FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS

FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS
C H A P T E R 1 FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Financial Accounting vs. Managerial Accounting
Focused on the needs of external users (e.g. investors and creditors) Part I Accounting information focused on the needs of external users is called financial accounting. For example, investors are interested in whether a business produces more overall income relative to risk. Part II Accounting information focused on the needs of internal users is called managerial accounting. For example, a regional manager in the business is interested in the store-by-store earnings under her control. Managerial Accounting Focused on the needs of internal users (management)

Accounting and Capital Allocation “MACRO Level Importance”
Resources are limited. Efficient use of resources often determines whether the economy and an individual business thrives. (Buy auto stocks? Invest in investment banks? Buy bank stocks? Invest in the BRIC countries? Lend money to AIG Insurance?) Financial Reporting Users of Financial Information Capital Allocation Information to help users with capital allocation decisions. To whom do you lend money? Which company’s stock would you buy? The process of determining how and at what cost (interest rate on loan; stock price willing to pay) money is allocated among competing interests. Investors, creditors, and other users

Need to Develop Standards
Various users need financial information Financial Statements Income Statement Statement of Stockholders’ Equity Balance Sheet Statement of Cash Flows Note Disclosure The accounting profession has attempted to develop a set of standards that are generally accepted and “universally” practiced. Generally Accepted Accounting Principles (GAAP) aka. “Cleverly Rigged Accounting Ploys” (CRAP)

Financial Statements and Financial Reporting
Additional Information Income Statement Statement of Changes in Stockholders’ Equity Balance Sheet Statement of Cash Flows Note Disclosures President’s letter Prospectuses, SEC Reporting (10K, 10Q) News releases Forecasts Environmental Reports Etc. GAAP Not GAAP

Government (SEC, IRS, other agencies)
Standard Setting CPAs and Accounting Firms Financial Community AICPA (AcSEC) FASB Preparers (e.g., FEI) Academicians Government (SEC, IRS, other agencies) Investing Public Industry Associations Accounting standards, interpretations, and bulletins are subject to INTENSE “Political Pressure”

Challenges Facing Financial Accounting
Nonfinancial Measurements—order backlog, contracts for future sales, customer satisfaction ratings Forward-looking Information—forecasts and projections Soft Assets—including ‘intellectual assets’; value of Coca-Cola’s trade name, secret formula Timeliness--annual, quarterly, daily, real-time

Financial Accounting Standards Board Concept Statement #1--Objectives of Financial Accounting
Financial reporting should provide information that: (a) is useful to present and potential INVESTORS and CREDITORS and other users in making rational investment, credit, and similar decisions. (b) helps potential investors and creditors and other users in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY of prospective CASH FLOWS. (c) clearly portrays the Economic Resources of an enterprise, the Claims to those Resources, and the effects of transactions, events, and circumstances that Change its Resources and Claims to those Resources.

Parties Involved in Standard Setting
Four organizations: Securities and Exchange Commission (SEC) American Institute of Certified Public Accountants (AICPA) Financial Accounting Standards Board (FASB) International Accounting Standards Board (IASB)

Securities and Exchange (SEC) Commission
Established by federal government (why?) Governs Accounting and Reporting for public companies SEC requires public companies to adhere to GAAP SEC has power to set GAAP but has “allowed” the private sector to do it (so far!) Enforcement (what happened to Arthur Andersen?) Securities Act of 1933 (New Securities issue) Securities Act of 1934 (Annual 10K reporting)

American Institute of CPAs
National professional organization Established the following: Committee on Accounting Procedures Accounting Principles Board 1939 to 1959 Issued 51 Accounting Research Bulletins (ARBs) Problem-by-problem approach failed 1959 to 1973 Issued 31 Accounting Principle Board Opinions (APBOs) Wheat Committee recommendations adopted in 1973

Financial Accounting Standards Board
Mission is to establish and improve standards of financial accounting and reporting. Differences between FASB and predecessor AICPA include FASB is: Full-time, Paid position Increased Independence--must ‘quit’ other jobs Broader Representation--NOT all CPAs

FASB’s Due Process Responsive to entire economic community (‘everyone’ gets to voice their views--good or bad?) Operates in full view of the public (transparency) Step 1 = Topic placed on agenda Step 2 = Research conducted and Discussion Memorandum issued. Step 3 = Public hearing Step 4 = Board evaluates research, public response and issues Exposure Draft Step 5 = Board evaluates responses and issues final Statement of Financial Accounting Standard Step 6 = Those that ‘lose’ seek redress in Congress!!!

Types of Pronouncements
FASB Standards (over 160), Interpretations (48--some over 100 pages long), and Staff Positions (over 50). Above are all “official GAAP” ARBs and APBs issued by the AICPA that have not been superceded also are “official GAAP” FASB Financial Accounting Concepts (part of the “Conceptual Framework Project--NOT ‘official’ GAAP) Emerging Issues Task Force (EITF) Statements covering new and unusual transactions (e.g., how to report losses from Hurricane Katrina) after review and approval by FASB are ‘preferred GAAP’

GAAP Codification 1.) With over 2,000 GAAP documents in the last 60 years, it has become very difficult even to ‘research’ a topic in GAAP and feel assured you have the most recent, ‘correct’ answer to your inquiry. 2.) The FASB’s GAAP codification project (just completed in July 2009) is an attempt to alleviate the problem and make GAAP research much more effective and efficient

GAAP Codification (Continued)
The Codification includes ALL authoritative U.S. GAAP in a single location, organized into 90 accounting topics and is available FREE (electronically accessible at Each topic has subsections such as: Overview and background Recognition Initial measurement Disclosure The topical structure is consistent with IFRS The codification will include real-time updates YOU Will Be Researching the Codification for selected homework assignments!

Changing Role of AICPA AICPA no longer issues authoritative accounting guidance for public companies (now done by FASB; SEC) AICPA no longer develops auditing standards (now done by Public Companies Accounting Oversight Board--PCAOB) AICPA continues to develop and grade the CPA examination. Is the CPA exam impossible to pass? Is it easier to pass in one state than another? What are the requirements for becoming a CPA? What are the education requirements in Penna.? What about the experience requirements? What’s the 150-hour requirement?

International Accounting Standards Board
International Financial Reporting Standards (IFRS or iGAAP), are issued by the IASB: Your textbook refers to them as “iGAAP” Every other source I’ve seen refers to them as IFRS US GAAP is ‘identified’ as being “rules based” (over 2,000 documents related to GAAP issued in last 60 years) while IFRS are ‘identified’ as being “principles based” Currently IFRS adopted by over 100 countries around the world: SEC has proposed time-table ‘forcing’ US public companies to switch to IFRS. Decision currently scheduled to be made in (Link to article on Comments) FASB and IASB have been working on ‘convergence’ project to combine the two sets of GAAP into the best of both.

Ethics in the Environment of Financial Accounting
You are a member of top management and your goal is to ‘maximize shareholder wealth’. Your annual performance bonus (and whether you keep your job or get fired) is based on meeting predetermined financial reporting and market goals--e. g., dollar amount of net income, earnings per share, better balance sheet. Would you like reported earnings be calculated with standards that are: Biased to produce higher earnings? Designed to describe what really happened? Would you like the balance sheet to: Omit some ‘questionable’ liabilities? Report all liabilities?

You are Company management
3.) Would you like the company’s auditors to be: a.) Understanding of management’s needs and willing to help out? b.) Focused on getting useful information into the hands of the financial statement users, even if they have to be very tough in dealing with you (their client--who hires and pays their fee) 4.) Would you prefer that earnings results be: a.) Smoothed and normalized to remove any volatility? b.) reported as they occur and let the users of the financial statements decide whether and how to smooth or normalize earnings?

Now assume you are the financial statement analyst trying to forecast future cash flows
Would you like reported earnings be calculated with standards that are: Biased to produce higher earnings? Designed to describe what really happened? Would you like the balance sheet to: a) Omit some ‘questionable’ liabilities? b) Report all liabilities? Would you like the company’s auditors to be: a.) Understanding of management’s needs and willing to help out? b.) Focused on getting useful information into the hands of the financial statement users, even if they have to be very tough in dealing with company management (their client--who hires and pays their fee)

Now assume you are the financial statement analyst trying to forecast future cash flows
4.) Would you prefer that earnings results be: a.) Smoothed and normalized to remove any volatility? b.) reported as they occur and let you, the users of the financial statements, decide whether and how to smooth or normalize earnings?

Sarbanes-Oxley Legislation (“SOX”)
Establishes an oversight board for accounting practices. The Public Company Accounting Over-sight Board (PCAOB) has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules. Implements stronger independence rules for auditors. Audit partner rotation; prohibited from offering certain types of consulting services to audit clients. Requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate Requires codes of ETHICS for senior financial officers. In addition, requires public companies’ management to attest to the effectiveness of their internal controls over financial reporting (AND auditors need to ‘audit’ it and report on it).

Class Assignment Review Questions and Homework for Ch. 1
Class Assignment Questions #1, 3, 5, 28, 32 (pages 22-23) Homework (pages 25-26): CA 1-12, CA 1-13, CA 1-15

CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING
C H A P T E R 2 CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Conceptual Framework The Need for a Conceptual Framework
(a Constitution for Financial Accounting) To develop a coherent set of standards and rules To solve new and emerging practical problems

FASB’s Conceptual Framework Project
Both the FASB and the IASB have “Conceptual Frameworks”—with many similarities MAJOR Difference = Measurement methods used in recognizing elements of the financial statements (e.g., option to use ‘fair value’ much more extensive in IFRS) Some Other Differences: “Consistency NOT included in IFRS ‘qualitative’ characteristics Stewardship as an Objective in IASB Conceptual Framework Accrual accounting explicitly listed as an ‘assumption’ in IASB Conceptual Framework FASB & IASB working on a ‘common’ conceptual framework as part of their ongoing ‘convergence project’

Development of Conceptual Framework
The FASB has issued six Statements of Financial Accounting Concepts (note that #3 has been superceded by #6) SFAC No.1 - Objectives of Financial Reporting (covered in Ch. 1) SFAC No.2 - Qualitative Characteristics of Accounting Information SFAC No.3 - Elements of Financial Statements (superceded by SFAC No. 6) SFAC No.4 - Objectives of Financial Reporting by Non-business Organizations SFAC No.5 - Recognition and Measurement in Financial Statements SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3) SFAC No.7 - Using Cash Flow Information and Present Value in Accounting Measurements

Third level Second level First level
ASSUMPTIONS Continuity (aka. “Going concern”) Economic entity Monetary unit-stable Timeliness (aka. “Periodicity”) PRINCIPLES Principle of revenue recognition Matching Disclosure is full and fair Cost--Historic cost measurement CONSTRAINTS Cost-benefit Materiality Industry practice Conservatism Third level QUALITATIVE CHARACTERISTICS Relevance Reliability Comparability Consistency ELEMENTS Assets, Liabilities, and Equity Investments by owners Distribution to owners Comprehensive income Revenues and Expenses Gains and Losses Second level Illustration 2-7 Conceptual Framework for Financial Reporting (page 50 in textbook) OBJECTIVES 1. Useful in investment and credit decisions 2. Useful in assessing timing, amount, and uncertainty of future cash flows 3. About enterprise resources, claims to resources, and changes in them I do NOT differentiate among Assumptions, Principles, and Constraints (and I ‘move’ Consistency from Qualitative Characteristic level to join assumptions, principles, and constraints) First level

Qualitative Characteristics Making Accounting Information Useful
Relevance – making a difference in a decision. Predictive value Feedback value Timeliness Reliability Verifiable Representational faithfulness Neutral - free of error and bias Reliability often clashes with Relevance—Manhattan Island example (which is better valuation: an average of 20 real estate appraisers or $24 for Investment in Manhattan Island? As an auditor, would you like to give an opinion on which valuation??

Mnemonic to Help Remember the Assumptions, Principles, and Constraints
Disclosure--full Cost/Benefit Continuity (“Going-Concern”) Consistency Cost--Historic Monetary Unit is Stable Matching Materiality Conservatism Economic Entity Principle of Revenue Recognition Timeliness (“Periodicity”) (Add “Industry Exceptions” to above Mnemonic)

ASSUMPTIONS, PRINCIPLES, AND CONCEPTS
Disclosure – Financial reports should include “any” information that could affect decisions made by external users. Parenthetical comments on face of statements Note disclosures Supplemental financial statements Cost/Benefit -- “any” (for example in the above disclosure requirement) must be tempered with the COST/BENEFIT CONSIDERATION

“Continuity” (“Going concern”) - the entity's life extends beyond the current period. a. Fundamental: assets are assumed to have future economic benefit. b. A business is assumed to continue “indefinitely” (long enough for company to use up it’s assets in normal operations). NEED TO EVALUATE VERY CLOSELY IN TODAY’S ECONOMIC ENVIRONMENT!

Consistency Principle - business entities should use the same accounting methods from one period to the next. a. Allows comparisons of performance and position across time. b. Changes in methods may signal manipulation. (This does NOT mean a company can never change accounting methods)

Cost--Historic - financial accounting information must be verifiable and reliable (objectively determined where possible rather than subjectively determined) a. Results can be “duplicated”—ask 20 historians what was the historic cost of Manhattan Island. You get 20 people saying $24. b. Opposite of “subjective measurement”. You get 20 people with 20 different answers if asked what is current ‘market value’ of Manhattan Island. c. Measurements continue to move away from historic cost: Market values increasing being used—marketable securities, derivatives, (IFRS – option to use Fair Market Value for PP&E)

Monetary unit is stable - measuring unit (e.g. dollar) is stable over time. Inflation “does NOT exist” Matching Principle - the effects of a given period (expenses) should be matched against the benefits (revenues) that result from them. “Let the expense follow the revenues.” (Example = Cost of Goods Sold Expense) (a) Focus on the income statement. (b) Associate cause and effect, match expenses with revenues to which they relate. (c) Key decision to be made is when to recognize (record) revenue—THEN Match Expense against Revenue (d) Not all Expenses can be ‘directly’ matched against Revenue. Some Expenses are ‘indirect’—costs in general of running the business for the period! (janitor’s salary, depreciation of computer)

Materiality Concept - only those transactions dealing with dollar amounts large enough to make a difference to financial statement users need to be accounted for in a manner consistent with the principles of financial accounting. (a) Size of transaction is relative. (b) Example: expense vs. depreciate (pencil sharpener). (c) Materiality requires judgment (NOT much help in professional literature). (d) User must be considered in determining materiality. (e) Consider “qualitative” aspects as well as “quantitative” ($10,000 bribe to Saudi Government official by GM). (f) SEC’s Staff Accounting Bulletin (SAB) #99 states “exclusive reliance on quantitative benchmarks to assess materiality in preparing financial statements is inappropriate”.

Conservatism Concept - "When in doubt, understate rather than overstate an entity's value.” (a) Only when significant uncertainty about the value of transaction exists, should the most conservative alternative be chosen. (b) Conservatism in its own right is NOT a desirable characteristic of accounting. It can be just as misleading as “being overly optimistic”. (“Big Bath” manipulation!) (c) Justification: legal liability of managers, directors, and auditors. (d) Example: LCM used in inventory valuation.

Economic entity - an individual company is separate and distinct from both its owner and all other entities. a. Ralph’s Used Car Company (a ‘proprietorship’) b. Parent and four subsidiaries (The economic entity may NOT necessarily be the same as the legal entity!)

Principle of Revenue Recognition Four criteria must be met before revenue can be shown in the income statement: (1) Production and sales efforts for product significantly completed. (2) Revenue amount can be objectively measured. (3) The major costs have been incurred and the rest can be reasonably estimated. (4) Eventual collection of cash is reasonably assured. In Summary, RECORD REVENUE when EARNED: Earnings Process is virtually complete—critical revenue producing activity has occurred (normally sale/delivery) AND remaining events (like collection of cash) are highly estimatable)

Timeliness (“Periodicity”) - time periods during which performance is measured for the economic entity. a. Based on users' need for timely information. b. Artificial time periods for reports (calendar, fiscal year, quarterly, ‘real-time on-line’). c. Timely (short period) vs. objective (longer period) tradeoffs.

Industry Exceptions - the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory. Examples: revenue recognition for agricultural products, installment sales, long-term construction accounting

Elements of Fin. Statements
Page 39 in textbook has the “fancy” definitions from FASB Concept Statement #6. Let’s quickly go through them and add ‘simplified’ common wordage alternative definitions for the elements that make up the financial statements.

Class Assignment Questions #2, 3, 5, 8, 9, 14, 16, 20, 25, 28 (pages 53-54) Homework (pages 57-58): Ex. 3, 4, 7

THE ACCOUNTING INFORMATION SYSTEM (The Accounting Cycle)
C H A P T E R 3 THE ACCOUNTING INFORMATION SYSTEM (The Accounting Cycle) Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

THE “MECHANICS” OF FINANCIAL ACCOUNTING (A Summary of Ch. 3)
Review the fundamental accounting equation. Discuss the two criteria required for entering an economic event into the accounting cycle. Explain the debit/credit scheme Discuss and illustrate the role of the Journal Entry, Journals, Posting to Ledger Accounts, and Trial Balances. Review the use of Adjusting Journal Entries. Explain how Financial Statements are prepared at the end of the accounting cycle. Illustrate the use of an Accounting Worksheet Describe and illustrate the procedures involved in the Closing Process and its importance.

THE FUNDAMENTAL ACCOUNTING EQUATION
Assets = Claims to Assets Assets = Liabilities + Stockholders’ Equity Assets = Liabilities + (Contributed Capital + RE) Characteristics: a. This equality must always be maintained. b. Equality is a necessary, but not sufficient condition. c. Equality is maintained by the double entry system of bookkeeping. Ending RE = Beginning RE + NI – Dividends Net Income = Revenues - Expenses

TWO CRITERIA FOR RECORDING ECONOMIC EVENTS
Criteria for recording a business or exchange transaction (economic event) in the accounting cycle. 1. Event Relevancy - economically significant and affects a firm's financial condition. (Assets, Liabilities, and/or Stockholders’ Equity are Affected!) 2. Objectivity - dollar values assigned to accounts (categories) in the Financial Statements must result from exchange transactions (involving firm and an “outside party”) that are backed by documented evidence.

Follow along on the board as I use the basic “Accounting Equation” of:
Debit/Credit Scheme Follow along on the board as I use the basic “Accounting Equation” of: (Assets = Liabilities + Owners’ Equity) to demonstrate how to learn the debit/credit scheme.

