Accounting and Financial Reporting Summary PDF

Chapter 1: Accounting in Action Accounting Activities and Users Three Activities Accounting involves the entire process of identifying, recording (systematic, chronological events of financial activities), and communicating economic events to decision makers (financial statements). Bookkeeping:...

Chapter 1: Accounting in Action Accounting Activities and Users Three Activities Accounting involves the entire process of identifying, recording (systematic, chronological events of financial activities), and communicating economic events to decision makers (financial statements). Bookkeeping: the recording of economic events - only one part of the accounting process Who Uses Accounting Data Internal Users Managers who plan, organise, and run the business Managerial accounting provides internal reports to help users make decisions abt their companies. => forward looking (what they expect will happen in the future). External Users Individuals and organisations outside a company who want financial info about the company. Common types: Investors (owners) => to decide whether to buy, hold, or sell ownership shares of a company. Creditors (suppliers, bankers, etc.) => to evaluate the risks of granting credit or lending money. Financial accounting provides eco and financial info for investors, creditors, and other external users. => backward looking (what happened over a year/period) Taxing authorities – whether company complies w tax laws. Regulatory agencies - whether company is operating within prescribed rules. Customers – whether company will continue to honour product warranties + support its product lines. Labour unions whether companies have ability to pay d wages and benefits to union members. The Building Blocks of Accounting Ethics in Financial Reporting Ethics: standards of conduct by which actions are judged as right/wrong, honest/dishonest, fair/not fair. Steps in analysing ethics cases and situations Accounting Standards Primary accounting standard-setting bodies: Generally Accepted Accounting Principles International Financial Reporting Standards (IFRS) => followed by +130 countries o Provide rules and principles for preparing financial reports => intended to make them consistent, transparent, easily comparable around the world. o Define type and amount of info that must be provided to users of financial statements so that they can make informed decisions. To increase comparability, in recent years the two standard-setting bodies made efforts to reduce the differences between IFRS and US GAAP => this process is called convergence Measurement Principles Relevance = financial info is capable of making a difference in a decision. Faithful representation = nrs and descriptions match what really existed or happened - they’re factual. Historical Cost Principle Dictates that companies record assets at their costs. Fair Value Principle States that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). - Fair value info may be more useful than historical cost for certain types of assets and liabilities. Assumptions Provide a foundation for the accounting process. Monetary Unity Assumption Requires that companies include in the accounting records only transaction data that can be expressed in money terms => enables accounting to quantify/measure eco events. - Vital to applying the historical cost principle. - Prevents inclusion of some info in the accounting records. ex: health of a company’s owner, the morale of employees, etc. Economic Entity Assumption An economic entity can be any organisation or unit in society. Requires that activities of entity be kept separate and distinct from activities of its owner and all other eco entities. Types of eco entities: Proprietorship: business owned by one person. Owner is often the manager/operator of business. Only a relatively small amount of capital is necessary to start in business as a proprietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for all debts of the business. There’s no legal distinction between the business as an eco unit and the owner, but accounting records of business activities are kept separate from personal records and activities of the owner. Partnership: business owned by two or more persons associated as partners. A partnership agreement sets forth terms such as, initial investment, duties of each partner, division of net income (loss), and settlement to be made upon death or withdrawal of a partner. Partnership transactions must be kept separate from personal activities of the partners. Corporations: a business organised as a separate legal entity under jurisdiction corporation law and having ownership divided into transferabl. e shares Shareholders enjoy limited liability => aren’t personally liable for the debts of the corporate entity; may transfer all or part of their ownership shares to other investors at any time, eg: sell their shares. The Accounting Equation Accounting equation applies to all eco entities regardless of size, nature of business, or form of business organisation. Foundation of double-entry system. Assets Resources a business owns, ex: machine building, inventory, cash. Common characteristics: capacity to provide future services or benefits. The service potential or benefit eventually results in cash inflows (receipts). Liabilities Claims against assets – existing debts + obligations, ex: bank loans, accounts + wage payable. Business of all sizes usually borrow money and purchase merchandise on credit => these eco activities result in payables of various sorts: Accounts payable. Note payable. Salaries and wages payable to employees and sales and real estate taxes payable to the local gov. Equity The ownership claims in a company’s total assets, ex: shares of a company. Share Capital – Ordinary Amounts paid in by shareholders for the ordinary shares they purchase. Retained Earnings Determined by 3 items: Revenues: the gross s in equity resulting from business activities entered into for the purpose of earning income. Result in an increase in an asset. Expenses: costs of assets consumed or services used in the process of earning revenue => they’re s in equity that result from operating the business. Dividends: distribution of cash or other assets to shareholders; they reduce retained earnings, however they’re not expenses. Analysis Business Transactions Accounting information system: system of collecting and processing transaction data and communicating financial information to decision-makers; Factors that shape this system: Nature of the company’s business Size of the company Types of transactions Volume of data Information demands of management, etc. Accounting information systems rely on a process => the accounting cycle. Accounting Transactions Transactions: business’s eco events recorded by accountants. External transactions: eco events between the company and some outside enterprise. Internal transactions: eco events that occur entirely within one company. Each transaction must have a dual effect on the accounting equation, eg: if an asset is increased:  in another asset, or  in a specific liability, or  in equity. Financial Statements 1. Income Statement: presents revenues and expenses and resulting net income/net loss for a specific period of time. Answers questions: How well did the company perform during the period? A year or a quarter period. When revenues > expenses net income When expenses > revenues net loss Net Income = Revenues - Expenses 2. Retained Earnings Statement: summarises s in retained earnings for a specific period of time. Answers question: Why did the company’s retained earnings change during the period? A year or a quarter period. Typical items that change retained earnings: o Net income (loss) will  retained earnings (will  retained earnings). o Dividends will  retained earnings. Ending RE = Beg. RE + Net Income - Dividends 3. Statement of Financial Position/Balance Sheet: reports assets, liabilities, and equity of a company at a specific date. Answers question: What is the company’s financial position at the end of the period? “As of DATE” Includes retained earnings, which comes from Statement of Retained Earnings. 4. Statement of Cash Flows: summarises info abt the cash inflows (receipts) and outflows (payments) for a specific period of time. Answers question: How much cash did the company generate + spend during the period? A year or a quarter period. Reports: o Cash effects of a company’s operations during a period o Investing activities o Financial activities o Net increase/decrease in cash during the period o Cash amount at the end of the period Operating cash flows are most important indicator. 5. Comprehensive Income Statement: presents other comprehensive income items that incl in the determination of net income  Chapter 2: The Recording Process The Account An individual accounting record of s and s in a specific asset, liability, or equity item. An account consists of 3 parts: The account is called T-account: 1. Title 2. A left - debit side (Dr.) 3. Right - credit side (Cr.) Debits and Credits Debit balance: if the total of the debit amounts > credits, when comparing totals of the two sides. Credit balance: if the credit amount > the debits. Positive => represents a receipt of cash. Negative =>represents a payment of cash. In the account form, we record the s in cash as debits and the s in cash as credits. Having s on one side and s on the other reduces recording errors + helps in determining the totals of each side of the account as well as the account balance. Debit and Credit Procedure Equality of debits and credits provides basis for the double-entry system of recording transactions. Under double entry-system, dual effect of each transaction is recorded in appropriate transactions => provides logical method for recording transactions + helps ensure accuracy of recorded amounts as well as detection of errors. If every transaction is recorded with equal debits and credits, the sum of all the debits to the accounts must be equal the sum of all the credits. Dr./Cr. Procedure for Assets and Liabilities Asset accounts normally show debit balances. Liability accounts normally show credit balances. The normal balance of an account is on the side where an increase in the account is recorded. Dr./Cr. Procedures for Equity Share Capital – Ordinary Companies issue share capital – ordinary in exchange for the owners’ investment paid into the company. Credits increase the Share Capital – Ordinary account, and debits decrease. Retained Earnings It’s the net income that is kept in the business => represents the proportion of equity that the company as accumulated through the profitable operation of the business. Credits (net income) increases the Retained Earnings account, and debits (dividends or net losses) decrease it. Dividends Is a company’s distribution to its shareholders => most common form of distribution: cash dividend. Dividends reduce the shareholders’ claims on retained earnings. Debits increase the Dividends account, and credits decrease it. Revenues and Expenses The effect of debits and credits on revenue accounts is the same as their effect on Retained Earnings. Expenses have opposite effect => expenses decrease equity since expenses decrease net income and revenues increase it. Credits to revenue accounts should exceed debits. Debits to expense accounts should exceed credits. Equity Relationships Summary of Debit/Credit Rules Dividends Expenses Debit , Credit  Assets Liabilities Equity Credit , Debit  Revenues The Journal It shows the debit and credit effects on specific accounts, for each transaction. General journal: has spaces for dates, account titles + explanations, references and two amount columns. The journal makes significant contributions to the recording process: 1. Discloses in one place the complete effects of a transaction. 