Chapter 1-1
C H A P T E R C H A P T E R 11
FINANCIAL ACCOUNTING AND FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDSACCOUNTING STANDARDS
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-2
Financial Accounting vs. Managerial AccountingFinancial Accounting vs. Managerial Accounting
Financial Accountin
g
Focused on the needs of external
users (e.g. investors and
creditors)
Managerial
Accounting
Focused on the needs of internal
users (management)
Chapter 1-3
Accounting and Capital Allocation Accounting and Capital Allocation “MACRO Level Importance”“MACRO Level Importance”
Accounting and Capital Allocation Accounting and Capital Allocation “MACRO Level Importance”“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?)
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 Financial
ReportingReporting
Financial Financial
ReportingReporting
Information to help Information to help
users with capital users with capital
allocation decisions.allocation decisions.
To whom do you To whom do you
lend money?lend money?
Which company’s Which company’s
stock would you stock would you
buy?buy?
Users of Users of
Financial Financial
InformationInformation
Users of Users of
Financial Financial
InformationInformation
Investors, creditors, Investors, creditors,
and other usersand other users
Capital AllocationCapital AllocationCapital AllocationCapital Allocation
The process of The process of
determining how and determining how and
at what cost (interest at what cost (interest
rate on loan; stock rate on loan; stock
price willing to pay) price willing to pay)
money is allocated money is allocated
among competing among competing
interests.interests.
Chapter 1-4
Need to Develop StandardsNeed to Develop StandardsNeed to Develop StandardsNeed to Develop Standards
Various users need financial information
Various users need financial information
The accounting profession has attempted to develop a set of standards that are
generally accepted and “universally” practiced.
Financial StatementsIncome StatementStatement of Stockholders’ EquityBalance SheetStatement of Cash FlowsNote Disclosure
Financial StatementsIncome StatementStatement of Stockholders’ EquityBalance SheetStatement of Cash FlowsNote Disclosure
Generally Accepted Generally Accepted
Accounting Principles Accounting Principles
(GAAP)(GAAP)
aka. “Cleverly Rigged aka. “Cleverly Rigged
Accounting Ploys”Accounting Ploys”
(CRAP)(CRAP)
Generally Accepted Generally Accepted
Accounting Principles Accounting Principles
(GAAP)(GAAP)
aka. “Cleverly Rigged aka. “Cleverly Rigged
Accounting Ploys”Accounting Ploys”
(CRAP)(CRAP)
Chapter 1-5
Income Statement
Statement of Changes in
Stockholders’ Equity
Balance Sheet
Statement of Cash Flows
Note Disclosures
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.
President’s letter
Prospectuses,
SEC Reporting (10K, 10Q)
News releases
Forecasts
Environmental Reports
Etc.GAAPGAAP Not GAAPNot GAAP
Financial StatementsFinancial Statements Additional InformationAdditional Information
Financial Statements and Financial Financial Statements and Financial ReportingReporting
Financial Statements and Financial Financial Statements and Financial ReportingReporting
Chapter 1-6
FASBFASBFASBFASB Preparers (e.g., FEI)
Preparers (e.g., FEI)
Financial Community
Financial Community
Government (SEC, IRS, other
agencies)
Government (SEC, IRS, other
agencies)
Industry Associations
Industry Associations
CPAs andAccounting Firms
CPAs andAccounting Firms
AICPA (AcSEC)AICPA (AcSEC)
AcademiciansAcademicians
Investing PublicInvesting Public
Accounting standards, Accounting standards, interpretations, and bulletins interpretations, and bulletins
are subject to INTENSE are subject to INTENSE “Political Pressure”“Political Pressure”
Standard SettingStandard SettingStandard SettingStandard Setting
Chapter 1-7
Challenges Facing Financial Challenges Facing Financial AccountingAccounting
Challenges Facing Financial Challenges Facing Financial AccountingAccounting
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
Chapter 1-8
Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that: Financial reporting should provide information that:
(a) is useful to present and potential INVESTORS and (a) is useful to present and potential INVESTORS and CREDITORS and other users in making rational CREDITORS and other users in making rational investment, credit, and similar decisions. investment, credit, and similar decisions.
(a) is useful to present and potential INVESTORS and (a) is useful to present and potential INVESTORS and CREDITORS and other users in making rational CREDITORS and other users in making rational investment, credit, and similar decisions. investment, credit, and similar decisions.
(b) helps potential investors and creditors and other users (b) helps potential investors and creditors and other users in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY of prospective CASH FLOWS. of prospective CASH FLOWS.
(b) helps potential investors and creditors and other users (b) helps potential investors and creditors and other users in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY in ASSESSING the AMOUNTS, TIMING, and UNCERTAINTY of prospective CASH FLOWS. of prospective CASH FLOWS.
(c) clearly portrays the Economic Resources of an (c) clearly portrays the Economic Resources of an enterprise, the Claims to those Resources, and the enterprise, the Claims to those Resources, and the effects of transactions, events, and circumstances that effects of transactions, events, and circumstances that Change its Resources and Claims to those Resources. Change its Resources and Claims to those Resources.
(c) clearly portrays the Economic Resources of an (c) clearly portrays the Economic Resources of an enterprise, the Claims to those Resources, and the enterprise, the Claims to those Resources, and the effects of transactions, events, and circumstances that effects of transactions, events, and circumstances that Change its Resources and Claims to those Resources. Change its Resources and Claims to those Resources.
Financial Accounting Standards Board Financial Accounting Standards Board Concept Statement #1--Objectives of Concept Statement #1--Objectives of
Financial AccountingFinancial Accounting
Financial Accounting Standards Board Financial Accounting Standards Board Concept Statement #1--Objectives of Concept Statement #1--Objectives of
Financial AccountingFinancial Accounting
Chapter 1-9
Parties Involved in Standard SettingParties Involved in Standard SettingParties Involved in Standard SettingParties Involved in Standard Setting
Four organizations:Four organizations:
Securities and Exchange Commission (SEC)
American Institute of Certified Public Accountants (AICPA)
Financial Accounting Standards Board (FASB)
International Accounting Standards Board (IASB)
Chapter 1-10
Securities Act of Securities Act of 19331933
(New Securities (New Securities issue)issue)
Securities Act of Securities Act of 19331933
(New Securities (New Securities issue)issue)
Securities Act of Securities Act of 19341934
(Annual 10K (Annual 10K reporting)reporting)
Securities Act of Securities Act of 19341934
(Annual 10K (Annual 10K reporting)reporting)
Securities and Exchange (SEC) Securities and Exchange (SEC) CommissionCommission
Securities and Exchange (SEC) Securities and Exchange (SEC) CommissionCommission
Established by federal government (why?)