The Accounting Equation
Relationship among the assets, liabilities, and stockholders’ equity of a business: The equation must be in balance after every transaction. For every Debit there must be a Credit.

Accounting Cycle Summarized (After having completed the “Transaction Analysis”)
Enter the transactions of the period in appropriate journals. Post from the journals to the ledger. Prepare a trial balance (unadjusted trial balance). Prepare adjusting journal entries and post to the ledger. Prepare a trial balance after adjusting (adjusted trial balance). Optional--Prepare an Accountant’s Worksheet Prepare the financial statements from the adjusted trial balance or Accountant’s Worksheet Prepare closing journal entries and post to the ledger. Prepare a trial balance after closing (post-closing trial balance). Optional--Prepare reversing entries and post to the ledger.

The Accounting Cycle Transactions 9. Optional--Reversing entries
1. Journalization 8. Post-closing trail balance 2. Posting to Ledger 7. Closing entries 3. Trial balance Optional Work Sheet 6. Financial Statements 4. Adjustments 5. Adjusted trial balance

Transaction Analysis a. Which financial statement accounts
First UNDERSTAND THE BUSINESS EVENT THAT OCCURRED!! THEN: a. Which financial statement accounts are affected by the transaction? b. What is the direction of the account effect? (Increase or Decrease) c. What is the dollar value of the transaction? (use the balance sheet valuation methods:) 1.) Historical Cost (Land) 2.) Lower of Cost or Market (Inventory) 3.) Net Realizable Value (Accounts Receivable) 4.) Fair Market Value (Trading Portfolio of Investments) 5.) Present Value (Capitalized Lease)

JOURNALS AND LEDGERS 1. The Journal (general journal) - contains a chronological list of the transactions entered into by a company, usually in journal entry form. a. Enter date of transaction. b. List the accounts to be debited/credited. c. Include the dollar amounts of debits/credits. d. Provide a brief explanation of the transaction. e. Enter a posting reference to the appropriate ledger accounts (discuss next). The Ledger - contains a running balance for each asset, liability, stockholders' equity, and temporary retained earnings account--revenue, expense, and dividend accounts. (“T” ledger accounts usually are used in the textbook and lectures instead of the 3-column running balance format of ledger account) Posting to the ledger accounts occurs throughout the accounting period (with computer systems—posting occurs at the same time that the journal entry is made).

1. Journalizing General Journal – a chronological record of transactions. Journal Entries are recorded in the journal. September 1: Stockholders invested $15,000 cash in the corporation in exchange for shares of stock.

2. Posting Posting – the process of transferring amounts from the journal to the ledger accounts.

2. Posting Posting – Transferring amounts from journal to ledger.

3. Unadjusted Trial Balance
Trial Balance – A list of each account and its balance; used to prove equality of debit and credit balances.

Use Class Problem #1 on next slide to illustrate:
ILLUSTRATION Use Class Problem #1 on next slide to illustrate: Transaction Analysis Debits/Credits Journal Entries Posting to Ledger Accounts “Unadjusted” Trial Balance

Link to Solution to Class Prob. 3-1

ADJUSTING JOURNAL ENTRIES
1. Definition - Journal entries recorded at the END of the accounting period to ensure that the financial statements will be correct—routine transactions recorded during the period may not result in proper presentation of the financial statements. 2. Characteristics of Adjusting Entries: a. Entered in the records at the end of the period. b. Involve both a temporary retained earnings account (aka. “nominal account”) and a permanent balance sheet account. 3. Types of adjusting journal entries a. Accruals b. Deferrals c. Revaluations

“ACCRUALS” TYPE OF ADJUSTING ENTRY
1. Adjusting journal entries that ensure revenues earned and expenses incurred during the current period are recorded. Because the cash has not been received or paid yet, the routine entries already made during the period would NOT have recognized these revenues and expenses (and the related asset or liability) 2. Examples include: a. Accrued interest on Bank CD (and receivable) Interest Receivable AND Interest Revenue b. Accrued wages earned by employees (and payable). Salaries Expense AND Salaries Payable

“DEFERRALS” TYPE OF ADJUSTING ENTRY
Deferrals - the process of “converting” either: 1.) a deferred cost (i.e., asset) into an expense: a. Supplies inventory (Dr Supplies expense, Cr Supplies) b. Merchandise inventory (Dr Cost of goods sold, Cr Inventory) c. Prepaid expenses (Dr Expense account, Cr Prepaid expense) d. Property, plant, and equipment (Dr Depreciation expense, Cr Accumulated depreciation) e. Definitive-Lived Intangibles (Dr Amortization expense, Cr Intangibles) 2.) a deferred revenue (i.e. liability) until revenue earned. a. Unearned revenues (Dr Unearned revenue, Cr Fees earned) Note that with Deferral type Adjusting Entries—a previously recorded event (usually the result of a cash transaction) is being ‘updated’.

“REVALUATIONS” TYPE OF ADJUSTING ENTRY
1. Revaluation adjustments – Adjusting Journal Entries designed to bring the dollar amounts of certain accounts in line with the existing facts. 2. Examples: a. Bad debt estimates. b. Adjustments due to bank reconciliations. c. Revaluations of inventories to apply LCM.

ILLUSTRATION OF ADJUSTING ENTRIES
Use Class Problem #2 on next slide to illustrate: Accrual Adjusting Journal Entries Deferral Adjusting Journal Entries Valuation Adjusting Journal Entries

Link to Solution to Class Prob. 3-2
Prepare adjusting entries based on the unadjusted trial balance above and the information below: 1.) The buildings have an estimated useful life of 50 years with no salvage value. Use straight-line depreciation. 2.) The equipment is depreciated at 10% of original cost per year 3.) Prepaid insurance totaling $1,500 ‘expired’ during the year 4.) It is estimated that 10% of the accounts receivable will NOT be collected 5.) Accrued salaries at year-end were $1,500 6.) Unearned rent revenue balance at year-end should be $1,200 Link to Solution to Class Prob. 3-2 Link to Solution for Class Problem 3-2

THE ACCOUNTANT’S WORKSHEET (See Appendix 3C—page 109)
The Worksheet - used at the end of an accounting period by the accountant to prepare an ‘informal’ trial run through the end of the period accounting steps. a. Advantages (1) Easier to trace/track your work. (2) Aids in finding posting and math errors. b. Worksheet step-by-step process: (1) Prepare Unadjusted Trial Balance - the list of accounts and end-of-period account balances copied from the general ledger to the worksheet (the first step). (2) Post adjusting entries - journal entries recorded at period end--Accruals, Deferrals, & Valuation adjustments (the second step). (3) Prepare “Adjusted Trial Balance” columns (the third step) (4) Prepare “Financial Statement” columns (the fourth step) Add another financial statement set of columns for the Retained Earnings Statement--locate it between the Income Statement set of columns and the Balance Sheet set of columns! (The beginning Retained Earnings, Dividends Declared, and Net Income should be extended to the Retained Earnings set of columns, NOT the Balance Sheet set of columns.) Preparation of the Accountant’s Worksheet will be one of the homework assignments for Ch. 3

Illustration of Accountant’s Worksheet
Link to first six columns on an Accountant’s Worksheet Link to last 8 columns on an Accountant’s Worksheet

PREPARING THE FINANCIAL STATEMENTS
1. Income statement - prepare from adjusted trial balance or accountant’s end of period worksheet 2. Statement of retained earnings - prepare from retained earnings general ledger account (after closing entries) or from the accountant’s end of period worksheet. 3. Balance sheet - prepare from adjusted trial balance or the accountant’s end of period worksheet. 4. Statement of cash flows - prepare by analyzing the change in every account but the Cash account.

ILLUSTRATION OF FOUR FINANCIAL STATEMENTS
Click on link to view an illustration of the four financial statements. Point out—’interrelationships’ among the four financial statements. How they ‘interconnect’!

THE CLOSING JOURNAL ENTRY PROCESS
1. AFTER adjusted trial balance and financial statements have been completed, THEN: 2. Closing journal entries - transfer end-of-period balances in the Revenue, Expenses, and Dividends Declared accounts (the temporary retained earnings accounts; aka. the ‘nominal’ accounts) to the permanent Retained Earnings account. (Do NOT use the “Income Summary” account) a. Closing process procedures. (1) Close Revenue accounts to Retained Earnings (2) Close Expense accounts to Retained Earnings (3) Close Dividends Declared to Retained Earnings. b. WHY need closing journal entries???? 3. Prepare the post-closing trial balance (aka. “after-closing trial balance”) – contains end-of- period balances for the permanent (balance sheet) accounts. Also represents beginning balances for next accounting period.

ILLUSTRATION OF CLOSING ENTRIES
Use Class Problem #3 to illustrate: Closing Journal Entries Post closing Trial Balance (First Show Adjusted Trial Balance – basis for preparing Closing Entries)

9. Reversing Entries After preparing the financial statements and closing the books, a company may reverse some of the adjusting entries before recording the regular transactions of the next period.

Summary of Reversing Entries (IF Used!)
All accrual adjusting entries would be reversed. All adjusting entries for deferrals where the company debited or credited the original cash transaction to an expense or revenue account would be reversed. Recognize that reversing entries do not have to be used. They may be necessary if a “poorly” designed accounting software package (or ‘inexperienced’ bookkeeper) that: i.) will be unable to properly account for subsequent cash received or paid in situation #1 above ii.) ‘records’ deferral situation in #2 incorrectly back at time of cash receipt or cash payment

Accounting Cycle Summarized
Enter the transactions during the period in the journal. Post from the journal to the ledger. Prepare an unadjusted trial balance. Prepare adjusting journal entries and post to the ledger. Prepare a trial balance after adjusting (adjusted trial balance). Optional--Prepare an Accountant’s Worksheet Prepare the financial statements from the adjusted trial balance or the Accountant’s Worksheet Prepare closing journal entries and post to the ledger. Prepare a trial balance after closing (post-closing trial balance). Optional--Prepare reversing entries and post to the ledger.

Class Assignment Questions -- # 4, 10, 11, 12, 21, and 22 (page 111) Homework -- Proprietary Problem A preformatted Excel worksheet is provided with some columns of the Accountant’s Worksheet already completed. Required: a.) Complete the Accountant’s Worksheet using Excel b.) Prepare an Income Statement, Retained Earnings Statement, and ‘classified’ Balance Sheet c.) Record in journal entry form the adjusting entries d.) Record in journal entry form the closing entries e.) Prepare a post-closing (aka. ‘after-closing’) trial balance

INCOME STATEMENT AND RELATED INFORMATION
C H A P T E R 4 INCOME STATEMENT AND RELATED INFORMATION Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter 4 Understand the uses and limitations of an income statement. Prepare a single-step income statement. Prepare a multiple-step income statement. Explain how to report ‘special items’: a.) Discontinued operations b.) Extraordinary items. Explain “intraperiod tax allocation”. Identify where to report earnings per share (EPS) information. Prepare a retained earnings statement. Explain how to report other comprehensive income. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Income Statement (aka. “Operating Statement)
Usefulness Evaluate past performance. Predicting future performance. Help assess the risk or uncertainty of achieving future cash flows.

Income Statement “Quality” of Earnings
Companies have incentives to manage income to meet or beat Wall Street expectations, so that market price of stock increases value of stock options increase bonus is bigger keep from being fired

Format of the Income Statement
Revenues for the period: Selling price of goods sold or services rendered Gross INCREASE in Retained Earnings component of stockholders’ equity Examples of Revenue Accounts Sales revenue Fees earned Interest revenue Dividend revenue Rent revenue

Expenses for the period: Costs incurred to run the business and generate the revenue Gross DECREASE in Retained Earnings component of stockholders’ equity Examples of Expense Accounts Cost of goods sold Depreciation expense Interest expense Rent expense Salary expense

Gains – Increases in income from “peripheral” or incidental transactions Losses - Decreases in income from “peripheral” or incidental transactions. Examples of Gains and Losses Sale of investment in Microsoft shares, Sale of old delivery truck, Impairment losses.

Single-Step Format The single-step statement has few categories or subtotals: Revenues Expenses Net Income Single- Step

Multiple-Step Format More categories and subtotals than ‘single step’ format 1. Operating Section 2. Nonoperating Section 3. Income tax

Reporting “Special” Items
1.) Discontinued Operations occurs when, there is no significant continuing involvement in a component of the business. (Own restaurants, steel mill, and shoe store--and sell the restaurants on June 12, 2010) Discontinued Operations must be reported in its own separate section of the income statement (following ‘Income from continuing operations’). The Discontinued Operations section would include both the results of operating the component of the business up to the disposal date and the gain or loss on the disposal. Discontinued items must be shown “net of tax.” EPS must be shown for Discontinued Operations

Reporting Discontinued Operations
Illustration: KC Corporation had after tax income from continuing operations of $5,000,000 in Prior to disposal, the restaurants operated at a pretax loss of $450,000 in On June 12, 2010, KC disposed of its restaurant division at a pretax loss of $270,000. Assume a tax rate of 30%. A partial income statement for KC: Income from continuing operations $5,000,000 Discontinued operations: Loss from operations, net of $135,000 tax benefit 315,000 Loss on disposal, net of $81,000 tax benefit 189,000 Total loss on discontinued operations 504,000 Net income $4,496,000 Earnings per share: Income from continuing operations $5.00 Discontinued operations Net income $4.50

Reporting Irregular Items
2.) Extraordinary items must be both of an Unusual Nature and Occur “Infrequently” Company must consider the environment in which it operates. Extraordinary items must be shown “net of tax.” Earnings per Share (EPS) must be shown for Extraordinary items

Reporting Extraordinary Items
Are these items Extraordinary? (a) A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare. (b) A citrus grower's Florida crop is damaged by frost. (c) Damage from Hurricane Katrina. YES NO NO

Reporting Extraordinary Items
Illustration: KC Corporation had after tax income from continuing operations of $4,000,000 in In addition, it suffered an unusual and infrequent pretax GAIN of $770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial income statement for KC Corporation beginning with income from continuing operations. Income from continuing operations $4,000,000 Extraordinary gain, net of $231,000 tax 539,000 Net income $4,539,000 Earnings per share: Income from continuing operations $4.00 Extraordinary gain Net income $4.54

Items NOT Getting ‘Special’ (Separate) Section
Unusual Gains and Losses Material items that are unusual or infrequent (considering the company’s ‘environment’), but not both, should be reported in a separate section just above “Income from continuing operations before income taxes.” Examples can include: Write-downs of inventories Impairment losses These items are NOT shown net-of-tax nor do they have own EPS As Management--would you ‘claim’ a loss was “extraordinary” or just ‘unusual’? What if it were a gain?

Illustration of “Unusual Gains & Losses”

ACCOUNTING CHANGES (Covered in more detail in Ch. 22)
1.) Changes in Accounting Principles (or “method”) Restate prior years’ financial statements that are being presented for comparative purposes (If impact goes back further than years presented, adjust beginning retained earnings balance for earliest year presented) Approach preserves comparability among years Examples include: change from FIFO to weighted-average cost change from the percentage-of-completion to the completed-contract method

2. Changes in Accounting Estimate
ACCOUNTING CHANGES 2. Changes in Accounting Estimate Accounted for in the period of change and future periods Not handled retrospectively (i.e., do NOT restate prior years’ financial statements presented for comparative purposes) Examples include: Useful lives and salvage values of depreciable assets Allowance for bad debts

Change in Estimate – An Illustration
Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2010 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Questions: What is the journal entry to correct the prior years’ depreciation? Prepare the journal entry in 2010 to record depreciation. No Entry Required

Change in Estimate Example
After 7 years First, establish remaining depreciable amount at date of change in estimate. Equipment cost $510,000 Salvage value ,000 Depreciable base 500,000 Useful life (original) years Annual depreciation $ 50,000 x 7 years = $350,000 Equipment $510,000 Accumulated depreciation 350,000 $160,000 Revised salvage value (5,000) Remaining depreciable amount $155,000

Change in Estimate Example
After 7 years Remaining depreciable base $ 155,000 Divide by remaining life years New depreciation $ 19,375 Depreciation Expense calculation for 2010. Journal entry for 2010 Depreciation expense 19,375 Accumulated depreciation 19,375 In how many of the 15 years, will the depreciation expense account be the “correct” $33,667 dollar amount? ([$510,000 Cost - $5,000 S.V.] / 15 years) Why ‘might’ management have ‘claimed’ the estimated useful life had increased from 10 years to 15 years?

3.) Corrections of Errors
Accounting Changes 3.) Corrections of Errors Result from: mathematical mistakes mistakes in application of accounting principles oversight or misuse of facts Corrections treated as prior period adjustments Retroactively correct any prior year’s financial statements being presented Adjust the beginning balance of retained earnings for the earliest year’s financial statements presented if error goes back further than earliest year

Correction of Errors -- Illustrated
In 2011, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in In 2011, Hillboro makes the following entry to correct for this error (ignore income taxes). Retained earnings 100,000 Accounts receivable 100,000 Note: Can’t debit Sales Revenue account (because 2010’s Sales Revenue account was ‘closed out to zero’ at the end of 2010) If the 2010 financial statements are presented for comparative purposes with the 2011 statements, the 2010 statements would be corrected for the error.

Intraperiod Tax Allocation
Relates the income tax expense to the specific items that give rise to the amount of the tax expense. Income tax is allocated (within the accounting period) to the following items: (1) Income from continuing operations before tax (2) Discontinued operations (3) Extraordinary items (4) Changes in accounting principle (5) Correction of errors

Earnings Per Share (EPS) (Ch. 16 provides detail coverage of EPS)
Net income - Preferred dividends Weighted average number of shares outstanding Measures the dollars earned by each share of common stock. Most often ‘quoted’ financial ratio. Must be disclosed on the the income statement for income from continuing operations, discontinued operations, extraordinary items, and net income. Often divided into Market Price per share to get the Price/Earnings (P/E) ratio.

