-of-period balance sheet shows the company’s financial position at the earlier point in time b. The income statement, statement of stockholders’ equity, and statement of cash flows report activity for a period of time c. The end-of-period balance sheet reports the company’s financial position at this later point in time Select the correct answer – Which of the following financial statements displays a company’s revenues and expenses? a. Balance Sheet b. Statement of Cash Flows  c. Statement of Stockholders’ Equity d. Income Statement Additional Information - Annual Report in Form 10-K (once a year) - All public companies must file a Form 10-K with the Securities and Exchange Commission (SEC) - Form 10-Q comes out quarterly (3 interim quarters for the 10-Q and then the 10-K is due at the end of the annual period which replaces the 10-Q) - Form 10-K includes: - The four primary financial statements - Balance Sheet, Income Statement, Statement of Stockholders’ Equity, Statement of Cash Flows - Management Discussion and Analysis (MD&A) - Notes to Financial Statements - Auditor’s Report - A 10-K is subject to “big R” and “little R” restatements → “big R” is a bigger error/mistake that may be grounds for litigations but “little R” happens when an accounting rule changed or something like that - Management Discussion and Analysis (opinions will be present here about competitors, the industry & managerial beliefs, etc) - Management’s interpretation of the company’s recent performance and financial condition - Management’s “forward-looking” opinions - The “safe harbor” against litigation where managers can speak freely about their company’s performance; very helpful - Notes to Financial Statements (no opinions) - Contains information about assumptions, estimates, measurement procedures, and details behind the summary numbers - Good if you want more detail/information about specific lines in a financial statement - Could be several pages long → helps you understand more information like where a company pays income taxes and why their income may be taxed at different levels year after year - Very factual with no opinions; meant to give you more information in a very matter-of-fact why - Auditor’s Report - The report of the independent auditor containing an opinion regarding the financial statements - State that a company is not materially deficient in their controls  - The controls within a company ensures that a company will produce accurate financial statements over and over again (mitigates errors and fraud) - Need to have checks & balances → the person who approves expenditures is not the same person that issues a check (an example of a control) - Accounts Receivable and Accounts Payable are two different departments (another example of a control) - CAMS → critical auditing matters; auditors are obligated to report on their concerns - Trying to get companies be more forward looking in their loss reserves instead of just basing entries on historical data - A lot of concern on CECL (current expected credit losses) - Financial institutions or companies that lend out money - Since new CECL standards have been implemented - This gives you even more information from the auditor’s report than ever before Technology in Accounting - Business Intelligence refers to the tools used in making data-based decisions - It would be impossible to do this manually with thousands of journal entries and transactions, so computing power must be used - Data Analytics refers to computational techniques which reveal patterns, trends and associations in human behavior - Data Visualization is the tool used to explain and disseminate the results of data analysis - Blockchain is a “distributed ledger” accounting system to track transactions (blocks) - Each member of the peer-to-peer network of users stores a copy of the encrypted transactions, resulting in a highly secure record of business transactions - Members include customers and suppliers (seamless transactions) - How do you understand the inputs and outputs of the blockchain as just one block? One of the challenges of blockchain - Meant to automate commerce and make the supply chain more efficient Environmental, Social, and Governance (ESG) - Socially Sustainable Investing - Companies are focused on more than just the bottom line of the traditional income statement - Financial responsibility goes hand-in-hand with social responsibility - Financial performance - Social performance - Environmental performance - Sustainability Reporting  - March 6, 2024: The SEC adopted final rules to mandate climate risk disclosures by public companies and in public offerings CHAPTER 2 The Accounting Cycle 1. Analyze - Analyze transactions from source documents 2. Record - Record transactions/making journal entries - A trial balance is just a sum by account of all the transactions you’ve recorded during a period - This is before any adjustments are made on entries 3. Adjust - Adjust accounts - Ex: when you buy a piece of equipment you will use for 5 years (capitalize this asset) → you must make an adjustment at the end of the period and depreciate the piece of equipment - Deferring the asset when you first capitalize it - An adjusted trial balance is after all adjustments have been made to entries → this is what you use for reporting financial statements 4. Report - Prepare financial statements 5. Close - Close temporary accounts - Permanent accounts are balance sheet accounts but revenues and expenses need to be zeroed out at the end of every period (these are the temporary accounts) 09/04/24: Class 3 - Chapter 2 Cont. & Chapter 3 Analyzing Transactions - The accounting equation provides a convenient way to analyze and summarize accounting transactions - Assets = Liabilities + Stockholders’ Equity Accounting Transaction - An economic event that must be recorded in the company’s accounting records - An event that affects any of the elements of the accounting equation―assets, liabilities, or stockholders’ equity - The accounting equation must stay in balance, therefore at least two elements are always affected by each recorded transaction - Double-entry accounting The Accounting Equation Expanded Select the correct answer – The first step in the accounting cycle is a) Report b) Analyze c) Record d) Adjust The Accounting Equation: An Illustration - Gloria De Luca established Della Gloria Pizzeria on December 1st of the current year. The following slides illustrate several accounting transactions - Be sure to note that the accounting equation remains in balance following the recording of each transaction - Assets = Liabilities + Stockholders’ Equity Issued Stock - Issued Stock: On December 1, Gloria invested $30,000 cash in exchange for the company’s common stock (contributed capital) - You need to invest in a company (first step) Paid Rent in Advance - Paid Rent in Advance: On December 1, Della Gloria Pizzeria prepaid a year’s building rent at $500 per month (12 x $500 = $6,000) Purchased Supplies Inventory on Account - Purchased Supplies Inventory on Account: On December 1, Della Gloria Pizzeria purchased pizza ingredients on account totaling $3,000 - Long-term vs current assets (most prepaid assets are current assets because they are usually prepaid for a year or so, not super long term) Signed Bank Note for Cash - Signed Bank Note for Cash: On December 1, Della Gloria Pizzeria obtained a two-year bank loan in the amount of $20,000. Annual interest charges on the note amount to 6 percent and are due each November 30 Purchased a Delivery Van - Purchased a Delivery Van: On December 2, Della Gloria Pizzeria purchased a delivery van for $15,000 using cash from the bank loan Hired a Part-Time Employee - The employee will be paid $1,000 per month - There is no accounting transaction at the time of hiring since no asset, liability, or stockholders’ equity account is affected at this time Sold Pizzas - Sold Pizzas: During December, Della Gloria Pizzeria sold $12,000 of pizzas for cash Paid Employee - Paid Employee: At the end of the month, Della Gloria Pizzeria paid its part-time employee $1,000  - If we hadn’t paid in cash and had to defer the payment, we would have to make a “wages payable” account as a liability Transaction Summary - Transaction Summary: At the end of the month, Della Gloria Pizzeria’s unadjusted balances are summarized. Net income will be lower once adjustments are made - An adjusted trial balance comes after and then financial statements can be generated - COGS (inventory changes), depreciation (capitalize assets → used for more than one accounting period so we can defer the expense), interest payable, etc Select the correct answer – Purchasing supplies on account involves a) An increase and a decrease to assets b) An increase in assets and a decrease to liabilities c) An increase in assets and an increase to liabilities d) A decrease to assets and a decrease to liabilities Transaction Analysis Template - Transaction Analysis Template: The Transaction Analysis Template is a “shorthand” way of communicating