Intermediate Financial Accounting I Handout PDF

Intermediate Financial Accounting I -Handout CHAPTER ONE DEVELOPMENT OF ACCOUNTING PRINCIPLES AND PRACTICES The age of international trade and the interdependence of national economies continue to evolve. Many of the largest companies in the w...

Intermediate Financial Accounting I -Handout CHAPTER ONE DEVELOPMENT OF ACCOUNTING PRINCIPLES AND PRACTICES The age of international trade and the interdependence of national economies continue to evolve. Many of the largest companies in the world often do more of their business in foreign lands than in their home countries. Companies now access not only their home country capital markets for financing, but others as well. With this globalization, companies are recognizing the need to have one set of financial reporting standards. Standard-Setting Organizations For many years, many nations have relied on their own standard-setting organizations. For example, Canada has the Accounting Standards Board, Japan has the Accounting Standards Board of Japan, Germany has the German Accounting Standards Committee, and the United States has the Financial Accounting Standards Board (FASB). The standards issued by these organizations are sometimes principles-based, rules-based, tax-oriented, or business-based. In other words, they often differ in concept and objective. The main international standard-setting organization is based in London, England, and is called the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRS), which are used on most foreign exchanges. IFRS is presently used or permitted in over 149 jurisdictions (similar to countries) and is rapidly gaining acceptance in other jurisdictions as well. IFRS has the best potential to provide a common platform on which companies can report, resulting in financial statements investors can use to compare financial information. As a result, our discussion focuses on IFRS and the organization involved in developing these standards— the International Accounting Standards Board (IASB). The two organizations that have a role in international standard-setting are the International Organization of Securities Commissions (IOSCO) and the IASB. International Organization of Securities Commissions (IOSCO) The International Organization of Securities Commissions (IOSCO) is an association of organizations that regulate the world’s securities and futures markets. Members are generally the main financial regulator for a given country. IOSCO does not set accounting standards. Instead, this organization is dedicated to ensuring that the global markets can operate in an efficient and effective basis. The member agencies (such as from France, Germany, New Zealand, and the United States) have resolved to:  Cooperate to promote high standards of regulation in order to maintain just, efficient, and sound markets.  Exchange information on their respective experiences in order to promote the development of domestic markets.  Unite their efforts to establish standards and an effective surveillance of international securities transactions.  Provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offenses. Page 1 Intermediate Financial Accounting I -Handout IOSCO supports the development and use of IFRS as the single set of high-quality international standards in cross-border offerings and listings. It recommends that its members allow multinational issuers to use IFRS in cross-border offerings and listings, as supplemented by reconciliation, disclosure, and interpretation where necessary to address outstanding substantive issues at a national or regional level. International Accounting Standards Board (IASB) The standard-setting structure internationally is composed of the following four organizations: 1. The IFRS Foundation provides oversight to the IASB, IFRS Advisory Council, and IFRS Interpretations Committee. In this role, it appoints members, reviews effectiveness, and helps in the fundraising efforts for these organizations. 2. The International Accounting Standards Board (IASB) develops, in the public interest, a single set of high-quality, enforceable, and global international financial reporting standards for general-purpose financial statements. 3. The IFRS Advisory Council (the Advisory Council) provides advice and counsel to the IASB on major policies and technical issues. 4. The IFRS Interpretations Committee assists the IASB through the timely identification, discussion, and resolution of financial reporting issues within the framework of IFRS. In addition, as part of the governance structure, a Monitoring Board was created. The purpose of this board is to establish a link between accounting standard-setters and those public authorities (e.g., IOSCO) that generally oversee them. Page 2 Intermediate Financial Accounting I -Handout Characteristics of the IASB The characteristics of the IASB, as shown below, reinforce the importance of an open, transparent, and independent due process. Membership: The Board consists of 14 full-time members. Members are well-paid, appointed for five-year renewable terms, and come from different countries. Autonomy: The IASB is not part of any other professional organization. It is appointed by and answerable only to the IFRS Foundation. Independence. Full-time IASB members must sever all ties from their past employer. The members are selected for their expertise in standard-setting rather than to represent a given country. Voting: A majority of votes are needed to issue a new IFRS. In the event of a tie, the chairperson is granted an additional vote. With these characteristics, the IASB and its members will be insulated as much as possible from the political process, favored industries, and national or cultural bias. The IASB’s conceptual framework for financial reporting A conceptual framework establishes the concepts that underlie financial reporting. A conceptual framework is a coherent system of concepts that flow from an objective. To be useful, rule- making should build on and relate to an established body of concepts. A soundly developed conceptual framework thus enables the IASB to issue more useful and consistent pronouncements over time, and a coherent set of standards should result. Indeed, without the guidance provided by a soundly developed framework, standard- setting ends up being based on individual concepts developed by each member of the standard-setting body. The conceptual framework has three levels. The first level identifies the objective of financial reporting that is, the purpose of financial reporting. The second level provides the qualitative characteristics that make accounting information useful and the elements of financial statements (assets, liabilities, and so on). The third level identifies the recognition, measurement, and disclosure concepts used in establishing and applying accounting standards and the specific concepts to implement the objective. Page 3 Intermediate Financial Accounting I -Handout Conceptual framework Objective of financial reporting The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. To make effective decisions, these parties need information to help them assess a company’s prospects for future net cash flows and/or provide a return to existing and potential investors, lenders, and other creditors. For example, a lender may need information in order to decide whether to loan money to a company. Similarly, an equity investor may need information about a company’s profitability in order to decide whether to purchase or sell shares. Management stewardship is how well management uses a company’s resources to create and sustain value. To evaluate stewardship, companies should provide information about their financial position, changes in financial position, and performance. They should also show how efficiently and effectively management and the board of directors have discharged their responsibilities to use Page 4 Intermediate Financial Accounting I -Handout the company’s resources wisely. Therefore, information that is useful in assessing stewardship can also be useful for assessing a company’s prospects for future net cash inflows. Information that is decision-useful to capital providers may also be helpful to users of financial reporting who are not capital providers. General-Purpose Financial Statements General-purpose financial statements provide financial reporting information to a wide variety of users. When a given company issues its financial statements, these statements help shareholders, creditors, suppliers, employees, and regulators to better understand its financial position and related performance. Users need this type of information to make effective decisions. To be cost- effective in providing this information, general-purpose financial statements are most appropriate. In other words, general-purpose financial statements provide, at the least cost, the most useful information possible. Equity Investors and Creditors The objective of financial reporting identifies investors and creditors as the primary user group for general-purpose financial statements. Identifying investors and creditors as the primary user group provides an important focus of general-purpose financial reporting. When a given company issues its financial statements, its primary focus is on investors and creditors because they have the most critical and immediate need for information in financial reports. Investors and creditors need this financial information to assess company’s ability to generate net cash inflows and to understand management’s ability to protect and enhance the assets of the company, which will be used to generate future net cash inflows. As a result, the primary user groups are not management, regulators, or some other non-investor group. Entity Perspective As part of the objective of general-purpose financial reporting, an entity perspective is adopted. Companies are viewed as separate and distinct from their owners (present shareholders) using this perspective. The assets of ABC S.co are viewed as assets of the company and not of a specific creditor or shareholder. Rather, these investors have claims on company’s assets in the form of liability or equity claims. The