2. Provides a chronological record of transactions. 3. Helps prevent or locate errors bcs debit + credit amounts for each entry can be easily compared. Journalizing Entering transaction data in the journal. Complete journal entries consist of: 1. Date of the transaction. 2. Accounts and amounts to be debited and credited. 3. Brief explanation of the transaction. Simple and Compound Entries Simple entry: involve only two accounts, one debit and one credit. Compound entry: requires three or more accounts. The Ledger and Posting The Ledger The entire group of accounts maintained by a company. Provides the balance in each of the accounts + keeps trach of changes in these balances. General ledger: contains all the asset, liability, and equity accounts. Standard Form of Account This format is called three-column form of account. It has 3 money columns – debit, credit and balance. Posting The procedure of transferring journal entries to the ledger accounts. Steps: Posting should be performed in chronological order => company should post all the debits and credits of one journal entry before proceeding to the next journal entry. Postings should be made on a timely basis to ensure that the ledger is up-to-date. Chart of Accounts This chart lists the accounts and the account nrs that identify their location in the ledger. The numbering system that identifies the accounts usually starts w the statement of financial position accounts and follows with the income statement accounts. The Recording Process Illustrated The purpose of transaction analysis is first to identify the type of account involved, and then to determine whether to make a debit or a credit to the account. Summary Illustration of Journalizing and Posting General Journal Entries General Ledger The Trial Balance List of accounts and their balances at a given time. Proves mathematical equality of debits and credits after posting. May uncover errors in journalizing and posting. Useful in preparation of financial statements. Steps for preparing a trial balance: 1. List the account titles and their balances in the appropriate debit or credit column. 2. Total the debit and credit columns. 3. Verify the equality of the two columns. Limitations of a Trial Balance It doesn’t guarantee freedom from recording errors, however numerous errors may exist even when totals of the trial balance columns agree: 1. A transaction isn’t journalized. 2. A correct journal entry isn’t posted. 3. A journal entry is posted twice. 4. Incorrect accounts are used un journalizing and posting. 5. Offsetting errors are made in recording the amount of a transaction. The trial balance doesn’t prove that the company has recorded all transactions or that the ledger is correct. Locating Errors Errors in a trial balance result from mathematical mistakes, incorrect posting, or transcribing data incorrectly. If a trial balance doesn’t balance, the following steps are often helpful: 1. If the error is €1, 10, or €100, re-add the trial balance columns and recompute the account balances. 2. If the error is divisible by 2, scan the trial balance to see whether a balance equal to half the error has been entered in the wrong column. 3. If the error is divisible by 9, retrace the account balances on the trial balance to see whether they’re incorrectly copied from the ledger. For ex, if a balance was €12 and it was listed as €21, a €9 error has been made. Reversing the order of nrs is called a transposition error. 4. If the error isn’t divisible by 2 or 9, scan the ledger to see whether an account balance in the amount of the error has been omitted from the trial balance, and scan the journal to see whether a posting of that amount has been omitted. Currency Signs and Underlining Currency signs don’t appear in journals or ledgers. Currency signs are typically used only in the trial balance and the financial statements. Chapter 3: Adjusting the Accounts Accrual-Basis Accounting and Adjusting Entries Time period assumption: accountants divide the eco life of a business into artificial time periods. Going concern assumption: business will remain in operation for the foreseeable future. Fiscal and Calendar Years Accounting time periods are generally a month, a quarter, or a year. Interim periods: monthly and quarterly periods. Fiscal year: an accounting time period that is one year in length. Many businesses use the calendar year (Jan 1 to Dec 31) as their accounting period. Cash-Basis Accounting vs Accrual-Basis Accounting Cash-Basis Accounting Companies record revenue at the time they receive cash; they record an expense at the time they pay out cash; the cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. Is justified for small businesses bcs they often have few receivables and payables. Accrual-Basis Accounting Companies record transactions that change a company’s financial statements in the periods in which the events occur. => follows time-period assumption => makes sure revenues and expenses are marked to the correct time periods, this allows the company to provide a better picture of its financial health and performance. Accrual basis is in accordance with IFRS. Medium and large companies use accrual-basis accounting. Recognizing Revenues and Expenses Revenue Recognition Principle Performance obligation: when a company agrees to perform a service or sell a product to a customer. - When the company meets this obligation, it recognizes revenue. This principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied => a company satisfies this by performing a service or providing a good to a customer. Expense Recognition Principle Requires that companies recognize expenses in the period in which they make efforts to generate revenue. The Need for Adjusting Entries Adjusting entries: ensure that revenue recognition and expense recognition are followed. They’re necessary because the trial balance may not contain up-to-date and complete data. This is true for several reasons: 1. Some events aren’t recorded daily bcs not efficient to do so. Ex: use of supplies and earning of wages by employees. 2. Some costs aren’t recorded during the accounting period bcs these costs expire w passage of time rather than bcs of recurring daily transactions. Ex: charges related to use of buildings and equipment, rent and insurance. 3. Some items may be unrecorded. Ex: a utility service bill that won’t be received until the next accounting period. Adjusting entries are required every time a company prepares financial statements. Every adjusting entry will include one income statement account and one balance sheet. Types of Adjusting Entries Adjusting entries are classified as either deferrals or accruals. Deferrals: 1. Prepaid expenses: expenses paid in cash before they’re used or consumed. 2. Unearned revenues: cash received before services are performed. Accruals: 1. Accrued revenues: revenues for services performed but not yet received in cash or recorded. 2. Accrued expenses: expenses incurred but not yet paid in cash or recorded. Adjusting Entries for Deferrals To defer means to postpone or delay. Deferrals: expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. The two types: prepaid expenses and unearned revenues. Prepaid Expenses When companies record payments of expenses that will benefit more than one accounting period. - When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future. Prepaid expenses are costs that expire either with the passage of time (ex: rent and insurance) or through use (ex: supplies). An adjusting entry for prepaid expenses results in an increase (debit) to an expense account and a decrease (credit) to an asset account. Supplies Oct. 5: supplies purchased => record asset. Oct. 31: supplies used => record supplies expense. Insurance Oct. 4: insurance purchased => record asset. Oct. 31: insurance expired => record insurance expense. Depreciation The process of allocating the cost of an asset to expense over its useful life. Need for adjustment An adjusting entry for depreciation is needed to recognize the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the end of the period. - Depreciation is an allocation concept, not a valuation concept => it allocated an asset’s cost to the periods in which it’s used; depreciation doesn’t attempt to report the actual change in the value of the asset. Contra asset account: accumulated depreciation – equipment; this account keeps track of the total amount of depreciation expense taken over the life of the asset. All contra accounts have increases, decreases and normal balances opposite to the account to which they relate. Oct. 1: equipment purchased => record asset. Oct. 31: depreciation recognized => record depreciation expense. Statement presentation The normal balance of a contra asset account is a credit. A theoretical alternative would be to decrease (credit) the asset account by the amount of depreciation each period. But using the contra account is preferable for a simple reason: It discloses both the original cost of the equipment and the total cost that has been expensed to date. Book/carrying value: the difference between the cost of any depreciable asset and its related accumulated depreciation. Unearned Revenues When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account. => a company now has a performance obligation (liability) to transfer a service to one of its customers. The adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account. Oct. 2: cash is received in advance => liability is recorded. Oct. 31: some service has been performed => some revenue is recorded. Adjusting Entries for Accruals The adjusting entry for accruals will increase both a statement of financial position and an income statement account. Accrued Revenues Revenues for services performed but not yet recorded at the statement date. An adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account. Without the adjusting entry, assets and equity on the statement of financial position and revenues and net income on the income statement are understated. Accrued Expenses Expenses incurred but not yet paid or recorded at the statement date, ex: interest, taxes, salaries, etc. An adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account. Accrued Interest Without this adjusting entry, liabilities and interest expense are understated, and net income and equity are overstated. Accrued Salaries and Wages Without the 1,200 adjustment for salaries and wages, Yazici’s expenses are understated 1,200 and its liabilities are understated 1,200. Summary of Basic Relationships Adjusted Trial Balance and Financial Statements Adjusted Trial Balance shows the balances of all accounts, including those adjusted, at the end of the accounting period. Purpose of an adjusted trial balance: - Prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. - Primary basis for the preparation of financial statements. Preparing the Adjusted Trial Balance Preparing Financial Statements Companies can prepare financial statements directly from the adjusted trial balance. Alternative Treatment of Deferrals Prepaid Expenses They become expired costs either through the passage of time (ex: insurance) or through consumption (ex: advertising supplies). Unearned Revenues Recognized as revenues at the time services are performed. Companies may credit (increase) a revenue account when they receive cash for future services. Financial Reporting Concepts Qualities of Useful Information The primary objective of financial reporting is to provide financial info that is useful to investors and creditors for making decisions abt providing capital. Useful info should possess two fundamental qualities: 1. Relevance: info is considered relevant if it provides info that has predictive value – helps provide accurate expectations abt the future, and has confirmatory value – confirms or corrects prior expectations. 