Oper. Decisions - 1 OPERATING DECISIONS

UNCOLLECTIBLE ACCOUNTS RECEIVABLE n When credit is extended, some amount of uncollectible receivables is generally inevitable. n If uncollectible receivables are probable and can be estimated, an estimate should be made of the amount uncollectible and recorded in the period in which the revenue was produced (allowance method). contra nThe Allowance for Doubtful Accounts is a contra account. account to Accounts Receivable.

INVENTORY RECORDING METHODS n Periodic inventory system -- Inventory value is determined only at particular times, such as end of the accounting period. -- Purchases recorded in “Purchases” account -- Cost of goods sold determined at the end of the period following a physical count

INVENTORY RECORDING METHODS n Perpetual inventory system -- The ongoing physical flow of inventory is monitored, and the cost of the inventory items is maintained on a continual basis. -- Purchases recorded directly in “Inventory” account -- Cost of goods sold is determined at the point sales revenue is recognized

COST FLOW METHODS An allocation of total cost of goods available for sale: Ending inventory Cost of goods sold Cost of goods Available (Beg. Inven. + Purch) cost flow The cost flow assumption used for accounting purposes physical flow can be different from the physical flow of goods through the company.

INVENTORY VALUES COST FLOW ASSUMPTIONS Specific cost identification Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO)

Oper. Decisions - 8 FIRST-IN, FIRST-OUT  Cost of the oldest inventory items are included in Cost of Goods Sold  Cost of the newest items are included in the Ending Inventory

Oper. Decisions - 9 LAST-IN, FIRST-OUT  Cost of the newest inventory items are included in Cost of Goods Sold  Cost of the oldest items are included in the Ending Inventory

Oper. Decisions - 10 PENSIONS  A pension is cash compensation received by an employee after the employee has retired  There are two types of pension plans: –Defined contribution plan –Defined benefit plan

Oper. Decisions - 11 POSTRETIREMENT BENEFITS OTHER THAN PENSIONS  Other employee benefits provided after retirement include –Health care plans –Life insurance plans  Accounting rules require that these benefits be recognized as an expense and a liability as they are incurred

Oper. Decisions - 12 INCOME TAXES  Income tax expense and the amount paid for income tax during a period are different for two reasons: –Income taxes are not paid in the same year in which they are incurred –A firm may choose one accounting method for tax purposes and another for financial reporting purposes

Oper. Decisions - 13 INCOME TAXES  Differences in financial income and taxable income are due to timing differences  Timing differences can be –Permanent or –Temporary

Oper. Decisions - 14 TIMING DIFFERENCES  Permanent differences –Enter into accounting income, but never into taxable income –These are statutory differences between GAAP and the Internal Revenue Code –For example, interest on state and local bonds is included in financial income, but not in taxable income

Oper. Decisions - 15 TIMING DIFFERENCES  Temporary differences –Some transactions affect taxable income in a different period from financial accounting income Depreciation methods Rent received in advance –The affects of these differences are recorded as deferred tax assets or liabilities and shown on the balance sheet

Oper. Decisions - 16 DEFERRED TAXES  Deferred Tax Liability –Requires a payment in the future –Is the expected income tax on income earned but not yet taxed –Is not an existing legal liability  Income Taxes Payable, based on taxable income on the tax return, is an existing legal liability

Oper. Decisions - 17 DEFERRED TAXES  Deferred Tax Asset –Represents the expected benefit of a future tax deduction for an expense item that has already been incurred but is not yet deductible for tax purposes –It can only be recognized if it is “more likely than not” that future income will be realized against which the deduction can be offset

Oper. Decisions - 18 CAPITALIZE VERSUS EXPENSE  An expenditure that is expected to benefit future periods is capitalized as an asset  All other expenditures are treated as expenses

Oper. Decisions - 19 CAPITALIZE VERSUS EXPENSE  Research and development costs –Research is defined as Those activities undertaken to discover new knowledge that will be useful in developing new products, services, or processes or that will result in significant improvement of existing products or processes –Development Applies the research findings to develop a plan or design for new or improved products and processes

Oper. Decisions - 20 CAPITALIZE VERSUS EXPENSE  Research and development costs are expensed in the period incurred due to the uncertainty surrounding the future economic benefits of R&D activities

Oper. Decisions - 21 CAPITALIZE VERSUS EXPENSE  Software development requires special treatment –All costs incurred up to the point where technological feasibility is established are to be expensed as research and development –After technological feasibility is established, costs incurred are capitalized Determining technological feasibility is a matter of judgement

Oper. Decisions - 22 CAPITALIZE VERSUS EXPENSE  Oil and gas exploration costs –Two methods of accounting for the cost of “dry holes”: Full cost method  All exploratory costs are capitalized and allocated to the cost of successful wells Successful efforts method  Exploratory costs for dry holes are expensed, and only exploratory costs for successful wells are capitalized

Oper. Decisions - 23 CAPITALIZE VERSUS EXPENSE  Advertising costs –Generally, advertising costs are expensed due to the uncertainty of their future economic benefits –In selected cases where the future benefits are more certain, advertising costs should be capitalized

Oper. Decisions - 24 CONTINGENCIES  A contingency is an uncertain circumstance involving a potential gain or loss that will not be resolved until some future event occurs

Oper. Decisions - 25 CONTINGENCIES  Three important definitions: –Probable Likely to occur –Remote Not likely to occur –Reasonably possible More than remote but less than likely

Oper. Decisions - 26 CONTINGENT LOSSES Likelihood Probable Reasonably possible Remote Accounting Action Recognize a probable liability if the amount can be reasonably estimated. Disclose a possible liability in a note. No recognition or disclosure unless contingency represents a guarantee. Then, note disclosure is required.

Oper. Decisions - 27 CONTINGENT GAINS Likelihood Probable Reasonably possible Remote Accounting Action An asset may be recorded if it seems assured and the amount can be reasonably estimated. Normally you would simply disclose facts in a note. Disclose a possible asset in a note, but be careful to avoid misleading implications. In practice, possible contingent gains are often not disclosed. No recognition or disclosure.

Oper. Decisions - 28 ACCOUNTING FOR LAWSUITS  If the facts of the case indicate that a loss is probable and the amount of the loss can be estimated, a loss should be reported on the income statement and a liability should be reported on the balance sheet

Oper. Decisions - 29 ACCOUNTING FOR ENVIRONMENTAL LIABILITIES  Most companies do not reflect these loss contingencies as liabilities on the balance sheet because the future cost of the cleanup is very difficult to estimate