entity perspective is consistent with the present business environment, where most companies engaged in financial reporting have substance distinct from their investors (both shareholders and creditors). Thus, the perspective that financial reporting should be focused only on the needs of shareholders often referred to as the proprietary perspective is not considered appropriate. Decision Usefulness Investors are interested in financial reporting because it provides information that is useful for making decisions (referred to as the decision-usefulness approach). When making these decisions, investors are interested in assessing (1) the company’s ability to generate net cash inflows and (2) management’s ability to protect and enhance the capital providers’ investments. Financial reporting should therefore help investors assess the amounts, timing, and uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans. Page 5 Intermediate Financial Accounting I -Handout Qualitative Characteristics of Accounting Information Companies can choose an acceptable accounting method, the amount and types of information to disclose by determining which alternative provides the most useful information for decision-making purposes (decision- usefulness). The IASB identified the qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes. Hierarchy of Qualitative Accounting Information Qualitative characteristics are either fundamental or enhancing characteristics, depending on how they affect the decision-usefulness of information. Regardless of classification, each qualitative characteristic contributes to the decision-usefulness of financial reporting information. However, providing useful financial information is limited by a pervasive constraint on financial reporting cost should not exceed the benefits of a reporting practice. Fundamental Quality Relevance Relevance is one of the two fundamental qualities that make accounting information useful for decision- making. To be relevant, accounting information must be capable of making a difference in a decision. Information with no bearing on a decision is irrelevant. Financial information is capable of making a difference when it has predictive value, confirmatory value, or both. Financial information has predictive value if it has value as an input to predictive processes used by investors to form their own expectations about the future. Relevant information also helps users confirm or correct prior expectations; it has confirmatory value. Materiality is a company-specific aspect of relevance. Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information. 6 Intermediate Financial Accounting I -Handout Fundamental Quality Faithful Representation Faithful representation is the second fundamental quality that makes accounting information useful for decision-making. Faithful representation means that the numbers and descriptions match what really existed or happened. Faithful representation is a necessity because most users have neither the time nor the expertise to evaluate the factual content of the information. To be a faithful representation, information must be complete, neutral, and free of material error. Completeness means that all the information that is necessary for faithful representation is provided. An omission can cause information to be false or misleading and thus not be helpful to the users of financial reports. Neutrality means that a company cannot select information to favor one set of interested parties over another. Providing neutral or unbiased information must be the overriding consideration. An information item that is free from error will be a more accurate (faithful) representation of a financial item. For example, if a given company misstates its loan losses, its financial statements are misleading and not a faithful representation of its financial results. However, faithful representation does not imply total freedom from error. This is because most financial reporting measures involve estimates of various types that incorporate management’s judgment. For example, management must estimate the amount of uncollectible accounts to determine bad debt expense. And determination of depreciation expense requires estimation of useful lives of plant and equipment, as well as the residual value of the assets. Enhancing Qualities Enhancing qualitative characteristics are complementary to the fundamental qualitative characteristics. Enhancing qualitative characteristics are: a. Comparability: Information that is measured and reported in a similar manner for different companies is considered comparable. Comparability enables users to identify the real similarities and differences in economic events between companies. b. Verifiability: means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. c. Timeliness means having information available to decision-makers before it loses its capacity to influence decisions. Having relevant information available sooner can enhance its capacity to influence decisions, and a lack of timeliness can rob information of its usefulness. 7 Intermediate Financial Accounting I -Handout d. Understandability: Decision-makers vary widely in the types of decisions they make, how they make decisions, the information they already possess or can obtain from other sources, and their ability to process the information. For information to be useful there must be a connection (linkage) between these users and the decisions they make. This link, understandability, is the quality of information that lets reasonably informed users see its significance. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely. Elements of Financial Statements The elements directly related to the measurement of financial position are assets, liabilities, and equity. These are defined as follows. i. Asset: A present economic resource controlled by the entity as a result of past events. (An economic resource is a right that has the potential to produce economic benefits). ii. Liability: A present obligation of the entity to transfer an economic resource as a result of past events. iii. Equity: The residual interest in the assets of the entity after deducting all its liabilities. The elements of income and expenses are defined as follows. i. Income: Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims. ii. Expenses: Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. Reporting Assumptions a. Economic Entity Assumption: The economic entity assumption means that economic activity can be identified with a particular unit of accountability. In other words, a company keeps its activity separate and distinct from its owners and any other business unit. b. Going Concern Assumption: Most accounting methods rely on the going concern assumption that the company will have a long life. Despite numerous business failures, most companies have a fairly high continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives and commitments. c. Monetary unit assumption: The monetary unit assumption means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. That is, the monetary unit is the most effective means of expressing to interested parties changes in capital and exchanges of goods and services. d. The periodicity (or time period) assumption: implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly. e. Accrual-basis accounting: means that transactions that change a company’s financial statements are recorded in the periods in which the events occur. Measurement, Recognition, and Disclosure Concepts Basic Principles of Accounting We generally use four basic principles of accounting to record and report transactions: 1. Measurement principles 2. Revenue recognition principles 8 Intermediate Financial Accounting I -Handout 3. Expense recognition principles 4. Full disclosure principles Measurement principles The most commonly used measurements are based on historical cost and current cost. Selection of which principle to follow generally reflects a trade-off between relevance and faithful representation. i. Historical Cost IFRS requires that companies account for and report many assets and liabilities on the basis of acquisition price. This is often referred to as the historical cost principle. Cost has an important advantage over other valuations: It is generally thought to be a faithful representation of the amount paid for a given item. To illustrate this advantage, consider the problems if companies select current selling price instead. Companies might have difficulty establishing a value for unsold items. Every member of the accounting department might value the assets differently. ii. Current Value Current value measures provide monetary information about assets, liabilities, and related income and expenses, using information updated to reflect conditions at the measurement date. Revenue recognition principles When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company satisfies this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. Expense Recognition Principle Expenses are defined as outflows or other ―using up‖ of assets or incurring of liabilities (or a combination of both) during a period as a result of delivering or producing goods and/or rendering services. It follows, then, that recognition of expenses is related to net changes in assets and earning revenues. In practice, the approach for recognizing expenses is, ―Let the expense follow the revenues.