Governs Accounting and Reporting for public companiesSEC 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?)
Chapter 1-11
American Institute of CPAsAmerican Institute of CPAsAmerican Institute of CPAsAmerican Institute of CPAs
National professional organization
Established the following:
Committee on Committee on Accounting Accounting ProceduresProcedures
Committee on Committee on Accounting Accounting ProceduresProcedures
Accounting Accounting Principles BoardPrinciples Board
Accounting Accounting Principles BoardPrinciples 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
Chapter 1-12
Mission is to establish and improve standards of Mission is to establish and improve standards of financial accounting and reporting. Differences financial accounting and reporting. Differences between FASB and predecessor AICPA include FASB between FASB and predecessor AICPA include FASB is:is:
Financial Accounting Standards BoardFinancial Accounting Standards BoardFinancial Accounting Standards BoardFinancial Accounting Standards Board
Full-time, Paid position
Increased Independence--must ‘quit’ other jobs
Broader Representation--NOT all CPAs
Chapter 1-13
Responsive to entire economic community (‘everyone’
gets to voice their views--good or bad?)
Operates in full view of the public (transparency)
FASB’s Due ProcessFASB’s Due ProcessFASB’s Due ProcessFASB’s Due Process
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!!!
Chapter 1-14
Types of PronouncementsTypes of PronouncementsTypes of PronouncementsTypes 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’
Chapter 1-15
GAAP CodificationGAAP Codification
1.) With over 2,000 GAAP documents in the last 1.) With over 2,000 GAAP documents in the last 60 years, it has become very difficult even to 60 years, it has become very difficult even to ‘research’ a topic in GAAP and feel assured ‘research’ a topic in GAAP and feel assured you have the most recent, ‘correct’ answer to you have the most recent, ‘correct’ answer to your inquiry.your inquiry.
2.) The FASB’s GAAP codification project (just 2.) The FASB’s GAAP codification project (just completed in July 2009) is an attempt to completed in July 2009) is an attempt to alleviate the problem and make GAAP alleviate the problem and make GAAP research much more effective and efficientresearch much more effective and efficient
Chapter 1-16
GAAP Codification (Continued)GAAP Codification (Continued)
The Codification includes ALL authoritative The Codification includes ALL authoritative U.S. GAAP in a single location, organized into U.S. GAAP in a single location, organized into 90 accounting topics and is available FREE 90 accounting topics and is available FREE (electronically accessible at (electronically accessible at http://http://asc.fasb.orgasc.fasb.org/home/home))
Each topic has subsections such as:Each topic has subsections such as: Overview and backgroundOverview and background RecognitionRecognition Initial measurementInitial measurement DisclosureDisclosure
The topical structure is consistent with IFRS The topical structure is consistent with IFRS The codification will include real-time updatesThe codification will include real-time updates
YOU Will Be Researching the Codification for selected homework assignments!
Chapter 1-17
Changing Role of AICPAChanging Role of AICPAChanging Role of AICPAChanging 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?
Chapter 1-18
International Accounting Standards International Accounting Standards BoardBoard
International Accounting Standards International Accounting Standards BoardBoard
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 2011. (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.
Chapter 1-19
Ethics in the Environment of Financial AccountingEthics 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.
1) Would you like reported earnings be calculated with standards that are:
a) Biased to produce higher earnings?
b) Designed to describe what really happened?
2) Would you like the balance sheet to:
a) Omit some ‘questionable’ liabilities?
b) Report all liabilities?
Chapter 1-20
You are Company managementYou 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?
Chapter 1-21
Now assume you are the financial statement Now assume you are the financial statement analyst trying to forecast future cash flowsanalyst trying to forecast future cash flows
1) Would you like reported earnings be calculated with standards that are:
a) Biased to produce higher earnings?b) Designed to describe what really happened?
2) Would you like the balance sheet to: a) Omit some ‘questionable’ liabilities? b) Report all liabilities?
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 company management (their client--who hires and pays their fee)
Chapter 1-22
Now assume you are the financial statement Now assume you are the financial statement analyst trying to forecast future cash flowsanalyst 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?
Chapter 1-23
Sarbanes-Oxley LegislationSarbanes-Oxley Legislation (“SOX”) (“SOX”)
Establishes an oversight board for accounting practices. Establishes an oversight board for accounting practices. The Public Company Accounting Over-sight Board The Public Company Accounting Over-sight Board (PCAOB) has oversight and enforcement authority and (PCAOB) has oversight and enforcement authority and establishes establishes auditingauditing, , quality controlquality control, and , and independence independence standardsstandards and rules. and rules.
Implements Implements stronger independence rules for auditorsstronger independence rules for auditors. . Audit partner rotation; Audit partner rotation; prohibited from offering certain prohibited from offering certain types of consulting services to audit clientstypes of consulting services to audit clients..
Requires CEOs and CFOs to personally certify that Requires CEOs and CFOs to personally certify that financial statements and disclosures are accuratefinancial statements and disclosures are accurate
Requires Requires codes of ETHICS for senior financial officerscodes of ETHICS for senior financial officers.. In addition, requires public companies’ management to In addition, requires public companies’ management to
attest to the effectiveness of their internal controls over attest to the effectiveness of their internal controls over financial reporting (AND auditors need to ‘audit’ it and financial reporting (AND auditors need to ‘audit’ it and report on it)report on it)..