2. Faithful Representation: info accurately depicts what really happened; info must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error. Enhancing Qualities Comparability: when different companies use the same accounting principles. Consistency: company uses the same accounting principles and methods from year to year. Verifiability: info is verifiable if independent observers, using the same methods, obtain similar results. Timely: must be available to decision-makers before it loses its capacity to influence decisions. Understandability: if presented in a clear and concise fashion, so that reasonably informed users of that info can interpret it and comprehend its meaning. Cost Constraint Weights the cost that companies incur to provide a type of info against its benefits to financial statement users. Chapter 4: Completing the Accounting Cycle p.1-20, 23-28 The Worksheet Is a multiple-column form used in the adjustment process and in preparing financial statements. It’s a working tool, not a permanent accounting record. The use of workshett is optimal. Steps in Preparing a Worksheet 1. Prepare a trial balance on the worksheet: Enter all ledger accounts with balances in the account titles column and then enter debit and credit amounts from the ledger in the trial balance columns. 2. Enter adjustment data: In entering the adjustments, use applicable trial balance accounts. If additional accounts are needed, insert them on the lines immediately below the trial balance totals. A different letter identifies the debit and credit for each adjusting entry = keying. Companies don’t journalize the adjustments until after they complete the worksheet and prepare the financial statements. 3. Enter adjusted balances in the adjusted trial balance columns: For each account, the amount in the adjusted trial balance columns is the balance that will appear in the ledger after journalizing and posting the adjusting entries. 4. Extend adjusted balances to appropriate statement columns: 5. Total the statement columns, compute net income (or net loss), and complete worksheet: The debit amount balances the income statement columns; the credit amount balances the statement of financial position columns. In addition, the credit in the statement of financial position column indicates the increase in equity resulting from net income. Preparing Financial Statements from a Worksheet After a company has completed a worksheet, it has at hand all data required for preparation of financial statements. The income statement is prepared from the income statement columns. The retained earnings statement and statement of financial position are prepared from the statement of financial position columns. Using a worksheet, companies can prepare financial statements before they journalize and post adjusting entries. However, the completed worksheet isn’t a substitute for formal financial statements. A worksheet is essentially a working tool of the accountant; companies do not distribute it to management and other parties. Preparing Adjusting Entries A worksheet isn’t a journal, and it can’t be used as a basis to ledger accounts. To adjust the accounts, the company must journalize the adjustments and post them to the ledger. The adjusting entries are prepared from the adjustment columns of the worksheet – the reference letter in the adjustment columns + explanations, help identify the adjusting entries. The journalizing and posting of adjusting entries follow the preparation of financial statements when a worksheet is used. Closing the Books At the end of the accounting period, the company makes the accounts ready for the next period. Temporary/nominal accounts: relate only to a given accounting period; they include all income statement accounts and the dividends account. The company closes all temporary accounts at end of the period. Permanent/real accounts: relate to one or more future accounting periods; they consist of all statement of financial position accounts, including equity accounts. Permanent accounts aren’t closed from period to period. Instead, the company carries forward the balances of permanent accounts into the next accounting period. Preparing Closing Entries Closing entries recognize in the ledger the transfer of net income (or net loss) and Dividends to Retained Earnings. The retained earnings statement shows the results of these entries. Closing entries produce a zero balance in each temporary account. => so, they’re ready to accumulate data the next accounting period separate from the data of prior periods. Journalizing and posting closing entries are a required step in accounting cycle. – performs this step after financial statements are prepared. Companies generally journalize and post-closing entries only at the end of the annual accounting period. => thus, all temporary accounts will contain data for the entire accounting period. Companies record closing entries in the general journal. Companies generally prepare closing entries directly from the adjusted balances in the ledger. They could prepare separate closing entries for each nominal account, but the following four entries accomplish the desired result more efficiently: 1. Debit each revenue account for its balance, and credit Income Summary for total revenues. 2. Debit Income Summary for total expenses, and credit each expense account for its balance. 3. Debit Income Summary and credit Retained Earnings for the amount of net income. 4. Debit Retained Earnings for the balance in the Dividends account, and credit Dividends for the same amount. Posting Closing Entries Preparing a Post-Closing Trial Balance Post-closing trial balance: after a company has journalized and posted all closing entries, it prepares another trial balance. Purpose: Prove the equality of the permanent account balances carried forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent – statement of financial position – accounts. The Accounting Cycle and Correcting Entries Summary of the Accounting Cycle Cycle begins with analysis of business transactions and ends with preparation of a post-closing trial balance. Step 1-3 may occur daily during the accounting period. Companies perform Steps 4-7 on a periodic basis, such as monthly, quarterly, or annually. Steps 8-9 – closing entries and a post-closing trial balance – usually take place only at the end of a company’s annual accounting period. There also two optional steps in the accounting cycle. Companies may use a worksheet in preparing adjusting entries and financial statements. In addition, they may use reversing entries. Reversing Entries – An Optional Step Some accountants prefer to reverse certain adjusting entries by making a reversing entry at the beginning of the next accounting period. Reversing entry is the opposite of adjusting entry made in the previous period. Correcting Entries – An Avoidable Step Errors may occur in the recording process. Companies should correct errors, as soon as they discover them, by journalizing and posting correcting entries. If the accounting records are free of errors, no correcting entries are needed. Classified Statement of Financial Position Groups together similar assets and liabilities, using a nr of standard classifications and sections. This is useful bcs items within a group have similar eco characteristics. These grouping help financial statement readers determine: 1. Whether the company has enough assets to pay its debts as they come due. 2. The claims of short-term and long-term creditors on the company’s total assets. Intangible assets Many companies have long-lived assets that don’t physically substance yet often are very valuable. Other intangible assets: goodwill, patents, copyrights, trademarks that give exclusive right of use for a specific period of time. Property, Plant and Equipment / Fixed/Plant Assets Assets with relatively long useful lives that a company is currently using in operating the business. This category incl: land, buildings, machinery and equipment, delivery equipment, and furniture. Depreciation: the practice of allocating the cost of assets to a nr of years. Companies do this by systematically assigning a portion of an asset’s cost as an expense each year. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life. Long-term Investments 1. Investments in shares and bonds of other companies that are normally held for many years. 2. Non-current assets such as land or buildings that a company isn’t currently using in its operating activities. 3. Long-term notes receivable. Current Assets Assets that a company expects to convert to cash or use up within one year or its operation cycle, whichever is longer. Operating cycle of a company is the average time that it takes to purchase inventory, sell it on account, and then collect cash from customers. => for most companies this cycle takes one year or less. Common types of current assets: 1. Cash. 2. Investments. 3. Receivables (note receivable and interest receivable). 4. Inventories. 5. Prepaid expenses (supplies and insurance). On the statement of financial position, companies usually list these items in the reverse order in which they expect to convert them into cash. Equity Non-Current Liabilities Obligations that a company expects to pay after one year. This category incl: bonds payable, mortgages payable, long-term notes payable, lease liabilities and pension liabilities. Current Liabilities Obligations that the company is to pay within the coming year or its operating cycle, whichever is longer. Common examples: accounts payable, salaries and wages payable, notes payable, interest payable and income taxes payable. Chapter 5: Accounting for Merchandise Operations p.1-7 + p.11 Merchandise Operations and Inventory Systems Retailers: merchandising companies that purchase and sell directly to consumers Wholesalers: merchandising companies that sell to retailers Income measurement process for a merchandising company Primary source of revenue for merchandising companies => sales revenue. Merchandising companies’ expenses: Cost of goods sold: total cost of merchandise sold during the period – this expense is directly related to the revenue recognized from the sales of goods Operating expenses. - Costs of Goods Sold and Gross Profit are unique to merchandising company => they’re not used by a service company. Operating Cycles Operating cycle of a merchandising company ordinarily is longer than that of a service company. Flow of Costs Beginning Inventory + Cost of Goods Purchased = cost of goods available for sale. As goods are sold, they’re assigned to cost of goods sold. Those goods that aren’t sold by the end of the accounting period represent ending inventory. Perpetual System In a perpetual inventory system companies keep detailed records of the cost of each inventory purchase and sale. These records show the inventory that should be on hand for every item. Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs. Periodic System In a periodic inventory system, companies don’t keep detailed inventory records of the goods on hand throughout the period. Instead, they determine the cost of goods sold only at the end of the accounting period – periodically. At that point, company takes a physical inventory count to determine the cost of goods on hand. To determine the costs of goods sold under a periodic inventory system, its necessary: 1. Determine the cost of goods on hand at the beginning of the accounting period. 2. Add to it the cost of goods purchased. 3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period. Advantages of Perpetual System Companies that sell merchandise with high unit values, such as automobiles, furniture, have traditionally used perpetual systems. Provides better control over inventories than a periodic system: Since inventory records show the quantities that should be on hand, the company can count the goods at any time to see whether the amount of goods actually on hand agrees with the inventory records. If shortages are uncovered, the company can investigate immediately. Although this system requires both additional clerical work and expense to maintain the subsidiary records, a computerized system can minimize this cost. Some businesses find it unnecessary or uneconomical to invest in a computerized perpetual inventory system. Many small merchandising businesses now use basic accounting software, which provides some of the essential benefits of a perpetual inventory system. Also, managers of small businesses find that they can control their merchandise and manage day-to-day operations using a period inventory system. Recording Purchases Under a Perpetual System A purchase invoice should support each credit purchase. This invoice indicates the total purchase price and other relevant info. However, the purchaser doesn’t prepare a separate purchase invoice. Instead, the purchaser uses as a purchase invoice a copy of the sales invoice sent by the seller. Under the perpetual inventory system, companies record purchases of merchandise for sale in the Inventory account. Recording Sales Under a Perpetual System In accordance with the revenue recognition principle, companies record sales revenue when the performance obligation is satisfied. A business document should support every sales transaction, to provide written evidence of the sale. Cash register documents provide evidence of cash sales. A sales invoice provides support for a credit sale. - The original copy goes to the customer, and the seller keeps a copy for use in recording the sale. - This invoice shows: date of sale, customer name, total sales price, and other relevant info. The seller makes two entries for each sale: First entry records the sale: the seller increases (debits) Cash (or Accounts Receivable, if a credit sale), and also increases (credits) Sales Revenue. Second entry records the cost of the merchandise sold: the seller increases (debits) Costs of Goods Sold, and also decreases (credits) Inventory for the cost of those goods. Chapter 6: Inventories Classifying and Determining Inventory Classifying Inventory How a company classifies its inventory depends on whether the firm is a merchandiser or a manufacturer. In a merchandising company, inventory consists of many different items. Ex: in a grocery store, canned goods, dairy products, and meats are just few of the inventory items on hand. These items have common characteristics: 1. They’re owned by the company. 2. They’re in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers need only one inventory classification, merchandise inventory, to describe the many different items that make up the total inventory. In a manufacturing company, some inventory may not yet be ready for sale. As result, manufacturers usually classify inventory into three categories: finished goods, work in process, and raw materials. - Finished goods inventory: manufactured items that are completed and ready for sale. - Work in process: portion of manufactured inventory that has been placed into the production process but is not yet complete. - Raw materials: basic goods that will be used in production but have not yet been placed into production. By observing the lvls and changes in the lvls of these three inventory types, financial statement users can gain insight into management’s production plans. - Low lvls of raw materials and high lvls of finished goods suggest that management believes it has enough inventory on hand and production will be slowing down – perhaps in anticipation of a recession. - High lvls of raw materials and low lvls of finished goods probably signal that management is planning to step up production. Many companies have significantly lowered inventory lvls and costs using, just-in time (JIT) inventory methods. Under this method, companies manufacture or purchase goods only when needed. Success of JIT system depends on reliable suppliers. Determining Inventory Quantities No matter whether they’re using periodic or perpetual inventory system, all companies need to determine inventory quantities at end of the accounting period. If using perpetual system, companies take a physical inventory: 1. To check the accuracy of their perpetual inventory records. 2. To determine amount of inventory lost due to wasted raw materials, shoplifting or employee theft. Companies using periodic inventory system take a physical inventory for two different purposes: To determine the inventory on hand at the statement of financial position date. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. Determining inventory quantities involve: 1. Taking a Physical Inventory: Involves counting, weighting or measuring each kind of inventory on hand. An inventory count is generally more accurate when goods aren’t being sold or received during the counting. Consequently, companies often take inventory when the business is closed or when business is slow. 2. Determining Ownership of Goods: Goods in transit: a complication in determining ownership is good in transit at end of the period. The company may have purchased goods that haven’t yet been received, or it may have sold goods that haven’t been delivered. To arrive at an accurate count the company must determine ownership of these goods. Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale: - When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyers when the public carrier accepts the goods from the seller. - When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer. Consigned goods: in some lines of business, it’s common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. Inventory Methods and Financial Effects After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold. => process can be complicated if a company has purchased inventory items at different times and prices. Specific Identification It requires that companies keep records of the original cost of each individual inventory item. Rather than keep track of the cost of each item sold, most companies make assumption about which units were sold => cost flow assumptions. Cost Flow Assumptions Two assumed cost flow methods: 1. First-in, first out (FIFO): Assumes that the earliest goods purchased are the first to be sold. Under this method, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. Under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. 2. Average cost: Allocates the cost of goods available for sale based on the weighted-average unit cost incurred. This method assumes that goods are similar in nature. Weighted-Average Unit = Cost of Goods Available for Sale + Total Units Available for Sale There’s no accounting requirement that the cost flow assumption be considered with the physical movement of the goods. Company management selects the appropriate cost flow method. The cost of goods sold formula in a periodic system is: Cost of Goods Sold = (Beginning Inventory + Purchases) – Ending Inventory. Financial Statement and Tax Effects of Cost Flow Methods Reasons companies adopt different inventory cost flow methods: 1. Income statement effects: - The ending inventories and the COGS are different. This difference is due to the unit costs that the company allocated to COGS and ending inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes. In period of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income: - In period of inflation, FIFO produces a higher net income bcs the lower unit costs of the first units purchased are matched against revenues. - In period of rising prices, FIFO reports a higher net income than average-cost. - If prices are falling, the results from the use of FIFO and average-cost are reversed. FIFO will report the lower net income and average-cost the higher. To management, higher net income = advantage. => causes external users to view company more favourably. Therefore, when prices are rising, companies tend to prefer FIFO bcs results in higher net income. 2. Statement of financial position effects: Major advantage of FIFO method is that in period of inflation, the costs allocated to ending inventory will approximate their current cost. Conversely, a shortcoming of the average-cost method is than in period of inflation, the costs allocated to ending inventory may be understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if inventory includes goods purchased in one or more prior accounting periods. 3. Tax effects: Both inventory on the statement of financial position and net income on the income statement are higher when companies use FIFO in period of inflation. => however, some companies use average-cost bcs it results in lower income taxes during times of rising prices. Using Inventory Cost Flow Methods Consistently Consistency concept: whatever cost flow method a company chooses, it should use that method consistently from one accounting period to another. Consistent application enhances comparability of financial statement over successive time periods. In contrast, using FIFO method one year and average-cost method the next year = difficult to compare the net incomes of the two years. Although consistent application is preferred, it doesn’t mean that a company may never change its inventory costing method => when it adopts different method, it should disclose in financial statements the change and its effects on net income. Effects of Inventory Errors Income Statement Effects The ending inventory automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of COGS and net income in two periods. The effects on COGS can be computed by first entering incorrect data in the formula and then substituting the correct data. COGS = Beginning Inventory + Cost of Goods Purchased – Ending Inventory - If beginning inventory is understanded, COGS will be understated, and net income overstated. - If ending inventory is understated, COGS will be overstated, and net income understated. - An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. - Over the two years, though, total net income is correct bcs the errors offset each other. Statement of Financial Position Effects Companies can determine the effect of ending inventory errors on the statement of financial position by using the basic accounting equation. Over the two years, though, total net income is correct bcs the errors offset each other. Inventory Statement Presentation and Analysis Presentation Inventory is classified in the statement of financial position as a current asset immediately above receivables. In a multiple-step income statement, COGS is subtracted from net sales. There should be disclosure of: 1. The major inventory classifications. 