‖ This approach is the expense recognition principle. To illustrate, companies recognize expenses not when they pay wages or make a product, but when the work (service) or the product actually contributes to revenue. Thus, companies tie expense recognition to revenue recognition. That is, by matching efforts (expenses) with accomplishment (revenues), the expense recognition principle is implemented in accordance with the definition of expense (outflows or other using up of assets or incurring of liabilities). Companies charge some costs to the current period as expenses (or losses) simply because they cannot determine a connection with revenue. Examples of these types of costs are officers’ salaries and other administrative expenses. Full Disclosure Principle In deciding what information to report, companies follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. Often referred to as the full disclosure principle, this practice recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to disclose matters that make a difference to users, yet (2) sufficient condensation to make the information understandable, keeping in mind costs of preparing and using it. 9 Intermediate Financial Accounting I -Handout Users find information about financial position, income, cash flows, and investments in one of three places: (1) within the main body of financial statements, (2) in the notes to those statements, or (3) as supplementary information. The notes to financial statements generally amplify or explain the items presented in the main body of the statements. If the main body of the financial statements gives an incomplete picture of the performance and position of the company, the notes should provide the additional information needed. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. Notes can be partially or totally narrative. Examples of notes include descriptions of the accounting policies and methods used in measuring the elements reported in the statements, explanations of uncertainties and contingencies, and statistics and details too voluminous for presentation in the financial statements. The notes can be essential to understanding the company’s performance and position. Supplementary information may include details or amounts that present a different perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in reliability. For example, oil and gas companies typically provide information on proven reserves as well as the related discounted cash flows. Supplementary information may also include management’s explanation of the financial information and its discussion of the significance of that information. For example, many business combinations have produced financing arrangements that demand new accounting and reporting practices and principles. In each of these situations, the same problem must be faced: making sure the company presents enough information to ensure that the reasonably prudent investor will not be misled Chapter Two Fair value measurement and Impairment Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value measurement is for a particular asset or liability. Therefore, when measuring fair value an entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following: a) The condition and location of the asset; and b) Restrictions, if any, on the sale or use of the asset. The effect on the measurement arising from a particular characteristic will differ depending on how that characteristic would be taken into account by market participants. The asset or liability measured at fair value might be either of the following: a) a stand-alone asset or liability (eg a financial instrument or a non-financial asset); or b) a group of assets, a group of liabilities or a group of assets and liabilities (eg a cash-generating unit or a business). 10 Intermediate Financial Accounting I -Handout Whether the asset or liability is a stand-alone asset or liability, a group of assets, a group of liabilities or a group of assets and liabilities for recognition or disclosure purposes depends on its unit of account. The unit of account for the asset or liability shall be determined in accordance with the IFRS that requires or permits the fair value measurement. A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions. A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either: a) in the principal market for the asset or liability; or b) in the absence of a principal market, in the most advantageous market for the asset or liability. An entity need not undertake an exhaustive search of all possible markets to identify the principal market or, in the absence of a principal market, the most advantageous market, but it shall take into account all information that is reasonably available. In the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market or, in the absence of a principal market, the most advantageous market. If there is a principal market for the asset or liability, the fair value measurement shall represent the price in that market (whether that price is directly observable or estimated using another valuation technique), even if the price in a different market is potentially more advantageous at the measurement date. The entity must have access to the principal (or most advantageous) market at the measurement date. Because different entities (and businesses within those entities) with different activities may have access to different markets, the principal (or most advantageous) market for the same asset or liability might be different for different entities (and businesses within those entities). Therefore, the principal (or most advantageous) market (and thus, market participants) shall be considered from the perspective of the entity, thereby allowing for differences between and among entities with different activities. Fair value at Initial Recognition When an asset is acquired or a liability is assumed in an exchange transaction for that asset or liability, the transaction price is the price paid to acquire the asset or received to assume the liability (an entry price). In contrast, the fair value of the asset or liability is the price that would be received to sell the asset or paid to transfer the liability (an exit price). Entities do not necessarily sell assets at the prices paid to acquire them. Similarly, entities do not necessarily transfer liabilities at the prices received to assume them. In many cases the transaction price will equal the fair value (eg that might be the case when on the transaction date the transaction to buy an asset takes place in the market in which the asset would be sold). When determining whether fair value at initial recognition equals the transaction price, an entity shall take into account factors specific to the transaction and to the asset or liability. If another IFRS requires or permits an entity to measure an asset or a liability initially at fair value and the transaction price differs from fair value, the entity shall recognize the resulting gain or loss in profit or loss unless that IFRS specifies otherwise. Valuation Techniques 11 Intermediate Financial Accounting I -Handout An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs. The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. Three widely used valuation techniques are: 1. The market approach, 2. The cost approach and 3. The income approach. An entity shall use valuation techniques consistent with one or more of those approaches to measure fair value. In some cases a single valuation technique will be appropriate (eg when valuing an asset or a liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (eg that might be the case when valuing a cash-generating unit). If multiple valuation techniques are used to measure fair value, the results (ie respective indications of fair value) shall be evaluated considering the reasonableness of the range of values indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances. If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reflects current market conditions, and it helps an entity to determine whether an adjustment to the valuation technique is necessary (eg there might be a characteristic of the asset or liability that is not captured by the valuation technique). After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, an entity shall ensure that those valuation techniques reflect observable market data (e.g The price for a similar asset or liability) at the measurement date. Valuation techniques used to measure fair value shall be applied consistently. However, a change in a valuation technique or its application (e.g A change in its weighting when multiple valuation techniques are used or a change in an adjustment applied to a valuation technique) is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. That might be the case if, for example, any of the following events take place: a) New markets develop; b) New information becomes available; c) Information previously used is no longer available; d) Valuation techniques improve; or e) Market conditions change Inputs to Valuation Techniques General Principles Valuation techniques used to measure fair value shall maximize the use of relevant observable inputs and minimize the use of unobservable inputs. 12 Intermediate Financial Accounting I -Handout Examples of markets in which inputs might be observable for some assets and liabilities (eg financial instruments) include exchange markets, dealer markets, brokered markets and principal-to-principal markets. An entity shall select inputs that are consistent with the characteristics of the asset or liability that market participants would take into account in a transaction for the asset or liability. In some cases those characteristics result in the application of an adjustment, such as a premium or discount (eg a control premium or non-controlling interest discount). However, a fair value measurement shall not incorporate a premium or discount that is inconsistent with the unit of account in the IFRS that requires or permits the fair value measurement. Premiums or discounts that reflect size as a characteristic of the entity’s holding (specifically, a blockage factor that adjusts the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by the entity, rather than as a characteristic of the asset or liability (eg a control premium when measuring the fair value of a controlling interest) are not permitted in a fair value measurement. In all cases, if there is a quoted price in an active market for an asset or a liability, an entity shall use that price without adjustment when measuring fair value. Inputs Based on Bid and Ask Prices If an asset or a liability measured at fair value has a bid price and an ask price (e.g an input from a dealer market), the price within the bid-ask spread that is most representative of fair value in the circumstances shall be used to measure fair value regardless of where the input is categorized within the fair value hierarchy. Fair Value Hierarchy To increase consistency and