Chapter 1-24
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 1Homework for Ch. 1
Class Assignment Questions #1, 3, 5, 28, 32 Class Assignment Questions #1, 3, 5, 28, 32 (pages 22-23)(pages 22-23)
Homework (pages 25-26):Homework (pages 25-26):
CA 1-12, CA 1-13, CA 1-15CA 1-12, CA 1-13, CA 1-15
Chapter 1-25
C H A P T E R C H A P T E R 22
CONCEPTUAL FRAMEWORK CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL UNDERLYING FINANCIAL
ACCOUNTING ACCOUNTING
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-26
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
Conceptual FrameworkConceptual FrameworkConceptual FrameworkConceptual Framework
Chapter 1-27
FASB’s Conceptual Framework ProjectFASB’s Conceptual Framework Project
Both the FASB and the IASB have “Conceptual Both the FASB and the IASB have “Conceptual Frameworks”—with many similaritiesFrameworks”—with many similarities MAJOR DifferenceMAJOR Difference = Measurement methods used in = Measurement methods used in
recognizing elements of the financial statements (e.g., recognizing elements of the financial statements (e.g., option to use ‘fair value’ much more extensive in IFRS)option to use ‘fair value’ much more extensive in IFRS)
Some Other Differences:Some Other Differences: ““Consistency NOT included in IFRS ‘qualitative’ Consistency NOT included in IFRS ‘qualitative’
characteristicscharacteristics Stewardship as an Objective in IASB Conceptual Stewardship as an Objective in IASB Conceptual
FrameworkFramework Accrual accounting explicitly listed as an ‘assumption’ in Accrual accounting explicitly listed as an ‘assumption’ in
IASB Conceptual FrameworkIASB Conceptual Framework FASB & IASB working on a ‘common’ conceptual FASB & IASB working on a ‘common’ conceptual
framework as part of their ongoing ‘convergence framework as part of their ongoing ‘convergence project’project’
Chapter 1-28
The FASB has issued six Statements of Financial Accounting Concepts (note that #3 has been superceded by #6)
The FASB has issued six Statements of Financial Accounting Concepts (note that #3 has been superceded by #6)
Development of Conceptual Development of Conceptual FrameworkFramework
Development of Conceptual Development of Conceptual FrameworkFramework
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
Chapter 1-29
ASSUMPTIONSASSUMPTIONS
1.1. CContinuity (aka. ontinuity (aka. “Going concern”)“Going concern”)
2.2. EEconomic entityconomic entity
3.3. MMonetary unit-stableonetary unit-stable
4.4. TTimeliness (aka. imeliness (aka. “Periodicity”)“Periodicity”)
PRINCIPLESPRINCIPLES
1.1. PPrinciple of revenue rinciple of revenue recognitionrecognition
2.2. MMatching atching
3.3. DDisclosure is full and isclosure is full and fairfair
4.4. CCost--Historic cost ost--Historic cost measurementmeasurement
CONSTRAINTSCONSTRAINTS
1.1. CCost-benefitost-benefit
2.2. MMaterialityateriality
3.3. IIndustry practicendustry practice
4.4. CConservatismonservatism
OBJECTIVESOBJECTIVES1. 1. Useful in investment and credit Useful in investment and credit
decisionsdecisions2. 2. Useful in assessing timing, Useful in assessing timing,
amount, and uncertainty of future amount, and uncertainty of future cash flowscash flows
3. About enterprise resources, 3. About enterprise resources, claims to resources, and changes claims to resources, and changes in themin them
ELEMENTSELEMENTS
Assets, Liabilities, and EquityAssets, Liabilities, and EquityInvestments by ownersInvestments by ownersDistribution to ownersDistribution to ownersComprehensive incomeComprehensive incomeRevenues and ExpensesRevenues and ExpensesGains and LossesGains and Losses
Illustration 2-7 Conceptual Framework for Financial Reporting (page 50 in textbook)
First level
Second level
Third level
QUALITATIVE QUALITATIVE CHARACTERISTICSCHARACTERISTICS
RelevanceRelevance
ReliabilityReliability
ComparabilityComparability
CConsistencyonsistency
I do NOT differentiate among Assumptions, Principles, and Constraints (and I ‘move’ Consistency from Qualitative Characteristic level to join assumptions, principles, and constraints)
Chapter 1-30
Qualitative Characteristics Making Qualitative Characteristics Making Accounting Information UsefulAccounting Information Useful
Qualitative Characteristics Making Qualitative Characteristics Making Accounting Information UsefulAccounting Information Useful
Relevance – making a difference in a decision.Predictive valueFeedback valueTimeliness
ReliabilityVerifiableRepresentational faithfulnessNeutral - free of error and bias
Reliability often clashes with Relevance—Manhattan Reliability often clashes with Relevance—Manhattan Island example (which is better valuation: an Island example (which is better valuation: an average of 20 real estate appraisers or $24 for average of 20 real estate appraisers or $24 for Investment in Manhattan Island? As an auditor, Investment in Manhattan Island? As an auditor, would you like to give an opinion on which would you like to give an opinion on which valuation??valuation??
Chapter 1-31
Mnemonic to Help Remember the Mnemonic to Help Remember the Assumptions, Principles, and ConstraintsAssumptions, Principles, and Constraints
DDisclosure--fullisclosure--full Cost/BenefitCost/Benefit CContinuity (“Going-Concern”)ontinuity (“Going-Concern”) CConsistencyonsistency Cost--HistoricCost--Historic MMonetary Unit is Stableonetary Unit is Stable MMatchingatching MMaterialityateriality CConservatismonservatism EEconomic Entityconomic Entity PPrinciple of Revenue Recognitionrinciple of Revenue Recognition TTimeliness (“Periodicity”)imeliness (“Periodicity”)(Add “Industry Exceptions” to above Mnemonic)(Add “Industry Exceptions” to above Mnemonic)
Chapter 1-32
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
DDisclosure – Financial reports should include “any” information that could isclosure – Financial reports should include “any” information that could affect decisions made by external users.affect decisions made by external users.