how a transaction or event affects the financial statements. The Template shows which financial statement components are affected, as well as the amount and direction of the effect (every action involves a reaction) Transaction Analysis Template Pt. 2 - Transaction Analysis Template: The effect of the pizza sales (Transaction 6) on the horizontal worksheet is reproduced below. Arrows show how the entries on the horizontal worksheet map into the balance sheet and income statement as reflected in the Template The “Account” System - The basic component of an accounting system is the account - The account is an individual record of the increases and decreases in a specific asset, liability, or stockholders’ equity item Recording Transactions - The initial step in the analysis and recording process is to identify evidence of a business transaction - Evidence comes in the form of source documents - Source documents include a supplier’s invoice, a sales receipt, and a bank deposit slip - A transaction is recorded once the source document is analyzed to determine which accounts are affected and the amounts involved Chart of Accounts - A chart of accounts is a list of the titles of all accounts in a business’s accounting system - Accounts are grouped by the five major components of the expanded accounting equation: assets, liabilities, stockholders’ equity, revenues and expenses The General Ledger - A general ledger is a listing of each account and the amounts from all transactions making up the balance in the account - The ending balances are used to prepare the company’s financial statements CHAPTER 3 Accrual Accounting involves 1. Double entry accounting 2. Revenue recognition & 09/09/24: Class 4 - Chapter 3 - Net income doesn’t completely capture your change in wealth based on your operations - Specifically on certain parts of the income statement - Creation of certain assets mean a change in wealth → but that isn’t always captured in net income (net income really only focuses on operational changes in wealth) - Economic income (change in wealth) vs net income (GAAP) - Accrual accounting is the basis of what we’ll be talking about for the rest of the semester - Required by GAAP and revenue recognition Accrual Accounting - Required by GAAP - Accrual accounting reports accounting transactions irrespective of whether the cash has been received or paid - Based on two primary principles: - Revenue recognition - Expense recognition (matching) Revenue Recognition - The Revenue Recognition Principle requires companies to - Recognize revenues in the period in which the company satisfies its contractual obligation to the customer - In an amount equal to the consideration the company expects to receive Revenue Recognition Principle - Revenue is recognized when earned - Cash may be received: (1) at the same time, (2) after, or (3) before revenue is recognized. For example… - Della Gloria Pizzeria sells pizzas to customers for cash. Cash is received at the same time the revenue is recognized - Cash may be received after revenue is recognized - Della Gloria sells pizzas to Gelson’s Market on account. Cash is received after the revenue is recognized  - When the revenue is recognized… - Then when the cash is eventually received... - Cash may be received before revenue is recognized - Ralphs Grocery store pays Della Gloria in advance for pizzas. Cash is received before the revenue is recognized. - When the cash is received… - The unearned revenue will be revenue we earn eventually (we’ve deferred the recognition of it → we’re capitalizing it by deferring it as opposed to making it apart of the income statement) - Then, when the revenue is eventually recognized.... Expense Recognition (Matching) - Expenses are recognized in the same period as the income they generate - This is called the MATCHING PRINCIPLE - If they cannot be matched, expense immediately - It is the recognition of revenue, and not the payment of cash that determines when an expense is recognized - Cash paid when expense incurred - Assume Della Gloria pays $150 in wages to an employee who works as a cashier in its pizzeria - Revenue is recognized as the cashier sells pizzas. Therefore, wages should be expensed in the same period - Cash paid before expense incurred - Assume Della Gloria buys $50 worth of ingredients to make the pizzas. - The purchase is not recognized as an expense until Della Gloria sells the pizzas it produces (decrease cash and increase supplies; no expenses until the pizzas are made and sold) → capitalizing this purchase to later expense it - In the period the revenues are recognized, the expense will also be recognized - Regardless of when the cash is paid, the ingredients will be expensed in the same period as the revenues that they generate - This “matches” the expenses with the revenues - Cash paid after expense incurred - Della Gloria owes $100 for utilities for the month. The utility company bills at the end of the month  - Then when the cash is paid to the utility company… Select the correct answer – Which of the following is a primary principle underlying accrual accounting? a) Materiality b) Cash flows c) Revenue recognition d) Income statement Unadjusted Balances - Unadjusted Balances: At the end of the month, Della Gloria Pizzeria’s unadjusted balances are summarized - We can generate a preliminary income state and balance sheet based on the unadjusted trial balance (which is based on the journal entries we made) Types of Adjustments  - Deferrals → do we leave these on the balance sheet or make a part of the income statement? - If it's not today’s expense, we defer it - Accruals → more common on the expense side, less common on the revenue side - In the case of revenue, you haven’t picked up a transaction yet - People are motivated to recognize revenue immediately (generally, you won’t have a lot of accrued revenue) - Lots of accrued expenses (expense associated with the current account period but you won’t pay off until the future) Deferred Revenue (*hang it up on the balance sheet but not apart of the income statement → capitalizing this revenue*) - Recognize revenue earned on products or services for which cash was received in a prior period - Companies may receive cash in advance for goods or services not yet rendered - Increase to Cash - Increase to Unearned Revenue (or Advances from Customers or Deferred Revenues) - Unearned Revenue is a liability account - Represents an obligation to deliver goods or services to customers in a future period - When goods or services are rendered, the revenue is earned, so an adjustment is required - Decrease to Unearned Revenue - Increase in Revenue - When cash is received before it is earned, the liability account Unearned Revenue is increased - When the revenue is ultimately earned, the Unearned Revenue account is reduced and an earned revenue account is increased (only right side of balance sheet is affected) Deferred Expenses (pre-paid → usually for current assets but sometimes long term assets too) - Recognize expenses incurred for cash expenditures made in a prior period - Many expenditures benefit multiple accounting periods, for example - Purchases of building, equipment, supplies - Prepayments of rent and advertising - Payment of insurance premiums covering more than one period - At the time of the expenditure, these outlays result in an increase in an asset account (e.g., prepaid rent) - At the end of every accounting period, the portion of the expenditure that has expired is estimated and recognized as an expense - Did we use up any of our inventory, pre-paids, etc during this accounting period? - The adjustment reduces the asset account and increases an expense account - Deferred Expenses: - (1) Della Gloria Pizzeria determined the end-of-year supplies inventory to be $500. This represents the amount of the $3,000 inventory purchase that has not been used up to produce pizzas. Thus, $2,500 of supplies have been used. This is recorded as an expense and termed “cost of goods sold” - (2) Della Gloria Pizzeria prepaid one year of its $500 per month building rent. Paid $6,000 for one year of rent on December 1. Represents $500 per month ($6,000/12). Thus, an adjustment of $500 for rent expense must be recorded for the month of December - (3) Della Gloria’s depreciation expense. - Depreciation is the process of allocating costs of long-lived assets that benefit more than one year (special just for PPE) - Buildings, equipment, vehicles, etc... - A portion of the asset’s cost is expensed each period - Depreciation expense  - Accumulated Depreciation - A contra account that offsets long-lived asset account - - Accounting depreciation tries to capture economic depreciation (recoup our costs over a period of time that we think is normal for this asset → we might have fully depreciated assets in our books if we end up maintaining an asset very well) - (3) Della Gloria Pizzeria purchased a used delivery van for $15,000. The van is expected to have a useful life of five years, at which time it will be completely