comparability in fair value measurements and related disclosures, this IFRS establishes a fair value hierarchy that categorizes into three levels the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). In some cases, the inputs used to measure the fair value of an asset or a liability might be categorized within different levels of the fair value hierarchy. In those cases, the fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement. Assessing the significance of a particular input to the entire measurement requires judgment, taking into account factors specific to the asset or liability. Adjustments to arrive at measurements based on fair value, such as costs to sell when measuring fair value less costs to sell, shall not be taken into account when determining the level of the fair value hierarchy within which a fair value measurement is categorized. The availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorized within Level 2 or Level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorized. If an observable input requires an adjustment using an unobservable input and that adjustment results in a significantly higher or lower fair value measurement, the resulting measurement would be categorized within Level 3 of the fair value hierarchy. For example, if a market participant would take into account the effect of a restriction on the sale of an asset when estimating the price for the asset, an entity would adjust the quoted price to reflect the effect of that restriction. If that quoted price is a Level 2 input and the adjustment is an 13 Intermediate Financial Accounting I -Handout unobservable input that is significant to the entire measurement, the measurement would be categorized within Level 3 of the fair value hierarchy. Level 1 input Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value whenever available. A Level 1 input will be available for many financial assets and financial liabilities, some of which might be exchanged in multiple active markets (eg on different exchanges). Therefore, the emphasis within Level 1 is on determining both of the following: a) The principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability; and b) Whether the entity can enter into a transaction for the asset or liability at the price in that market at the measurement date. An entity shall not make an adjustment to a Level 1 input except in the following circumstances: When an entity holds a large number of similar (but not identical) assets or liabilities (eg debt securities) that are measured at fair value and a quoted price in an active market is available but not readily accessible for each of those assets or liabilities individually (ie given the large number of similar assets or liabilities held by the entity, it would be difficult to obtain pricing information for each individual asset or liability at the measurement date). In that case, as a practical expedient, an entity may measure fair value using an alternative pricing method that does not rely exclusively on quoted prices (eg matrix pricing). However, the use of an alternative pricing method results in a fair value measurement categorized within a lower level of the fair value hierarchy. a) When a quoted price in an active market does not represent fair value at the measurement date. That might be the case if, for example, significant events (such as transactions in a principal-to-principal market, trades in a brokered market or announcements) take place after the close of a market but before the measurement date. An entity shall establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the adjustment results in a fair value measurement categorized within a lower level of the fair value hierarchy. b) When measuring the fair value of a liability or an entity’s own equity instrument using the quoted price for the identical item traded as an asset in an active market and that price needs to be adjusted for factors specific to the item or the asset. If no adjustment to the quoted price of the asset is required, the result is a fair value measurement categorized within Level 1 of the fair value hierarchy. However, any adjustment to the quoted price of the asset results in a fair value measurement categorized within a lower level of the fair value hierarchy. If an entity holds a position in a single asset or liability (including a position comprising a large number of identical assets or liabilities, such as a holding of financial instruments) and the asset or liability is traded in an active market, the fair value of the asset or liability shall be measured within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the entity. That is 14 Intermediate Financial Accounting I -Handout the case even if a market’s normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price. Level 2 inputs Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following: a) Quoted prices for similar assets or liabilities in active markets. b) Quoted prices for identical or similar assets or liabilities in markets that are not active. c) Inputs other than quoted prices that are observable for the asset or liability, for example: i. Interest rates and yield curves observable at commonly quoted intervals; ii. Implied volatilities; and iii. Credit spreads. d) Market-corroborated inputs. Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability. Those factors include the following: a. The condition or location of the asset; b. The extent to which inputs relate to items that are comparable to the asset or liability; and c. The volume or level of activity in the markets within which the inputs are observed. An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorized within Level 3 of the fair value hierarchy if the adjustment uses significant unobservable inputs. Level 3 Inputs Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. Assumptions about risk include the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and the risk inherent in the inputs to the valuation technique. A measurement that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one when pricing the asset or liability. For example, it might be necessary to include a risk adjustment when there is significant measurement uncertainty (eg when there has been a significant decrease in the volume or level of activity when compared with normal market activity for the asset or liability, or similar assets or liabilities, and the entity has determined that the transaction price or quoted price does not represent fair value. An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. In developing unobservable inputs, an entity may begin with its own data, but it shall adjust those data if reasonably available information indicates that other market 15 Intermediate Financial Accounting I -Handout participants would use different data or there is something particular to the entity that is not available to other market participants (eg an entity-specific synergy). An entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, an entity shall take into account all information about market participant assumptions that is reasonably available. Unobservable inputs developed in the manner described above are considered market participant assumptions and meet the objective of a fair value measurement. Disclosure An entity shall disclose information that helps users of its financial statements assess both of the following: a. For assets and liabilities that are measured at fair value on a recurring or non-recurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements. b. For recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period. An entity shall consider all the following: a. The level of detail necessary to satisfy the disclosure requirements; b. How much emphasis to place on each of the various requirements; c. How much aggregation or disaggregation to undertake; and d. Whether users of financial statements need additional information to evaluate the quantitative information disclosed. 16 Intermediate Financial Accounting I -Handout Chapter Three Cash and Receivables Cash, the most liquid of assets, is the standard medium of exchange and the basis for measuring and accounting for all other items. Companies generally classify cash as a current asset. Cash consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments such as money orders, certified checks, cashier’s checks, personal checks, and bank drafts are also viewed as cash. Some negotiable instruments provide small investors with an opportunity to earn interest. These items, more appropriately classified as temporary investments than as cash, include money market funds, money market savings certificates, certificates of deposit (CDs), and similar types of deposits and ―short-term paper.‖ These securities usually contain restrictions or penalties on their conversion to cash. Money market funds that provide checking account privileges, however, are usually classified as cash. Reporting Cash Although the reporting of cash is relatively straightforward, a number of issues merit special attention. These issues relate to the reporting of: 1. Cash equivalents. 2. Restricted cash. 3. Bank overdrafts. Cash Equivalents A common current classification is ―Cash and cash equivalents.