Calculating EPS--An Example
Compute EPS for 2009 Net Income $1,357,000; $50,000 cash dividend paid on preferred stock Shares of common stock: Issued and outstanding on January 1, 2009 = 500,000 shares April 1, issued additional 48,000 shares at $72. per share October 1, 2009 – 52,800 shares reacquired and retired at $65. per share Calculate denominator (the ‘weighted-average’ common shares outstanding): 500,000 (500,000 X 12/12) 36,000 (48,000 X 9/12) (13,200) (52,800 X 3/12) 522,800 Weighted Average Common Shares Outstanding Calculate earnings per share: $2.50 EPS ($1,357,000 Net Income minus $50,000 Preferred Dividend)

EPS Illustration

Retained Earnings Appropriated vs. Unappropriated Retained Earnings Companies may have a ‘large’ Retained Earnings account balance (and a relatively large Cash balance) yet the board of directors may not want to pay cash dividends. To inform investors of the possible reason(s) for not paying dividends: 1.) Disclose the reasoning in the Notes that accompany the financial statements or 2.) “Appropriated Retained Earnings”--divide the total Retained Earnings balance on the Balance Sheet into Appropriated and Unappropriated components

Comprehensive Income Comprehensive Income -- includes all changes in stockholders’ equity during a period except those resulting from investments by owners and dividends paid to stockholders Comprehensive Income thus includes: Net income--all revenues and gains, expenses and losses included on the Income Statement, AND Other gains and losses that ‘bypass’ net income but are included as “Other Comprehensive Income or Loss” component of Stockholders’ Equity on the Balance Sheet (e.g., Unrealized Gain or Losses on Available for Sale security investment; Unamortized Prior Service cost related to defined benefits pension plan)

Comprehensive Income Three approaches to reporting Comprehensive Income: A second separate income statement; A combined statement of comprehensive income; or As part of the statement of stockholders’ equity Each of the three approaches is illustrated on the next slides

Comprehensive Income--Illustrated
Illustration 4-19 A “Second” separate income statement

Combined income statement
Comprehensive Income Combined income statement

Include as part of Statement of Stockholder’s Equity
Comprehensive Income Include as part of Statement of Stockholder’s Equity Illustration 4-20

Balance Sheet Presentation
Comprehensive Income Balance Sheet Presentation Illustration 4-21 The Accumulated Other Comprehensive Income of $90,000 is reported in the stockholders’ equity section of the Balance Sheet.

GAAP vs. IFRS Differences
Presentation of the income statement under U.S. GAAP follows either a single-step or multiple-step format. International Financial Reporting Standard (IFRS) does not mention a single-step or multiple-step approach. In addition, under U.S. GAAP, companies must report an item as extraordinary if it is unusual in nature and infrequent in occurrence considering the ‘environment’ of the company. Extraordinary items are prohibited under IFRS (iGAAP).

Class Assignment Questions--#16 (skip ‘d’), 21, 22, 23, 30, 37 (pages ) Homework: (pages 167 and 175) Prob. 4-7 Professional Research Assignment--using FASB Codification

BALANCE SHEET AND STATEMENT OF CASH FLOWS
C H A P T E R 5 BALANCE SHEET AND STATEMENT OF CASH FLOWS Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter 5 Explain the uses and limitations of a Balance Sheet. Identify the elements appearing on a Balance Sheet. Prepare a “classified” Balance Sheet. Identify balance sheet items requiring “disclosure” and various ways the required disclosure can be accomplished. Indicate the purpose and content of the Statement of Cash Flows. Prepare a simply Statement of Cash Flows (Chapter 23 will provide extensive coverage of the preparation of the Statement of Cash Flows). 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Usefulness of the Balance Sheet
Evaluating the capital structure (debt and equity sources). Assess risk and future cash flows. Analyze the company’s: Liquidity (various assets’ “nearness to cash”) Solvency (ability to pay the bills when due) Financial flexibility (‘free’ cash availability to meet crises and take advantage of opportunities)

Limitations of the Balance Sheet
Most assets and liabilities are reported at historical cost. Use of judgments and estimates. Many items of financial value are omitted.

Classification in the Balance Sheet
Three General Classifications Assets, Liabilities, and Stockholders’ Equity Companies further divide these classifications:

Balance Sheet Current Assets
Cash and other assets a company expects to convert into cash, sell, or consume within one year or in the operating cycle, whichever is longer.

Balance Sheet – “Current Assets”
Cash & Cash Equivalents Generally Cash = any monies available “on demand.” Cash equivalents - short-term highly liquid investments that mature within three months or less. Restrictions or commitments must be disclosed.

Short-Term Investments Portfolios Type Valuation Classification Held-to-Maturity Debt Amortized Cost Current or Non-current* Trading Debt or Equity Fair Value Current Available- for-Sale Debt or Equity Fair Value Current or Non-current* *The “Held-to-Maturity” and “Available-for-Sale” could be either Current Assets OR Non-Current Assets depending on “Management’s Intent”

Receivables Claims held against customers and others for money, goods, or services. Accounts receivable – oral promises Notes receivable – written promises Question: What is the proper valuation for Receivables? Answer: Net Realizable Value

Accounts Receivable – Presentation Options 1 Current Assets: Cash $ 346 Accounts receivable 500 Less allowance for doubtful accounts Inventory Total current assets $1,633 2 Current Assets: Cash $ 346 Accounts receivable, net of $25 allowance 475 Inventory Total current assets $1,633

Inventories Questions: 1.) What is the proper valuation for Inventories? Answer: Lower-of-cost-or-market (LCM) 2.) Any required disclosure related to valuation method? Method of determining cost (e.g., FIFO or LIFO).

Prepaid Expenses Cash Payment BEFORE Expense Recorded Prepayments often occur in regard to: insurance supplies rent advertising Question: How can Prepaid Expenses be classified as a current asset (they will not be converted into cash within the next year or operating cycle if longer)? Answer: They will be ‘consumed’ within the next year and will NOT require reduction in cash since already ‘paid for’.

Current Assets - “Summary” Cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer.

Balance Sheet – “Noncurrent Assets”
Long-Term Investments Generally consists of four types: Securities – Available for Sale; Hold-to-Maturity Debt Securities Land held for investment, Long-term Notes Receivable Special funds (e.g. Bond Sinking Fund) Nonconsolidated subsidiaries or affiliated companies.

Long-Term Investments Investments in bonds and stocks* Long-term Notes Receivable and Land held for Speculation Special Funds Nonconsolidated Subs, Affiliated Companies *“Held-to-Maturity” and “Available-for-Sale” Investments could be either Current Assets OR Long-Term Assets depending on “Management’s Intent”

Property, Plant, and Equipment Tangible, Long-lived, Used in the regular operations of the business. Question: What is the proper valuation for PP&E? Answer: US GAAP = Depreciated Cost IFRS = Choice of Depreciated Cost or FMV!

Lack physical substance and are not financial instruments. Get their value from their economic/legal rights. Limited-Life intangibles are amortized. Indefinite-Life intangibles are tested annually for impairment. Intangibles IFRS Valuation = Choice of Amortized Cost or FMV!

Other Assets This section should include only unusual items sufficiently different from assets in the other categories. Both “Prepaid Pension Cost” and “Deferred Income Taxes” will be covered in detail in Intermediate II.

Balance Sheet – “Current Liabilities”
“Obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities.” * To be classified as a Current Liability, the Note Payable must be due within one year or operating cycle whichever is longer

Balance Sheet – “Long-Term Liabilities”
“Obligations that a company does not reasonably expect to liquidate within one year or the normal operating cycle whichever is longer.” All covenants and restrictions must be disclosed.

Balance Sheet – “Stockholders’ Equity”
Three parts, (1) Capital Stock, (2) Additional Paid-In Capital, and (3) Retained Earnings.

Balance Sheet - Format Account Form

Report Form LO 3

Ways to Accomplish Required Disclosure
Terminology and Classification – what you ‘call’ the item on the Balance Sheet and where you ‘put it’ discloses information (e.g., Accounts Receivable shown as a current asset) Parenthetical Explanations Disclosure Notes (including Significant Accounting Policies) Supporting Schedules Cross-Referencing Use of Contra and Adjunct Accounts

The Statement of Cash Flows
Purpose of the Statement of Cash Flows To provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement provides answers to the following questions: Where did the cash come from? What was the cash used for? What was the change in the cash balance?

Content and Format Three different activities: Operating, Investing, Financing

Three Categories of Cash Flows Operating Investing* Financing Cash inflows and outflows from “day-in, day-out” normal operations. Cash inflows and outflows from purchase and later sale of non-current assets. Cash inflows and outflows from non-current liabilities and equity. *Investing activities is the investing activities of the COMPANY (NOT the Stockholders) Chapter 5 presents only a ‘brief’ introduction to the Statement of Cash Flows; Chapter 23 (to be covered in Intermediate II) is devoted entirely to an extensive coverage of the Statement of Cash Flows.

IFRS classifies some cash flows differently than GAAP (we’ll look at the differences in Intermediate II)

Information Needed: (1) comparative balance sheets, (2) the current income statement, and (3) selected transaction data. “Process” – Steps to follow: (1) complete the heading and last three lines of Statement of Cash Flows (2) complete Operating Activities section by converting accrual basis Income Statement to Cash Flows (3) complete analysis by ‘examining’ change in every account balance during the year EXCEPT CASH account Class Problem on next page.

Information for Class Problem Paradise Consulting Company
Link to Solution for Ch. 5 Class Problem

Significant Noncash Activities Significant financing and investing activities that do not affect cash are reported in either a separate schedule at the bottom of the statement of cash flows or in the notes. Examples include: Issuance of common stock to purchase assets. Conversion of bonds into common stock. Issuance of debt to purchase assets.

Usefulness of the Statement of Cash Flows
Without cash, a company will not survive. Cash flow from Operations: High amount - company able to generate sufficient cash to pay its bills and take advantage of opportunities (“Cash is King”). Low or negative amount - company may have to borrow or issue equity securities to pay bills. Would you lend money to the company? Would you buy the new issue of equity securities?

Ratio Analysis Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends in these relationships. Selected ratios related to topics already covered are on the next few slides. Other ratios will be covered as topics are covered in subsequent chapters.

Current Cash to Debt Coverage Ratio
Ratio Analysis Financial Liquidity Current Cash to Debt Coverage Ratio Net Cash Provided by Operating Activities = Average Current Liabilities Ratio indicates whether the company can pay off its current liabilities from its operations. A ratio near 1:1 is good.

Cash Debt Coverage Ratio
Ratio Analysis Financial Flexibility Net Cash Provided by Operating Activities Cash Debt Coverage Ratio = Average Total Liabilities This ratio indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations. What is going to happen to the company if it has to ‘liquidate its assets to repay its liabilities?

Ratio Analysis Free Cash Flow
The amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity.

Ratio Analysis -- Rate of Return on Assets
Rate of Return on Assets measures a firm’s success in using assets to generate earnings. It is calculated based on dollar amounts from the Income Statement (CH. 4) and the Balance Sheet (this chapter). Net Income Average Total Assets Rate of Return on Assets = $51.6 $ / 2 Rate of Return on Assets = Rate of Return on Assets = 6.4% (Is 6.4% ‘good’? Compare it to what?)

Ratio Analysis The analyst obtains further insight into the behavior of Return of Assets by disaggregating it into components of profit margin on sales and asset turnover as follows: Rate of Return on Assets Profit Margin on Sales Asset Turnover = x Net Income Net Income Net Sales = x Average Total Assets Net Sales Average Total Assets “Pennies of profit on each dollar of sales” Ability to generate sales revenue from use of assets Grocery store vs. Fur salon Grocery store vs. Fur Salon

Rate of Return on Assets
Ratio Analysis The analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows: Rate of Return on Assets Profit Margin on Sales Asset Turnover = x $64.2 $64.2 $420.1 = x ($ ) / 2 $420.1 ($ ) / 2 8.7% = 15.28% x .569

Class Assignment Questions #2, 6, 7, 21, 22, 28, 32, 36 (pages ) Homework: (pages ) CE 5-4 Ex. 5-15 Prob. 5-1

ACCOUNTING AND THE TIME VALUE OF MONEY
C H A P T E R 6 ACCOUNTING AND THE TIME VALUE OF MONEY Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter 6 Distinguish between simple and compound interest.
Use appropriate compound interest tables. Identify the ‘variables’ needed to solve time-value-of-money problems. Draw Time-Line Diagrams Solve future and present value of single amount problems. Solve future value of ordinary annuity problems. Solve present value of ordinary and annuity due problems. Calculate issuance price of bonds, prepare amortization schedule, and record related journal entries. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Simple Interest vs. Compound Interest
principal sum stays the same from period to period computed by adding the interest earned in one period to the amount on which interest is computed in future periods

Simple Interest Illustrated
Ron Marshall invests $10,000 in an investment that will return 8% SIMPLE INTEREST per year. The investment is for 3 years. What total amount will Marshall receive? $800 times 3 years = $2,400 total interest The total that Marshall will receive is $12,400. ($10, principal + $2,400. SIMPLE interest)

Compound Interest Illustrated
Ron Marshall invests $10,000 in an investment that will return 8% COMPOUND INTEREST per year. The investment is for 3 years. What total amount will Marshall receive? Beginning "Compound Year Investment Interest Earned" "Ending Investment" $10, $ $10,800 , ,664 , ,597 The total that Sanchez will receive is $12,597. ($10,000. principal + $2,597. COMPOUND interest) Most business situations use Compound Interest

Time Value of Money 1.) Two slides illustrating the IMPACT of time value of money in “Investing for Retirement” situations 2.) “Let’s Make a Deal” (Illustration of importance of considering TIMING of cash flow, not just dollar amount of cash flow) 3.) “Time-line diagrams” and my ‘formula’ slides for time-value-of-money

Example #1—Investing for Retirement
If you invest $10,000 TODAY to earn interest at 20% compound annual interest rate, what total dollar amount will you have when you are ready to retire 30 YEARS FROM NOW? Answer = $2,373,763.

Example #2—Investing for Retirement
If you invest $200 per month starting today (at age 45), that earns 20% compounded annually, you would have invested a total of $48,000 by age 65. At 65, when you retire, you would have $494,402. If you had started saving $200 per month at age 40 (and thus invested $12,000 extra over those 5 years), how much would you have at age 65? Answer = $1,249,278 Quote from Albert Einstein: “The most awesome power of the universe is that of COMPOUND INTEREST”

Let’s Make a Deal (I’ll tell you what’s behind each of the three doors before you have to pick!)

DOOR # 1 TODAY, I’LL GIVE YOU $10.

THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $10.
DOOR #2 THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $10.

THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $12.60.
DOOR #3 THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $12.60.

SUMMARY DOOR #1 = TODAY GET $10.
DOOR #2 = GET PROMISE OF $10 TO BE RECEIVED 3 YEARS FROM NOW DOOR #3 = GET PROMISE OF $12.60 TO BE RECEIVED 3 YEARS FROM NOW Which Door “Don’t” You Want? WHY? Assuming 8% COMPOUND, annual interest; do you want Door #1 OR Door #3?

Choosing an Appropriate Interest Rate
Three Components of Interest: “Pure” Rate of Return Expected Inflation Rate Credit Risk Rate

1.) Future Value of (Single Present Amount)
Now $ ? F = P (Factor: n=3, i (8%), Table 6-1 on page 309) F = $10. ( ) F = $12.60 YOU DO NOT HAVE TO USE THE FORMULAS IN THE TEXTBOOK, YOU CAN USE ‘MY FORMULAS’ IF YOU WISH!!!

Time Periods (‘n’ rows) and Interest Rate Column (‘i)
When using tables, the left-hand column refers to the number of interest compounding periods (n) The columns on the tables are the interest rate per compounding period (i) Interest can, of course, be paid on a quarterly or semiannual basis To use the tables in these cases, it is necessary to: (a) divide the annual interest rate by the number of compounding periods in the year to find the appropriate interest rate column (i) (b) multiply the number of compound interest periods in one year by the number of years to find (n)

Example of Future Value of (Single Present Amount)
Clock Corporation has $1,000,000 in cash to invest for 1 year. The money is placed in an account that pays 8 percent annual interest -- compounded quarterly. How much cash will the company have at the end of the year? Put “time-line diagram” on the board. F = P (factor, n = 4; i=2%; Table 6-1 page 308)) F = $1,000,000 times F = $1,082,430 The company will have $1,082,430 at the end of the year.

2.) Present Value of (Single Future Amount)
Now ? $12.60 P = F (Factor: n=3; i (8%); Table 6-2 on page 311) P = $12.60 (.79383) P = $10.

Example of a Present Value of (Single Future Amount)
Don Smith wants to have $2,000 at the end of three years. How much must he invest today in a 5 percent investment (annual compound interest) to achieve this goal? Put “time-line diagram” on the board P = F (factor, n=3; i=5%; Table 6-2 Page 310) P = $2,000 times P = $1,728 Don must invest $1,728 today to have the $2,000 he will need at the end of three years.

Annuities Annuity requires:
Periodic payments or receipts (called rents) of the same amount each period, Same-length interval between such rents, and Same interest rate applies to all the rents. Two Types Ordinary annuity - rents occur at the end of each period. Annuity Due - rents occur at the beginning of each period.

3.) Future Value of an “Ordinary” Annuity
Now $ $ $10 ? Fa = A (Factor: n=3; i (8%); Table 6-3 on page 313) Fa = $10 ( ) Fa = $32.46

Example of Future Value of an “Ordinary Annuity”
Your parents agree to set aside cash at the end of each year to pay off your $10,000 college loan due in 5 years. They will make 5 annual contributions by the time the loan is due. The fund is projected to earn 8 percent, compounded annually. What must be the amount that your parents must save annually (1st savings one year from now--ordinary annuity when cash flows are at the end of each period)? Use Future Value of Ordinary Annuity Formula, but solve for “A” the annual annuity amount. Put “time-line diagram” on the board Fa = A (factor, n=5; i=8%; Table 6-3, Page 313) $10,000 = A ( ) A = $10,000/ = $1,705 The required annual payment to the fund is $1,705.