worthless. Monthly depreciation expense is computed as $15,000 / 60 months = $250 per mo. Accrued Revenue (doesn’t happen very often) - Recognize revenue earned on sales for which the cash will be received in a later period - Adjustment is required to recognize revenues during the period in which they are are earned - Increase to Accounts Receivable - Increase to a Revenue account - When the cash is received in a future period - Increase to Cash - Decrease to Accounts Receivable - (4) Della Gloria’s accounts receivable Della Gloria Pizzeria delivered an order for $200 of pizza on December 31. The customer will not be paying for the pizza until January 7th of the next year. Thus, an adjustment is required to accrue the revenue and to record the amount receivable from the customer Accrued Expenses - Recognize expenses incurred for which cash will be paid in a later period  - Examples of expenses that are incurred before the period in which they are paid: - Employee wages - Utilities - Income taxes - Adjustment required to recognize expenses during the period in which they are incurred - Increase a liability such as wages payable on the balance sheet - Increase a related expense account in the income statement - When the cash is paid in a future period - Decrease in Cash - Decrease in the liability account 09/11/24: Class 5 - Chapter 3 Cont. Quiz #1 will be on Monday chapters 1-3 (open note and open book → prepare notes from ch. 1-3 this weekend) and on the class syllabus - More conceptual questions - Can’t go back on questions after you answer them on the quiz Fully adjusted balance sheet / adjusted trial balance Select the correct answer – Which of the following is not a type of accrual adjustment? a) Common stock b) Accrued expenses c) Prepaid expenses d) Unearned revenue Prepare Financial Statements - The adjusted balances provide the necessary information. - Prepare the statements in the following order: 1. Income Statement - We need net income that then flows into statement of stockholders equity 2. Statement of Stockholders’ Equity - Retained earnings number then flows into balance sheet  3. Balance Sheet - Once we have the balance sheet, we are ready for statement of cash flows 4. Statement of Cash Flows Della Gloria Pizzeria Income Statement Della Gloria Pizzeria Statement of Stockholders’ Equity Della Gloria Pizzeria Balance Sheet Quality of Accounting Numbers - The degree to which a company’s financial statements fairly present its underlying economic financial condition and performance - Accrual accounting involves many estimates and judgments - Analysts judge how conservative or aggressive the estimates are - The more closely the financial statements fairly present the company’s underlying economics, the higher the quality of the financial statements - Example: If there’s 0 cash flow but a positive net income, you must be accruing revenue or capitalizing some expenses that you paid for but not recognizing as expenses. There could be good reasons for that in the short-term but in the long-term, there won’t be negative or 0 cash flow with a positive net income - Example: credit terms of net 10 when the industry is net 30 → losing sales to their competitors. The business then goes to net 30 (for 20 days they don’t receive cash but their net income will still be positive because they’re recognizing the revenue). This would be okay because of their business decision to change to net 30 (not because of fraud, etc). This shows there can be reasons why 0 cash flow or negative cash flow can be present with positive net income - Remember WorldCom → egregious example of over capitalization of expenses (fraud) - They overstated their earnings but over capitalizing expenses - Goal of due diligence → to understand the quality of the numbers!  - Trying to determine earnings quality Select the correct answer – The first financial statement to be prepared a) Income statement b) Balance sheet c) Statement of cash flows d) Statement of stockholders’ equity Permanent and Temporary Accounts - Permanent accounts are accounts whose balances carry over from one accounting period to the next. - These accounts are reported in the Balance Sheet - Temporary accounts are used to gather information for a particular accounting period and then reset to zero by transferring the balance to a permanent account - These accounts are reported in the Income Statement Closing Process - Temporary accounts are zeroed out at the close of the accounting period in order to “start fresh” in the next period - The balances in these accounts are transferred to Retained Earnings―a permanent account - Dividends are also closed to Retained Earnings Summary of the Accounting Cycle 09/16/24: Class 6 - Quiz #1 & Chapter 4 Equations: - Assets = Liabilities + Stockholders’ Equity - Net assets = Stockholders’ Equity - Net Assets = Assets - Liabilities CHAPTER 4 Conceptual Framework - FASB’s Conceptual Framework - Defines the objectives of financial reporting - Provides a list of qualitative characteristics that make financial information useful - Constantly in the process of updating and refining US GAAP Financial Reporting Quality - Objectives of Financial Reporting  - Goal of financial accounting is to facilitate the efficient allocation of resources - Financial reports provide investors, creditors and lenders with information that is useful in making investment decisions - Financial reports provide information about: - Company resources - Claims against those resources - How effectively and efficiently the company deploys its resources - Qualities of Useful Accounting Information - Information must be relevant - Predict value or confirmatory value - Must faithfully represent what it purports to represent - Substance over form - Fair presentation - Completeness - Neutral - Other characteristics include - Comparability - Verifiability (by the independent and internal auditors, regulators, etc) - Timeliness - Understandability - Materiality Finding Financial Accounting Information - Where do investors and prospective investors find the accounting information they need? - Securities and Exchange Commission (SEC) requires quarterly(10Q) and annual reports (10K) from public companies - 8K comes out when there’s a specific event that’s significant to shareholders or other users of financial statements - Includes primary financial statements, footnotes, and discussion by management - Must be audited by an independent auditor (much more regulated now than in the past → peer reviews used to be the standards) - Available at the SEC’s website and typically, the company’s website Classified Balance Sheet - Presents the assets and liabilities of a business in separate subgroups - Common groupings: - Current assets - Long-term assets - Current liabilities - Long-term liabilities - Stockholders’ equity Current Assets - Cash and other assets that can be converted into cash or used up within the normal operating cycle, or one year, whichever is longer - Generally less than one year because operating cycle is usually 30, 60, or 90 days - In other current assets → could include prepaid assets, short term investments, etc - Some prepaid assets may be a long term asset - Listed in order of liquidity Long-Term Assets - Assets the company does not expect to convert into cash during the normal operating cycle, or one year, whichever is longer. - Common types: - Property, plant, and equipment - Intangible assets - Goodwill → an intangible asset that represents the extra amount paid to acquire a company above the fair market value of its assets - Comes from a business - Patents, intellectual property, etc - Other long-term assets - Long-term investments (loans, bonds, equity, etc) Property, Plant, & Equipment - Common examples: - Land (you don’t depreciate land because it doesn’t go away) - Buildings - Equipment - Vehicles - Furnishings Intangible Assets - Assets that lack a physical presence - Common examples - Brand names - Copyrights - Patents - Trademarks Current Liabilities - Liabilities that must be settled within the normal operating cycle, or one year, whichever is longer - Common examples: - Accounts payable - Accrued expenses payable - Short-term notes payable - Other current liabilities - More examples: current portion of long-term debt, interest payable, unearned revenue, dividends payable, income taxes payable, notes payable, etc - For the most part, unearned revenue will be a current liability - Most notes payable are short-term Long-Term Liabilities - Obligations not due to be settled within the normal operating cycle, or one year, whichever is less - Common examples - Long-term notes payable - Bonds payable - More examples: leases, mortgages, unfunded pension liabilities, etc Stockholders’ Equity - The residual ownership interest in the assets of a business after its liabilities have been paid off - Two major categories (common stock & retained earnings) - Amount invested by stockholders - Common stock - Cumulative net income of the business that has not been distributed to its stockholders - Retained earnings Balance Sheet Presentation - Two formats are used - Account form - Report form - Account form - Assets on the left - Liabilities and Stockholders’ Equity on the right - Report form - Assets on the top - Liabilities and Stockholders’ Equity below Select the correct answer – Which of the following is not a subgroup on a classified balance sheet?  