Parenthetical comments on face of statementsParenthetical comments on face of statements Note disclosuresNote disclosures Supplemental financial statementsSupplemental financial statements
CCost/Benefit -- “any” (for example in the above disclosure requirement) ost/Benefit -- “any” (for example in the above disclosure requirement)
must be tempered with the must be tempered with the COST/BENEFIT CONSIDERATIONCOST/BENEFIT CONSIDERATION
Chapter 1-33
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
““CContinuity” (“Going concern”) - the entity's life extends beyond ontinuity” (“Going concern”) - the entity's life extends beyond the current period.the current period.
a. Fundamental: assets are assumed to havea. Fundamental: assets are assumed to have future economic benefit.future economic benefit.
b. A business is assumed to continue b. A business is assumed to continue “ “indefinitely” (long enough for company toindefinitely” (long enough for company to use up it’s assets in normal operations).use up it’s assets in normal operations).
NEED TO EVALUATE VERY CLOSELY IN TODAY’S NEED TO EVALUATE VERY CLOSELY IN TODAY’S ECONOMIC ENVIRONMENT!ECONOMIC ENVIRONMENT!
Chapter 1-34
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
CConsistency Principle - business entities should use the same onsistency Principle - business entities should use the same accounting methods from one period to the next.accounting methods from one period to the next.
a. Allows comparisons of performance anda. Allows comparisons of performance and position across time.position across time.
b. Changes in methods may signal manipulation.b. Changes in methods may signal manipulation.
(This does NOT mean a company can never (This does NOT mean a company can never change accounting methods)change accounting methods)
Chapter 1-35
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
CCost--Historic - financial accounting information must be ost--Historic - financial accounting information must be verifiablverifiable e and and reliablereliable (objectively determined where possible rather (objectively determined where possible rather than subjectively determined)than subjectively determined)
a. Results can be “duplicated”—ask 20 historians what was a. Results can be “duplicated”—ask 20 historians what was the historic cost of Manhattan Island. You get 20 people the historic cost of Manhattan Island. You get 20 people saying $24.saying $24.
b. Opposite of “subjective measurement”. You get 20 people b. Opposite of “subjective measurement”. You get 20 people with 20 different answers if asked what is current ‘market with 20 different answers if asked what is current ‘market value’ of Manhattan Island.value’ of Manhattan Island.
c. Measurements continue to move away from historic cost:c. Measurements continue to move away from historic cost:
Market values increasing being used—marketable securities, Market values increasing being used—marketable securities, derivatives, (IFRS – option to use Fair Market Value for PP&E)derivatives, (IFRS – option to use Fair Market Value for PP&E)
Chapter 1-36
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
MMonetary unit is stable - measuring unit (e.g. dollar) is stable over time. onetary unit is stable - measuring unit (e.g. dollar) is stable over time. Inflation “does NOT exist”Inflation “does NOT exist”
MMatching Principle - the effects of a given period (expenses) atching Principle - the effects of a given period (expenses) should be matched against the benefits (revenues) that result should be matched against the benefits (revenues) that result from them. from them. “Let the expense follow the revenues.” “Let the expense follow the revenues.”
(Example = Cost of Goods Sold Expense)(Example = Cost of Goods Sold Expense)
(a) Focus on the income statement.(a) Focus on the income statement.
(b) Associate cause and effect, match expenses with (b) Associate cause and effect, match expenses with revenues to which they relate.revenues to which they relate.
(c) Key decision to be made is when to recognize (record) (c) Key decision to be made is when to recognize (record) revenue—THEN Match Expense against Revenuerevenue—THEN Match Expense against Revenue
(d) Not all Expenses can be ‘directly’ matched against (d) Not all Expenses can be ‘directly’ matched against Revenue. Some Expenses are ‘indirect’—costs in general Revenue. Some Expenses are ‘indirect’—costs in general of running the business for the period! (janitor’s salary, of running the business for the period! (janitor’s salary, depreciation of computer)depreciation of computer)
Chapter 1-37
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
MMateriality Concept - only those transactions dealing with dollar ateriality Concept - only those transactions dealing with dollar amounts large enough to make a difference to financial statement amounts large enough to make a difference to financial statement users need to be accounted for in a manner consistent with the users need to be accounted for in a manner consistent with the principles of financial accounting.principles of financial accounting.
(a) Size of transaction is relative.(a) Size of transaction is relative.
(b) Example: expense vs. depreciate (pencil sharpener).(b) Example: expense vs. depreciate (pencil sharpener).
(c) Materiality requires judgment (NOT much help in professional (c) Materiality requires judgment (NOT much help in professional literature).literature).
(d) User must be considered in determining materiality.(d) User must be considered in determining materiality.
(e) Consider “qualitative” aspects as well as “quantitative” (e) Consider “qualitative” aspects as well as “quantitative” ($10,000 bribe to Saudi Government official by GM). ($10,000 bribe to Saudi Government official by GM).
(f) SEC’s Staff Accounting Bulletin (SAB) #99 states “exclusive (f) SEC’s Staff Accounting Bulletin (SAB) #99 states “exclusive reliance on quantitative benchmarks to assess materiality in reliance on quantitative benchmarks to assess materiality in preparing financial statements is inappropriate”. preparing financial statements is inappropriate”.
Chapter 1-38
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
CConservatism Concept - "When in doubt, understate rather than onservatism Concept - "When in doubt, understate rather than overstate an entity's value.”overstate an entity's value.”
(a) Only when significant uncertainty about the value(a) Only when significant uncertainty about the value of transaction exists, should the most of transaction exists, should the most conservative alternative be chosen.conservative alternative be chosen.
(b) Conservatism in its own right is NOT a desirable (b) Conservatism in its own right is NOT a desirable characteristic of accounting. It can be just as characteristic of accounting. It can be just as misleading as “being overly optimistic”. misleading as “being overly optimistic”. (“Big Bath” manipulation!)(“Big Bath” manipulation!)
(c) Justification: legal liability of managers, directors,(c) Justification: legal liability of managers, directors, and auditors.and auditors.
(d) Example: LCM used in inventory valuation.(d) Example: LCM used in inventory valuation.