2. The basis of accounting (cost or lower-of-cost-or-net realized value). 3. The cost method (FIFO or average cost). Lower-of-Cost-or-Net Realizable Value When the value of inventory is lower than its cost, companies must write down the inventory to its net realizable value => done by valuing the inventory at the lower-of-cost-or net realizable value (LCNRV) in the period in which the price decline occurs. LCNRV is an example of the accounting concept of prudence (the best choice among accounting alternatives is the method that is least likely to overstate assets and net income). Under LCNRV basis, net realizable value refers to the net amount that a company excepts to realize/receive from the sale of inventory. It’s the estimated selling price in the normal course of business, less estimated costs to complete and sell. Companies apply LCNRV to the items in inventory after they have used one of the inventories costing methods (FIFO or average cost) to determine cost. Analysis Common ratios used to manage and evaluate inventory lvls are inventory turnover and a related measure, days in in inventory. Inventory turnover measures the nr of times on average the inventory is sold during the period. Purpose is to measure the liquidity of the inventory. 𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 A variant of the inventory turnover is days in inventory => measures the average nr of days inventory is held. Calculated as 365 divided by the inventory turnover. There are typical lvls of inventory in every business. Companies that are able to keep their inventory at lower lvls and higher turnovers and still satisfy customer needs are the most successful. Inventory Cost Flow Methods in Perpetual Inventory Systems First In, First Out (FIFO) Under perpetual FIFO, the company charges to COGS the cost of the earliest goods on hand prior to each sale. The results under FIFO in a perpetual system are the same as in a periodic system. Average-Cost The average-cost method in a perpetual inventory system = moving-average method. Under this method, the company computes a new average after each purchase by dividing the cost of goods available for sale by the units on hand. Estimating inventories Circumstances that explain why companies sometimes estimate inventories: 1. The gross profit method: Estimates the cost of ending inventory applying a gross profit rate to net sales. This method is relatively simple but effective. Accountants, auditors, and managers frequently use the gross profit method to test the reasonableness of the ending inventory amount. - To use this method, a company needs to know its net sales, cost of goods available for sale, and gross profit rate. Then company then can estimate its gross period for the period. - This method is based on the assumption that gross profit rate will remain the same. But, it may not remain constant due to change in merchandising policies or in mkt conditions. => in such cases, company should adjust the rate to reflect current operating conditions. In some cases, companies can obtain a more accurate estimate by applying this method on a department or product-line basis. - Companies shouldn’t use this method to prepare financial statements at the end of the year. These statements should be based on a physical inventory count. 2. The retail inventory method: Under this method, a company’s records must show both the cost and retail value of the goods available for sale. This method facilitates taking a physical inventory at the end of the year. The major disadvantage, is that it’s an average technique => thus, may produce incorrect inventory valuation of the mix of the ending inventory isn’t representative of the mix in the goods available for sale. LIFO Inventory Method This method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of goods. Under this method, the costs of the latest goods purchased are the first to be recognized in determining COGS. In periods of rising prices, use of the LIFO methods results in lower income taxes and higher cash flow. Chapter 8: Accounting for Receivables Recognition of Accounts Receivable Receivables: amounts due from individuals and companies. Are claims expected to be collected in cash. Are important bcs they represent one of a company’s most liquid assets. Types of Receivables Accounts receivable: the amounts customers owe on account. They result from sale of goods and services. Companies generally expect to collect accounts receivable within 30 to 60 days. Usually most significant type of claim held by a company. Notes receivable: a written promise for amounts to be received; the note normally requires the collection of interest and extends for time periods of 60-90 days or longer. Notes and accounts receivable that result from sales transactions are often called trade receivables. Other receivables include non-trade receivables such as interest receivable, loans to company officers, advances to employees, and income tax refundable. Recognizing Accounts Receivable Valuation and Disposition of Accounts Receivable Valuing Accounts Receivable Companies report accounts receivable on the statement of financial position as an asset. But determining the amount to report is sometimes difficult because some receivables will become uncollectible. Each customer must satisfy the credit requirements of the seller before the credit sale is approved. Inevitably, though, some accounts receivables become uncollectible. Ex: a customer may not be able to pay bcs of a decline in its sales revenue due to a downtown in the economy. Two methods are used in accounting for uncollectible account: 1. Direct Write-Off Method: Under this method, when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense. - Bad Debt Expense will only show actual losses from uncollectible. Under this method, companies often record bad debt expense in a period different from the period in which they record the revenue. The method doesn’t attempt to match bad expense to sales revenue in the income statement. Nor does show accounts receivable in the statement of financial position at the amount the company actually expects to receive. Consequently, unless bad debt losses are insignificant, the direct write-off method isn’t acceptable for financial reporting purposes. 2. Allowance Method: This method involves estimating uncollectible accounts at the end of each period. This provides better matching of expenses w revenues on the income statement. Also ensures that companies state receivables on the statement of financial position at their cash (net) realizable value. Cash (net) realizable value is the net amount the company expects to receive in cash. It excludes amounts that the company estimates it won’t collect. Thus, this method reduces receivables in the statement of financial position by the amount of estimated uncollectible receivables. Companies must use the allowance method for financial reporting purposes when bad debts are material in amount. This method has 3 essential features: 1. Companies estimate uncollectible accounts receivable. They match this estimated expense against revenues in the same accounting period in which they record the revenues. 2. Companies debt estimated uncollectible to Bad Debt Expense and credit them to Allowance for Doubtful Accounts through an adjusting entry at the end of each period. Allowance for Doubtful Accounts is a contra account to Accounts Receivable. 3. When companies write off a specific account, they debit actual uncollectible to Allowance for doubtful Accounts and credit that amount to Accounts Receivable. Recording Estimated Uncollectibles Allowance for Doubtful Accounts shows the estimated amounts of claims on customers that the company expects will become uncollectible in the future. Companies use a contra account instead of a direct credit to Accounts Receivable because they do not know which customers will not pay. Companies don’t close Allowance for Doubtful Accounts at the end of the fiscal year. Recording the Write-Off of an Uncollectible Account Companies use various methods of collecting past-due accounts, such as letters, calls, and legal action. When they have exhausted all means of collecting a past-due account and collection appears impossible, the company writes off the account. To prevent premature or unauthorized write-offs, authorized management personnel should formally approve each write-off. To maintain segregation of duties, the employee authorized to write off accounts shouldn’t have daily responsibilities related to cash or receivables. The company doesn’t increase bad debt expense when the write-off occurs. Under the allowance method, companies debit every bad debt write-off to the allowance account rather than to Bad Debt Expense. A write-off affects only statement of financial position accounts. The write-off of the account reduces both Accounts Receivable and Allowance for Doubtful Accounts. Recovery of an Uncollectible Account The company makes two entries to record the recovery of a bad debt. 1. It reverses the entry made in writing off the account. This reinstates the customer’s account. 2. It journalizes the collection in the usual manner Estimating the Allowance Frequently, companies estimate the allowance as a percentage of the outstanding receivables. Under the percentage-of-receivables basis, management establishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts. To estimate the ending balance more accurately in the allowance account, a company often prepares a schedule, called aging the accounts receivable. This schedule classifies customer balances by the length of time they have been unpaid. => the longer a receivable is past due, the less likely is to be collected. Disposing of Accounts Receivable Companies sell receivables for two major reasons: 1. May be only reasonable source of cash. 2. Billing and collection are often time-consuming and costly. Its therefore often easier for a retailer to sell the receivables to another party with expertise in billing and collection matters. Sales of Receivables to a Factor A common sale of receivables is a sale to a factor. A factor is a finance company or bank that buys receivables from businesses and then collects the payments directly from the customers. Factoring is a multibillion-dollar business. National Credit Card Sales Three parties are involved when national credit cards are used in retail sales: 1. The credit card issuer, who is independent of the retailer. 2. The retailer. 3. The customer. A retailer’s acceptance of a credit card is another form of selling (factoring) the receivable. Accounting for Credit Card Sales The retailer generally considers sales from the use of credit card sales as cash sales. The retailer must pay to the bank that issues the card a fee for processing the transactions. The retailer records the credit card slips in a similar manner as checks deposited from a cash sale. Notes Receivables Companies may also grant credit in exchange for a formal credit instrument known as promissory note. A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. Promissory notes may be used: 1. When individuals and companies lend or borrow money. 2. When the amount of the transaction and the credit period exceed normal limits. 