a) Current liabilities b) Long-term assets c) Net sales d) Stockholders’ equity Single-Step Income Statement - A single-step income statement is the simplest form of an income statement - The sum of the expenses is subtracted from the sum of the revenues in a single step to arrive at net income Multi-Step Income Statement - A multi-step income statement presents revenues and expenses in distinct categories to aid in financial analysis - Because service companies do not sell goods, they do not show cost of goods sold Merchandising Company: Multi-Step Income Statement - Cost of goods sold is subtracted from net sales to determine gross profit on sales - This amount represents the profit left after considering cost of goods sold - This is the amount available to cover a business’s operating expenses (such as wages and rent), hopefully leaving enough left over for a profit Multi-Step Income Statement - Operating expenses are those expenses that relate to the company’s primary operating activities - Other income and expense includes revenues and expenses not part of primary operating activities - Examples include interest income, interest expense, and gains or losses from the sale of property, plant, and equipment - A multi-step income statement provides more detail to the financial statement user with four measures of company performance: 1. Gross profit on sales 2. Income from operations 3. Income before income taxes 4. Net income Select the correct answer – Which of the following is not part of a multi-step income statement? a) Operating expenses b) Net sales c) Income from operations d) Current assets 09/18/24: Class 7 - Chapter 4 Cont. & Chapter 5 Ratio Analysis - Can be used in evaluating the company’s financial condition and performance - The balance in one (or more) account divided by the balance of one (or more) other account - Some types of ratio analysis: - Trend analysis - Comparisons over time - Benchmarking - Comparisons to a competitor Working with the Balance Sheet - Usually we use average in the denominator from the balance sheet because it needs to be over the entire year (and the balance sheet is just a point in time at the end of the year, so this could be different from the average throughout the entire year) - The balance sheet provides information on the firm’s financial health - It identifies how assets are financed: - Debt (loans) - Equity (stock) - Balance sheet ratios often analyze liquidity and solvency White Board Notes → Ratio Examples/Categories  - Profitability → profit (from income statement) - Efficiency/activity/productivity → accounts receivable turnover, days in sales, inventory turnover, etc (comparing an asset item to an income statement item, but COGS or revenue instead of profitability). Tells us how efficiently we’re deploying our assets - Liquidity – short-term (balance sheet) → current assets over current liabilities (can we pay our bills? Do we have enough assets to pay for liabilities?). How much cash are we generating from operations and can we cover our current liabilities with that? Short-term ability to meet your obligations. Coverage ratios → do we have enough EBIT/EBITA/earnings to cover our interest expenses or fixed charges? - Solvency – capital structure – long-term → total liabilities over total assets (how much of my balance sheet is financed by liabilities in comparison to equity?). Do we have the right amount of debt in the long-term; will we be able to pay it back? Do we have any debt capacity? Liquidity - Ability to pay short-term financial obligations - Amount of cash and how quickly cash can be generated. - Common ratio: - Current ratio - The amount of current assets relative to current liabilities - Current assets / Current liabilities Solvency - Ability to pay long-term financial obligations - Measure of ability to survive over the long-term - Common ratio: - Debt-to-total assets ratio - Measure of riskiness  - More debt relative to assets results in higher risk - Total liabilities / Total assets Working with the Income Statement - Profitability Analysis - Analysis of profit, or net income - Common ratio - Profit margin (return on sales) - Helps in comparison of different size firms - Net income / Net sales Select the correct answer–Which of the following involves an analysis of the income statement?  a) Current ratio b) Profit margin c) Debt-to-total assets ratio d) Free cash flow Working with the Statement of Stockholders’ Equity - Provides information on the company’s change in stockholders’ equity during the period - Consists of two components - Contributed capital - Earned capital Retained Earnings Blue Space Technologies’ Statement of Stockholders’ Equity Select the correct answer–Which of the following is a component of Stockholders’ Equity? a) Cash b) Earned capital c) Accounts payable d) Prepaid rent Working with the Statement of Cash Flows - Provides information on the company’s change in cash over a period - Sources of cash  - Uses of cash - Categorized by type of cash flow - Operating - Investing - Financing Select the correct answer–Which of the following would not appear on a company’s statement of cash flows? a) Cash from operating activities b) Total assets c) Net change in cash d) Cash flow for investing activities CHAPTER 5 Fraud - Any act by management or employees of a business involving an intentional deception for personal gain - Types of fraud: - Embezzlement of cash - Theft of assets - Filing of false insurance claims - Financial statement fraud - Punishable crime The Fraud Triangle - Pressure - Nearly all frauds committed by individuals under either financial or vice pressure - Financial statement fraud is often associated with pressure to “make the numbers” - Rationalization - Most fraudsters come up with rationalizations to overcome the feeling of guilt - Opportunity - Fraud is only attempted if there is a perceived chance of getting away with it - Fraud prevention efforts by businesses primarily devoted to reducing the opportunity Internal Control - Internal Control - Measures undertaken by a business to reduce the opportunity to commit fraud - “Internal control is a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance: That information is reliable, accurate and timely. Of compliance with applicable laws, regulations, contracts, policies and procedures.” (source unknown) - COSO Framework (Committee of Sponsoring Organizations of the Treadway Commission) - Developed to help companies structure and evaluate their internal controls - Five components of COSO 1. Control Environment 2. Risk Assessment 3. Control Activities 4. Information and Communication 5. Monitoring Activities COSO Framework – Control Environment - Control environment sets the tone of the organization - Environment of ethical values and integrity - Management’s philosophy and management style - Foundation for all other components of internal control COSO Framework – Risk Assessment - Risk assessment identifies and analyzes relevant risks - External risks include economic conditions, industry competitors and regulation - Internal risks include operating conditions - Risk assessment must be an ongoing and iterative process COSO Framework – Control Activities - Internal controls are the measures undertaken by a business: - to ensure the reliability of its accounting data - to protect its assets from theft or unauthorized use  - to ensure that employees are following policies and procedures - to evaluate the performance of employees, departments and the company - Management is responsible for internal controls which provide reasonable assurance that the controls meet objectives Control Activities - Prevention controls are intended to deter a problem before it occurs - Training, education, hiring the right people, etc - Detection controls are designed to uncover problems after they occur - Prevention is much more desirable than detection - Rather prevent them before they happen - But, both should be in place COSO Framework – Control Activities - Prevention and detection controls should include: - Clear lines of authority and responsibility through written policies and procedures - Implement segregation of duties. Separate the three functions of authorization, recording, and custody - Hire competent personnel and provide adequate training (and pay a fair wage) - Use preprinted control numbers on all business documents such as sales invoices and checks - Develop plans and budgets and compare actual outcomes to the plan - Maintain adequate accounting records - Provide physical and electronic controls such as locks and security cameras COSO Framework – Information and Communication - Management must