Chapter 1-39
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
EEconomic entity - an individual company isconomic entity - an individual company is separate and distinct from both its owner and allseparate and distinct from both its owner and all other entities.other entities. a. Ralph’s Used Car Company (a ‘proprietorship’)a. Ralph’s Used Car Company (a ‘proprietorship’)
b. Parent and four subsidiariesb. Parent and four subsidiaries
(The economic entity may NOT necessarily be the same as the (The economic entity may NOT necessarily be the same as the legal entity!)legal entity!)
Chapter 1-40
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
PPrinciple of Revenue Recognitionrinciple of Revenue Recognition
Four criteria must be met before revenue can be shown in the Four criteria must be met before revenue can be shown in the income statement:income statement:
(1) Production and sales efforts for product (1) Production and sales efforts for product significantly completed.significantly completed.(2) Revenue amount can be objectively measured.(2) Revenue amount can be objectively measured.(3) The major costs have been incurred and the(3) The major costs have been incurred and the rest can be reasonably estimated.rest can be reasonably estimated.(4) Eventual collection of cash is reasonably (4) Eventual collection of cash is reasonably assured.assured.
In Summary, RECORD REVENUE when EARNED:In Summary, RECORD REVENUE when EARNED:Earnings Process is virtually Earnings Process is virtually complete—critical complete—critical revenue producing activity has occurred (normally revenue producing activity has occurred (normally sale/deliverysale/delivery) ) AND remaining events (like collection AND remaining events (like collection of cash) are highly estimatable)of cash) are highly estimatable)
Chapter 1-41
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
TTimeliness (“Periodicity”) - time periods during imeliness (“Periodicity”) - time periods during which performance is measured for the economic which performance is measured for the economic entity.entity.
a. Based on users' need for timely information.a. Based on users' need for timely information.
b. Artificial time periods for reports (calendar,b. Artificial time periods for reports (calendar, fiscal year, quarterly, ‘real-time on-line’).fiscal year, quarterly, ‘real-time on-line’).
c. Timely (short period) vs. objective (longer c. Timely (short period) vs. objective (longer period) tradeoffs.period) tradeoffs.
Chapter 1-42
ASSUMPTIONS, PRINCIPLES, AND CONCEPTSASSUMPTIONS, PRINCIPLES, AND CONCEPTS
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
Chapter 1-43
Elements of Fin. StatementsElements of Fin. Statements
Page 39 in textbook has the “fancy” definitions Page 39 in textbook has the “fancy” definitions from FASB Concept Statement #6.from FASB Concept Statement #6.
Let’s quickly go through them and add Let’s quickly go through them and add ‘simplified’ common wordage alternative ‘simplified’ common wordage alternative definitions for the elements that make up the definitions for the elements that make up the financial statements.financial statements.
Chapter 1-44
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 2Homework for Ch. 2
Class Assignment Questions #2, 3, 5, 8, 9, 14, Class Assignment Questions #2, 3, 5, 8, 9, 14, 16, 20, 25, 28 (pages 53-54)16, 20, 25, 28 (pages 53-54)
Homework (pages 57-58):Homework (pages 57-58):
Ex. 3, 4, 7Ex. 3, 4, 7
Chapter 1-45
C H A P T E R C H A P T E R 33
THE ACCOUNTING THE ACCOUNTING INFORMATION SYSTEMINFORMATION SYSTEM(The Accounting Cycle)(The Accounting Cycle)
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-46
THE “MECHANICS” OF FINANCIAL ACCOUNTINGTHE “MECHANICS” OF FINANCIAL ACCOUNTING(A Summary of Ch. 3)(A Summary of Ch. 3)
Review the fundamental accounting equation.Review the fundamental accounting equation. Discuss the two criteria required for entering an economic event Discuss the two criteria required for entering an economic event
into the accounting cycle.into the accounting cycle. Explain the debit/credit schemeExplain the debit/credit scheme Discuss and illustrate the role of the Journal Entry, Journals, Discuss and illustrate the role of the Journal Entry, Journals,
Posting to Ledger Accounts, and Trial Balances.Posting to Ledger Accounts, and Trial Balances. Review the use of Adjusting Journal Entries.Review the use of Adjusting Journal Entries. Explain how Financial Statements are prepared at the end of the Explain how Financial Statements are prepared at the end of the
accounting cycle.accounting cycle. Illustrate the use of an Accounting WorksheetIllustrate the use of an Accounting Worksheet Describe and illustrate the procedures involved in the Closing Describe and illustrate the procedures involved in the Closing
Process and its importance.Process and its importance.
Chapter 1-47
THE FUNDAMENTAL ACCOUNTING EQUATIONTHE FUNDAMENTAL ACCOUNTING EQUATION
Assets = Claims to AssetsAssets = Claims to Assets
Assets = Liabilities + Stockholders’ EquityAssets = Liabilities + Stockholders’ Equity
Assets = Liabilities + (Contributed Capital + RE)Assets = Liabilities + (Contributed Capital + RE)
Characteristics:Characteristics:
a. This equality must always be maintained. a. This equality must always be maintained.
b. Equality is a necessary, but not sufficient condition. b. Equality is a necessary, but not sufficient condition.
c. Equality is maintained by the double entry system of c. Equality is maintained by the double entry system of
bookkeeping.bookkeeping.
Ending RE = Beginning RE + NI – DividendsEnding RE = Beginning RE + NI – Dividends
Net Income = Revenues - ExpensesNet Income = Revenues - Expenses
Chapter 1-48
TWO CRITERIA FOR RECORDINGTWO CRITERIA FOR RECORDINGECONOMIC EVENTSECONOMIC EVENTS
Criteria for recording a business or exchange transaction (economic Criteria for recording a business or exchange transaction (economic event) in the accounting cycle.event) in the accounting cycle.
1. Event 1. Event RelevancyRelevancy - economically significant and - economically significant and affects a firm's financial condition. (affects a firm's financial condition. (Assets, Liabilities,Assets, Liabilities, and/or Stockholders’ Equity are Affected!)and/or Stockholders’ Equity are Affected!)