4.) Present Value of an “Ordinary” Annuity
Now ? $ $ $10 Pa = A (Factor: n = 3; i (8%), Table 6-4 on page 315) Pa = $10 ( ) Pa = $25.77

Example of Present Value of an “Ordinary Annuity”
Cathy Crosby sold a piece of property and is to receive three equal annual payments of $5,000 beginning one year from today. What is the present value of this sale if the current interest rate is 4 percent, compounded annually? Put “time-line diagram” on the board Pa = A (factor, n=3; i=4%; Table 6-4 on page 314) Pa = $5,000 times Pa = $13,875 The present value of the $5,000 annuity stream is $13,875

5.) Present Value of an “Annuity Due”
Periodic rents occur at the BEGINNING of the period. Now $ $ $10 ? Pad = A (Factor: n = 3; i (8%), Table 6-5 on page 317) Pad = $10 ( ) Pad = $27.83

Example of Present Value of an “Annuity Due”
Space Odyssey, Inc., leases a communications satellite for 4 years with annual rental payments of $4.8 million to be made at the beginning of each year. If the relevant annual interest rate is 11%, what is the present value of the rental obligations? Put “time-line diagram” on the board Pad = A (factor, n=4; i=11%; Table 6-5 on page 317) Pad = $4.8 million times Pad = $16,529,808 The present value of the $4.8 million annuity stream is $16,529,808

Rents begin after a specified number of periods.
Deferred Annuities -You are NOT Responsible for Deferred Annuities Rents begin after a specified number of periods. Future Value Present Value 100,000 100,000 100,000 1 2 3 4 19 20

Bonds Payable Liability--Issue Date
Bond Selling Price (CASH) Bond Certificate at Face (“Maturity”) Value Corporation Bond Investors On the issue date, the bondholders give the company the market value, or selling price of the bond issue. The company gives the bondholders a bond certificate promising to pay periodic interest and to return the principal on the maturity date. Bond Issue Date

Bonds Payable--Interest Payments
Bond Interest Payments (CASH) Corporation Investors Bond Interest Payments At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as bond face value times the stated interest rate on the bond times the time the bond has been outstanding during the year. Cash Interest Payment = Principal × Cash Interest Rate × Time Bond Issue Date

Bonds Payable--Maturity Date
Bond Face Value (CASH) at Maturity Date Corporation Investors At the maturity date, the company pays the bondholders the bond’s face value. Bond Issue Date Bond Maturity Date

Selling Price of Bonds Payable
The selling price of a bond is determined by the “market” based on the time value of money. Two Cash Flows to be paid: $12,000 annual cash interest payments $200,000 cash payment at maturity today ……….10 $200,000 Principal Payment $ ? Selling Price = $? $12,000 $12, $12, $12,000 interest payments . 12

Illustration--Bonds Payable Issued at “Discount”
XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, The bonds pay interest annually on December 31. The market rate of interest on bonds of a similar default risk is 10% on the date the bonds are issued. Requirements: 1.) Calculate the issuance (selling price) of the bonds: a.) Using ‘formulas’ b.) Using “PV” function in Excel 2.) Prepare an amortization table for the 10 interest payments 3. Prepare the required "journal entry" to record: a.) The issuance of the bonds payable on January 2, 2008 b.) The first annual interest payment on Dec. 31, 2008 (USING THE EFFECTIVE INTEREST METHOD—NOT STRAIGHT LINE--TO AMORTIZE THE BOND DISCOUNT) c.) The retirement of the bonds on the maturity date Link to Excel worksheet with Solutions to Class Problem

Summary of Time Value of Money Situations You Are Responsible For
Single Dollar Amounts Annuities Future value of a single present amount Present value of a single future amount Solving for other unknowns (i.e., ‘n’ the number of interest periods and ‘i’ the interest rate per interest period) Future value of ordinary annuity Future value of annuity due* (NOT Responsible for this one) Present value of ordinary annuity Present value of annuity due Solving for other unknowns (i.e., ‘n’ the number of interest periods; ‘i’ the interest rate per interest period); ‘A’ the annuity amount) * Your textbook does NOT provide a Table for Future Value of an Annuity Due (and we are NOT going to create the Table) Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation. Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt. Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets. Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees. Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss: difference between the actual return and the expected return on plan assets and, amortization of the unrecognized net gain or loss from previous periods

Deferred Annuities (That You are NOT Responsible For)
Rents begin after a specified number of periods. Future Value - Calculation same as the future value of an annuity not deferred. Present Value - Must recognize the interest that accrues during the deferral period. Future Value Present Value 100,000 100,000 100,000 1 2 3 4 19 20

Class Assignment Questions #3, 4, 6, 9, 17 (skip ‘b’), 18 (page 295) Homework: (pages ) Ex. 3; Prob. 2 (skip ‘b’); and Proprietary Problem on next slide (similar to class problem--BUT Market interest rate on date bonds were issued for the homework is 4%)

Proprietary Ch. 6 Homework Problem
XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, The bonds pay interest annually on December 31. The market rate of interest on bonds of a similar default risk is 4% on the date the bonds are issued. Requirements: 1.) Calculate the issuance (selling price) of the bonds: a.) Using ‘formulas’ b.) Using “PV” function in Excel 2.) Prepare an amortization table for the 10 interest payments 3. Prepare the required "journal entry" to record: a.) The issuance of the bonds payable on January 2, 2008 b.) The first annual interest payment on Dec. 31, 2008 (USING THE EFFECTIVE INTEREST METHOD—NOT STRAIGHT LINE--TO AMORTIZE THE BOND PREMIUM) c.) The retirement of the bonds on the maturity date

C H A P T E R 7 CASH AND RECEIVABLES
Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Cash and Receivables -- Summary of Chapter 7
What is cash? Reporting cash Petty cash fund Bank reconciliation Recognition and valuation of accounts receivable Recognition and valuation of notes receivable Disposition of accounts and notes receivable Ratio analysis Impairment of long-term receivable (loans)

What is Cash? Cash Examples: coins, currency, checking accounts, money orders, certified checks, cashier’s checks, personal checks, and savings accounts. What about ‘posted-dated checks’, IOUs, postage stamps--are they included in Cash? Cash Equivalents: short-term, highly liquid investments that are both: a.) readily convertible to cash, and b.) so near their maturity (within 90 days) that they present insignificant risk of changes in interest rates. Examples: Treasury bills, Commercial paper, and Money market funds. With the market drying up for ‘auction securities’ (a cash equivalent) during the credit crises, the combining of cash and cash equivalents on the balance sheet may become infrequent!

Reporting Cash Restricted Cash
Companies segregate restricted cash from “regular” cash for reporting purposes. Examples, restricted for: (1) plant expansion, (2) retirement of long-term debt, and (3) compensating balances -- ‘legally restricted’. Bank Overdrafts When a company writes a check for more than the amount in its cash account, it generally is reported as a current liability. Offset against cash account only when available cash is present in another account in the same bank on which the overdraft occurred.

The Imprest Petty Cash System (part of Internal Control System over Cash)
Used to pay small amounts for miscellaneous expenses. Record $300 transfer of funds to petty cash to establish the petty cash fund: Petty Cash 300 Cash 300 The petty cash custodian obtains signed receipts from each individual to whom he or she pays cash from the fund, BUT no journal entries are made to record the disbursements as they are made from the fund.

The Imprest Petty Cash System (Continued)
Custodian receives a company check to replenish the fund. Office Supplies Expense 42 Postage Expense 53 Entertainment Expense 76 Cash Over and Short 2 Cash 173 IF material--adjusting entry needed at end of accounting period for any unreplenished disbursements in the petty cash fund.

Bank Reconciliation Schedule explaining any differences between the bank’s and the company’s records of cash. Reconciling Items: Deposits in transit. Outstanding checks. Bank charges and credits. Bank or Depositor errors. Time Lags We will use the ‘dual’ format bank reconciliation used in your textbook (Appendix 7A): 1.) Bank balance reconciled to correct bank balance 2.) Book balance reconciled to correct book balance

Bank Reconciliation -- Example (Also journal entries based on completed reconciliation)

Completed Bank Reconciliation

Journal Entries for Bank Reconciliation Example
Nov. 30 Cash 780 Interest revenue 600 Accounts payable 180 Accounts receivable 220 Bank service charge expense 18 Cash

Accounts Receivable (aka.“Trade Receivable”)
Receivables Claims held against customers and others for money, goods, or services. Oral promises of the customer to pay for goods and services sold. Written promises to pay a sum of money on a specified future date. Accounts Receivable (aka.“Trade Receivable”) Notes Receivable

Non-trade Receivables (i.e., Misc. Receivables)
Advances to officers and employees. Advances to subsidiaries. Deposits to cover potential damages or losses. Deposits as a guarantee of performance or payment. Dividends and interest receivable. Claims against: Insurance companies for casualties sustained. Defendants under suit. Governmental bodies for tax refunds. Common carriers for damaged or lost goods. Creditors for returned, damaged, or lost goods. Customers for returnable items (crates, containers, etc.).

10 % Discount for Wholesalers
Accounts Receivables “Trade Discounts” Reductions from the list price Not recognized in the accounting records Customers are billed net of trade discounts 10 % Discount for Wholesalers

“Cash Discounts” (aka. Sales Discounts)
Accounts Receivables “Cash Discounts” (aka. Sales Discounts) Inducements for prompt payment Payment terms are 2/10, n/30 As the buyer, would you take your money out of an investment where it is earning 8% to take advantage of a cash discount of 2/10,n30? As a seller, why would you offer ‘cash discounts’ to your customers?

Accounts Receivables Non-recognition of Interest on Accounts Receivable GAAP specifically excludes from present value considerations “receivables arising from transactions with customers in the normal course of business which are due in customary trade terms not exceeding approximately one year.” Short-term Accounts Receivables do however need to be presented at Net Realizable Value (NRV) which necessitates an adequate Allowance for Doubtful Accounts (aka. “Allowance for Bad Debts” or just plain “Allowance”)

Accounts Receivable What is the NRV of the accounts receivable on the partial Balance Sheet above?

Valuation of Accounts Receivable
Methods of Accounting for Uncollectible Accounts Direct Write-Off Theoretically undesirable: No matching Receivable not stated at net realizable value Not GAAP Allowance Method Losses are Estimated: Percentage-of-sales (aka. “income statement approach”) Percentage-of-receivables/”aging” (aka. “balance sheet approach”) GAAP

Uncollectible Accounts Receivable
Summary Percentage of Sales (income statement approach): Bad debt expense estimate is related to an income statement account (Sales Revenue), any balance in the allowance account is ignored. Achieves a proper matching of expenses and revenues. Percentage of Receivables (balance sheet approach): Results in a more accurate valuation of receivables on the balance sheet. Method may also be applied using an aging schedule.

Class Example Record journal entries for the following:
The Ex., Why, Zee Company began operations on Jan. 1, 2008. Record journal entries for the following: Monthly sales on account of $20,000 Monthly estimated bad debts of 1% of sales on account Write off of John Jones’s individual account receivable for $150 when it ultimately proves uncollectible. Write off of Janice Smith’s individual account receivable for $280 when it ultimately proves uncollectible Unexpectantly recover the amount due from Mr. Jones when he sends to Ex., Why, Zee Company a check for $150. Collect $175,000 of Accounts Receivable (in addition to the above $150 from Mr. Jones) At December 31, 2008 year-end, the adjusting entry to revise Allowance account to the current estimated balance of $1,400. Link to the Solution for Bad Debt Accounting

Recording of Notes Receivable
Record at Face Value, set up Allowance Short-Term Note Record at Present Value* of cash expected to be collected Long-Term Note Issued at Interest Rates Stated cash interest rate = Market rate Stated rate interest rate > Market rate Stated rate interest rate < Market rate Face Value Premium Discount Subsequent to receipt of note receivable: a.) Note disclosure is required showing Fair Market Value of Note b.) Option to actually ‘revalue’ Note to Fair Market Value c.) Test for ‘impairment’ loss

Non (or Zero)-Interest-Bearing Note
Illustration: Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note. The market rate of interest for a note of similar risk is 9 percent. How does Jeremiah record the receipt of the note? i = 9% $10,000 Principal $0 $0 $0 Interest 1 3 3 n = 3

Zero-Interest-Bearing Note
PV of Principal P = F (factor) P = $10,000 x P = $7,721.80

Journal Entries for Zero-Interest-Bearing note Present value of expected future cash flows ($10,000. principal and zero interest) = $7,721.80

Unrealistically Low Interest-Bearing Note
Illustration: Morgan Corp. 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. How does Morgan record the receipt of the note? i = 12% $10,000 Principal $1,000 1,000 1,000 Interest 1 2 3 n = 3

PV of INTEREST Pa = A (factor) Pa = $1,000 x Pa = $2,402

PV of PRINCIPAL P = F (factor) P = $10,000 x P = $7,118 Interest Principal Total present value = $9,520 ($2,402 + $7,118)

Journal Entries Cash 1,000 Discount on notes receivable 142 Interest revenue 1,142

Notes Received for Property, Goods, or Services
In a “bargained transaction” entered into at arm’s length, the stated cash interest rate is presumed to be fair unless: No interest rate is stated, or Stated interest rate is unreasonable, or Face amount of the note is materially different from the current cash sales price.

Illustration Oasis Development Co. sold a corner lot to Rusty Pelican as a restaurant site. Oasis accepted in exchange a five-year note having a face (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 market value of $20,000. Oasis uses the fair market value of the land, $20,000, as the present value of the note. Oasis therefore records the sale as: Notes Receivable 35,247 Discount on Notes Receivable ($35,247 - $20,000) 15,247 Land 14,000 Gain on Sale of Land 6,000 Note: “Gain” of $6,000 recorded at time of ‘sale’ while $15,247 of Interest Revenue will be recorded over life of note.

Illustration (recording fair value option)
Assume that Escobar Company has notes receivable that have a fair value of $810,000 and a carrying amount of $620,000. Escobar decides on December 31, 2010, to use the fair value option for these receivables. This is the first valuation of these recently acquired receivables. At December 31, 2010, Escobar makes an adjusting entry to record the increase in value of Notes Receivable and to record the unrealized holding gain, as follows. Notes Receivable 190,000 Unrealized Holding Gain or Loss—Income 190,000

Disposition of Accounts and Notes Receivable
Owner may transfer accounts or notes receivables to another company for cash: Competition (‘industry characteristic’) Sell receivables because money is tight. Billing / collection are time-consuming and costly. Transfer accomplished by: Borrow using receivables as collateral for the loan Sale of receivables -- a sale occurs only if the seller surrenders control of the receivables to the buyer.

Illustration of Secured Borrowing
On April 1, 2010, Prince Company assigns $500,000 of its accounts receivable to the Third National Bank as collateral for a $300,000 loan due July 1, The assignment agreement calls for Prince Company to continue to collect the receivables. Third National Bank assesses a finance charge of 2% of the accounts receivable, and interest on the loan is 10% (a realistic rate of interest for a note of this type). Instructions: Prepare the April 1, 2010, journal entry for Prince Company. Prepare the journal entry for Prince’s collection of $350,000 of the accounts receivable during the period from April 1, 2010, through June 30, 2010. On July 1, 2010, Prince paid Third National all that was due from the loan it secured on April 1, 2010.

Illustration of Secured Borrowing - Continued
Which category of Cash Flow (Operating or Financing) for ‘a’ and ‘c’?

Sales of Receivables Sale Without Recourse Sale With Recourse
The ‘Factor’ (finance company or bank that purchases the receivables) assumes risk of collection (i.e., bad debts) Transfer is outright sale of receivable Seller records loss on sale Seller uses “Due from Factor” (asset account) to cover for possible discounts, returns, and allowances Sale With Recourse Seller guarantees payment to purchaser Estimated liability (“Recourse Obligation”) for possible uncollectible accounts set up)

Sales of Receivables -- WITHOUT RECOURSE
Illustration: Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). Crest Textiles makes the following journal entry for the receivables transferred without recourse. Cash ($500,000 less 3% finance charge and 5% ‘holdback’) ,000 Due from Factor (the ‘holdback’ of 5% of $500,000) ,000 Loss on Sale of Receivables (3% x $500,000) ,000 Accounts Receivable ,000

Sales of Receivables -- WITH RECOURSE
Illustration: Assume Crest Textiles sold the receivables on a with recourse basis. Crest Textiles determines that this recourse obligation has a fair value of $6,000. To record the sale of the receivables with recourse, Crest Textiles records the following journal entry: Cash ,000 Due from factor (“holdback”) ,000 Loss on Sale of Receivables (3% of $500,000 plus the Recourse Liab.) ,000 Accounts Receivable ,000 Recourse Liability (Crest would have to ‘make good’ if bad , debts proved to be abnormally high)

Presentation of Receivables
General rules in classifying receivables are: Segregate the different types of receivables that a company possesses, if material. Appropriately offset the valuation accounts (Allowances) against the proper receivable accounts. Determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer. Disclose any loss contingencies that exist on the receivables. Disclose any receivables designated or pledged as collateral. Disclose all significant concentrations of credit risk arising from receivables.

Ratio Analysis of Receivables
This Ratio used to: Assess the liquidity of the receivables. Is an average collection period of 39.7 days ‘good’? What would you compare it to? Industry average (or ‘best competitors’ average) Prior years “Expected” or “forecasted”

Impairment of Receivables
Companies evaluate their receivables to determine their ultimate collectibility. Allowance method is appropriate when: probable that an asset has been impaired and amount of the loss can be reasonably estimated. For long-term receivables (such as loans) that are identified as impaired, companies perform an additional impairment evaluation. The impairment test -- Impairment loss is calculated as the difference between the investment in the loan (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan’s historical effective interest rate.

Illustration At December 31, 2009, Ogden Bank recorded an investment of $100,000 in a loan to Carl King. The loan has an historical effective-interest rate of 10 percent, the principal is due in full at maturity in three years, and interest is due annually. The loan officer performs a review of the loan’s expected future cash flows and utilizes the present value method for measuring the required impairment loss.

Illustration: Computation of Impairment Loss
Recorded investment $100,000 Less: Present value of ‘estimated’ cash flows: P = F (factor) P = $100,000 (.75132) $75,132 Pa = A (factor) Pa = $5,000 ( ) 12, ,563 LOSS ON IMPAIRMENT $12,437 Recording Impairment Losses Bad Debt Expense 12,437 Allowance for Doubtful Accounts 12,437

Subprime Loan Crisis. From 2000 to 2005 home prices appreciated at rapid rate. Low interest rates also encouraged speculation, as many believed that home prices would continue to increase. Speculators (“flippers”) intended to sell the house in a short period. Many adjustable-rate debt with short-term low teaser rates that would adjust to higher market rates after two or three years. Many lending institutions gave loans to individuals whose financial condition would make it difficult for them to make the payments over the life of the loan. These loans, often referred to as subprime loans.