communicate that control responsibilities must be taken seriously - Communication must be an ongoing and iterative process COSO Framework – Monitoring Activities - The internal control system should be monitored to assess the quality of the system’s performance - Internal audits are one type of monitoring activity Conduct Internal Audits - The internal audit function provides appraisals of a company’s internal control and financial records - The internal auditor must determine if adequate controls are in place - And whether the controls in place are functioning as they should Control Failures - Companies cannot completely prevent internal control failures - Employee theft - Employee collusion - Two or more employees work together to circumvent internal controls  - Difficult to prevent or detect Sarbanes-Oxley Act (SOX) - With SOX, Congress has legislated that public companies must maintain an adequate system of internal controls - SOX includes provisions to keep management accountable - External auditors must attest to the adequacy of the company’s internal controls (Section 404) - CEO and CFO have to sign off on financial statements as a result of SOX - SOX also created the PCAOB, fully funded by the SEC Select the correct answer–The internal control that requires no one individual is assigned too much responsibility is a) Maintain adequate accounting records b) Segregation of duties c) Conduct internal audits d) Use control numbers Accounting for Cash - Cash includes coins, currency, checks, money orders, checking accounts, and savings accounts - Considered to be cash if - It is accepted by a bank or other financial institution for deposit, and - It is free from restrictions that would prevent its use for paying debts - Many near-cash items are not considered to be cash: - Certificates of Deposit (CD’s) with maturity over 90 days are considered investments - Non-sufficient funds checks (NSF) are accounted for as other receivables - For financial reporting, cash is a current asset often combined with cash equivalents on the balance sheet - Cash equivalents are highly liquid, short-term investments of 90 days maturity or less in risk free securities such as U.S. Treasury bills and money market funds Internal Controls for Cash - Cash is highly desired, easily concealed and quickly convertible into other assets and is thus, an especially attractive target for theft and fraud - Because cash is so easily misappropriated, elaborate internal controls have been developed to safeguard it - Controls for cash typically include: - Written policies and procedures over handling and accounting for cash - Segregation of duties - Bank reconciliation 09/23/24: Class 8 - Chapter 5 Cont. Written Policies and Procedures for Cash - Written policies and procedures over handling and accounting for cash examples include: - Cash received must be deposited with the bank on a daily basis. Cash on hand must be physically secured - Bank statements must be reconciled monthly by someone not involved with recording or authorizing cash transaction Segregations of Duties for Cash - Segregation of duties related to cash include: - Person responsible for deposits or disbursements not also responsible for recording the receipt or disbursement in the books - Person who approves purchases not also responsible for disbursing payments for purchases - Person responsible for depositing cash receipts should not also be responsible for making cash disbursement The Bank Reconciliation - A bank reconciliation is a schedule that reconciles the cash balance appearing on the bank statement with the cash balance showing in the company’s books - Items such as outstanding checks, deposits in transit, interest earned, and bank fees can result in reconciling items Select the correct answer–Proper controls over cash includes each of the following except a) Bank reconciliations b) Internal audits c) Same person makes cash deposits and cash disbursements d) Segregation of duties related to approval and recording Effective Cash Management - Monitoring cash - Statement of cash flows identifies inflows and outflows. - Statement of cash flows also identifies whether cash is increasing or decreasing - Sufficient cash on hand is needed to pay day-to-day costs such as wages and suppliers, however too much cash on hand is wasteful - Primary activity of effective cash management - Manage receivables (if you minimize receivables, people will go elsewhere that offer better credit options) - Manage inventory levels (you may not have enough to minimize inventory levels and customers will go to your competitors instead) - Manage payables (your suppliers would not be happy if you stretch your payables out too far in the future) - You must have all three of these accounts if you want to remain competitive in your industry  - Short term → you can decrease net working capital, but long term this doesn’t make sense - Net working capital = current assets - current liabilities - Invest excess cash - Doesn’t make sense to have too much cash sitting in the balance sheet in a bank → you should invest this cash or use it - Some cash will need to be accessible for operating activities, can’t all be invested - Excess cash implies cash that is more than what you need to run the operations of the business Auditing and Internal Control - Financial Statement Audit – Demanded by users - Outside parties, such as investors and bankers demand an independent assessment of the company - Performed by an independent external CPA firm - Providing assurance to shareholders that the financial statements are fairly presented - Since SOX, they must also report on the sufficiency of the internal control over financial statements - Auditors must issue CAMs (critical audit manners) as well. An example might be how the company estimates their CECL - CECL (current estimates of credit losses) must also be included - The SEC requires all publicly-traded companies to have independent audits - Financial Statement Audit – Process and content - Audit report states the auditor’s opinion on whether the financial statements are “fairly presented” - Auditing procedures established by the Public Company Accounting Oversight Board (PCAOB) - Collects and analyzes data in order to substantiate the amounts reported in the financial statements - Operational Audits - An evaluation of activities, systems, and internal controls - Used to determine efficiency, effectiveness, and economy Preparing a Bank Reconciliation - One of the purposes of bank reconciliation may be to correct errors (on the deposit and withdrawal side) - Left side is the bank statement side - Right side is per the general ledger - The sides may be different because of timing differences, automatic payments, - “AND Corrections” → people make mistakes, misrecordings may happen. You can adjust for errors at every step of the process Environment, Social, and Governance (ESG) - Being a socially responsible company sometimes means doing more than simply following the letter of the law - Social responsibility requires creating a culture of ethical behavior that promotes not just making money, but making money in a responsible way - Cutting corners may work in the short run but is not a sustainable business practice - Maximize STAKEHOLDERS’ wealth (includes customers, creditors, employees, suppliers, society at large, etc) instead of just stockholders’ wealth - ESG is permeating ways that companies manage themselves - SEC is requiring more disclosures about business practices that aren’t even financially related at all CHAPTER 6 Accounts Receivables - Accounts receivable results from sales of goods or services “on account” (on a credit basis)  - Assume Scripps Corp. makes a $10,000 sale on account. What accounts are affected? Accounts receivable and revenues - What accounts are affected when the customer pays Scripps the $10,000? Losses from Accounts Receivable - Why do businesses sell goods or services on account? - To increase their volume of sales relative to a cash-only policy - They might go to a competitor that offers credit options if you do not (need to have it to remain competitive) - What is the cost of granting credit to customers? - Not everyone is able to pay their debts! - Credit losses are an operating expense that is referred to as “bad debt expense.” This is a part of doing business, you won’t always get paid - Typically classified as a selling expense in the income statement. - Not every region of the world offers credit options, so some industries in certain parts of the world may not even use Accounts Receivables at all. Cash only How Do We Account for Bad Debt Expense? - According to GAAP: - Companies must estimate the amount of bad debt expense during the period in which the credit sales are recognized (so you don’t violate the matching principle) - The bad debt expense must be recognized in the same period as the credit sales - Why not wait until the customer fails to pay, and then record an expense for bad debts? - This is called the “direct write-off” method - It