‖ Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash and (b) subject to an insignificant risk of changes in value. IFRS suggests that only investments with original maturities of three months or less at acquisition qualify under these definitions. In addition, the cash and cash equivalents should be held for the purposes of meeting short-term cash commitments and not for investment purposes. Examples of cash equivalents are government bonds, commercial paper, and certain money market funds. Some companies combine cash with short-term investments on the statement of financial position. In these cases, they describe the amount of the short-term investments either parenthetically or in the notes. Restricted Cash Petty cash, payroll, and dividend funds are examples of cash set aside for a particular purpose. In most situations, these fund balances are not material. Therefore, companies do not segregate them from cash in the financial statements. When material in amount, companies segregate restricted cash from ―regular‖ cash for reporting purposes. The reason is that the cash is not being held for the purpose of meeting short-term cash commitments. They are, instead, being held for a more specific purpose. Note that this treatment would be used even if the specific investments would otherwise qualify as cash equivalents. Companies classify restricted cash either in the current assets or in the non-current assets section, depending on the date of availability or disbursement. Classification in the current section is appropriate if using the cash for payment of existing or maturing obligations (within a year or the operating cycle, whichever is longer). On the other hand, companies show restricted cash in the non-current section of the statement of financial position if holding the cash for a longer period of time. 17 Intermediate Financial Accounting I -Handout Bank Overdrafts Bank overdrafts occur when a company writes a check for more than the amount in its cash account. Companies should report bank overdrafts in the current liabilities section, combining them to the amount reported as accounts payable. If material, companies should disclose these items separately, either on the face of the statement of financial position or in the related notes. Internal Control Internal control is a process designed to provide reasonable assurance regarding the achievement of objectives related to operations, reporting, and compliance. In more detail, it consists of all the related methods and measures adopted within an organization to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations. Internal control systems have five primary components as listed below. A control environment. It is the responsibility of top management to make it clear that the organization values integrity and that unethical activity will not be tolerated. This component is often referred to as the ―tone at the top.‖ Risk assessment. Companies must identify and analyze the various factors that create risk for the business and must determine how to manage these risks. Control activities. To reduce the occurrence of fraud, management must de- sign policies and procedures to address the specific risks faced by the company. Information and communication. The internal control system must capture and communicate all pertinent information both down and up the organization, as well as communicate information to appropriate external parties. Monitoring. Internal control systems must be monitored periodically for their adequacy. Significant deficiencies need to be reported to top management and/or the board of directors. Principles of Internal Control Activities The specific control activities used by a company will vary, depending on management’s assessment of the risks faced. This assessment is heavily influenced by the size and nature of the company. The six principles of control activities are as follows. Establishment of responsibility Segregation of duties Documentation procedures Physical controls Independent internal verification Human resource controls Cash Receipts Controls OVER-THE-COUNTER RECEIPTS In retail businesses, control of over-the-counter receipts centers on cash registers that are visible to customers. A cash sale is entered in a cash register (or point-of- sale terminal), with the amount clearly visible to the customer. This activity prevents the sales clerk from entering a lower amount and pocketing the difference. The customer receives an itemized cash register receipt slip and is expected to count the change 18 Intermediate Financial Accounting I -Handout received. The cash register’s tape is locked in the register until a supervisor removes it. This tape accumulates the daily transactions and totals. At the end of the clerk’s shift, the clerk counts the cash and sends the cash and the count to the cashier. The cashier counts the cash, prepares a deposit slip, and deposits the cash at the bank. The cashier also sends a duplicate of the deposit slip to the accounting department to indicate cash received. The super- visor removes the cash register tape and sends it to the accounting department as the basis for a journal entry to record the cash received. In some instances, the amount deposited at the bank will not agree with the cash recorded in the accounting records based on the cash register tape. These differences often result because the clerk hands incorrect change back to the retail customer. In this case, the difference between the actual cash and the amount reported on the cash register tape is reported in a Cash Over and Short account. For example, suppose that the cash register tape indicated sales of $6,956.20 but the amount of cash was only $6,946.10. A cash shortfall of $10.10 exists. To account for this cash shortfall and related cash, the company makes the following entry. Cash………………………………………………$6,946.10 Cash shortage or overage…………………………$10.10 Sales Revenue……………………………………………….$6,956.20 Cash Over and Short is an income statement item. It is reported as miscellaneous expense when there is a cash shortfall and as miscellaneous revenue when there is an overage. MAIL RECEIPTS All mail receipts should be opened in the presence of at least two mail clerks. These receipts are generally in the form of checks. A mail clerk should endorse each check ―For Deposit Only.‖ This restrictive endorsement reduces the likelihood that someone could divert the check to personal use. Banks will not give individual cash when presented with a check that has this type of endorsement. The mail clerks prepare, in triplicate, a list of the checks received each day. This list shows the name of the check issuer, the purpose of the payment, and the amount of the check. Each mail clerk signs the list to establish responsibility for the data. The original copy of the list, along with the checks, is then sent to the cashier’s department. A copy of the list is sent to the accounting department for recording in the accounting records. The clerks also keep a copy. This process provides excellent internal control for the company. By employing at least two clerks, the chance of fraud is reduced. Each clerk knows he or she is being observed by the other clerk(s). To engage in fraud, they would have to collude. The customers who submit payments also provide control because they will contact the company with a complaint if they are not properly credited for payment. Because the cashier has access to the cash but not the records, and the accounting department has access to the records but not the cash, neither can engage in undetected fraud. Cash Disbursements Controls Companies disburse cash for a variety of reasons, such as to pay expenses and liabilities or to purchase assets. Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash. One exception is payments for incidental amounts that are paid out of petty cash. 19 Intermediate Financial Accounting I -Handout VOUCHER SYSTEM CONTROLS Most medium and large companies use vouchers as part of their internal control over cash disbursements. A voucher system is a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper. The system begins with the authorization to incur a cost or expense. It ends with the issuance of a check for the liability incurred. A voucher is an authorization form prepared for each expenditure. Companies require vouchers for all types of cash disbursements except those from petty cash. The starting point in preparing a voucher is to fill in the appropriate information about the liability on the face of the voucher. The vendor’s invoice provides most of the needed information. Then, an employee in the accounts payable department records the voucher (in a journal called a voucher register) and files it according to the date on which it is to be paid. The company issues and sends a check on that date, and stamps the voucher ―paid.‖ The paid voucher is sent to the accounting department for recording (in a journal called the check register). A voucher system involves two journal entries, one to record the liability when the voucher is issued and a second to pay the liability that relates to the voucher. Petty Cash Fund Controls Better internal control over cash disbursements is possible when companies make payments by check. However, using checks to pay small amounts is both impractical and a nuisance. For instance, a company would not want to write checks to pay for postage due, working lunches, or taxi fares. A common way of handling such payments, while maintaining satisfactory control, is to use a petty cash fund to pay relatively small amounts. The operation of a petty cash fund, often called an imprest system, involves: 1. Establishing the fund, 2. Making payments from the fund, and 3. Replenishing the fund ESTABLISHING THE PETTY CASH FUND Two essential steps in establishing a petty cash fund are (1) appointing a petty cash custodian who will be responsible for the fund, and (2) determining the size of the fund. Ordinarily, a company expects the amount in the fund to cover anticipated disbursements for a three- to four-week period. To establish the fund, a company issues a check payable to the petty cash custodian for the stipulated amount. For example, if Zhuˉ Ltd. decides to establish a NT$3,000 fund on March 1, the general journal entry is as follows. Mar. 1 Petty Cash 3,000 Cash 3,000 (To establish a petty cash fund) MAKING PAYMENTS FROM THE PETTY CASH FUND The petty cash custodian has the authority to make payments from the fund that conforms to prescribed management policies. Usually, management limits the size of expenditures that come from petty cash. Likewise, it may not permit use of the fund for certain types of transactions (such as making short-term loans to employees). Each payment from the fund must be documented on a pre-numbered petty cash receipt (or petty cash voucher). 