Background - Example: Subprime loan crisis
Beyond the subprime loans was the practice of securitization

Class Assignment Questions # 1, 4, 5, 8, 11, 15, 16, 19, 21, 28 (pages ) Homework (pages ): BE7-1 Ex (part ‘b’ only), Ex (part ‘a’ only), Ex. 7-27 Prob. 7-2, Prob. 7-12

VALUATION OF INVENTORIES:
C H A P T E R 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Why Inventory is so Important
INVENTORIES—just another specific asset we will cover—right??? Answer = WRONG!!! UNDERSTAND. 1. Very important asset if firm sells a product (GM, Wal-Mart, Dell Computers) 2. Results in biggest EXPENSE on Income Statement! 3. Buy for $200 from vendor, sell to customer for $180—how are we doing? 4. Buy from catalog for $80 (which is less than $82 charged by local vendor). Then pay $6. shipping charge—how are we doing?

Importance of Inventories (cont’d.)
5. Run out of inventory and production line shuts down. How we doing? (“Just-in-Time” inventory levels) 6. Obsolete/overstocked inventory on hand. How are we doing? 7. “More efficient supply chain” (EDI)—let supplier access your computer inventory records to determine when and how much to ship to you—good idea? 8. Inventory returns by customers to us and from us back to vendors—how are we doing? 9. Cash discounts for prompt payment—good idea? 10. Inventory errors—common? Any impact on Financial Statements?

Summary of Chapter 8 Identify major classifications of inventory for merchandising company and a manufacturing company. Distinguish between perpetual and periodic inventory systems. Identify the effects of inventory errors on the current year’s and following year’s financial statements. Understand the items to include as inventory cost (all reasonable and necessary costs of acquiring the inventory and getting it ready for sale). Describe and compute inventory and cost of goods sold expense for the various inventory cost flow methods (Specific Identification, FIFO, LIFO, Weighted-Average Cost). Identify the major advantages and disadvantages of the various inventory cost flow methods. Explain the significance and use of a LIFO reserve. Explain the dollar-value LIFO method. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Classification of Inventories
Manufacturer Raw Materials Work in Process Finished Goods Merchandiser Merchandise Inventory or

Inventory Cost Flow

IMPORTANT ‘FORMULA’ TO UNDERSTAND
Companies must allocate the cost of all the goods available for sale between the goods that are still on hand (i.e., Ending Inventory) and the goods that were sold during the period (i.e., COST OF GOODS SOLD EXPENSE)

‘Formula’ Inputs for Ending Inventory
Quantity of inventory on hand--the inventory that the company has legal title to on the date of the financial statements (goods on hand, goods in transit [depending on shipping terms], consigned goods, special sales agreements). Costs to include for inventory (all reasonable and necessary costs of acquiring the inventory and getting it ready for sale). Cost flow assumption selected (Specific Identification, FIFO, LIFO, Weighted-Average Cost)

Systems for maintaining inventory records Perpetual system or Periodic system
Purchases of merchandise are debited to Inventory. Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts (cash discounts) are credited to Inventory. Cost of goods sold is debited and Inventory is credited for each sale. Subsidiary records show quantity and cost of each type of inventory on hand. The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

Systems for maintaining inventory records Perpetual system or Periodic system
Purchases of merchandise are debited to “Purchases”. Ending Inventory determined by physical count. Calculation of Cost of Goods Sold: Beginning inventory $ 100,000 Purchases, net 800,000 Goods available for sale 900,000 Ending inventory 125,000 Cost of goods sold (“plug”) $ 775,000

Perpetual vs. Periodic -- An Illustration
Festive Company had the following transactions during the current year. Record these transactions using the Perpetual and Periodic systems.

Perpetual vs. Periodic -- An Illustration
Inventory ,400 Purchases ,400 Cash (or Accounts Payable) ,400 Cash (or Accounts Payable) ,400 Accounts Receivable ,200 Accounts Receivable ,200 Sales Revenue ,200 Sales Revenue ,200 Cost of Goods Sold Expense (600 x $6.) 3,600 NO Entry Inventory ,600 Inventory (ending per count) ,400 No entry necessary to adjust inventory The Inventory account shows the correct ending balance of $2,400 ($600 bb + $5,400 bought - $3,600 sold) Cost of Goods Sold Expense (plug) 3,600 Purchases ,400 Inventory (beginning)

Errors in Measuring Ending Inventory
Misstatements in inventory will cause errors in the following areas: Income Statement Cost of Goods Sold, Gross Profit, Taxes, Net Income Balance Sheet Inventory, Retained Earnings Because the ending inventory of one period becomes the beginning inventory of the next period, ending inventory errors affect two accounting periods (two Income Statements but only one Balance Sheet). 10

Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.
As Reported As Corrected Year Year 2 Year 1 Year 2 Sales C of G. Sold: Begin. Inv +Purchases Gds. Avail - Ending Inv =C. of G. Sold Gross Profit What were the effects of the error on the Yr. 1 Financial Statements: Income Statement? Balance Sheet?

Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.
As Reported As Corrected Year 1 Year 2 Year 1 Year 2 Sales C of G. Sold: Begin. Inv +Purchases Gds. Avail - Ending Inv * * =C of G. Sold Gross Profit *No ‘new’ error in calculating Year 2’s ending inventory! What were the effects of the error on the Yr. 2 Financial Statements: Income Statement? Balance Sheet?

What was the effect of OVERSTATING the Year 1 ending inventory by $6
What was the effect of OVERSTATING the Year 1 ending inventory by $6? (ignore taxes) Year Year 2 Sales Begin. Inventory + Purchases Goods Avail. 4 Sale - Ending Inventory Cost of Goods Sold Gross Profit Net Income Ret. Earn, end. Bal. No effect Overstated $6 Understated $6 No effect Overstated $6 Understated $6 No effect (why?) Does Bal. Sheet Balance? Does Bal. Sheet Balance?

Accounting for Purchase (Cash) Discounts
Using the Periodic System Purchases ,000 Purchases ,800 ** Accounts Payable ,000 Accounts Payable ,800 Accounts Payable ,000 Accounts Payable ,920 * Purchase Discounts Cash ,920 Cash ,920 Accounts Payable ,000 Accounts Payable ,880 Cash ,000 Purchase Discounts Lost (‘stupidity exp.) Cash ,000 * $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

FIFO LIFO Weight-Average Cost Specific Identification
Which Cost Flow Assumption to Adopt? FIFO LIFO Cost Flow Assumption Adopted does NOT need to be the same as the Physical Movement of Goods Weight-Average Cost Specific Identification We’ll illustrate the calculations then discuss which inventory cost flow method is ‘correct’!

HAPPY HARRY’S USED CARS
Purchase 1965 VW Beetle for $400. Purchase 2009 Rolls Royce for $350,000. Inventory Count at year end = 1 car What is Cost of Ending Inventory? What is Cost of Goods Sold Expense? What is the only inventory “costing” method that makes any sense? SPECIFIC IDENTIFICATION!

Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases Inventory Data June 1 Inventory 80 units @ $10.00 $ 800 6 Purchase 220 units @ $12.50 2,750 25 200 units @ $14.00 2,800 Goods available 4 sale 500 units $6,350 Sales 280 units On hand June 30 Specific Identification Method Specific Identification Method 980 70 $14.00 1,250 100 $12.50 $2,730 220 units at cost of $ 500 50 $10.00 $3,620 Cost of goods sold 2,730 Less June 30 inventory $6,350 Cost of goods avail. for sale

Specific Identification
Used when a company’s inventory consists of many high priced items that are easy to differentiate (e.g., a car dealer) What about the 10,000 test tubes in the ending inventory of a scientific apparatus warehouse? Would specific identification work as an inventory costing method? When a company’s inventory consists of many high-priced, low-turnover goods the record keeping necessary to use specific identification is more practical.

FIFO = First-In, First-Out
First COSTS into inventory are the first COSTS out of inventory: Question: Where are the costs going when they leave inventory? Answer = To COST OF GOODS SOLD EXPENSE on the Income Statement Thus under FIFO--The first (earliest) costs into inventory are transferred to Cost of Goods Sold Expense when inventory items are sold. Thus under FIFO--The last (most recent) inventory purchase COSTS remain in ending inventory. ENDING INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF GOODS SOLD EXPENSE! 14

FIFO/LIFO Comparison (My Simple Example)
Beg. 1 $ Beg. 1 $3. Purchases: Purchases: 1 $ $4. 1 $ $5. 1 $ $6. Available $ Available $18. 1 unit End.Inv. ? unit End.Inv. ? 3 units CofGS ? units CofGS ?

FIFO (My Simple Example)
Beg. 1 unit @ $3. Purchases: $12 Cost of Goods Sold Expense 1 $4. 1 $5. 1 $6. Available $18. 1 unit End Inv 3 units CofGS $12.

First-In, First-Out (FIFO) Method An Illustration
Assumes that the first costs into inventory will be the first costs out of inventory for the units sold. Ending inventory is thus composed of inventory costs from the LAST (most recent) purchases. Inventory Data June 1 Inventory 80 units @ $10.00 $ 800 6 Purchase 220 units @ $12.50 2,750 25 200 units @ $14.00 2,800 Goods available 4 sale 500 units $6,350 Sales 280 units On hand June 30 First-In, First-Out (FIFO) Method 200 $14.00 from purchase of June $2,800 20 $12.50 from purchase of June 220 units in Ending Inventory at a cost of $3,050 $3,300 Cost of goods sold (plug) 3,050 Less June 30 inventory (calculate) $6,350 Cost of goods avail. for sale

LIFO = Last-In, First-Out
Last COSTS into inventory are the first COSTS out of inventory: Question: Where are the costs going when they leave inventory? Answer = To COST OF GOODS SOLD EXPENSE on the Income Statement Thus under LIFO--The last (most recent purchase) costs into inventory are transferred to Cost of Goods Sold Expense when inventory items are sold. Thus under LIFO--The first (earliest) inventory purchase (including beginning inventory) COSTS remain in ending inventory. ENDING INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF GOODS SOLD EXPENSE! 14

FIFO/LIFO Comparison (My Simple Example)
Beg. 1 $ Beg. 1 $3. Purchases: Purchases: 1 $ unit @ $4. 1 $ unit @ $5. 1 $ unit @ $6. Available $ Available $18. 1 unit End.Inv. ? unit End.Inv. ? 3 units CofGS ? units CofGS ?

LIFO (My Simple Example)
Beg $3. Purchases: 1 $4. 1 $5. 1 $6. Available $18. 1 unit End. Inv _ 3 units CofGS $15. $3 Ending Inventory $15 Cost of Goods Sold Expense

Last-In, First-Out (LIFO) Method An Illustration
Inventory Data June 1 Inventory 80 units @ $10.00 $800 6 Purchase 220 units @ $12.50 2,750 25 200 units @ $14.00 2,800 Goods available 4 sale 500 units $6,350 Sales 280 units On hand June 30 Ending inventory is priced using the earliest purchases (Including Beg. Inventory) Last-In, First-Out (LIFO) Method 80 $10.00 from June 1 inventory $ 800 140 $12.50 from purchase of June ,750 220 units in Ending Inventory at a cost of $2,550 $3,800 Cost of goods sold 2,550 Less June 30 inventory $6,350 Cost of goods avail. for sale © Royalty Free C Squared Studios/ Getty Images

Weighted-Average Cost Method
Inventory Data June 1 Inventory 80 units @ $10.00 $800 6 Purchase 220 units @ $12.50 2,750 25 200 units @ $14.00 2,800 Goods available 4 sale 500 units $6,350 Sales 280 units On hand June 30 Inventory is priced at the weighted average cost of the goods available for sale during the period Cost of Goods Available for Sale ÷ Units Available for Sale = Weighted-Average Unit Cost $6,350 ÷ 500 units = $12.70 Ending Inventory = 220 $12.70 = $2,794 . $3,556 Cost of goods sold 2,794 Less June 30 inventory $6,350 Cost of goods avail. for sale © Royalty Free C Squared Studios/ Getty Images

Impact of Inventory Costing Methods Alternatives
Which method would you chose if it were your company? WHY? Limit your choices to just FIFO or LIFO!

LIFO Inventory existing at December 1, 2010
LIFO “LIQUIDATION” Illustration: Basler Co. has 30,000 pounds of steel in its inventory on December 1, 2010, with cost determined as shown below. The CEO says she needs YOU (the controller) to ‘do something’ in order to utilize an NOL Carryforward that is scheduled to expire on December 31, Will a LIFO Liquidation accomplish the CEO’s goal and save your job? Legal? Ethical? LIFO Inventory existing at December 1, 2010 From ,000 pounds at $4. $32,000 From ,000 pounds at $ ,000 From ,000 pounds at $ ,000 From ,000 pounds at $ ,000 30, $205,000

LIFO Liquidation (Continued)
STOP BUYING INVENTORY (LIFO liquidation) Result is that as sales are made in December, the old (low) inventory costs leave inventory. At the end of 2010, only 6,000 pounds of steel remain in inventory.

Select FIFO Method (In a period of Rising Prices)
Practical Advantages: Higher net income (and earnings per share) in a period of rising prices. Higher stock price? Which also may mean higher bonus for management and/or increase in value of the shares of stock (and stock options) they own! Theoretical Advantage: Ending inventory on balance sheet is closest to current values = realistic view of inventory DISADVANTAGES: “Phantom FIFO Profit”--does not provide a good matching of current costs and revenues Pay higher taxes to government than LIFO

Select LIFO Method (In a period of Rising Prices)
Practical Advantages: Pay less income taxes in a period of rising prices (thus keep more cash—rather than pay it to IRS) Opportunity to ‘manage income’ (LIFO Liquidation) Theoretical Advantage: Best suited for the income statement because it matches revenues and cost of goods sold DISADVANTAGES: Lower net income ‘Terrible’ current balance sheet value of inventory, particularly during a prolonged period of price increases and decreases

Each Year, Can you switch ‘back and forth’ from One Inventory Costing Method to Another ???
NO -- the Consistency concept requires that companies use the same accounting methods from year to year. The consistency assumption allows financial statement users to compare the company’s current year’s results with those of prior years. This does NOT mean a company can never change accounting methods. We covered changes in Accounting Principles back in Chapter 4 —Retrospectively go back and change the prior years’ financial statements to make them comparable with the method used in the current year. (Note: A change from FIFO to LIFO does NOT result in restating prior years’ financial statements) 2

Can you Get the “Best of Both Worlds” (FIFO on ‘books’ and LIFO on the Corporate Tax Return)????
NO, because of LIFO CONFORMITY RULE—passed by Congress: If a company uses LIFO for tax purposes, the IRS requires the same method for financial reporting (i.e., ‘the books’) What will happen if the U.S. switches to IFRS—which does NOT allow LIFO?

Remaining “Miscellaneous” Topics in Ch. 8
“Perpetual” calculations of Inventory for FIFO and LIFO (vs. “Periodic” calculations previously illustrated) LIFO Reserve “Dollar Value LIFO (vs. ‘specific units’ LIFO calculations previously illustrated)

Perpetual Calculations Compared to Periodic Calculations – An Illustration
Call-Mart Inc. had the following transactions in its first month of operations. Purchases: 2,000 x $4.00 $ 8,000 6,000 x $ ,400 2,000 x $4.75 9,500 Cost of Goods Available for Sale $43,900 Need to allocate the $43,900 between Ending Inventory (calculate) and Cost of Goods Sold Expense (plug)

First-In, First-Out (FIFO) -- Periodic
FIFO -- Periodic Method (previously covered) $ $9,500 $ ,600 $27,100 27,100 $16,800

First-In, First-Out (FIFO) -- Perpetual
FIFO -- Perpetual Method Note: FIFO Perpetual always will yield the same Ending Inventory and Cost of Goods Sold as FIFO Periodic

Last-In, First-Out (LIFO) -- Periodic
LIFO -- Periodic Method (previous covered) $ $8,000 $ ,600 $25,600 25,600 $18,300

Last-In, First-Out (LIFO) -- Perpetual
LIFO -- Perpetual Method Note: LIFO Perpetual can result in different answer than LIFO Periodic

Special Issues Related to LIFO
LIFO Reserve Many companies use LIFO for tax and external financial reporting purposes FIFO for internal reporting purposes and required disclosure of ‘what inventory and earnings would have been’ if FIFO had been used The dollar amount in the “LIFO Reserve” at the end of the year: Makes it relatively easy to ‘convert’ an ending inventory calculated under LIFO to what it would have been using FIFO. Changes in the dollar amount in the “LIFO Reserve” from one period to the next: Makes it relatively easy to ‘convert’ Cost of Goods Sold Expense (and thus Gross Profit) calculated under LIFO to what it would have been using FIFO

Dollar-Value LIFO Changes in the total dollar value of a “pool of inventory items” are used to determine inventory; not physical quantity on a per unit basis. Advantages: Much easier than costing each different inventory item for companies that have a large number of inventory items. Government provides ‘price indices’ so companies do NOT have to calculate their own ‘indices’ Used by major retail stores (called “Dollar-Value-Retail-Lifo”)

Dollar-Value LIFO Process 1st Step in Process: separate the increased dollar amount of ending inventory (computed using FIFO) into TWO components: 1.) Increase in inventory due to increase in inventory prices during year 2.) “Quantity Increase (or decrease) due to actual increase (or decrease) in inventory quantities during year (year-end inventory in “base year prices” compared to prior’s year inventory at base year prices) 2nd Step in Process: calculate the incremental “layer” for the year (Quantity change times price index for current year) 3rd Step in Process: Add incremental layer to prior year inventory (Note: If there is a decrease in inventory quantity = reduce previous year(s) layers in a LIFO pattern) Illustration on next slide

Dollar-Value LIFO -- Illustrated

Class Assignment Questions #1, 3, 6, 7, 8, 16, 18 (skip ‘c’), 19, 20 (pages ) Homework (pages ): BE 4, 5 Ex. 17, 25

ADDITIONAL VALUATION ISSUES
C H A P T E R 9 INVENTORIES: ADDITIONAL VALUATION ISSUES Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter 9 Describe and apply the lower-of-cost-or-market rule. Discuss accounting issues related to purchase commitments. Estimating ending inventory using the gross profit method. Determine ending inventory by applying the retail inventory method. Inventory ratios. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Lower-of-Cost-or-Market (LCM)
A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. Market = Replacement Cost Lower of Cost or Replacement Cost (subject to two constraints—ceiling and floor) Loss should be recorded when loss occurs, not in the period of sale.

Lower-of-Cost-or-Market (LCM) Conservatism Concept
Decline in the Replacement Cost of the inventory usually means there also has been a decline in the expected selling price of inventory (aka. ”loss of economic utility”) Ceiling and Floor Refinements to Replacement Cost: Ceiling - net realizable value—expected selling price less any costs of selling (e.g., inventory item owed is damaged) Floor - net realizable value less a normal profit margin (e.g., company has a legally enforceable agreement with a customer so that the selling price will NOT drop as much as a low replacement cost indicates). In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. IFRS does NOT consider replacement cost or the ‘floor’ constraint.