3. In settlement of accounts receivable. The party making the promise to pay is called the maker. The party to whom payment is to be made is called the payee. Notes receivable give the holder a stronger legal claim to assets than do accounts receivable. Notes receivable can be readily sold to another party. Promissory notes are negotiable instruments (as are checks), meaning they can be transferred to another party by endorsement. Determining the Maturity Date If the life of a note is expressed in terms of months, you find the date when it matures by counting the months from the date of issue. If the due date is stated in terms of days, you need to count the exact nr of days to determine the maturity date. Ex: the maturity date of a 60 day note dated July 17 is September 15. Computing Interest Interest = Face Value of Note x Annual Interest Rate x Time in Terms of One Year The interest rate specified in a note is an annual rate of interest. When the maturity date is stated in days, the time factor is often the nr of days divided by 360. Remember that when counting days, omit the date that the note is issued but include the due date. When the due date is stated in months, the time factor is the nr of months divided by 12. Recognizing Notes Receivable The company records the note receivable at its face value. No interest revenue is reported when the note is accepted bcs the revenue recognition principle doesn’t recognize revenue until the performance obligation is satisfied. Interest is earned (accrued) as time passes. If a company issues cash in exchange for a note, the entry is a debit to Notes Receivable and a credit to Cash in the amount of the loan. Valuing Notes Receivable Valuing short-term notes receivable is the same as valuing accounts receivable. Like accounts receivable, companies report short-term notes receivable at their cash (net) realizable value. The notes receivable allowance account is Allowance for Doubtful Accounts. Disposing of Notes Receivables Notes may be held to their maturity date, at which time the face value plus accrued interest is due. In some situations, the maker of the note defaults, and the payee must make an appropriate adjustment. The holder of the note may also speed up conversion to cash by selling the receivables. Honor of Notes Receivable A note is honored when its maker pays in full at its maturity date. The amount due at maturity is the face value of the note plus interest for the length of time specified on the note. Accrual of Interest Receivable If the company prepares financial statement as of 30. September, they have to accrue interest bcs they have earned interest, but not received it yet. At the maturity on Nov 1, the company receives €10,375 (€10,000 repayment, €300 Interest Receivable accrued on Sept 30 and €75 earned during October). Dishonor of Notes Receivable A dishonored (defaulted) note is a note that isn’t paid in full at maturity. A dishonored note receivable is no longer negotiable. As the payee still has a claim against the maker of the note for both the note and the interest, the note holder usually transfers the Notes Receivables account to an Accounts Receivables account. Presentation and Analysis If a company has significant receivables, analysts carefully review the company’s financial statement disclosures to evaluate how well the company is managing its receivables. Presentation Companies should identify in the statement of financial position or in the notes to the financial statements each of the major types of receivables. Short term receivables appear in current assets section. Short term investments appear after short-term receivables (bcs more liquid). Companies report the gross amount of receivables and the allowance for doubtful accounts. Analysis Investors and company managers compute financial ratios to evaluate the liquidity of a company’s accounts receivable. They use the accounts receivable turnover to assess the liquidity of the receivables. This ratio measures the nr of times, on average, the company collects accounts receivable during the period. The higher the turnover, the more liquid the company’s receivables. Accounts Receivable Turnover = Net Credit Sales + Average Net Accounts Receivable A variant of the accounts receivable turnover that makes the liquidity even more evident is its conversion into an average collection period in terms of days. 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑌𝑒𝑎𝑟 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 𝑖𝑛 𝐷𝑎𝑦𝑠 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 Companies frequently use the average collection period to assess the effectiveness of a company’s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period (that is, the time allowed for payment). Chapter 9: Plant Assets, Natural Resources and Intangible Assets Plant Asset Expenditures Plant assets: resources that have three characteristics – have a physical substance (definite size and shape), are used in the operations of a business, and aren’t intended for sale to customers. Also called property, plant and equipment; plant equipment; and fixed assets. These assets are expected to be of use to the company for a nr of yrs. Except for land, plant assets decline in service potential over their useful lives. Bcs they’re key role in ongoing operations, companies keep plant assets in good operation condition. Also replace worn-out or outdated plant assets, and expand productive resources as needed. Determining the Cost of Plant Assets Cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use. Land Companies often use land as a site for a manufacturing plant or office building. Cost of land includes: 1. Cash purchase price. 2. Closing costs such as title and attorney’s fees. 3. Real estate brokers’ commissions. 4. Accrued property taxes and other liens assumed by the purchaser. Land improvements Structural additions with limited lives that are made to land. Ex: driveways, parking lots, fences, etc. Cost of land improvements includes: all expenditures necessary to make the improvements ready for the intended use. Land improvements have limited useful lives – even when well maintained, they’ll eventually be replaced => as result, companies’ expense (depreciate) the cost of land improvements over their useful lives. Buildings Facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. Companies debit to the Buildings account all necessary expenditures related to purchase or construction of a building. When a building is purchased, such costs include, purchase price, closing costs (attorney’s fees, title insurance, etc.), and the real estate broker’s commission. When a new building is constructed, its costs consist of the contact price + payments for architects’ fees, building permits, and excavation costs. In addition, companies charge interest costs to the Buildings account. Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building ready for use. However, inclusion of interest costs in the cost of a constructed building is limited to interest costs incurred during the construction period. => when construction has been completed, the company records subsequent interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense. Equipment Includes assets used in operation, such as store check-out counters, factory machinery, etc. Cost of equipment includes: 1. Cash purchase price. 2. Sales taxes. 3. Freight charges. 4. Insurance during transit paid by the purchaser. Expenditures During Useful Life During useful life of a plant asset, a company may incur costs for ordinary repairs, additions, or improvements. Ordinary repairs: expenditures to maintain the operation efficiency and productive life of the unit. Usually are fairly small amounts that occur frequently. - Companies record such repairs as debits to Maintenance and Repairs Expense as they are incurred. => bcs they’re immediately charged as an expense against revenues, these costs are often referred to as revenue expenditures. Additions and improvements: costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset. Usually are material in amount and occur infrequently. - They increase company’s investment in productive facilities. - Companies generally debit these amounts to the plant asset affected. Often referred as capital expenditures. Companies must use good judgment in deciding between a revenue expenditure and a capital expenditure. Materiality refers to the impact of an item’s size on a company’s financial operations. Materiality concept states that if an item wouldn’t make a difference in decision-making, the company doesn’t have to follow IFRS in reporting that item. Depreciation Methods Depreciation: process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Cost allocation enables companies to properly match expenses with revenues in accordance with the expense recognition principle. Depreciation is a process of cost allocation, not a process of asset valuation. So, the book value (cost less accumulated depreciation) of a plant asset might be quite different from its fair value. => in fact, if an asset is fully depreciated, it can have zero book value but still have a positive fair value. Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. WHY? Because usefulness to the company and revenue-producing ability of each asset will decline over the asset’s useful life. => depreciation doesn’t apply to land – usefulness and revenue-producing ability remains intact over time. => in fact, it can get greater overtime bcs of scarcity of good land sites. - Land isn’t a depreciable asset. During a depreciable asset’s useful life, its revenue-producing ability declines bcs of wear and tear. The revenue-producing ability can also decline due to obsolescence – process of becoming out of date before the asset physically wars out. Recognizing depreciation on an asset doesn’t result in an accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset’s cost that the company has charged to expense. It isn’t a cash fund. Going concern assumption states that the company will continue in operation for the foreseeable future. If a company doesn’t use this assumption, then plant assets should be stated at their fair value. Factors in Computing Depreciation 1. Cost: all expenditures necessary to acquire the asset and make it ready for intended use; companies record plant assets at cost, in accordance with the historical cost principle. 2. Useful life: an estimate of the expected productive life, also called service life, of the asset for its owner. Estimate of the expected life based on need for repair, service life, and vulnerability to obsolescence. 