20 Intermediate Financial Accounting I -Handout REPLENISHING THE PETTY CASH FUND When the money in the petty cash fund reaches a minimum level, the company replenishes the fund. The petty cash custodian initiates a request for reimbursement. The individual prepares a schedule (or summary) of the payments that have been made and sends the schedule, supported by petty cash receipts and other documentation, to the treasurer’s office. The treasurer’s office examines the receipts and supporting documents to verify that proper payments from the fund were made. The treasurer then approves the request and issues a check to restore the fund to its established amount. At the same time, all supporting documentation is stamped ―paid‖ so that it cannot be submitted again for payment. To illustrate, assume that on March 15 Zhuˉ Ltd.’s petty cash custodian requests a check for NT$2,610. The fund contains NT$390 cash and petty cash receipts for postage NT$1,320, freight-out NT$1,140, and miscellaneous expenses NT$150. The general journal entry to record the check is as follows. Mar. 15 Postage Expense………………………………………….1,320 Freight-Out………………………………………………..1,140 Miscellaneous Expense……………………………………150 Cash……………………………………………………….2,610 (To replenish petty cash fund) Note that the reimbursement entry does not affect the Petty Cash account. Replenishment changes the composition of the fund by replacing the petty cash receipts with cash. It does not change the balance in the fund. Writing Checks A check is a written order signed by the depositor directing the bank to pay a specified sum of money to a designated recipient. There are three parties to a check: (1) the maker (or drawer) who issues the check, (2) the bank (or payer) on which the check is drawn, and (3) the payee to whom the check is payable. A check is a negotiable instrument that one party can transfer to another party by endorsement. Each check should be accompanied by an explanation of its pur- pose. In many companies, a remittance advice attached to the check. Bank Statements A bank statement shows the depositor’s bank transactions and balances.4 Each month, a depositor receives a statement from the bank. It shows (1) checks paid and other debits (such as debit card transactions or direct withdrawals for bill payments) that reduce the balance in the depositor’s account, (2) deposits and other credits that increase the balance in the depositor’s account, and (3) the account balance after each day’s transactions. The bank statement lists in numerical sequence all ―paid‖ checks, along with the date the check was paid and its amount. Upon paying a check, the bank stamps the check ―paid‖; a paid check is sometimes referred to as a canceled check. On the statement, the bank also includes memoranda explaining other debits and credits it made to the depositor’s account. 21 Intermediate Financial Accounting I -Handout Reconciling the Bank Account The bank and the depositor maintain independent records of the depositor’s checking account. People tend to assume that the respective balances will always agree. In fact, the two balances are seldom the same at any given time, and both balances differ from the ―correct‖ or ―true‖ balance. Therefore, it is necessary to make the balance per books and the balance per bank agree with the correct or true amount a process called reconciling the bank account. The need for agreement has two causes: 1. Time lags that prevent one of the parties from recording the transaction in the same period as the other party. 2. Errors by either party in recording transactions. Time lags occur frequently. For example, several days may elapse between the time a company mails a check to a payee and the date the bank pays the check. Similarly, when the depositor uses the bank’s night depository to make its deposits, there will be a difference of at least one day between the time the depositor records the deposit and the time the bank does so. A time lag also occurs when- ever the bank mails a debit or credit memorandum to the depositor. The incidence of errors depends on the effectiveness of the internal controls of the depositor and the bank. Bank errors are infrequent. However, either party could accidentally record a £450 check as £45 or £540. In addition, the bank might mistakenly charge a check to a wrong account by keying in an incorrect account name or number. The following steps should reveal all the reconciling items that cause the difference between the two balances. Step 1. Deposits in transit. Compare the individual deposits listed on the bank statement with deposits in transit from the preceding bank reconciliation and with the deposits per company records or duplicate deposit slips. Deposits recorded by the depositor that have not been recorded by the bank are the deposits in transit. Add these deposits to the balance per bank. Step 2. Outstanding checks. Compare the paid checks shown on the bank statement with (a) checks outstanding from the previous bank reconciliation, and (b) checks issued by the company as recorded in the cash payments journal (or in the check register in your personal checkbook). Issued checks recorded by the company but that have not yet been paid by the bank are outstanding checks. Deduct outstanding checks from the balance per bank. Step 3. Errors. Note any errors discovered in the foregoing steps and list them in the appropriate section of the reconciliation schedule. For example, if the company mistakenly recorded as £169 a paid check correctly written for £196, it would deduct the error of £27 from the balance per books. All errors made by the depositor are reconciling items in determining the adjusted cash balance per books. In contrast, all errors made by the bank are reconciling items in determining the adjusted cash balance per bank. Step 4. Bank memoranda. Trace bank memoranda to the depositor’s records. List in the appropriate section of the reconciliation schedule any unrecorded memoranda. For example, the company would deduct from the balance per books a £5 debit memorandum for bank service charges. Similarly, it would add to the balance per books £32 of interest earned. 22 Intermediate Financial Accounting I -Handout Example: The bank statement for Laird Company plc shows a balance per bank of £15,907.45 on April 30, 2017. On this date the balance of cash per books is £11,589.45. Using the four reconciliation steps, Laird deter- mines the following reconciling items. Step 1. Deposits in transit: April 30 deposit (received by bank on May 1). £2,201.40 Step 2. Outstanding checks: No. 453, £3,000.00; no. 457, £1,401.30; no. 460, £1,502.70. 5,904.00 Step 3. Errors: Laird wrote check no. 443 for £1,226.00 and the bank correctly paid that amount. However, Laird recorded the check as £1,262.00. 36.00 Step 4. Bank memoranda: a. Debit—NSF check from J. R. Baron for £425.60 425.60 b. Debit—Charge for printing company checks £30.00 30.00 c. Credit—Collection of note receivable for £1,000 plus interest earned £50, less bank collection fee £15.00 1,035.00 23 Intermediate Financial Accounting I -Handout ENTRIES FROM BANK RECONCILIATION The company records each reconciling item used to determine the adjusted cash balance per books. If the company does not journalize and post these items, the Cash account will not show the correct balance. Laird Company plc would make the following entries on April 30. COLLECTION OF NOTE RECEIVABLE This entry involves four accounts. Assuming that the interest of £50 has not been accrued and the collection fee is charged to Miscellaneous Expense, the entry is: Apr. 30 Cash………………………………………………….1,035.00 Miscellaneous Expense………………………………….15.00 Notes Receivable……………………………………………….....1,000.00 Interest Revenue……………………………………………………50.00 (To record collection of note receivable by bank) BOOK ERROR The cash disbursements journal shows that check no. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is: Apr. 30 Cash 36.00 +36 Accounts Payable—Andrea 36.00 +36 Company (To correct error in recording Cash Flows check +36 no. 443) NSF CHECK As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is: Apr. 30 Accounts Receivable—J. R. Baron 425.60 Cash 425.60 (To record NSF check) BANK SERVICE CHARGES Depositors debit check printing charges (DM) and other bank service charges (SC) to Miscellaneous Expense because they are usually nominal in amount. The entry is: Apr. 30 Miscellaneous Expense 30.00 Cash 30.00 (To record charge for printing company checks) Receivables Receivables (often referred to as loans and receivables) are claims held against customers and others for money, goods, or services. For financial statement purposes, companies classify receivables as either current (short-term) or non-current (long-term). Companies expect to collect current receivables within a year or during the current operating cycle, whichever is longer. They classify all other receivables as non-current. Receivables are further classified in the statement of financial position as either trade or non-trade receivables. 24 Intermediate Financial Accounting I -Handout Customers often owe a company amounts for goods bought or services rendered. A company may sub classify these trade receivables, usually the most significant item in its current assets, into accounts receivable and notes receivable. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. They represent ―open accounts‖ resulting from short-term extensions of credit. A company normally collects them within 30 to 60 days. Notes receivable are written promises to pay a certain sum of money on a specified future date. They may arise from sales, financing, or other transactions. Notes may be short-term or long-term. Non-trade receivables arise from a variety of transactions. Some examples of non- trade receivables are: 1. Advances to officers and employees. 2. Advances to subsidiaries. 3. Deposits paid to cover potential damages or losses. 4. Deposits paid as a guarantee of performance or payment. 5. Dividends and interest receivable. 