LCM over Two Years – Ignoring Ceiling or Floor Refinements
Lower-of-Cost-or-Market (LCM) Historical cost = $100. Replacement cost at end of Year 1= $80 LCM over Two Years – Ignoring Ceiling or Floor Refinements Year 1 LCM Write down: Loss on Inventory 20 Inventory (from $100 to $80) Conservative for Year 1?: Income Statement Loss of $20 will lower Net Income Balance Sheet Asset Inventory reduced to $80. Year 2 If Sell for $200 at beginning of Year 2: Accounts Rec Sales Revenue Cost of Good Sold Inventory Conservative for Year 2?: Income Statement shows ‘income’ of $120. What would the income have been IF the ‘conservative’ LCM had NOT been followed in Year 1? (CAN “CONSERVATISM CONCEPT” Possibly Lead to “BIG BATH” Accounting????)

“Market” number to use to compare to cost will be the MIDDLE number of the three market numbers Ceiling = NRV Not > Replacement Cost Cost Market Not < Floor = NRV less Normal Profit Margin GAAP LCM

How LCM Works – An Illustration Individual Items Basis

How LCM Works – An Illustration Individual Items, Major Categories, Total Inventory Individual Items method is most ‘conservative’ of the three

Ending inventory (cost) $ 415,000 Ending inventory (LCM—Individual items) 350,000 Adjustment to LCM $ 65,000 Recording LCM – Journal Entry Two possible ways to record ‘write-down’ Loss on inventory ,000 Inventory (or Allowance on inventory) 65,000 Cost of goods sold 65,000 Inventory ,000 In U.S. GAAP, inventory written down under the lower-of-cost-or-market valuation may NOT be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period.

Extending LCM to Purchase “Commitments” Generally seller retains title to the inventory until the actual sale to the customer (buyer) takes place. LCM for buyer -- If the contract selling price ($10. cost) is greater than the current market price ($8. replacement cost), AND the buyer expects that losses will occur when the actual inventory purchase occurs, the buyer should recognize losses under the purchase commitment NOW in the same manner as if the buyer had already purchased the inventory. (The buyer can protect himself/herself by ‘hedging’ -- entering into a ‘selling contract’ for the same quantity of the same inventory item held under the purchase commitment) If material, the buyer should disclose details of purchase commitments and any ‘hedges’ in a footnote.

Purchase Commitments Illustration: St. Regis Paper Co. signed timber-cutting contracts to be executed in 2012 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2011, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2011. Unrealized Holding Loss (Income Statement) 3,000,000 Estimated Liability on Purchase Commitments 3,000,000 When St. Regis cuts the timber at a cost of $10 million, it would make the following entry. Inventory ,000,000 Estimated Liability on Purchase Commitments 3,000,000 Cash ,000,000

Estimating Inventory -- Gross Profit Method
Provides an estimate of ending inventory for management and auditor. Uses past gross profit percentages in calculation. A single blanket gross profit rate may not be representative. Only acceptable for interim (generally quarterly) reporting purposes.

Estimating Inventory--Gross Profit Method
Illustration: Cetus Corp. has a beginning inventory of $60,000 and purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross profit on selling price is 30 percent*. Cetus applies the gross profit (aka. ‘gross margin’) method as follows. Beginning Inventory $ 60,000 Purchases ,000 Cost of Goods Available for Sale $260,000 Estimated Cost of Goods Sold Exp ,000 (70% x $280,000 Sales) Estimated Cost of Ending Inventory $64,000 *It is possible the gross profit percent could be a percentage ‘mark-up on cost’ (A method for Cost Accounting)

Estimating Inventory -- Gross Profit Method Another Illustration
Astaire Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May. Instructions: Compute the estimated inventory at May 31, assuming that the gross profit is 25% of net sales.

Estimating Inventory -- Gross Profit Method
Solution to the 2nd Illustration Compute the estimated inventory assuming gross profit is 25% of net sales Inventory, May $ 160,000 Purchases (gross) ,000 Purchase discounts (12,000) Freight-in , ,000 Cost of Goods Available for Sale $ 818,000 Estimated Cost of Goods Sold (75% of $930,000*) (697,500) Estimated ending inventory, May $ 120,500 Sales (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) ,000*

Retail Inventory Method
A method used by retailers: 1.) To estimate ending inventory without a physical count 2.) As a ‘check’ to compare to the physical inventory ‘count’ Requires retailers to keep records of: the total cost and retail value of goods purchased, the total cost and retail value of the goods available for sale, and the sales for the period. Some companies refine the retail method by computing inventory separately by departments or class of merchandise

Retail Inventory Method – An Illustration
Fuque Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2011. Prepare a schedule computing estimated ending inventory following the conventional retail method (lower of average cost or market)

Retail Inventory - LCM Method
= / To calculate ending inventory at ‘cost’ – move “markdowns, net” up with markups (and thus included in cost to retail percentage)

Presentation and Analysis
Accounting standards require disclosure of: composition of the inventory, financing arrangements, and costing methods employed. Ratio Analysis: Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory.

Ratios -- Inventory Turnover & Average Days to Sell Inventory
INVENTORY TURNOVER -- Measures the number of times on average a company sells the inventory during the period. NUMBER OF DAYS SUPPLY OF INVENTORY ON HAND (aka. “Average Days to Sell”) -- Measures the average number of days between when a company acquires inventory and when they sell it. Average Days to Sell = 365 days / 7.5 times = 48.7 days Is 48.7 days supply of inventory on hand too little or too much? What would you compare the 48.7 days to?

Summary of IFRS vs. GAAP Differences Related to Inventories
U.S. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. U.S. GAAP defines market as replacement cost subject to the ceiling and floor constraints. In U.S. GAAP, inventory written down under the lower-of-cost-or-market valuation may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period.

Class Assignment Questions #1, 2, 6, 9, 10, 15, 17, 18 (page 468) Homework (pages ): BE 1, 2, 3, 5, 6, 7, 9 Prob. 6

ACQUISITION AND DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT
C H A P T E R 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter 10 What should be included in the asset classification of property, plant, and equipment? Understand the “capitalize” as asset or expense decision. Identify the costs to include in initial acquisition of property, plant, and equipment. Describe the accounting problems associated with self-constructed assets – including ‘interest capitalization’. Describe the accounting treatment for costs subsequent to acquisition (post-acquisition expenditures). Describe the accounting treatment for the disposal of property, plant, and equipment. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Property, Plant, and Equipment ASSETS
Property, plant, and equipment includes land, buildings, and equipment (machinery, furniture, tools). Three Major characteristics include: “Used in operations” and not for resale (i.e. NOT Inventory or Land Held as an Investment). Long-term in nature and usually depreciated. Possess physical substance.

“Capitalize” as Asset or Expense
Asset (benefit more than current period) Ppd. Ins. Del. Truck Coal Mine Patent Expenditure vs. Ins. Exp. Depr. Exp. Depletion Amortization Exp Exp. Expense (benefit just the current period)

Acquisition of PP&E (Recorded at Cost or Fair Market Value?)
U.S. GAAP = Value at Historical Cost (Subsequently to be depreciated—except for Land) Historical cost is reliable. Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold. U.S. GAAP states: “property, plant, and equipment should not be written up to reflect appraisal, market, or current values which are above cost.” IFRS allows either Historical Cost OR Fair Market Value (If Fair Value is selected--property, plant, or equipment must be REVALUED TO CURRENT VALUE regularly)

Acquisition of PP&E – What Costs to Include in Acquisition Cost?
ALL REASONABLE AND NECESSARY COST OF ACQUIRING THE ASSET AND GETTING IT READY FOR ITS INTENDED USE SHOULD BE ADDED TO THE ASSET. WHY?: MATCHING (If expenditure is related to the asset and the ‘benefits’ from the expenditure will be obtained over the life of the asset, then the cost should be spread over the life of the asset (i.e., matched with the revenue being generated by using the asset over its life). Or is the above ‘hogwash’ that doesn’t provide ‘relevant’ information to help financial statement readers make better decisions? If you are considering lending money to Ford Motor Company (or buying their stock) does the depreciated cost of Ford’s Dearborn, Michigan factory—built in of any relevancy to you?

Cost of Land and Buildings
Cost of Land Cost of Buildings Includes all costs to acquire land and ready it for use. Costs typically include: Includes all costs related directly to acquisition or construction. Costs include: closing costs, such as title to the land, attorney’s fees, and recording fees; costs of grading, filling, draining, and clearing; assumption of any liens, mortgages, or encumbrances on the property; and the purchase price; Additional land improvements that have an indefinite life. (1) materials, labor, and overhead costs incurred during construction; (2) professional fees and building permits. What about Interest Cost incurred on funds borrowed to finance construction of the building?

Cost of Equipment Cost of Equipment
Include all costs incurred in acquiring the equipment and preparing it for use. Costs typically include: purchase price, freight and handling charges insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs.

Cost of Self-Constructed Assets
Costs typically include: Materials and direct labor Overhead can be handled in two ways: Assign no fixed overhead Assign a portion of all overhead to the construction process. Companies use the second method extensively. What about Interest Cost incurred on funds borrowed to finance construction of the building, bridge, submarine?

Interest Costs During Construction
Three approaches have been suggested to account for the interest incurred in financing the construction. Should Financing Costs During Construction be Capitalized as part of the Cost of the Asset? $ ? $ 0 Capitalize NO interest during construction It’s Interest Expense Capitalize actual debt financing costs incurred during construction (with modification) Capitalize all financing costs incurred during construction BOTH “Debt” and “Equity” costs of financing construction GAAP IFRS recently changed their rules to parallel U.S. GAAP—as part of the ‘convergence project’

GAAP requires — capitalizing interest cost incurred during construction (with modification). Consistent with historical cost — all costs incurred to bring the asset to the condition for its intended use. Capitalization considers three items: Qualifying assets. Capitalization period. Amount to capitalize.

Qualifying Assets: Assets requiring a LONG period of time to get them ready for their intended use (e.g., nuclear power plant, submarine, bridge, factory building). Two types of assets: Assets under construction for a company’s own use (e.g., constructing their own building which they plan to occupy). Assets intended for sale or lease that are constructed or produced as discrete projects (e.g., building a bridge for the state government).

Capitalization Period: Begins when: Expenditures for the asset have begun. Interest costs are being incurred. Ends when: The asset is substantially complete and ready for use.

Interest Costs During Construction-- Illustrated
KC Corporation borrowed $200,000 at 12% interest from State Bank on Jan. 1, 2011, for the specific purpose of constructing special-purpose equipment (qualifies for interest capitalization). Construction on the equipment began on Jan. 1, 2011, and the following expenditures were made prior to the project’s completion on Dec. 31, 2011 (capitalization period = from 1/1/11 to 12/31/11) All other general debt existing on Jan. 1, 2011: $500,000, 14%, 10-year bonds payable $300,000, 10%, 5-year note payable 1

Step 1-Determine whether asset qualifies for capitalization of interest = YES Step 2-Determine the capitalization period = Jan. 1, 2011 to Dec. 31, 2011 Step 3-Compute weighted-average accumulated expenditures*

Step 4 - Compute the Interest to Capitalize on the $250,000 weighted-average expenditures: $24,000 interest 12% interest rate of specific debt) + 6,250 interest 12.5%* weighted-average rate on other debt) $30,250 Total Interest to Capitalize Journal entry to Capitalize Interest Equipment ,250 Interest expense 30,250 All other debt: $500, % $70,000 +300, % +30,000 Total $800, $100,000 Weighted-average interest rate on all other debt $100,000 interest $800,000 principal 12.5%*

Other Issues in Recording Acquisition of PP&E
Cash Discounts: whether taken or not — generally considered a reduction in the cost of the asset (capitalized cost of PP&E should include all “reasonable and necessary” costs of acquiring the asset and getting it ready for use). Deferred-Payment Contracts — Assets, purchased through long-term credit, are recorded at the present value of the consideration exchanged. Contributions of PP&E -- Record asset at fair market value and record revenue Lump-Sum Purchases aka. ‘basket purchases’ — Allocate the total cost among the various assets on the basis of their fair market values (really a ‘joint-cost allocation problem’—similar to using relative sales value to allocate cost in previous textbook chapter) Issuance of Stock — The market value of the stock issued is a fair indication of the cost of the property acquired.

“Contributions” of PP&E
Hasty Auto Company receives ‘free’ title to land and factory building from Poor City in exchange for establishing a new manufacturing operations. Hasty should: use the fair value of the asset to establish its value on the books and should recognize contributions received as revenues in the period received.

Basket Purchase Allocation (aka. “Joint Cost” Allocation Situation)
Matrix, Inc. purchased land and a building for $5,000,000 cash. An independent appraiser estimated that the land has a fair market value of $2,000,000, and the building has a fair market value of $6,000,000. How will we assign the $5,000,000 cost between the land and building? First However—”Don’t lose site of the forest for the trees” Part I Let’s assume that Matrix purchases land and a building. We know the building is depreciated but land is not depreciated, so we must separate out the cost of this basket purchase. The company hires an independent appraiser to determine the fair market value of the land without the building and the building without all the adjoining land. Part II Based upon the appraisal, Matrix has determined that seventy-five percent of the cost should be assigned to the building and the remaining twenty-five percent should be assigned to the land. We are allocating cost on the basis of relative fair market value. Part III Given this information, we will assign three million seven hundred fifty thousand dollars to the building and the remaining one million two hundred fifty thousand dollars is assigned to the land.

Post-Acquisition Expenditures
In general, post-acquisition costs incurred to achieve the original estimated useful life and salvage value are recorded as expense (repairs and maintenance) when incurred. To capitalize post-acquisition costs, one of the following conditions must be present: “Efficiency” of asset must have increased: Quantity of units produced from asset must be increased. Quality of units produced from asset must be enhanced. Useful life of the asset must have increased.

Costs that Are Expensed The cost of routine maintenance and minor repairs that are incurred to keep an asset in good working order are expensed as incurred. Assume Radar Inc. spent $200 cash for routine maintenance on machinery. Part I The cost of routine maintenance and minor repairs are charged to expense as incurred. Part II Assume Matrix spent two hundred dollars cash for routine maintenance on a piece of machinery it uses in the production process. The two hundred dollar expense reduces income and stockholders’ equity and our cash account. The expenditure represents a cash outflow in the operating activities section of the statement of cash flows. Part III The proper journal entry is to debit, or increase, maintenance expense and credit, or decrease, cash by two hundred dollars.

Costs that Are Capitalized—”Improvement” Expenditures that improve the “efficiency” (either “quality or quantity”) of an asset are capitalized as part of the cost of that asset. Assume Rary Co. spent $5,000 cash for a major overall of equipment to improve efficiency. Part I Expenditures on productive assets that improve the quality of the asset are not charged to expense but rather to the cost of the asset. These expenditures increase the cost basis of the asset. Part II Matrix spent five thousand dollars cash for a major overall that dramatically improved the efficiency of a piece of equipment it owns. The cash account decreases, and the equipment account increases by five thousand dollars. We show a cash outflow for the additional investment in the equipment in the investing activities section of the statement of cash flows Part III The journal entry to record the expenditure is to debit, or increase, the equipment account and credit, or reduce, the cash account by five thousand dollars.

Costs that “Extend the Life” of an Asset The amount of the expenditure should reduce the balance in the accumulated depreciation account. Assume Matrix, Inc. spent $8,000 cash to rebuild major components of the equipment that extended the life of equipment four years. Part I Still other types of expenditures on productive assets extend their useful lives. These expenditures are shown as a reduction in accumulated depreciation which, in effect, increases the book value of the assets. Part II Matrix spend eight thousand dollars to extend the life of a piece of equipment it owns. Our cash account goes down and we reduce the balance in accumulated depreciation by eight thousand dollars. The investing activities section of the statement of cash flows shows an outflow of eight thousand dollars for the expenditure. Part III Matrix prepares a journal entry to debit, or reduce, accumulated depreciation on the equipment and credit, or reduce cash for eight thousand dollars.

Disposition of PP&E A company may retire plant assets voluntarily or dispose of them by sale, involuntary conversion, exchange, or abandonment. Depreciation must be taken up to the date of disposition.

Journal Entries on September 1, 2011
SALE of PP&E Assets Ottawa Corporation owns machinery that cost $20,000 when purchased on July 1, Depreciation has been recorded at a rate of $2,400 per year, resulting in a balance in Accumulated Depreciation of $8,400 at December 31, The machinery is sold on September 1, 2011, for $10,500. Journal Entries on September 1, 2011 Depreciation expense ($2,400 x 8/12) 1,600 Accumulated depreciation ,600 Cash ,500 Accumulated depreciation ,000* Machinery ,000 Gain on sale * $8,400 + $1,600 = $10,000

Involuntary Conversion of PP&E
Sometimes an asset’s service is terminated through some type of involuntary conversion such as fire, flood, theft, or condemnation. Companies report the difference between the amount recovered (e.g., from a condemnation award or insurance recovery), if any, and the asset’s book value as a gain or loss. Gains or losses may qualify as “extraordinary items” if unusual and infrequent considering the company’s environment.

Summary of Gain and Loss Recognition on Exchanges of Non-Monetary Assets
The FASB recently changed from a ‘similar’/’dissimilar’ method of recording exchanges of non-monetary assets to an ‘economic substance’ approach that parallels IFRS handling of non-monetary asset exchanges.

Journal Entry to Record Exchange of Non-Monetary Asset
Accounting for Exchanges of PP&E that Have Commercial (Economic) Substance Arc, Inc. trades its used machine for a new model. The exchange has commercial (economic) substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair market value (FMV) of $6,000. Arc Inc. gives $7,000 Cash plus their old machine for the new machine. Journal Entry to Record Exchange of Non-Monetary Asset Equipment ($6,000 FMV of asset given up, plus $7,000 cash paid) 13,000 Accumulated Depreciation—Equipment ,000 Loss on Disposal of Equipment ($8,000 book value vs. $6,000 FMV) 2,000 Equipment -- old ,000 Cash ,000 How would the journal entry have been different if the FMV of the used machine traded was $11,000? Gain on Disposal of $3,000; and Equipment acquired $18,000

Exchanges that Lack Commercial (Economic) Substance
1.) If LOSS is indicated (Loss if book value > FMV) = Record the Loss on exchange 2.) If GAIN is indicated (i.e., book value < FMV): No cash received – Do NOT record gain, decrease cost basis of newly acquired asset for amount of unrecognized gain Some cash received – Record ‘portion’ of gain related to cash (“boot”) received , decrease cost basis of newly acquired asset for amount of unrecognized gain. Portion of gain recorded: If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process is complete.