is not allowed because it violates the matching principle - GAAP requires matching the expenses of selling on credit with the sales revenues that are generated by the credit sales - You want to properly state your income in the associated period Allowance Method - Estimating the amount of bad debts is called “the allowance method” of accounting for bad debts - Bad debt expense is an estimate because at the time of the sale, we do not know which customers will end up not paying - The estimate results in an adjustment to the contra-asset account Allowance for Doubtful Accounts - Another contra-asset account → accumulated depreciation - The contra-asset accounts typically reduce the asset accounts - There are also contra-liability accounts and contra-equity accounts Reporting Allowance for Doubtful Accounts - The allowance account (a contra account) is subtracted from gross accounts receivable to yield a net realizable amount (the gross amount less the expected bad debts) - Assume that Scripps Company has gross accounts receivable of $100,000. They estimate their accounts receivable has a net realizable value of $96,000 Select the correct answer–The allowance method of accounting for bad debts is consistent with which accounting principle? a) Relevance b) Timeliness c) Matching d) Materiality Estimating Credit Losses - The “Percentage of Net Sales Method” uses the credit sales for the period to estimate Bad Debt Expense - Income statement approach - Estimating the expense first and then make an adjustment to the balance sheet - The “Aging Method” uses the age of the accounts receivable outstanding to estimate Bad Debt Expense - Balance sheet approach - Estimating the balance sheet first and then the expense afterwards Percentage of Sales Method - Percentage of Sales Method - Estimates bad debt expense as a percentage of credit sales for a given period - Percentage used is usually based on the company’s historical experience with credit losses - Let’s look at an example... Example: Percentage of Sales Method - Assume Avery Company has credit sales for the year of $700,000 and past experience is that three percent of these sales will ultimately not be collected - What will Bad Debt Expense be? - $700,000 x 0.03 = $21,000 - How will recording this affect the financial statements? Accounts Receivable Aging Method - The Aging Method - Uses the age of the accounts receivable to estimate bad debts. - An “aging schedule” categorizes receivables based upon how long they are overdue  - Based on your current balance sheet. Cutting up your total accounts receivable into layers of cake (where each layer of cake has a different experience) - Past collection experience is used to estimate the probability that the receivables in each category will be uncollectible - The sum of the uncollectible amounts in the aging schedule is used to record the bad debt expense - Let’s see an example... Example: Aging Method - Assume Avery’s accounts receivable is $30,000, and “aged” as below. - The “Amount” X “Probability of Non-collection”= “Allowance Required” - Sum of “Allowance Required” across categories equals the total required Allowance for Doubtful Accounts on the balance sheet - Example: Aging Method - Assume the Allowance for Doubtful Accounts has a balance of $400 before the aging is calculated. - What should Avery record as Bad Debt Expense for the period? - The adjustment to record bad debt expense would be as follows: - Following this adjustment:  - Accounts receivable: $30,000 - Allowance for doubtful accounts: ($2,370) - *Ending Allowance Account = $2,370 = $400 + $1970 - Net Accounts Receivable: $27,630 09/25/24: Class 9 - Chapter 6 Cont. Writing Off Specific Receivables - A receivable is written off when the company determines it is uncollectible (i.e., the customer will not pay) - Assume Eco-Prime Company has the following Accounts Receivable and Allowance balances: - Assume a specific customer, who owes $200, will not pay. What is the adjustment to record the “write-off”? - To record the write off of a $200 receivable that is determined to be uncollectible: - How does the write-off of the $200 affect the net income or total assets? - It has no effect on net income or total assets - The net realizable value of accounts receivable is unchanged by the account write off Financial Statement Effect of Allowance Method Recovery of Accounts Written Off - Occasionally an account that was written off will eventually be collected - Assume a $200 account that was written off is later collected - How does this affect the financial statements? Recovery of Accounts Written Off Example - To record the receipt of $200 for an account that was previously written off Select the correct answer–How do the aging method and the percentage of sales method differ? a) The percentage of sales method first estimates the balance in the allowance account and then computes bad debt expense. Whereas the aging method first estimates the bad debt expense for the period and adjusts the allowance account b) The aging method first estimates the balance in the allowance account and then computes bad debt expense. Whereas the percentage of sales method first estimates the bad debt expense for the period and adjusts the allowance account c) There is no difference between the two methods regarding how they estimate the balance in the aging account and compute bad debt expense Select the correct answer–Town Co. began the period with $20,000 of accounts receivable and an allowance for doubtful accounts balance of $1,000. If Town wrote-off $100 of receivables and then recovered $50 of this amount, what would be the net receivables balance? a) $19,000 b) $18,900 c) $18,950 d) $19,950 Credit Card Sales - When a credit card is used for a purchase, - The seller receives payment from a credit card company - The customer pays the credit card company - The seller is charged a credit card fee - Advantages of accepting credit cards  - The credit card companies (typically financial institutions) determine the creditworthiness of the customer - The seller typically receives the payment faster - Two ways a seller will collect from the credit card issuer: (1) immediately or (2) on a delayed basis - What accounts are affected for a $1,500 credit card sale with 3% fee and immediate collection? - What accounts are affected for a $1,500 credit card sale with 3% fee and delayed collection? Notes Receivable - Promissory notes receivable are often used - When the credit period is longer than 30- to 60-days - Purchases of property and equipment - To replace overdue accounts receivable - Routinely for loans to individuals and businesses - Key characteristics include: - Promise to pay a sum of money at a future date - The dated can be fixed or on demand - Signed by the maker (lender)I’m , payable to payee or bearer (borrower) - Interest rate, usually stated in annual terms - Interest and principal on short-term notes paid at maturity - Balance sheet disclosure - Short-term Notes Receivable are current assets on the balance sheet - Long-term Notes Receivable are noncurrent assets (long-term assets)  - Interest receivable on a Note is a current asset - Income statement disclosure - Companies must distinguish between “operating” and “financing” items - Interest Income and Expense are financing items.* (usually net on the income statement) - Usually classified as “other income and expense.” - * Interest Income may actually result from an investing activity Interest Calculation - Interest is calculated according to the following formula: - Interest = Principal x Interest rate x Time - Compute interest on a 3 month note for $10,000 at an annual interest rate of 6 percent - Interest = $10,000 x.06 x 3/12 = $150 Determining Maturity Date - To determine a note’s maturity date it is necessary to count the days or months - For example, a 90-day note dated March 15th would have a maturity date of June 13th - If, instead, the duration was expressed in months, 3-months from March 15th would be June 15th Recording Notes Receivable and Interest - Recording Notes Receivable and Interest - On August 1st, Argyle Company accepts a 3-month, 6% note receivable in the amount of $10,000 to settle an account receivable. The financial statement effect is shown below: - Notice Argyle increases Notes Receivable and decreases Accounts Receivable - The collection of the note receivable on November 1st has the following effect on Argyle’s financial statements:  - Cash received includes both principal and interest Adjusting Entry for Interest Income - When the term of a note receivable extends beyond the end of an accounting period, an adjusting entry is necessary to accrue the interest earned in the period - Argyle Company holds a 90-day, $50,000 note receivable, with an annual rate of 6%, dated December 16th. The adjusting entry at December 31 would have the following financial statement effect: Collection of Note - The collection of the $50,000 note on its maturity date has the following effect on Argyle Company’s financial statements Select the correct answer–Calculate the amount of interest income on a $30,000, 90 day note at an annual interest rate of 4 percent. a) $250 b) $300 c) $600 d) $1,200 - $30,000 x 0.04 x 90/360 = $300 Analyzing Receivables - Receivables are a significant and important asset for most companies - Management and Wall Street analysts use a variety of financial measures to monitor and evaluate receivables, including: - Accounts receivable turnover - Average collection period - Analyzing receivables: To illustrate these financial indicators, consider the following financial information for Julius Company: Select the correct answer–Savanna Co. reports net sales of $50,000, cost of goods sold of $40,000, and average accounts receivable of $5,000. What is Savanna’s average collection period?  