6. Claims against: a. Insurance companies for casualties sustained. b. Defendants under suit. c. Governmental bodies for tax refunds. d. Common carriers for damaged or lost goods. e. Creditors for returned, damaged, or lost goods. f. Customers for returnable items (crates, containers, etc.). Because of the peculiar nature of non-trade receivables, companies generally report them as separate items in the statement of financial position. Recognition of Accounts Receivable Accounts receivable generally arise as part of a revenue arrangement. For example, if Lululemon Athletica, Inc. (CAN) sell yoga outfit to Jennifer Burian for $100 on account, when does Lululemon recognize revenue (the sale) and the related accounts receivable? As per the revenue recognition principle indicates that Lululemon should recognize revenue when it satisfies its performance obligation by transferring the good or service to the customer. It follows that in the Lululemon situation, the yoga outfit is transferred when Jennifer obtains control of this outfit. When this change in control occurs, Lululemon should recognize an account receivable and sales revenue. Lululemon makes the following entry, assuming that $100 is the amount it expects to receive from Jennifer. Accounts Receivable 100 Sales Revenue 100 The concept of change of control is the deciding factor in determining when a performance obligation is satisfied and an account receivable recognized. Here are some key indicators used to determine that Lululemon has transferred and that Jennifer has obtained control of the yoga outfit. 1. Lululemon has the right to payment from the customer. If Jennifer is obligated to pay, it indicates that control has passed to the customer. 2. Lululemon has passed legal title to the customer. If Jennifer has legal title to the goods, it indicates that control has passed to the customer. 25 Intermediate Financial Accounting I -Handout 3. Lululemon has transferred physical possession of the goods. If Jennifer has physical possession, it indicates that control has passed to the customer. 4. Lululemon no longer has significant risks and rewards of ownership of the goods. If Jennifer now has the significant risks and rewards of ownership, it indicates that control has passed to the customer. 5. Jennifer has accepted the asset. Valuation of Accounts Receivable Two methods are used in accounting for uncollectible accounts: (1) the direct write- off method and (2) the allowance method. The following sections explain these methods. Direct Write-Off Method for Uncollectible Accounts Under the direct write-off method, when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that on December 10, 2022, Cruz Ltd. writes off as uncollectible Yusado’s NT$8,000,000 balance. The entry is as follows. December 10, 2022 Bad Debt Expense 8,000,000 Accounts Receivable (Yusado) 8,000,000 (To record write-off of Yusado account) Under this method, Bad Debt Expense will show only actual losses from uncollectibles. The company will report accounts receivable at its gross amount. Supporters of the direct write-off-method (which is often used for tax purposes) contend that it records facts, not estimates. It assumes that a good account receivable resulted from each sale, and that later events revealed certain accounts to be uncollectible and worthless. From a practical standpoint, this method is simple and convenient to apply. But the direct write-off method is theoretically deficient. It usually fails to record expenses as incurred and does not result in receivables being stated at cash realizable value on the statement of financial position. As a result, using the direct write-off method is not considered appropriate, except when the amount uncollectible is immaterial. Allowance Method for Uncollectible Accounts The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. This ensures that companies state receivables on the statement of financial position at their cash realizable value. Cash realizable value is the net amount the company expects to receive in cash. At each financial statement date, companies estimate uncollectible accounts and cash realizable value using information about past and current events as well as forecasts of future collectability. As a result, the statement of financial position reflects the current estimate of expected uncollectible account losses at the reporting date, and the income statement reflects the effects of credit deterioration (or improvement) that has taken place during the period. Many companies set their credit policies to provide for a certain percentage of uncollectible accounts. (In fact, many feel that failure to reach that percentage means that they are losing sales due to overly restrictive credit policies.) Thus, the IASB requires the allowance method for financial reporting purposes when bad debts are material in amount. This method has three essential features: 26  Intermediate Financial Accounting I -Handout 1. Companies estimate uncollectible accounts receivable and compare the new estimate to the current balance in the allowance account. 2. Companies debit estimated increases in uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period. 3. When companies write off a specific account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable. Recording Estimated Uncollectibles To illustrate the allowance method, assume that in 2022, its first year of operations, Brown Furniture has credit sales of £1,800,000. Of this amount, £150,000 remains uncollected at December 31. The credit manager estimates that £10,000 of these sales will be uncollectible. The adjusting entry to record the estimated uncollectibles (assuming a zero balance in the allowance account) is: December 31, 2022 Bad Debt Expense 10,000 Allowance for Doubtful Accounts 10,000 (To record estimate of uncollectible accounts) Recording the Write-Off of an Uncollectible Account When companies have exhausted all means of collecting a past-due account and collection appears impossible, the company should write off the account. In the credit card industry, for example, it is standard practice to write off accounts that are 210 days past due. To illustrate a receivables write-off, assume that the financial vice president of Brown Furniture authorizes a write-off of the £1,000 balance owed by Randall plc on March 1, 2023. The entry to record the write-off is: March 1, 2023 Allowance for Doubtful Accounts 1,000 Accounts Receivable (Randall plc) 1,000 (Write-off of Randall plc account) Bad Debt Expense does not increase 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 debit to Bad Debt Expense would be incorrect because the company has already recognized the expense when it made the adjusting entry for estimated bad debts. Instead, the entry to record the write-off of an uncollectible account reduces both Accounts Receivable and Allowance for Doubtful Accounts. Recovery of an Uncollectible Account Occasionally, a company collects from a customer after it has written off the account as uncollectible. 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 records the collection in the usual manner. To illustrate, assume that on July 1, 2023, Randall plc pays the £1,000 amount that Brown Furniture had written off on March 1. These are the entries: 27 Intermediate Financial Accounting I -Handout July 1, 2023 Accounts Receivable (Randall plc) 1,000 Allowance for Doubtful Accounts 1,000 (To reverse write-off of account) Cash 1,000 Accounts Receivable (Randall plc) 1,000 (Collection of account) Note that the recovery of a bad debt, like the write-off of a bad debt, affects only statement of financial position accounts. The net effect of the two entries above is a debit to Cash and a credit to Allowance for Doubtful Accounts for £1,000. Estimating the Allowance To simplify the preceding explanation, we assumed we knew the amount of the expected uncollectibles. In ―real life,‖ companies must estimate that amount when they use the allowance method. As indicated, expected uncollectible accounts are estimated based on information about past events (loss experience), adjusted for current conditions and reasonable forecasts of factors that would affect uncollectible accounts. While much judgment is involved, the goal is to develop the best estimate of expected uncollectible receivables. For example, a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts. This procedure provides a reasonably accurate estimate of the receivables’ realizable value. Hence, it is referred to as the percentage-of-receivables approach. Companies may apply this method using one composite rate that reflects an estimate of the uncollectible receivables. Or, companies may set up an aging schedule of accounts receivable, which applies a different percentage based on past experience to the various age categories. An aging schedule also identifies which accounts require special attention by indicating the extent to which certain accounts are past due. Wilson reports bad debt expense of €26,610 for this year, assuming that no balance existed in the allowance account. To change the illustration slightly, assume that the allowance account had a credit balance of €800 before adjustment. In this case, Wilson adds €25,810 (€26,610 − $800) to the allowance account and makes the following entry. Bad Debt Expense 25,810 Allowance for Doubtful Accounts 25,810 Wilson & Co. Aging Schedule Name of Balance Under 30 30–60 61–90 91–120 Over 120 Customer Dec. 31 days days days days days 28 Intermediate Financial Accounting I -Handout Western Stainless € 98,000 € 15,000 € 65,000 €18,000 Steel Brockway Steel 320,000 280,000 40,000 Freeport Sheet & 55,000 €55,000 Tube Allegheny Iron 74,000 50,000 10,000 €14,000 Works €547,000 €345,000 €115,000 €18,000 €14,000 €55,000 Percentage Estimated to Be Required Balance in Age Amount Uncollectible* Allowance Under 30 days €345,000 0.8% € 2,760 30–60 days 115,000 4.0 4,600 61–90 days 18,000 15.0 2,700 91–120 days 14,000 20.0 2,800 Over 120 days 55,000 25.0 13,750 Year-end balance of allowance for doubtful accounts €26,610 * Estimates are based on historical loss rates, taking into consideration whether and, if so, how the historical loss rates differ from what is currently expected over the life of the trade receivables (on the basis of current conditions and reasonable and supportable forecasts about the future). Notes Receivable A note receivable is supported by a formal promissory note, a written promise to pay a certain sum of money at a specific future date. Such a note is a negotiable instrument that a maker signs in favor of a designated payee who may legally and readily sell or otherwise transfer the note to others. Although all notes contain an interest element because of the time value of