Practice Problem on Non-Monetary Exchanges of PP&E
CA 10-5 (page 533) as example of exchange of non-monetary assets Link to Solution

Disposition of Plant Assets
Miscellaneous Problems If a company scraps or abandons an asset without any cash recovery, it recognizes a loss equal to the asset’s book value. If scrap value exists, the gain or loss that occurs is the difference between the asset’s scrap value and its book value. If an asset still can be used even though it is fully depreciated, it may be kept on the books at historical cost less accumulated depreciation.

Class Assignment Questions #1, 2, 7, 8, 10, 12, 16 (pages ) Homework (pages ): Ex. 5, 16, 23 Prob. 9

DEPRECIATION, IMPAIRMENTS, AND DEPLETION
C H A P T E R 11 DEPRECIATION, IMPAIRMENTS, AND DEPLETION Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter Eleven
Explain the concept of depreciation. Identify the factors involved in the depreciation process. Compare activity, straight-line, accelerated, and MACRS methods of depreciation. Explain the accounting issues related to asset impairment. Explain the accounting procedures for depletion of natural resources. Explain how to report property, plant, equipment, and natural resources on the financial statements.

Depreciation = Cost Allocation
Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. Allocating costs of long-term assets: P&E (this chapter) = Depreciation expense Intangibles (Ch. 12) = Amortization expense Natural resources (this chapter) = Depletion expense

Factors Involved in the Depreciation Calculation
What is the asset’s cost? (all reasonable and necessary costs of acquiring the asset and getting it ready for its intended use--Chapter 10) What is the asset’s ESTIMATED useful life? (Estimated useful life of an asset often differs from its physical life (obsolescence to consider)). What is the asset’s ESTIMATED salvage value? (What amount of the asset’s cost will be recouped upon disposal at the end of its use) Which method of cost allocation is best? (Methods listed on next slide)

Depreciation - Methods of Cost Allocation
The profession requires the depreciation method employed be “systematic and rational.” Examples include: Activity method (units of use or production). Straight-line method. Sum-of-the-years’-digits.* Declining-balance method. Group and composite methods. Hybrid or combination methods. Accelerated methods Special methods We will also cover “MACRS” depreciation method used for tax purposes * Some textbooks no longer cover the ‘sum-of-the-years-digits’ method of depreciation.

Activity Method of Depreciation
Facts First: Calculate depreciation rate per unit: $500,000 cost - $50,000 estimated salvage value 30,000 hours estimated useful life Second: Calculate depreciation amount Multiply actual usage (assume 4,000 hours) during the period times the $15. rate = $60,000 depreciation $15.

Straight-Line Depreciation Method
Facts Calculate straight-line depreciation: Cost - Estimated Salvage Value Estimated Useful Life in Years $500,000 - $50,000 5 Years $90,000

“Accelerated” Depreciation Methods (Sum-of-the-Years’-Digits)
Facts First: Calculate ‘fraction’ for the current year Numerator is number of years of estimated life remaining as of the beginning of the year Denominator is “sum” of the ‘digits’ in the asset’s life (e.g., for a 5-year estimated life, the denominator of the fraction would be 15 ( ) OR “n(n+1) / 2” Second: Calculate depreciation by multiplying fraction times the (cost minus the estimated salvage value) First year: 5 times ($500,000 - $50,000) = $150,000 15

“Accelerated” Depreciation Methods (Sum-of-the-Years’-Digits)
Sum-of-the-Years’-Digits--All Five Years

“Accelerated” Depreciation Methods (Declining Balance)
Facts Declining-Balance Method Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method (most often double the straight-line rate) Does not deduct the salvage value in computing the depreciation base. Does NOT depreciate below salvage value--depreciation ceases when salvage value is reached

“Accelerated” Depreciation Methods (Declining Balance)
Double-Declining-Balance Method First: Calculate depreciation rate (the straight-line rate is 20%; so DDB rate is 40%) Second: Calculate depreciation amount (Multiply the DDB rate times the BOOK VALUE AT THE BEGINNING OF THE CURRENT YEAR)!!

Modified Accelerated Cost Recovery System
(MACRS) MACRS (depreciation for tax return purposes) differs from GAAP in three respects: a mandated tax life, which is generally shorter than the economic life; mostly accelerated depreciation (double-declining balance for assets with a class life of 3, 5, 7, and 10 years) -- with a ‘built-in’ ½ year convention); and an assigned salvage value of zero.

Modified Accelerated Cost Recovery System
(MACRS) * “Built-in” automatic switch to straight-line method

Modified Accelerated Cost Recovery System (MACRS) -- An Illustration
Link to Income Tax Journal Entry for all four years.

Special Depreciation Methods
(Commonly used in a Specific Industry [e.g., Utilities]) Group method used when the assets are similar in nature and have approximately the same useful lives (e.g., railroad ties, telephone poles). Composite approach used when the assets are dissimilar and have different lives (e.g., rowboats, pedal boats, float tubes, and kayaks). Companies are also free to develop tailor-made depreciation methods, provided the method results in the allocation of an asset’s cost in a systematic and rational manner (Hybrid or Combination Methods).

Special Depreciation Issues
How should companies compute depreciation for partial periods? Companies normally compute depreciation on the basis of the nearest full month. Other methods are acceptable (e.g., 1/2 year convention; nearest full year; full year in year of acquisition; nothing in first year) Does depreciation provide for the replacement of assets? CASH is needed to replace the assets (Debit to: Depreciation Expense and Credit to: Accum. Depr. does NOT directly set aside any CASH). [However, there is a Cash “Savings” due to fact depreciation expense is deductible on the corporate tax return.] How should companies handle revisions in depreciation rates? Change in Accounting Estimates handled “retrospectively”. Covered back in Ch. 4 (and will be covered again in Ch. 22) Of what value is depreciated book value to the financial statement reader?????

Depletion Natural resources, often called wasting assets, include petroleum, natural gas, minerals, and timber. The accounting for Natural Resources is similar to the Accounting for PP&E: Cost includes all reasonable and necessary cost of acquiring the natural resource and getting it ready for sale: (i.e., Acquisition cost of the deposits and development costs). [Unlike PP&E, an additional “restoration” cost might be incurred for natural resources related to ‘environmental’ concerns.] Depletion (rather than depreciation) is the term used for the process of allocating the cost of natural resources. (Depletion calculation parallels the ‘activity method’ of depreciation)

Depletion Calculation -- An Illustration
Company purchased 9,000 acres of timberland in 2009 at a cost of $1,200 per acre. At the time of purchase the land without the timber was valued at $200 per acre. During 2009, Hernandez selectively logged and sold 700,000 board feet of timber, of the estimated 3,000,000 board feet. First: Calculate the depletion rate per board foot of timber Total cost – Est. salvage value = Depletion cost per unit Total estimated units available $9,000,000 Cost - $ -0- 3,000,000 board feet = $3. Depletion per board foot Second: Calculate the depletion dollar amount for the period Units extracted x Cost per unit = Depletion 700,000 board feet extracted X $3. = $2,100,000

Depletion -- Miscellaneous Issues
Liquidating dividends -- distributing dividends in excess of earnings (usually as the result of a company’s only asset generating a tremendous amount of cash and the asset will NOT be replaced when its life is over) Oil & Gas Industry: Full cost concept -- capitalize the cost of drilling ‘dry’ wells (used by ‘smaller’ exploration companies) Successful efforts concept -- only capitalize the cost of the wells that prove to be productive and expense the cost of drilling the ‘dry’ wells (used by large international oil companies) Want to buy some shares of Derstine Oil Drilling Inc.? First year’s net income was phenomenal!

Presentation of Property, Plant, Equipment, and Natural Resources (Including Disclosures)
Basis of valuation (cost) Pledges, liens, and other commitments Depreciation expense for the period. Balances of major classes of depreciable assets. Accumulated depreciation. A description of the depreciation methods used. Disclosures

Impairments refer to ‘other than temporary’ declines in asset’s value.
When the carrying amount of an asset (including PP&E, Natural Resources, and Intangibles) is not recoverable, a company records a write-down of the asset and the records an impairment loss. Impairments refer to ‘other than temporary’ declines in asset’s value. Examples of events leading to an impairment: Decrease in the market value of an asset (e.g., sub-prime mortgages held as an investment). Adverse change in legal factors or in the business climate. An accumulation of costs in excess of the amount originally expected to acquire or construct an asset (e.g., loss on long-term construction project). A forecast that demonstrates continuing losses associated with an asset.

Measuring Impairments
Review events for possible impairment. If the review indicates impairment, apply (under U.S. GAAP) the following TWO step process*: The “recoverability test” -- If the sum of the expected future net cash flows (NOT discounted) from the long-lived asset is less than the book value of the asset, an impairment has occurred. Assuming an impairment, the impairment loss is the amount by which the book value of the asset exceeds the fair value of the asset (its market value--the present value of expected future net cash flows). *IFRS uses only the 2nd step, thus resulting in more impairment losses being recorded (more conservative approach)

Impairment Flowchart Note that U.S. GAAP does NOT permit ‘restoration’ of impairment loss on assets held for use. IFRS does permit ‘restoration’ if subsequent events indicate the loss has been reversed.

Impairments Illustrated
Turet Company at December 31, 2010 owns the following equipment and plans to continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years. Questions to answer on next slide

Impairments Illustrated
(a) Apply ‘recoverability’ test to determine if there is ‘impairment’ YES -- $8,000,000 book value > $7,000,000 Undiscounted future cash flows (b) Prepare the journal entry to record the impairment of the asset Loss on impairment ,600,000 Accumulated depreciation ,600,000 ($8,000,000 vs. $4,400,000 fair value [discounted future cash flows]) (c) Prepare the journal entry to record depreciation expense for 2011. Depreciation expense ,100,000 Accumulated depreciation ,100, ($4,400,000 “new cost basis” divided by 4 years remaining life) (d) The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value. NOT permitted under U.S. GAAP

U.S. GAAP vs. IFRS -- PP&E Similarities
Under both IFRS and U.S. GAAP, interest costs incurred during construction must be capitalized. IFRS, like U.S. GAAP, capitalizes all direct costs in self-constructed assets. The accounting for exchanges of nonmonetary assets has recently converged between IFRS and U.S. GAAP. IFRS permits the same depreciation methods (straight-line, accelerated, units-of-production) as U.S. GAAP.

U.S. GAAP vs. IFRS -- PP&E Differences
IFRS permits PP&E asset revaluations to market value (which are not permitted in U.S. GAAP). In accounting for impairment losses, IFRS does not use the first-stage recoverability test used under U.S. GAAP—comparing the undiscounted cash flows to the book value. Thus, the IFRS test is more strict than U.S. GAAP. IFRS allows for the subsequent recovery of an impairment loss write-down. U.S. GAAP does NOT allow for a subsequent recovery on assets used in the business.

Class Assignment Questions # 1, 2, 3, 5, 10, 13, 14, 16, 17, 31, 33 (pages ) Homework (pages ): Ex. 5, 18, 21, 25

C H A P T E R 12 I N T A N G I B L E A S S E T S
Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter 12 Describe the characteristics of intangible assets. Identify the costs to capitalize for intangible assets. Describe the types of intangible assets. Explain the procedure for amortizing ‘definitive-lived’ intangible assets. Explain the accounting issues related to intangible-asset impairments. Explain the conceptual issues related to goodwill. Describe the accounting procedures for recording goodwill. Identify the conceptual issues and accounting for research and development costs and similar costs. Indicate the financial statement presentation of intangible assets and related items. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Characteristics of Intangible Assets
Are long-lived, lack physical existence, and are not financial instruments Get their value from their exclusive legal/economic rights. Two Types of Intangibles and Accounting Treatment Definitive (Limited) Life Amortize & 2-step Impair.Test Indefinite Life Do NOT Amortize and 1-step Impair. Test Patents Copyrights Franchises or licenses Trademarks or trade names Goodwill (has ‘unique’ 2-step impairment test)

Recording Acquisition of Intangible Assets
Purchased Intangibles: Recorded at cost. Includes all costs reasonable and necessary costs to acquire the intangible asset and get it ready for its intended use. Internally Created Intangibles: Generally expensed.

Accounting for Intangibles -- A Summary

Intangibles with Definitive Life (Amortize and 2-step Impairment Test)
Franchise (or license) with a limited life should be amortized to expense over the life of the franchise. Copyright is granted for the life of the creator plus 70 years. Amortize over estimated useful life -- which may be shorter than legal life. Customer lists, order or production backlogs, and both contractual and non-contractual customer relationships. Amortize over estimated useful life. Patent gives the holder exclusive use for a period of 20 years. Amortize over estimated useful life (Legal fees incurred successfully defending a patent are capitalized to Patent account.)

Impairment of Definitive-Life Intangibles
Same as the 2-step impairment for PP&E assets in Chapter 11. ‘Recoverability test’--If the sum of the expected future net cash flows (NOT discounted) is less than the book value of the asset, an impairment has occurred. ‘Fair value test’--The impairment loss is the amount by which the book value of the asset exceeds the fair value -- market value of the asset. If a market value is not available, Discounted expected future net cash flows can be used to estimate fair value of the asset. The loss is reported as part of income from continuing operations, “Other expenses and losses” section. Why do you believe companies argued (successfully) with the FASB for the ‘recoverability’ test’s provision of using Undiscounted expected future cash flows?

Impairment of Definitive-Life Intangible Asset (An Illustration)
Presented below is information related to a copyright owned by Carmello Company at December 31, 2010. The copyright has a remaining useful life of 10 years. Perform step-1 -- the ‘recoverability test’ (is an impairment loss indicated)? Perform step-2 -- the ‘fair value test’ to determine the dollar amount of the impairment loss to record. Prepare the journal entry to record the impairment loss at December 31, 2010.

Impairment of Definitive-Life Intangible Asset (An Illustration)
Recoverability test: If the sum of the UNDISCOUNTED expected future net cash flows is less than the book value of the asset, an impairment has occurred. Fair Value Test: What is the dollar amount of the impairment loss to be recorded? Prepare journal entry. Loss on impairment 1,100,000 Copyrights 1,100,000

Intangibles with Indefinite Life (Do NOT amortize; 1-step Impairment Test)
Trademark or trade name has legal protection for indefinite number of 10-year renewal periods. Franchise with an indefinite life should be carried at cost and not amortized. “Purchased” Goodwill (we will cover Goodwill after reviewing the impairment test procedures for indefinite-life intangible assets -- other than goodwill). You also will study goodwill in Advanced Accounting course.

Impairment of Indefinite-Life Intangibles (Other than Goodwill)
Should be tested for impairment at least annually. ‘Recoverability test’ is NOT used. Impairment test is the ‘Fair Value Test’. If the fair value of asset (market value--can use discounted cash flows as estimate of market value if market value is not available) is less than the book value, an impairment loss is recognized for the difference. Illustration on next slide.

Journal Entry to Record Impairment Loss
Impairment of Indefinite-Life Intangibles (Other than Goodwill -- An Illustration) Mohemath Oil Company has just been notified by the government of the country of Korveniran that its franchise “in perpetuity” to drill for oil will be revoked in two years. Mohemath Oil Company, which had recorded the franchise as an indefinite-life intangible asset, expects discounted cash flows for the remaining two years of the franchise to be $3,000,000. The book value of the franchise is $4,000,000. ‘Recoverability’ Test: NONE should be preformed ‘Fair Value Test’: Indicates an impairment loss of $1,000,000 ($4,000,000 book value > $3,000,000 fair value Journal Entry to Record Impairment Loss Loss on impairment 1,000,000 Franchise asset ,000,000

Goodwill Goodwill is evidenced when a company has ‘excess earnings’ (i.e., the company’s rate of return on assets is greater than the industry average). Goodwill can be attributed to a number of different reasons (e.g., skilled labor force, great management team, superior product quality, excellent customer service, etc.) Goodwill only is recorded when an entire business is purchased because goodwill cannot be separated from the business as a whole. Goodwill is recorded as the excess of the cost of purchasing another company over the FMV of the identifiable net assets of the company acquired. (C > FMV for NA acquired). Internally created goodwill should NOT be capitalized. One company ‘generates’ goodwill (“excess earnings”) internally, while another company ‘buys’ goodwill. Will their financial statements differ? How will they differ? Would internally generated goodwill impact the Stock Price (even though it is not shown as a asset)?

Recording Goodwill -- An Illustration
Marshall Co. pays $400,000 cash to purchase the net assets of Tractorling Company--whose Balance Sheet is presented below. The FAIR VALUE of Tractorling’s Net Assets are

Recording Goodwill -- An Illustration (Continued)
Remember that Goodwill is C > FMV of NA acquired

Recording Goodwill -- An Illustration (Continued)
Marshall Co.’s Journal Entry to record purchase of Tractorling Goodwill of $50,000 = $400,000 Cost - $350,000 FMV of Net Assets Acquired Notice in the above journal entry that the identifiable net assets acquired from Tractorling are being recorded at their Fair Market Value -- NOT their ‘cost basis’ on Tractorling’s books! What will be the accounting in the future for the Goodwill Asset now on Marshall’s financial statements?

“Negative” Goodwill (Cost < FMV of Net Assets Acquired)
“Bargain Purchase” Purchase price less than the fair value of net assets acquired (e.g., ‘forced sale’ of business when owner dies). Amount is recorded as a gain by the purchaser.

Impairment of Goodwill
‘Different’ two-step process used to test Goodwill for impairment Step 1: If fair value is less than the book value of the net assets (including goodwill), then perform a second step to determine possible goodwill impairment. Step 2: Determine the fair value of the goodwill (“implied value” of goodwill) and compare to book value of goodwill.

Impairment of Goodwill -- An Illustration
Presented below is net asset information related to Marshall’s Tractorling unit as of December 31, 2011 (one year after Marshall acquired Tractorling for $400,000--including $50,000 for Goodwill): At December 31, 2011, Marshall estimates the discounted future cash flows from the Tractorling unit to be approximately $335,000. Marshall also has received an offer to sell the Tractorling division for $335,000. Both are indicators of fair value of the Tractorling division at December 31, 2011. *All identifiable assets’ and liabilities’ book and fair value amounts are the same as of December 31, 2011.