a) 10 times b) 36.5 days c) 45.6 d) Cannot be determined from this information. - Avg. collection period = 365 /(A/R turnover) = 365 / ($50,000/$5,000) = 36.5 days Environmental, Social, and Governance - Many companies include within their mission statements their commitment to being a good corporate citizen - Commitments to sustainable business practices may reduce expenses and protect the environment by using resources more efficiently, minimizing waste, managing supply chains, and raising awareness 09/30/24: Class 10 - Quiz #2 & Chapter 7 CHAPTER 7 Different Firms, Different Inventories - Manufacturers - Convert raw materials into finished goods - Focus of managerial accounting - Merchandising firms - Wholesalers - Buy finished products in large volume and sell in smaller quantities to retailers - Retailers - Typically buy goods from wholesalers for sale to consumers Categories of Inventory - Merchandisers generally only have one type of inventory - Finished goods, ready for sale - Manufacturers have three categories of inventory: - Raw materials―items to be used in the production of products - Work-in-process―items partially completed - Finished goods―items fully manufactured and ready for sale Costs Included in Inventory - All necessary costs incurred to acquire the inventory and deliver it to the buyer’s place of business - Purchase price - Taxes and shipping costs - Inventory cost are reduced by - Purchase returns and allowances - Purchase discounts Inventory Management - Just-in-Case Inventory - Inventory held as a buffer for unexpected problems - Costly due to storage and financing costs - You invest more in inventory than what you need - Just-in-Time Manufacturing - Seeks to minimize the amount of inventory on hand - Costly due to risk of lost sales if inventory runs out - You want to have the inventory out & available right before you sell it - To avoid carrying unexpected inventory on the balance sheet, but there could be supply chain issues Inventory Cost Flows - COGS are supplies inventory for a manufacturer, but just items you plan to sell if you’re a merchandiser - Sometimes there are special charges/accounts that won’t go into cost of goods sold (example → one of your warehouses burns down that has inventory in it, you wouldn’t include that in COGS but in a special account so you don’t go negative) - Closed system with some slight exceptions In schedule form: Physical Count of Inventory - A physical count is taken to determine or verify the amount of inventory on hand - Why might the actual inventory differ from the amount of inventory on the books? - Theft - Spoilage - Errors - Steps in the physical inventory count - Count the individual items - Determine the unit cost and multiply by number of items - Add the total cost of the individual items to obtain total cost Inventory Costing Systems - Perpetual system - The cost of merchandise sold is calculated after every sale - Inventory balance is kept “perpetually” up-to-date (tracking as everything goes out the door) - Provides greatest control over monitoring inventory levels - Better able to determine theft or spoilage - Periodic system - Cost of merchandise sold is computed periodically when a physical count of remaining inventory is taken - Simple and easy to implement - Actual balance of inventory is unknown until the periodic count - You don’t know what your inventory is until you do a physical count Select the correct answer–Which of the following best describes the flow of inventory costs? a) The cost of goods purchased plus beginning inventory is greater than the cost of goods sold plus ending inventory b) The cost of goods purchased plus beginning inventory is less than the cost of goods sold plus ending inventory c) The cost of goods purchased plus beginning inventory is equal to the cost of goods sold plus ending inventory (CLOSED SYSTEM) d) The cost of goods available for sale is equal to ending inventory less beginning inventory Inventory Costing Methods - Inventory is recorded at its acquisition cost - Purchase price of an item of inventory may change over time - Companies make assumptions about which items have sold and which are still in inventory Goods Flow vs Cost Flow - Physical flow of goods―Goods flow - The actual flow of goods from acquisition to sale - Accounting cost flow assumption―Cost flow  - An assumed flow of the cost of goods from acquisition to sale - The two flows need not be the same! Methods of Costing Inventory - All methods produce different costs assigned to cost of goods sold and inventory - Specific identification, First-in-First-out (FIFO), Last-in-First-out (LIFO), weighted-average cost 10/02/24: Class 11 - Chapter 7 Cont. Specific Identification Method - The purchase cost of each specific unit is tracked - The cost of the specific inventory item sold becomes the cost of goods sold - Often used for high-value products that can be easily identified separately - Expensive jewelry - Automobiles - Watercraft - Large (expensive) Electronics - Expensive Appliances First-In, First-Out (FIFO) - Assumes the earliest units purchased are the first units sold (COGS) → consider the costs of the oldest inventory. Profits are lower, so your taxes are lower - Assumes that the units purchases more recently remain on hand (ending inventory) Last-In, First-Out (LIFO) - Assumes that the most recent units purchased are the first units sold (COGS) → consider the costs of the newest inventory - Assumes that the first units purchased remain on hand (ending inventory) Weighted-Average Cost Method - Averages the cost of purchases so that units are valued at an average, with each unit valued at the same cost - New purchases cause a re-averaging of unit costs Valuing Inventory Example Valuing Inventory using FIFO Method Valuing Inventory Using LIFO Method Valuing Inventory Using Weighted-Average Method  - Ending inventory under FIFO is higher than ending inventory under LIFO - COGS under LIFO is higher than COGS under FIFO - Cost of goods available for sale are the same under both methods - CLOSED SYSTEM Select the correct answer–Which of the following statements is NOT correct? a) Specific identification cost method costs inventory at the actual cost of each unit b) FIFO assumes the oldest goods are sold first c) LIFO assumes the last goods purchased are still on hand d) Weighted-average cost method spreads the total dollar cost of the goods available for sale equally among all units Valuing Inventory Example Comparing Methods - For FIFO → gross profit is the highest, ending inventory is highest - For LIFO → gross profit is the lowest, ending inventory is lowest - For weighted-average → gross profit and ending inventory are in the middle - 55% of the S&P 500 uses FIFO Impacts of Cost Flow Methods - Specific identification most closely identifies the actual cost of goods sold and ending inventory  - FIFO approximates the physical goods flow for most firms - LIFO is popular because of potential tax savings - Weighted-average cost is often associated with large inventories of undifferentiated goods (commodities) Errors Inventory Count - Because this year’s beginning inventory is prior year’s ending inventory, inventory errors at the end of last year, will affect both last year and this year! - Recall the computation of COGS Inventory Error Example - Watson Co. had the following information: a. Beginning inventory for Year 1 totaled $30,000. b. Current year purchases totaled $300,000. c. The inventory count reported $40,000 at end of Year 1. d. After issuing the financials, Watson found that the count included $5,000 of items counted twice! The correct ending inventory should have been $35,000 - How did the ending inventory overstatement effect: - Year 1 Cost of Goods Sold? - Year 1 Net Income? - Year 1 Ending Retained Earnings? Inventory Error Example Inventory Error Example–Deeper - Suppose Watson Co. did not catch the error in Year 1 and had the following information for Year 2:  a. Beginning inventory for Year 2 totaled $40,000 (which includes the $5,000 overstatement). b. Purchases totaled $300,000 (same as prior year). c. Its inventory count showed ending inventory for Year 2 of $45,000 (which does NOT contain any errors). - How did the Year 2 beginning inventory overstatement affect: - Year 2 Cost of Goods Sold? - Year 2 Net Income? - Year 2 Ending Retained Earnings? Inventory Error Example–Deeper - Pattern of income is wrong, but net retained earnings is correct (self-correcting error) Inventory Error Example–Summary - Net effect of the error was to shift some income from Year 2 to Year 1! - Over the 2 years, the net effect was zero! - Ending inventory overstatements will  - Overstate income in the year of the overstatement. - But understate income in the following year by the same amount - Ending inventory understatements will - Understate income in the year of the understatement. - But overstate income in the following year by the same amount - Once ending inventory is accurately stated, the errors “cancel out”―but the “pattern” of income is incorrect! 