money, companies classify them as interest-bearing or non-interest-bearing. Interest-bearing notes have a stated rate of interest. Zero-interest-bearing notes (non-interest-bearing) include interest as part of their face amount. Notes receivable are considered fairly liquid, even if long- term, because companies can easily convert them to cash (although they might pay a fee to do so). Companies frequently accept notes receivable from customers who need to extend the payment period of an outstanding receivable. Or they require notes from high-risk or new customers. In addition, companies often use notes in loans to employees and subsidiaries, and in the sales of property, plant, and equipment. In some industries (e.g., the pleasure and sport boat industry), notes support all credit sales. The majority of notes, however, originate from lending transactions. The basic issues in accounting for notes receivable are the same as those for accounts receivable: recognition, valuation, and derecognition. Recognition of Notes Receivable 29 Intermediate Financial Accounting I -Handout Companies record and report long-term notes receivable at the present value of the cash they expect to collect. When the interest stated on an interest-bearing note equals the effective (market) rate of interest, the note is recorded at face value. When the stated rate differs from the market rate, the cash exchanged (present value) differs from the face value of the note. Companies then record this difference, either a discount or a premium, and amortize it over the life of a note to approximate the effective (market) interest rate. Note Issued at Face Value To illustrate the discounting of a note issued at face value, assume that Bigelow SA lends Scandinavian Imports €10,000 in exchange for a €10,000, three-year note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10 percent. Face value of the note €10,000 Present value of the principal: €10,000 (PVF3,10%) = €10,000 ×.75132 €7,513 Present value of the interest: €1,000 (PVF-OA3,10%) = €1,000 × 2.48685 2,487 Present value of the note (10,000) Difference € – 0– In this case, the present value of the note equals its face value because the market (effective) and stated rates of interest are the same. Bigelow records the receipt of the note as follows. Notes Receivable 10,000 Cash 10,000 Bigelow recognizes interest revenue each year as follows. Cash 1,000 Interest Revenue 1,000 Note not Issued at Face Value Zero-Interest-Bearing Notes If a company receives a zero-interest-bearing note, its present value is the cash paid to the issuer. Because the company knows both the future amount and the present value of the note, it can compute the interest rate. 30 Intermediate Financial Accounting I -Handout This rate is often referred to as the implicit interest rate. Companies record the difference between the future (face) amount and the present value (cash paid) as a discount and amortize it to interest revenue over the life of the note. To illustrate, Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note, the present value of which is $7,721.80. The implicit rate that equates the total cash to be received ($10,000 at maturity) to the present value of the future cash flows ($7,721.80) is 9 percent (the present value of 1 for three periods at 9 percent is.77218). Jeremiah records the note receivable for the present value ($7,721.80), as follows. Notes Receivable 7,721.80 Cash 7,721.80 Companies amortize the discount, and recognize interest revenue annually using the effective-interest method. Schedule of Note Discount Amortization Effective-Interest Method 0% Note Discounted at 9% Cash Received Interest Revenue Discount Amortized Carrying Amount of Note Date of issue $ 7,721.80 a b End of year 1 $ –0– $ 694.96 $ 694.96 8,416.76c End of year 2 –0– 757.51 757.51 9,174.27 End of year 3 –0– 825.73d 825.73 10,000.00 $ –0– $2,278.20 $2,278.20 a$7,721.80 ×.09 = $694.96 b$694.96 − $0 = $694.96 c$7,721.80 + $694.96 = $8,416.76 d5„ adjustment to compensate for rounding Jeremiah records interest revenue at the end of the first year using the effective- interest method as follows. Notes Receivable 694.96 Interest Revenue ($7,721.80 ×.09) 694.96 31 Intermediate Financial Accounting I -Handout Interest-Bearing Notes Often the stated rate and the effective rate differ. The zero-interest-bearing note is one example. To illustrate a more common situation, assume that Morgan Group makes a loan to Marie Co. and receives in exchange a three-year, €10,000 note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is 12 percent. Morgan computes the present value of the two cash flows as follows: Face value of the note €10,000 Present value of the principal: €10,000 (PVF3,12%) = €10,000 ×.71178 €7,118 Present value of the interest: €1,000 (PVF-OA3,12%) = €1,000 × 2.40183 2,402 Present value of the note 9,520 Difference (Discount) € 48 0 In this case, because the effective rate of interest (12 percent) exceeds the stated rate (10 percent), the present value of the note is less than the face value. That is, Morgan exchanged the note at a discount. Morgan records the present value of the note as follows. Notes Receivable 9,520 Cash 9,520 Morgan then amortizes the discount and recognizes interest revenue annually using the effective-interest method. Schedule of Note Discount Amortization Effective-Interest Method 10% Note Discounted at 12% Cash Received Interest Revenue Discount Amortized Carrying Amount of Note 32 Intermediate Financial Accounting I -Handout Date of issue € 9,520 End of year 1 €1,000a €1,142b €142c 9,662d End of year 2 1,000 1,159 159 9,821 End of year 3 1,000 1,179 179 10,000 €3,000 €3,480 €480 a€10,000 ×.10 = €1,000 b€9,520 ×.12 = €1,142 c€1,142 − €1,000 = €142 d€9,520 + €142 = €9,662 On the date of issue, the note has a present value of €9,520. Additional interest revenue spread over the three- year life of the note, as a result, is €480 (€10,000 −€9,520). At the end of year 1, Morgan receives €1,000 in cash. But its interest revenue is €1,142 (€9,520 ×.12). The difference between €1,000 and €1,142 is the amortized discount, €142. Morgan records receipt of the annual interest and amortization of the discount for the first year as follows (amounts per amortization schedule). Cash 1,000 Notes Receivable 142 Interest Revenue 1,142 The carrying amount of the note is now €9,662 (€9,520 + €142). Morgan repeats this process until the end of year 3. When the present value exceeds the face value, the note is exchanged at a premium. Companies record the premium on a note receivable as a debit and amortize it using the effective-interest method over the life of the note as annual reductions in the amount of interest revenue recognized. Notes Received for Property, Goods, or Services When a note is received in exchange for property, goods, or services in a bargained transaction entered into at arm’s length, the stated interest rate is presumed to be fair unless one of the following occurs. 1. No interest rate is stated. 2. The stated interest rate is unreasonable. 3. The face amount of the note is materially different from the current cash sales price for the same or similar items or from the current fair value of the debt instrument. In these circumstances, the company measures the present value of the note by the fair value of the property, goods, or services or by an amount that reasonably approximates the fair value of the note. To illustrate, Oasis Development Co. sold a corner lot to Rusty Pelican as a restaurant site. Oasis accepted in exchange a five-year note having a maturity value of $35,247 and no stated interest rate. The land originally cost Oasis $14,000. At the date of sale, the land had a fair value of $20,000. Given the criterion above, Oasis uses the fair value of the land, $20,000, as the present value of the note. Oasis therefore records the sale as: Notes Receivable 20,000 Land 14,000 33 Intermediate Financial Accounting I -Handout Gain on Disposal of Land ($20,000 − $14,000) 6,000 Valuation of Notes Receivable Like accounts receivable, companies record and report short-term notes receivable at their cash realizable value—that is, at their face amount less all necessary allowances. The primary notes receivable allowance account is Allowance for Doubtful Accounts. The computations and estimations involved in valuing short- term notes receivable and in recording bad debt expense and the related allowance exactly parallel that for trade accounts receivable. Companies estimate the amount of uncollectibles by an analysis of the receivables. Other Issues Related to Receivables Additional issues related to receivables are: 1. Derecognition of receivables. 2. Presentation and analysis. Derecognition of Receivables At what point should a receivable no longer be included as an asset of a company like Unilever (NLD)—that is, derecognized? One situation occurs when the receivable no longer has any value; that is, the contractual rights to the cash flows of the receivable no longer exist. For example, if Unilever has a receivable from a customer who declares bankruptcy, the value of this receivable has expired. Similarly, when Unilever collects a receivable when due, it removes this receivable from its books. In both cases, Unilever no longer has any contractual rights to these receivables. As a result, the receivables are derecognized. A second situation often occurs if Unilever transfers (e.g., sells) a receivable to another company, thereby transferring the risks and rewards of ownership to this other company. As an example, if Garcia Company sells its receivables to Holt Inc. and transfers all the risks and rewards of ownership to Holt, the receivables are derecognized. Although this guideline is straightforward, it is sometimes difficult to assess whether some or all of the risks and rewards of ownership are transferred. The following discussion highlights the key issues related to transfers of receivables. Transfers of Receivables There are various reasons for the transfer of receivables to another party. For example, in order to accelerate the receipt of cash from receivables, companies may transfer receivables to other companies for cash. In addition, for competitive reasons,