Impairment of Goodwill -- An Illustration (Continued)
Step 1: The $335,000 fair value of the Tractorling unit is below its $350,000 book value (including goodwill). Therefore, an impairment has occurred. Step 2: Calculate and record journal entry for the impairment of Goodwill. $ ,000 300,000 35,000 50,000 $ (15,000) Loss on impairment ,000 Goodwill ,000

Impairment of Goodwill -- An Illustration (Continued)
At December 31, 2012, it is estimated that the Tractorling unit’s fair value increased to $345 million. Prepare the journal entry (if any) to record this increase in fair value. No entry. Subsequent reversal of recognized impairment losses is not permitted under U.S. GAAP Would a journal entry have been required to record the recovery in fair value under IFRS? Answer = NO (although IFRS permits recording recovery of previously recorded impairment losses in other situations, it does NOT allow it for Goodwill).

Summary of Impairment Tests

Research and Development (R&D) Costs
R&D expenditures frequently result in something that a company patents or copyrights and sells, such as: new product, process, idea, formula, composition, or literary work. Because of difficulties related to identifying R&D costs with particular saleable products and determining the dollar amount and timing of future benefits (if any), Research & Development (R & D) costs are expensed when incurred.

Other Costs Similar to R & D Costs
Expensed as Incurred Start-up costs for a new operation. Initial operating losses. Advertising costs. “Industry exception” Some computer software development costs are capitalized -- see next slide.

Accounting for Computer Software Costs
Capitalize or Part of Research & Development Expense (R&D): Until a company has established technological feasibility for a software product, it should charge to R&D expense the costs incurred in creating the software. Once technological feasibility is established (when the company has completed a detailed program design or a working model), then subsequent development costs are capitalized. Reporting Software Costs: Unamortized software costs. The total amount charged to expense The amounts, if any, written down to net realizable value.

Presentations of Intangibles and R&D
Balance sheet Intangible assets shown as a separate classification. Contra accounts normally not used for intangible assets. Income statement Report amortization expense and impairment losses in continuing operations. Total R&D costs charged to expense must be disclosed.

Presentations of Intangibles

Presentations of R&D Costs

Review Question Indicate how items on the list below would generally be reported in the financial statements. Item Reported As 1. Investment in a subsidiary company 2. Timberland 3. Cost of engineering activity required to advance the design of a product to the manufacturing stage. 4. Lease prepayment 5. Cost of equipment obtained under a capital lease. 6. Cost of searching for applications of new research findings. 1. Long-term investments 2. Natural resources 3. R & D expense 4. Prepaid rent 5. PP&E (Chapter 21 covers Leases) 6. R & D expense

Review Question (Continued)
Indicate how items on the list below would generally be reported in the financial statements. Item Reported As 7. Cost incurred in the formation of a corporation. 8. Operating losses incurred in the start-up of a business. 9. Training costs incurred in start-up of new operation. 10. Purchase cost of a franchise. 11. Goodwill generated internally. 12. Cost of testing in search of product alternatives. 7. Expense 8. Operating loss 9. Expense 10. Intangible 11. Not recorded 12. R & D expense

Indicate how items on the list below would generally be reported in the financial statements. Item Reported As 13. Goodwill acquired in the purchase of a business. 14. Cost of developing a patent. 15. Cost of purchasing a patent from an inventor. 16. Legal costs incurred in securing a patent. 13. Intangible 14. R & D Expense 15. Intangible 16. Intangible

Indicate how items on the list below would generally be reported in the financial statements. Item Reported As 17. Cost of purchasing a copyright. 18. Research and development costs. 19. Cost of developing a trademark. 20. Cost of purchasing a trademark. 17. Intangible 18. R & D Expense 19. Expensed 20. Intangible

Class Assignment Questions # 3, 4, 8, 9, 12, 23, 24 (pages ) Homework (pages ): Ex. 3, 4, 13, 14

CURRENT LIABILITIES AND CONTINGENCIES
C H A P T E R 13 CURRENT LIABILITIES AND CONTINGENCIES Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Summary of Chapter 13 Describe the nature, type, and valuation of current liabilities. Explain the classification issues of short-term debt expected to be refinanced. Identify types of employee-related liabilities. Identify the criteria used to account for and disclose gain and loss contingencies. Explain the accounting for different types of loss contingencies. Indicate how to present and analyze liabilities and contingencies. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

What is a Liability? FASB, defines liabilities as:
“Probable Future Sacrifices of Economic Benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” I define liabilities as “debts or obligations to ‘outsiders’ “(outsiders = anyone but the owners; therefore employees -- Salaries Payable -- are ‘outsiders’)

What is a Current Liability?
Current liabilities are “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities.” (My definition = debts due within one year, or operating cycle if longer, requiring use of current assets) Typical Current Liabilities Accounts payable. Notes payable ?. Current maturities of long-term debt (“Wheaties Bond”). Short-term obligations expected to be refinanced. Dividends payable. Customer deposits. Unearned revenues. Sales taxes payable. Income taxes payable. Employee wage withholdings. Employer payroll taxes payable.

Accounts Payable (trade accounts payable)
Balances owed to others for goods, supplies, or services purchased on open account. Arise because of time lag between receipt of goods or services and the payment for them. The terms of the sale (e.g., 2/10, n/30) state period of extended credit.

Notes Payable Notes Payable
Written promises to pay a certain sum of money on a specified future date. Arise from purchases, financing, or other transactions. Notes classified as short-term or long-term. Notes may be interest-bearing or zero-interest-bearing (i.e., ‘discounted note).

Notes Payable -- “Interest-Bearing Note” Illustrated
On June 1, 2009, Golden Inc. borrows $50,000 from the bank and gives the bank a one-year, 6% note. Principal and Interest due on May 31, Golden’s accounting year ends on December 31. Prepare journal entries related to the note. Golden Inc.’s Journal Entries for 2009 and 2010 6/1/09 Cash ,000 Note Payable ,000 12/31/09 Interest Expense ,750 Interest Payable ,750 Note Payable ,000 5/31/10 Interest Payable ,750 Interest Expense ,250 Cash ,000

Notes Payable -- “Zero-Interest-Bearing Note” Illustrated
On June 1, 2009, Golden Inc. borrows $50,000 from the bank and gives the bank a one-year, zero-interest-bearing note. The ‘discount rate’ (“implicit interest rate” is 6%). The $50,000 face amount is due on May 31, the maturity date. Golden’s accounting year ends on December 31. Golden Inc.’s Journal Entries for 2009 and 2010 6/1/09 Cash ,000 Discount on Note Payable 3,000 Note Payable ,000 12/31/09 Interest Expense ,750 Discount on Note Payable ,750 5/31/10 Interest Expense ,250 Discount on Note Payable ,250 Note Payable ,000 Cash ,000

Notes Payable -- “Zero-Interest-Bearing Note” Illustrated
The Discount on Notes Payable is a contra liability account to Notes Payable. Golden’s Dec. 31, 2009 Balance Sheet (partial) Current liabilities: Notes Payable $50,000 Less: Discount on Notes Payable ,250* $48,750 (* $1,250 = $3,000 original balance less $1,750 amortized to interest expense on Dec. 31, 2009) What ‘interest rate’ did Golden actual pay on the “zero-interest-bearing note? Answer: 6.4% $3,000 interest/$47,000 cash received

Debts Maturing in Next Year NOT requiring Use of Current Asset to “Pay it off”
Exclude debts maturing in next year from current liabilities IF maturing liabilities are to be: 1. Retired by assets accumulated that have not been shown as current assets, 2. Refinanced, or retired from the proceeds of a new debt issue, or 3. Converted into capital stock. To be excluded from current liabilities, management must demonstrate BOTH the intent and ability to refinance on a long-term basis. “Ability to refinance on a long-term basis” may be demonstrated by actually having refinanced on a long-term basis, or entered into a non-cancelable long-term refinancing agreement with reputable party.

Current Obligations Expected to be Refinanced
Debts Expected to be Refinanced NO Mgmt. Intends of Refinance Classify as Current Liability YES Demonstrates Ability to Refinance NO YES Actual Refinancing after balance sheet date but before issue date Financing Agreement Noncancellable with Capable Lender or Exclude Debt from Current Liabilities and Reclassify as LT Debt

On December 31, 2010, Alexander Company had $1,200,000 of short-term debt in the form of notes payable due February 2, On January 21, 2011, the company issued 25,000 shares of its common stock for $36 per share, receiving $900,000 proceeds after brokerage fees and other costs of issuance. On February 2, 2011, the proceeds from the stock sale, supplemented by an additional $300,000 cash, are used to liquidate the $1,200,000 debt. The December 31, 2010, balance sheet is issued on February 23, 2011. Instructions Show how the $1,200,000 of short-term debt should be presented on the December 31, 2010, balance sheet.

Alexander Company Balance Sheet (Partial) December 31, 2010 Current liabilities: Notes payable Long-term debt: Notes payable refinanced Total liabilities $ 300,000 900,000 $1,200,000 Note disclosure should include: A general description of the financing agreement. The terms of any new obligation incurred or to be incurred. The terms of any equity security issued or to be issued.

Actual Refinancing of Short-Term Debt

(Chapter 15 in Intermediate Accounting II)
Dividends Payable Amount owed by a corporation to its stockholders as a result of board of directors’ authorization. (Chapter 15 in Intermediate Accounting II) Generally paid within three months. Undeclared dividends on cumulative preferred stock are not recognized as a liability (but must be disclosed). Dividends payable in the form of shares of stock are not recognized as a liability. Reported in equity.

Customer Deposits Customer Deposits
Include returnable cash deposits received from customers (e.g., utility customers with poor credit may be required to post a refundable deposit, landlord requires deposit of one or two months rent from tenant). May be classified as current or long-term depending on the circumstances.

Unearned Revenues Payment received before delivering goods or rendering services (e.g., Magazine Publisher) Unearned and Earned Revenue Accounts

Unearned Revenues -- An Illustration
The publishers of “Fly Fishing for Carp” Magazine sold 12,000 annual subscriptions on August 1, 2010, for $18 each. Prepare August 1, 2010, journal entry and the December 31, 2010, annual adjusting entry. Aug. 1 Cash 216,000 Unearned revenue 216,000 (12,000 x $18) Dec. 31 Unearned revenue 90,000 Subscription revenue 90,000 ($216,000 x 5/12 = $90,000)

Sales Taxes Payable Sales Taxes Payable-- Retailers must collect sales taxes from customers on sales of certain products and certain services and then remit the sales tax collected to the proper governmental authority. Example: Dillons Corporation made credit sales of $30,000 which are subject to 6% sales tax. The corporation also made cash sales which totaled $20,670 including the 6% sales tax. (a) prepare the entry to record Dillons’ credit sales. (b) Prepare the entry to record Dillons’ cash sales. (a) Accounts receivable 31,800 Sales 30,000 Sales tax payable ($30,000 x 6% = $1,800) 1,800 (b) Cash 20,670 Sales ($20,670  1.06 = $19,500) 19,500 Sales tax payable 1,170

Income Tax Payable Corporations must prepare a corporate income tax return* and compute the income tax payable resulting from the operations of the current period. Taxes payable are a current liability Corporations must make periodic estimated tax payments throughout the year. Differences between taxable income and accounting income sometimes occur (Chapter 19). [* Corporations (Subchapter ‘S’ and LLCs) recognized by the IRS as partnerships do NOT pay corporate income taxes]

Employee Payroll Related Current Liabilities
Amounts owed to employees for salaries or wages are reported as a current liability (i.e., “Salaries Payable”) Also reported as current liabilities would be payroll deductions withheld from employees’ pay checks (Fed. income Tax, FICA and Medicare, State & Local income tax; pension contributions; medical, dental, vision contributions, etc.) Employer Payroll Related Current Liabilities Payroll Taxes incurred by Employer: FICA & Medicare (matching employee withholding) Unemployment Taxes (State & Federal)

Payroll -- Current Liability ( An Illustration)
Assume a weekly payroll of $10,000 entirely subject to F.I.C.A. and Medicare (7.65%), federal (0.8%) and state (4%) unemployment taxes, with income tax withholding of $1,320 and union dues of $88 deducted. Journal entry to record salaries and wages paid Salaries and wages expense 10,000 Withholding taxes payable 1,320 F.I.C.A taxes payable 765 Union dues payable 88 Cash 7,827 Journal entry to record employer payroll taxes Payroll tax expense ,245 F.I.C.A taxes payable Federal unemployment tax payable State unemployment tax payable Employees’ take-home pay of $7,827 vs. $11,245 payroll cost to Employer!

Accrue for Compensated Absences Current Liability
Accrue throughout the year, a current liability for paid absences for vacation, illness, and holidays; and bonuses if all the following conditions exist: The obligation relates to rights that vest or accumulate. The employer’s obligation is attributable to employees’ services already rendered. Payment of the compensation is probable. The amount can be reasonably estimated. Accrue = Spread expense throughout the year; not all recorded as expense when paid!

Contingencies “An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.”

Gain Contingencies Typical GAIN Contingencies are:
Possible receipts of monies from gifts and donations. Possible refunds from the government in tax disputes. Pending court cases with a probable favorable outcome. Tax loss carryforwards (Chapter 19). Gain contingencies are usually not recorded. (Why not?) Disclosed only if probability of receipt is high.

Loss Contingency ‘May” be Recorded
Loss Contingencies Loss Contingency ‘May” be Recorded The likelihood that the future event will confirm the incurrence of a loss and a liability can range from probable to remote. Three degrees of probability: Probable. Reasonably possible. Remote.

Probable Accrue Reasonably Possible Disclose Remote Ignore
Loss Contingencies Probability Accounting Probable Accrue Reasonably Possible Disclose Remote Ignore

Loss Contingencies Cone Inc. is involved in a lawsuit at December 31, Prepare the December 31 entry, if any, assuming: it is probable that Cone will be liable for $900,000 it is reasonably possible--not probable--that Cone will be liable for any payment as a result of this suit. (c) It is only a very remote possibility that Cone will be liable for any payment as a result of the lawsuit. (a) Lawsuit loss 900,000 Lawsuit liability 900,000 (b) No entry is necessary. Disclosure required. (c) No entry or disclosure is necessary. Do you believe that Loss Contingencies would be a difficult or easy area to audit?

Loss Contingencies Note the first item listed below as a “Loss Contingency” that Usually is Accrued—but does NOT result in a liability being recorded!

Litigation, Claims, and Assessments
Loss Contingencies Litigation, Claims, and Assessments Companies must consider the following factors, in determining whether to record a liability with respect to pending or threatened litigation and actual or possible claims and assessments. Time period in which the action occurred. Probability of an unfavorable outcome. Ability to make a reasonable estimate of the loss.

Environmental Liabilities
Loss Contingencies Environmental Liabilities A company must recognize an asset retirement obligation (ARO) when it has an existing legal obligation associated with the retirement of a long-lived asset and when it can reasonably estimate the amount of the liability. NOTE: The SEC argues that if the liability is within a range, and no amount within the range is the best estimate, then management should recognize the minimum amount of the range.

Loss Contingencies -- Environmental Liabilities
Environmental Liabilities--existing legal obligations, which require recognition of a liability include, but are not limited to: decommissioning nuclear facilities, dismantling, restoring, and reclamation of oil and gas properties, certain closure, reclamation, and removal costs of mining facilities, closure and post-closure costs of landfills.

Loss Contingencies -- Environmental Liabilities (An Illustration)
On January 1, 2010, Wildcat Oil Company erected an oil platform. Wildcat is legally required to dismantle and remove the platform at the end of its useful life, estimated to be five years. Wildcat estimates this will cost $1,000,000. Based on a 10 percent discount rate, the fair value of the asset retirement obligation on January 1, 2010 is estimated to be $620,920 ($1,000,000 x ). Journal Entry to records this Asset Retirement Obligation (ARO) Drilling platform 620,920 Asset retirement obligation 620,920 Over the next five years: (1) the $620,920 Drilling Platform Asset will be depreciated AND (2) interest needs to be recognized as the ARO Liability ‘grows’ until it is $1,000,000 in five years.

Loss Contingencies -- Environmental Liabilities (An Illustration)
Using the straight-line method, Wildcat makes the following journal entry each of the next five years to record depreciation of the Drilling Platform. Depreciation expense ($620,920 / 5) 124,184 Accumulated depreciation 124,184 Wildcat also needs to record interest expense and the related increase in the asset retirement obligation. The first year’s journal entry on December 31, 2010 would be: Interest expense ($620,092 x 10%) ,092 Asset retirement obligation ,092 Similar entries would be made each year--based on an amortization schedule If the actual cost to demolish the drilling platform differs from the ARO liability amount--the difference is recorded as a gain or loss.

Loss Contingencies Self-Insurance
Self-insurance is not insurance, but risk assumption. There is little theoretical justification for the establishment of a liability based on a hypothetical charge to insurance expense. Self-Insurance ‘reserves’ (“cookie jars”) have been improperly used in the past by management to ‘manage earnings’

Disclosure Requirements for Contingencies
Disclosure should include: Nature of the contingency. An estimate of the possible loss or range of loss. Companies should disclose certain other contingent liabilities. Guarantees of indebtedness of others. Obligations of commercial banks under “stand-by letters of credit.” Guarantees to repurchase receivables (or any related property) that have been sold or assigned.

Disclosure Requirements for Contingencies (An Illustration)
Disclosure of Loss Contingency through Litigation

Balance Sheet Presentation of Current Liabilities

Cash + Marketable Securities + Net Receivables
Ratio Analysis Analysis of Current Liabilities Liquidity regarding a liability is the expected time to elapse before its payment. Two ratios to help assess liquidity are: Current Assets Current Ratio = Current Liabilities Cash + Marketable Securities + Net Receivables Acid-Test Ratio (aka. “Quick Ratio”) = Current Liabilities

Ratio Analysis -- An Illustration
Costner Company has been operating for several years, and on December 31, 2010, presented the following balance sheet. Compute the current ratio: $210,000 3.0 to 1 = 70,000 Compute the acid-test ratio: $115,000 1.64 to 1 = 70,000 “Window Dressing”!!!!!!

Class Assignment Questions #1, 3, 7, 9, 13, 20, 21, 22, 26, 30 (page 669) Homework (pages ): CE 13-1, CE 13-2 Ex. 1, 2, 8, 13

FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS

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FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS

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