3. Residual value: an estimate of the asset’s value at the end of its useful life. Depreciation Methods Each method is acceptable under IFRS. Management selects the method they believe it’s the most appropriate – objective is to select the method that best measures an asset’s contribution to revenue over its useful life. Once it selects a method, it should apply it consistently over the useful life of the asset. No matter which method is used, the total amount depreciated over the useful life of the asset is its depreciable cost. Depreciable Cost = Cost – Residual Value 1. Straight line method: Under this method, companies expense the same amount of depreciation for each year of the asset’s useful life. Its solely measured by the passage of time. To compute depreciation under this method, companies need to determine depreciable cost. And need to determine the annual depreciation expense. Annual Depreciation Expense = Depreciation Cost : Useful Life (in years) Alternatively, we can also compute an annual rate of depreciation. Depreciation schedule using an annual rate: 2. Units-of-activity method: Under this method, useful life is expressed in terms of the total units of production or use expected from the asset, rather than as a time period. Ideally suited to factory machinery. This method isn’t suited for buildings or furniture bcs depreciation for these assets is more a function of time than of use. Depreciable Cost per Unit = Depreciable Cost : Total Units of Activity Annual Depreciation Expense = Depreciation Cost per Unit x Units of Activity during the Year 3. Double-Declining balance: This method produces a decreasing annual depreciation expense over the asset’s useful life. The periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset. The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year. Book value at the beginning of the year is the cost of the asset => bcs the balance in accumulated depreciation at the beginning of the asset’s useful life is zero. In subsequent years. Book value is the different between cost and accumulated depreciation. This method ignores residual value in determining the amount to which the decline-balance rate is applied. However, residual value doesn’t limit the total depreciation that can be taken => depreciation stops when the asset’s book value equals expected residual value. A common declining-balance rate is double the straight-line rate => method is called double-declining- balance method. Annual Depreciation Expense = Book Value at the Beginning of Year x Declining-Balance Rate Because the declining-balance produces higher depreciation expense in the early years than in the later years, its considered an accelerated-depreciation method. The declining-balance method is compatible with the expense recognition principle. Comparison of methods Component depreciation Requires that any significant parts of a plant asset that have significantly different estimated useful lives should be separately depreciated. IFRS requires component depreciation for plant assets – even though we assumed that plant assets use a single depreciation rate. Depreciation and Income Taxes Tax laws allow company taxpayers to deduct depreciation expense when they compute taxable income. => however, tax laws often don’t require to impose same depreciation method on the tax return that is used in preparing financial statements. Many companies use straight-line in their financial statements to maximize net income. And use accelerated-depreciation method on their tax returns to minimize their income taxes. Revaluation of Plant Assets IFRS allows companies to revalue plant assets to fair value at the reporting date. Gain Situation Loss Situation The impairment loss of $25,000 reduces net income. Comparison of this loss situation with the previous gain situation illustrate important point: Losses are reported in net income. Gains are reported in other comprehensive income. Revision Periodic Depreciation Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicate that annual depreciation estimates are inadequate or excessive, the company should change the amount of depreciation expense. When a change in an estimate is required, the company makes the change in current and future years. It doesn’t change depreciation in prior years. To determine new annual depreciation expense, the company first computes the asset’s depreciable cost at the time of the revision. It then allocates the revised depreciable cost to the remaining useful life. Plant Asset Disposals When disposing of a plant asset, the company removes all amounts related to the asset. This includes the original cost and the total depreciation to date in the accumulated depreciation account. Retirement of Plant Assets What happens if a fully depreciated plant asset is still useful to the company? The asset and its accumulated depreciation continue to be reported on the statement of financial position, without further depreciation adjustment, until the company retires the asset. Reporting the asset and related accumulated depreciation on the statement of financial position informs the financial statement reader that the asset is still in use. Once fully depreciated, no additional depreciation should be taken, even if an asset is still being used. If a company retires a plant asset before its fully depreciated, and no cash is received for scrap or residual value, a loss on disposal occurs. Companies report a loss on disposable of plant assets in the “Other income and expense” section of the income statement. Sale of Plant Assets In a disposable by sale, the company compares the book value of the asset with the proceeds received from the sale. If the proceeds of the sale exceed the book value of the plant asset sold, a gain on disposal occurs. If the proceeds of the sale are less than then book value of the plant asset sold, a loss on disposal occurs. Gain on Sale Loss on Sale Natural resources and Intangible Assets Natural Resources and Depletion Common natural resources consist of standing timber and resources extracted from the ground, such as oil, gas, and minerals. Standing timber is considered a biological asset under IFRS. IFRS defines extractive industries as those businesses involved in finding and removing natural resources located in or near the earth’s crust. The acquisition of cost an extractable natural resource is the price needed to acquire the resource and prepare it for its intended use. Depletion: allocation of the cost of natural resources in a rational and systematic manner over the resource’s useful life. Companies generally use the units-of-activity method to compute depletion. => bcs depletion generally is a function of the units extracted during the year. Under the units-of-activity method, companies divide the total cost of the natural resource minus residual value by the nr of units estimated to be in the resource. The result is depletion cost per unit. To compute depletion, the cost per unit is then multiplied by the nr of units extracted. 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡−𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 Depletion Cost per Units = 𝑇𝑜𝑡𝑎𝑙 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑈𝑛𝑖𝑡𝑠 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒. Intangible Assets Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that don’t possess physical substance. Evidence of intangible may exist in form of contacts/licenses. Intangibles may arise from: 1. Gov grants, such as patents, copyrights, licenses, trademarks, and trade names. 2. Acquisition of another business, in which the purchase price includes a payment for goodwill. 3. Private monopolistic arrangements arising from contractual agreements, such as franchises and leases. Accounting for Intangible Assets Companies record intangible assets at cost => cost consists of all expenditures necessary for the company to acquire the right, privilege, or competitive advantage. They’re categorized as having either limited life or indefinite life. If it has limited life, company allocated its cost over the asset’s useful life using a process that allocates the cost of intangible – amortization. The cost of intangible assets with indefinite lives shouldn’t be amortized. Companies amortize the cost of a patent over its 20-year life or its useful life, whichever is shorter. Patents An exclusive right issued by a patent office that enables the recipient to manufacture, sell, or otherwise control an invention for a specified nr of yrs from the date of the grant. Its non-renewable, but companies can extend the legal life of it by obtaining new patents for improvements or other changes in the basic design. The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent. The owner adds those costs to the Patents account and amortizes them over the remaining life of the patent. The patent holder amortizes the cost of a patent over its legal life or its useful life, whichever is shorter. Copyrights Govs grant copyrights, which give owner exclusive right to reproduce and sell an artistic or published work. Copyrights extend for the life of the creator plus a specified nr of years, which can vary by country but is commonly 70 yrs. The cost of a copyright is the cost of acquiring and defending it. Useful life of it is shorter, so they’re usually amortized over a relatively short period of time. Trademarks/Trade Names A word, jingle, phrase or symbol that identifies a particular enterprise or product. Creator or original user may obtain exclusive legal right to the trademark by registering it with a patent office or similar governmental agency. Such registration provides a specified nr of yrs of protection, which can vary but normally is 20yrs. Registration may be immediately renewed as long it’s in use. Franchises and Licenses Franchise: contractual arrangement between a franchisor and a franchisee. The franchisor grants the franchisee the right to sell certain products, perform specific services, or use certain trademarks or trade names, usually within a designated geographic area. Another type of franchise is that entered into between a governmental body (commonly municipalities) and a company. This franchise permits the company to use public property in performing its services. => such operating rights are licenses. When a company incurs costs in connection with the purchase of a franchise or license, it should recognize an intangible asset. Annual payments made under a franchise agreement are recorded as operating expenses in the period in which they’re incurred. Goodwill Represents value of all favorable attributes that relate to a company that isn’t tied to any other specified asset. Goodwill is unique. Unlike assets such as investments and plant assets, which can be sold individually in the marketplace, goodwill can be identified only with the business as a whole. Companies record goodwill only when an entire business is purchased. In that case, goodwill is the excess of cost over the fair value of the net assets (assets less liabilities) acquired. Goodwill isn’t amortized bcs it’s considered to have an indefinite life. Statement Presentation and Analysis Presentation Analysis Using ratios, we can analyze how efficiently a company uses its assets to generate sales. Asset turnover analyzes the productivity of a company’s assets. Asset turnover = Net Sales : Average Total Assets Exchange of Plant Assets Companies record a gain or loss on the exchange of plant assets. The rationale for recognizing a gain or loss is that most exchanges have commercial substance. => an exchange has commercial substance if the future cash flows change as a result of the exchange. The exchange has commercial substance. Loss Treatment In recording an exchange at loss it’s required to: 1. Eliminate the book value of the asset given up. 2. Record the cost of the asset acquired. 3. Recognize the loss on disposal of plant assets. 4. Record the cash paid or received. Gain Treatment In recording an exchange at a gain it’s required to: 1. Eliminate the book value of the asset given up. 2. Record the cost of the asset acquired. 3. Recognize the gain on disposal of plant assets. 