2. 2. ObjectivityObjectivity - dollar values assigned to accounts - dollar values assigned to accounts (categories) in the Financial Statements must result from (categories) in the Financial Statements must result from exchange transactions (involving firm and an “outsideexchange transactions (involving firm and an “outside party”) that are backed by party”) that are backed by documented evidencedocumented evidence. .
Chapter 1-49
Debit/Credit SchemeDebit/Credit Scheme
Follow along on the board as I use the basic Follow along on the board as I use the basic “Accounting Equation” of: “Accounting Equation” of:
(Assets = Liabilities + Owners’ Equity)(Assets = Liabilities + Owners’ Equity)
to demonstrate how to learn theto demonstrate how to learn the
debit/credit scheme.debit/credit scheme.
Chapter 1-50
The Accounting EquationThe Accounting EquationThe Accounting EquationThe Accounting Equation
Relationship among the assets, liabilities, and Relationship among the assets, liabilities, and stockholders’ equity of a business: stockholders’ equity of a business:
The equation must be in balance after every The equation must be in balance after every transaction. For every transaction. For every DebitDebit there must be a there must be a CreditCredit..
Chapter 1-51
Accounting Cycle Summarized (After having Accounting Cycle Summarized (After having completed the “Transaction Analysis”)completed the “Transaction Analysis”)
Accounting Cycle Summarized (After having Accounting Cycle Summarized (After having completed the “Transaction Analysis”)completed the “Transaction Analysis”)
1. Enter the transactions of the period in appropriate journals.
2. Post from the journals to the ledger.
3. Prepare a trial balance (unadjusted trial balance).
4. Prepare adjusting journal entries and post to the ledger.
5. Prepare a trial balance after adjusting (adjusted trial balance).
6. Optional--Prepare an Accountant’s Worksheet
7. Prepare the financial statements from the adjusted trial balance or Accountant’s Worksheet
8. Prepare closing journal entries and post to the ledger.
9. Prepare a trial balance after closing (post-closing trial balance).
10.Optional--Prepare reversing entries and post to the ledger.
Chapter 1-52
The Accounting CycleThe Accounting CycleThe Accounting CycleThe Accounting Cycle
TransactionsTransactions
1. Journalization1. Journalization
6. Financial Statements6. Financial Statements
7. Closing entries7. Closing entries
8. Post-closing trail balance
8. Post-closing trail balance
9. Optional--Reversing entries
9. Optional--Reversing entries
3. Trial balance3. Trial balance
2. Posting to Ledger2. Posting to Ledger
5. Adjusted trial balance5. Adjusted trial balance
4. Adjustments4. Adjustments
Optional Work Sheet
Optional Work Sheet
Chapter 1-53
Transaction AnalysisTransaction Analysis
First UNDERSTAND THE BUSINESS EVENT THAT First UNDERSTAND THE BUSINESS EVENT THAT OCCURRED!! THEN:OCCURRED!! THEN:
a. a. WhichWhich financial statement financial statement accountsaccounts are affected by the transaction?are affected by the transaction?
b. What is the direction of the account b. What is the direction of the account effect? (effect? (Increase or DecreaseIncrease or Decrease))
c. What is the c. What is the dollar valuedollar value of the transaction? of the transaction? (use the balance sheet valuation methods:) (use the balance sheet valuation methods:)
1.) Historical Cost (Land)1.) Historical Cost (Land)2.) Lower of Cost or Market (Inventory)2.) Lower of Cost or Market (Inventory)3.) Net Realizable Value (Accounts Receivable)3.) Net Realizable Value (Accounts Receivable)4.) Fair Market Value (Trading Portfolio of 4.) Fair Market Value (Trading Portfolio of
Investments)Investments)5.) Present Value (Capitalized Lease)5.) Present Value (Capitalized Lease)
Chapter 1-54
JOURNALS AND LEDGERSJOURNALS AND LEDGERS
1.1. The JournalThe Journal (general journal) - contains a chronological list of the transactions (general journal) - contains a chronological list of the transactions entered into by a company, usually in journal entry form.entered into by a company, usually in journal entry form.
a. Enter date of transaction.a. Enter date of transaction.b. List the accounts to be debited/credited.b. List the accounts to be debited/credited.c. Include the dollar amounts of debits/credits.c. Include the dollar amounts of debits/credits.d. Provide a brief explanation of the transaction.d. Provide a brief explanation of the transaction.e. Enter a posting reference to the appropriate ledger accounts (discuss next).e. Enter a posting reference to the appropriate ledger accounts (discuss next).
2. 2. The LedgerThe Ledger - contains a running balance for each asset, liability, stockholders' - contains a running balance for each asset, liability, stockholders' equity, and temporary retained earnings account--revenue, expense, and dividend equity, and temporary retained earnings account--revenue, expense, and dividend accounts. (“T” ledger accounts usually are used in the textbook and lectures accounts. (“T” ledger accounts usually are used in the textbook and lectures instead of the 3-column running balance format of ledger account)instead of the 3-column running balance format of ledger account)
Posting to the ledger accounts occurs throughout the accounting period (with Posting to the ledger accounts occurs throughout the accounting period (with computer systems—posting occurs at the same time that the journal entry is computer systems—posting occurs at the same time that the journal entry is made).made).
Chapter 1-55
General JournalGeneral Journal – a chronological record of transactions. Journal Entries are recorded in the journal.
1. Journalizing1. Journalizing1. Journalizing1. Journalizing
September 1: Stockholders invested $15,000 cash in the corporation in exchange for shares of stock.
Chapter 1-56
Posting Posting – the process of transferring amounts from the journal to the ledger accounts.
2. Posting2. Posting2. Posting2. Posting
Chapter 1-57
Posting Posting – Transferring amounts from journal to ledger.
2. Posting2. Posting2. Posting2. Posting
Chapter 1-58
Trial Trial BalanceBalance – A list of each account and its balance; used to prove equality of debit and credit balances.