10/07/24: Class 12 - Chapter 7 Cont. & Chapter 8 Inventory Example –Bloated Balance Sheets - Companies with overstated inventory are sometimes said to have a “bloated balance sheet” - Bloated balance sheets result in earnings that are overstated during the year (or years) when the balance sheet is overstated, - But then reduce earnings when the error is ultimately corrected - Research has found that bloated balance sheets can fool investors into overvaluing the stock prices of public companies during the periods in which the operating assets are overstated Select the correct answer–The inventory method that yields the highest cost of goods sold during periods of rising costs a) Specific identification b) FIFO c) LIFO d) Weighted-average cost Inventory Costing - Inventory is originally recorded at its cost. - If the inventory’s Net Realizable Value (NRV) declines below its recorded cost, it must be written down - Lower of Cost or Net Realizable Value rule. - NRV = Estimated selling price, less the expected costs of selling. - Inventory values can decline for two reasons - Damage or obsolescence - Drop in demand that lowers the price buyers are willing to pay for the inventory Lower of Cost or Net Realizable Value (LCNRV) - Companies must ensure that the recorded cost of ending inventory (cost) does not exceed the current selling price less costs of selling (NRV) LCNRV Example - LCNRV Example: How does the $44 write-down to NRV affect the financial statements of Wags Co.? Gross Profit Percentage - Can be a bell-weather of a company’s financial health. - Gross profit percentage indicates a company’s ability to sell its products at acceptable prices - Tells us how much a company generates from each sales dollar, after paying for the cost of goods sold, to cover its other expenses and provide a profit Gross Profit Percentage Analyzing the Gross Profit Percentage - Benchmarking analysis - Compares a company with its competitors - Trend analysis - Analyzes changes in the percentage over time - Higher percentages - Consistent with strong market power and the ability to sell goods at a high mark-up - Lower percentages - May indicate difficulty in pricing products. - May also indicate an attempt to compete by charging lower prices. Select the correct answer–Premiere Co. reports net sales of $50 million, cost of goods sold of $21 million, and net income of $7 million. What is Premiere’s gross profit percentage? a) 42% b) 58% c) 14% d) 33% - Gross profit / Net sales - (Net sales – cost of goods sold) / Net sales ($50M - $21M) / $50M = 58% Inventory Turnover Ratio - Indicates how many times a year, on average, a firm sells its inventory - Higher inventory turnover ratios indicate - Higher profitability. - Lower ending inventory levels, which means less funds tied up in inventory and less risk of inventory obsolescence - Assume Wags Co. maintained an average inventory level of $300, and its cost of goods sold for the year was $7,500. Wags’ inventory turnover is: Days’ Sales in Inventory - Day’s sales in inventory is an extension of inventory turnover. - By dividing inventory turnover into 365 (days in a year), this ratio indicates how many days, on average, it takes a company to sell its inventory  - For Wags Co. this is: Select the correct answer–Pick Co. reports average annual inventory of $200 and cost of goods sold of $1,000. What can be said of Pick’s inventory? a) Inventory takes, on average, 5 days to sell. b) Inventory turns over, on average, 5 times a year. c) Inventory turns over, on average, 73 times a year. d) The selling price of inventory decreases during the year. - Inventory turnover = Cost of goods sold / average inventory = $1,000 / $200 = 5 times per year Inventory Costing Using a Perpetual Inventory System - Periodic inventory system - Inventory balances and cost of goods sold are computed at the end of the accounting period, after a physical count - This is the method we used in the chapter to illustrate the various inventory costing methods - Perpetual inventory system - Inventory balances and cost of goods sold are updated after every purchase and every sale - Accounts kept perpetually up-to-date - Periodic versus Perpetual system - Inventory costing with specific identification is the same under both - FIFO, LIFO and weighted average costs may differ, depending on the sales and purchase activity during the period Valuing Inventory Using FIFO Valuing Inventory Using LIFO Valuing Inventory Using Weighted-Average Summary Results of Different Inventory Costing Methods LIFO Inventory Reserve - When prices are rising, LIFO results in lower ending inventory balances as compared with FIFO - In some settings, this difference can be very large - This difference reduces the ability of users to make comparisons across companies - “Comparability” is a qualitative characteristic that makes accounting information useful - What is the LIFO Inventory Reserve? - A measure of the difference between the value of a company’s ending inventory reported under LIFO and what the inventory would have been valued under FIFO - SEC requires all LIFO companies to report their LIFO Inventory Reserve in a footnote - Disclosure of the LIFO Reserve helps facilitate financial statement analysis - LIFO can have a material effect on ratios - The LIFO reserve is used to adjust for differences in these ratios LIFO Inventory Reserve Example - Assume ABC Company uses LIFO and reports ending inventory of $820. - Under FIFO, ending inventory would be valued at $1,190. - ABC’s LIFO Inventory Reserve = $1,190 (under FIFO) - $820 (under LIFO) = $370 - Assume that current assets = $2,100 and current liabilities = $1,400. - What is ABC’s current ratio? Environmental, Social, and Governance - Being a good corporate citizen means worrying about things beyond getting your inventory costs down at any cost - One area of concern is potential abuses in the supply chain, such as unfair labor practices and the use of child labor - Companies such as Target maintain an ethical manufacturing program that includes supplier compliance standards 1/09/24: Class 13 - Appendix D APPENDIX D Debt Security - A financial instrument that creates a creditor relationship for the debt holder - U.S. Treasury bills - Notes  - Bonds - Commercial Paper Equity Security - A financial instrument that represents an ownership interest in a Company - Shares of stock - Preferred or common stock Acquisition of Debt and Equity Securities - May be acquired directly from issuing entity - Initial public offering (IPO) - Secondary public offerings - Investors acquire securities through secondary capital market - Consists of individual and institutional investors buying or selling securities - Organized exchanges include New York Stock Exchange - Over-the-counter market is less formal Investments in Debt Securities - Debt securities are placed in one of three categories (under ASC 320) - Trading securities (will be traded in the next year) - Available-for-sale securities (debt securities that don’t fit into trading or held-to-maturity) - Held-to-maturity securities (held onto until maturity) - Management decides which category a debt security falls into it - These categories are important because they will affect basic accounting - The accounting events of concern are the - Purchase - Interest income recognition - Balance sheet valuation - Sale or redemption Guidelines for Debt Investments  - FV-NI (fair value to net income) → market to market every reporting period for trading securities - FV-OCI (fair value to other comprehensive income on the income statement) → the valuation account is like a contra asset account; either deduct for a price drop or add for price increases. Make a change in the valuation account and then report them in the stockholders’ equity for available-for-sale securities - AOCI → place to store a valuation increase or decrease without changing the income statement yet - Held-to-maturity securities don’t use fair value at all - When shifting from held-to-maturity to trading securities (selling their assets) → shift from amortized costs to fair value (this will be a loss on their income statement) Investments in Equity Securities - Equity securities are classified into three categories