4. Record the cash paid or received. Chapter 10: Current Liabilities Accounting for Current Liabilities Current liability: a debt that a company expects to pay within one year or the operating cycle, whichever is longer. Debts that don’t meet this criterion are non-current liabilities. Types of current liabilities: Notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable. Notes Payable Are often used instead of accounts payable bcs they give the lender formal proof of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet short-term financial needs. Usually require the borrower to pay interest. Are issued for varying periods of time => those due for payment within one year of the statement of financial position date are usually classifies as current liabilities. Interest = Face Value of Note x Annual IR x Time in Terms of One Year Value-Added and Sales Taxes Payable Consumption taxes are generally either value-added tax (VAT) or sales tax. Purpose of these taxes: generate revenue for the gov similar to the company or personal income tax. They accomplish same objective: tax the final consumer of the good or service. Value-Added Taxes Payable Used by tax authorities more than sales taxes. It’s placed on a product or service whenever value is added at a stage of production and at final sale. A VAT is a cost to the end user, normally a private individual, similar to a sales tax. In a VAT taxation system, the VAT is collected every time a business purchases products from another business in the product’s supply chain. Example: Assume that Hill Farms Wheat grows wheat and sells it to Sunshine Baking for €1,00. Hill Farms Wheat makes the following entry to record the sale, assuming the VAT is 10%. Hill Farms Wheat then remits the €100 to the tax authority. Sales Taxes Payable Example: Cooley Grocery sells loaves of bread totaling €800 on a given day. Assuming a sales tax rate of 6%, Cooley make the following entry record the sale. When the company remits the taxes to the taxing agency, it debits Sales Taxes Payable and credits Cash. The company doesn’t report sales taxes as an expense. It simply forwards to the gov the amount paid by the customers. Thus, Cooley Grocery only as a collection agent for the taxing authority. Unearned Revenues How do companies account for unearned revenues that are received before goods are delivered or services are performed? 1. When a company receives the advance payment, it debits Cash and credits a current liability account identifying the source of the unearned revenue. 2. When the company recognizes revenue, it debits an unearned revenue account and credits a revenue account. Salaries and Wages Companies report as a current liability the amounts owed to employees for salaries or wages at the end of an accounting period. In addition, they often also report as current liabilities the following items related to employee compensation: 1. Payroll Deductions. 2. Bonuses. Payroll Deductions Most common types of payroll deductions: taxes, insurance premiums, employee savings and union dues. To the extent that a company has not remitted the amounts deducted to the proper authority at the end of the accounting period, it should recognize them as current liabilities. Social Security Taxes Most govs provide a lvl of social benefits (for retirement, unemployment, income, disability, and medical benefits) to individuals and families. => the benefits are generally funded from taxes assessed on both the employer and the employees. Funds for these payments generally come from taxes levied on both the employer and the employee. Employers collect the employee’s share of this tax by deducting it from the employee’s gross pay, and remit it to the gov along with their share. The gov often taxes both the employer and the employee at the same rate. Companies should report the amount of unremitted employee and employer Social Security tax on gross wages paid as a current liability. Income Tax Withholding Income tax laws require employers to withhold from each employee’s pay the applicable income tax due on those wages. The employer computes the amount of income tax to withhold according to a gov-prescribed formula or withholding tax table. Amount depends on the length of the pay period and each employee’s taxable wages, marital status, and claimed dependents. Payroll Deductions Example: Employee Assume the company has a weekly payroll of €10,000 (gross earnings) entirely subjected to Social Security taxes (8%), with income tax withholding of €1,320 and union dues of €88 deducted. If weekly payroll is due on January 14, the company records the salaries and wages payable (net pay) and the employee payroll deduction as follows: After recording payroll for the week, the company records the payment of the payroll as follows: Payroll Deduction Example: Employer As the employer, the company is also required to pay Social Security taxes (employer payroll taxes). It records payroll taxes related to the January 14 payroll as follows: Profit-Sharing and Bonus Plans Many companies give bonus to certain or all employees in addition to their regular salaries or wages. A company may consider bonus payments to employees as additional salaries and wages and should include them as a deduction in determining the net income for the year. Current Maturities of Long-Term Debt Companies identify current maturities of long-term debt on the statement of financial position as long- term debt due within one year. It’s not necessary to prepare adjusting entry to recognize the current maturity of long-term debt. At the statement of financial position date, all obligation due within one year are classified as current, and all other obligation as non-current. Reporting and Analyzing Current Liabilities Reporting Uncertainty A provision is a liability of uncertain timing or amount (sometimes referred to as an estimated liability). Very common and may be reported either as current or non-current depending on the date of expected payment. Common types: litigation expense, warranty expense or product guarantees, and environmental damage. Difference between a provision and other liabilities (such as accounts or notes payable) is that a provision has greater uncertainty about the timing or amount of the future expenditure required to settle the obligation. Recognition of a Provision Companies accrue an expense and related liability for a provision only if the following three conditions are met: 1. A company has a present obligation as a result of a past event. 2. It’s probable that an outflow of resources will be required to settle the obligation. The term probable is defined as “more likely than not to occur” = greater than 50% 3. A reliable estimate can be made of the amount of the obligation. If they’re not met, no provision is recognized. Reporting a Provision The accounting for warranty costs is based on the expense recognition principle. => the estimated cost of honoring product warranty contracts should be recognized as an expense in the period in which the sales occurs. Example: Reporting of Current Liabilities Current liabilities are reported after non-current liabilities on the statement of financial position. Analysis of Current Liabilities Use of current and non-current classification makes it possible to analyze a company’s liquidity. Liquidity refers to ability to pay maturing obligations and meet unexpected needs for cash. Relationship of current assets to current liabilities is critical in analyzing liquidity. => we can express relationship as a currency amount (working capital) and as a ratio (current ratio). o Excess of current assets over current liabilities = working capital. Current Assets – Current Liabilities = Working Capital o The current ratio permits us to compare the liquidity of different-sized companies and of a single company at different times. Current Assets : Current Liabilities = Current Ratio Chapter 12: Corporations – Organization, Share Transactions, and Equity The Corporate Form of Organization Corporation: an entity separate and distinct from its owners. Is created by law, and its continued existence depends upon the statutes of the jurisdiction in which it’s incorporated. As a legal entity, a corporation has most of the rights and privileges of a person. The exceptions relate to privileges that only a living person can exercise, such as the right to vote or to hold public office. It’s subjected to the same duties and responsibilities as a person. Common ways to classify corporations are by purpose and by ownership. o Public held corporation may have thousands of shareholders. o Private held corporation usually has only a few shareholders and doesn’t offer its shares for sale to the general public. Characteristics of a Corporation Forming a Corporation File an application w the appropriate gov agency in the jurisdiction in which incorporation is desired => application describes name and purpose of corporation, the types and nrs that are authorized to be issued, the names of the individuals that formed the company, and the nr of shares that these individuals agreed to purchase. - It is to company’s advantage to incorporate in a state/country whose laws are favorable to the corporate form of business organization. After gov approves application, it grants a charter => an approved copy of the application form, or a separate document containing the same basic idea. Upon receipt of its charter, the corporation establishes by-laws. => they establish the internal rules and procedures for conducting the affairs of the corporation. Corporations engaged in commerce outside their state or country must also obtain a license from each of those govs in which they do business. The license subjects the corporation’s operating activities to the general corporation laws of that state/country. Costs incurred in the formation of a corporation: organization costs. These incl: legal and gov fees, and promotional expenditures involved in the organization of the business. Corporations expense organization costs as incurred. Determining amount and timing of future benefits is so difficult that it’s standard procedure to take a conservative approach of expensing these costs immediately. Shareholder Rights When chartered, the corporation may begin selling ownership rights in the form of shares. When a corporation has only one class of shares = ordinary shares. Proof of share ownership is evidenced by a form = share certificate. Share Issue Considerations Authorized Shares The charter indicates the amount of shares that a corporation is authorized to sell. The total amount of authorized shares at the time of incorporation normally anticipates both initial and subsequent capital needs. As result, nr of shares authorized generally exceeds nr initially sold. If it sells all authorized shares, a corporation must obtain consent of jurisdiction to amend its charter before it can issue additional shares. The authorization of ordinary shares doesn’t result in a formal accounting entry. => reason is that the event has no immediate effect on either corporate assets or equity. Issuance of Shares A corporation can issue ordinary shares directly to investors. It can also issue shares indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors. Direct issue => closely held companies. Indirect issue => publicly held corporation. In an indirect issue, the investment banking firm may agree to underwrite the entire share issue. In this arrangement, the investment banker buys the shares from the corporation at a stipulated price and resells them to investors. The corporation thus avoids any risk of being unable to sell the shares. It also obtains immediate use of cash received from the underwrites. The investment banking firm assumes the risk of reselling the shares, in return for an underwriting fee. How does a corporation set the price for a new issue of shares? 1. The company’s anticipated future earnings. 2. Its expected dividend rate per share. 3. Its current financial position. 4. The current state of the economy. 5. The current state of the securities market.