3. Unadjusted Trial Balance3. Unadjusted Trial Balance3. Unadjusted Trial Balance3. Unadjusted Trial Balance
Chapter 1-59
ILLUSTRATIONILLUSTRATION
Use Class Problem #1 on next slide toUse Class Problem #1 on next slide to
illustrate:illustrate: Transaction AnalysisTransaction Analysis Debits/CreditsDebits/Credits Journal EntriesJournal Entries Posting to Ledger AccountsPosting to Ledger Accounts ““Unadjusted” Trial BalanceUnadjusted” Trial Balance
Chapter 1-60
Link to Solution to Class Prob. 3-1Link to Solution to Class Prob. 3-1
Chapter 1-61
ADJUSTING JOURNAL ENTRIESADJUSTING JOURNAL ENTRIES
1.1. Definition - Journal entries recorded at the END of the accounting Definition - Journal entries recorded at the END of the accounting period to ensure that the financial statements will be correct—period to ensure that the financial statements will be correct—routine transactions recorded during the period may routine transactions recorded during the period may notnot result in result in proper presentation of the financial statements.proper presentation of the financial statements.
2.2. Characteristics of Adjusting Entries:Characteristics of Adjusting Entries:a. Entered in the records at the end of the period.a. Entered in the records at the end of the period.b. Involve both a temporary retained earnings account (aka. b. Involve both a temporary retained earnings account (aka. “nominal account”) and a permanent balance sheet account.“nominal account”) and a permanent balance sheet account.
3.3. Types of adjusting journal entries Types of adjusting journal entries a. Accrualsa. Accruals b. Deferralsb. Deferrals c. Revaluationsc. Revaluations
Chapter 1-62
““ACCRUALS” TYPE OF ADJUSTING ENTRYACCRUALS” TYPE OF ADJUSTING ENTRY
1. 1. Adjusting journal entriesAdjusting journal entries that ensure revenues earned and that ensure revenues earned and expenses incurred during the current period are recorded. expenses incurred during the current period are recorded. Because the cash has not been received or paid yet, the Because the cash has not been received or paid yet, the routine entries already made during the period would NOT routine entries already made during the period would NOT have recognized these revenues and expenses (and the have recognized these revenues and expenses (and the related asset or liability)related asset or liability)
2. Examples include:2. Examples include:
a. Accrued interest on Bank CD (and receivable)a. Accrued interest on Bank CD (and receivable) Interest Receivable AND Interest RevenueInterest Receivable AND Interest Revenue
b. Accrued wages earned by employees (and payable).b. Accrued wages earned by employees (and payable). Salaries Expense AND Salaries PayableSalaries Expense AND Salaries Payable
Chapter 1-63
““DEFERRALS” TYPE OF ADJUSTING ENTRYDEFERRALS” TYPE OF ADJUSTING ENTRY
DeferralsDeferrals - the process of “converting” either: - the process of “converting” either:
1.) 1.) a deferred costa deferred cost (i.e., asset) into an expense: (i.e., asset) into an expense:
a. Supplies inventory (Dr Supplies expense, Cr Supplies)a. Supplies inventory (Dr Supplies expense, Cr Supplies)
b. Merchandise inventory (Dr Cost of goods sold, Cr Inventory)b. Merchandise inventory (Dr Cost of goods sold, Cr Inventory)
c. Prepaid expenses (Dr Expense account, Cr Prepaid expense)c. Prepaid expenses (Dr Expense account, Cr Prepaid expense)
d. Property, plant, and equipment (Dr Depreciation expense, d. Property, plant, and equipment (Dr Depreciation expense, Cr Accumulated depreciation)Cr Accumulated depreciation)
e. Definitive-Lived Intangibles (Dr Amortization expense, Cr Intangibles)e. Definitive-Lived Intangibles (Dr Amortization expense, Cr Intangibles)
2.) 2.) a deferred revenuea deferred revenue (i.e. liability) until revenue earned. (i.e. liability) until revenue earned.
a. Unearned revenues (Dr Unearned revenue, Cr Fees earned)a. Unearned revenues (Dr Unearned revenue, Cr Fees earned) Note that with Note that with Deferral type Adjusting EntriesDeferral type Adjusting Entries——a previously recorded eventa previously recorded event (usually the (usually the
result of a cash transaction) result of a cash transaction) is being ‘updated’is being ‘updated’..
Chapter 1-64
““REVALUATIONS” TYPE OF ADJUSTING ENTRYREVALUATIONS” TYPE OF ADJUSTING ENTRY
1. Revaluation adjustments – Adjusting Journal Entries designed to bring 1. Revaluation adjustments – Adjusting Journal Entries designed to bring the dollar amounts of certain accounts in line with the existing facts.the dollar amounts of certain accounts in line with the existing facts.
2. Examples:2. Examples:
a. Bad debt estimates.a. Bad debt estimates.
b. Adjustments due to bank reconciliations.b. Adjustments due to bank reconciliations.
c. Revaluations of inventories to apply LCM.c. Revaluations of inventories to apply LCM.
Chapter 1-65
ILLUSTRATION OF ADJUSTING ENTRIESILLUSTRATION OF ADJUSTING ENTRIES
Use Class Problem #2 on next slide to Use Class Problem #2 on next slide to illustrate:illustrate: Accrual Adjusting Journal EntriesAccrual Adjusting Journal Entries Deferral Adjusting Journal EntriesDeferral Adjusting Journal Entries Valuation Adjusting Journal EntriesValuation Adjusting Journal Entries
Chapter 1-66
Prepare adjusting entries based on the unadjusted trial balance above and the information below: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.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 year2.) The equipment is depreciated at 10% of original cost per year 3.) Prepaid insurance totaling $1,500 ‘expired’ during the year3.) Prepaid insurance totaling $1,500 ‘expired’ during the year 4.) It is estimated that 10% of the accounts receivable will NOT be collected4.) It is estimated that 10% of the accounts receivable will NOT be collected 5.) Accrued salaries at year-end were $1,5005.) Accrued salaries at year-end were $1,500 6.) Unearned rent revenue balance at year-end should be $1,2006.) Unearned rent revenue balance at year-end should be $1,200
LinkLink to Solution to Class Prob. 3-2 to Solution to Class Prob. 3-2
Link to Solution for Class Problem 3-2Link to Solution for Class Problem 3-2
Chapter 1-67
THE ACCOUNTANT’S WORKSHEETTHE ACCOUNTANT’S WORKSHEET(See Appendix 3C—page 109)(See Appendix 3C—page 109)
The Worksheet - used at the end of an accounting period by the accountant to 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.prepare an ‘informal’ trial run through the end of the period accounting steps.
a.a. AdvantagesAdvantages
(1) Easier to trace/track your work.(1) Easier to trace/track your work.(2) Aids in finding posting and math errors.(2) Aids in finding posting and math errors.
b.b. Worksheet step-by-step process:Worksheet step-by-step process:
(1) Prepare Unadjusted Trial Balance - the list of accounts and end-of-(1) Prepare Unadjusted Trial Balance - the list of accounts and end-of-period account balances copied from the general ledger to the period account balances copied from the general ledger to the worksheet (the first step). worksheet (the first step).
(2) Post adjusting entries - journal entries recorded at period end--(2) Post adjusting entries - journal entries recorded at period end--
Accruals, Deferrals, & Valuation adjustments (the second step).Accruals, Deferrals, & Valuation adjustments (the second step). (3) Prepare “Adjusted Trial Balance” columns (the third step)(3) Prepare “Adjusted Trial Balance” columns (the third step)
(4) Prepare “Financial Statement” columns (the fourth step) (4) Prepare “Financial Statement” columns (the fourth step) Add another financial statement set of columns for the Retained Add another financial statement set of columns for the Retained
Earnings Statement--locate it between the Income Statement set of Earnings Statement--locate it between the Income Statement set of columns and the Balance Sheet set of columns! (The beginning columns and the Balance Sheet set of columns! (The beginning Retained Earnings, Dividends Declared, and Net Income should be Retained Earnings, Dividends Declared, and Net Income should be extended to the Retained Earnings set of columns, NOT the extended to the Retained Earnings set of columns, NOT the Balance Sheet set of columns.)Balance Sheet set of columns.)
Preparation of the Accountant’s Worksheet will be one of the homework Preparation of the Accountant’s Worksheet will be one of the homework assignments for Ch. 3assignments for Ch. 3
Chapter 1-68
Illustration of Accountant’s WorksheetIllustration of Accountant’s Worksheet
LinkLink to first six columns on an Accountant’s to first six columns on an Accountant’s WorksheetWorksheet
LinkLink to last 8 columns on an Accountant’s to last 8 columns on an Accountant’s WorksheetWorksheet
Chapter 1-69
PREPARINGPREPARING THE FINANCIAL STATEMENTSTHE FINANCIAL STATEMENTS Preparing the Financial Statements:Preparing the Financial Statements:
1. Income statement - prepare from adjusted trial balance or 1. Income statement - prepare from adjusted trial balance or accountant’s end of period worksheetaccountant’s end of period worksheet
2.2. Statement of retained earnings - prepare from retained earnings Statement of retained earnings - prepare from retained earnings general ledger account (after closing entries) or from the general ledger account (after closing entries) or from the accountant’s end of period worksheet.accountant’s end of period worksheet.
3.3. Balance sheet - prepare from adjusted trial balance or the Balance sheet - prepare from adjusted trial balance or the accountant’s end of period worksheet.accountant’s end of period worksheet.
4.4. Statement of cash flows - prepare by analyzing the change in Statement of cash flows - prepare by analyzing the change in every account but the Cash account.every account but the Cash account.
Chapter 1-70
ILLUSTRATION OF FOUR FINANCIAL ILLUSTRATION OF FOUR FINANCIAL STATEMENTSSTATEMENTS
Click on Click on linklink to view an illustration of the four to view an illustration of the four financial statements.financial statements. Point out—’interrelationships’ among the four Point out—’interrelationships’ among the four
financial statements. How they ‘interconnect’!financial statements. How they ‘interconnect’!
Chapter 1-71
THE CLOSING JOURNAL ENTRY PROCESSTHE CLOSING JOURNAL ENTRY PROCESS1. 1. AFTER adjusted trial balance and financial statementsAFTER adjusted trial balance and financial statements have been have been completed, THEN:completed, THEN:
2. 2. Closing journal entriesClosing journal entries - transfer end-of-period balances - transfer end-of-period balances in the Revenue, Expenses, and Dividends Declared accounts (the temporary in the Revenue, Expenses, and Dividends Declared accounts (the temporary retained earnings accounts; aka. the ‘nominal’ accounts) to the permanent Retainedretained earnings accounts; aka. the ‘nominal’ accounts) to the permanent Retained Earnings account. (Do NOT use the “Income Summary” account)Earnings account. (Do NOT use the “Income Summary” account)
a. Closing process procedures.a. Closing process procedures. (1) Close Revenue accounts to Retained Earnings (1) Close Revenue accounts to Retained Earnings (2) Close Expense accounts to Retained Earnings(2) Close Expense accounts to Retained Earnings
(3) Close Dividends Declared to Retained Earnings(3) Close Dividends Declared to Retained Earnings..
b. WHY need closing journal entries????b. WHY need closing journal entries????
3. Prepare the 3. Prepare the post-closing trial balance (aka. “after-closing trial balance”)post-closing trial balance (aka. “after-closing trial balance”) – contains – contains end-of- period balances for the permanent (balance sheet) accounts. Also end-of- period balances for the permanent (balance sheet) accounts. Also represents beginning balances for next accounting period.represents beginning balances for next accounting period.
Chapter 1-72
ILLUSTRATION OF CLOSING ENTRIESILLUSTRATION OF CLOSING ENTRIES
Use Class Problem #3 Use Class Problem #3 to illustrate:to illustrate: Closing Journal EntriesClosing Journal Entries Post closing Trial BalancePost closing Trial Balance
(First Show (First Show Adjusted Trial Balance Adjusted Trial Balance – basis for – basis for preparing Closing Entries)preparing Closing Entries)
Chapter 1-73
9. Reversing Entries9. Reversing Entries9. Reversing Entries9. Reversing Entries
After preparing the financial After preparing the financial statements and closing the books, a statements and closing the books, a company may reverse some of the company may reverse some of the adjusting entries before recording the adjusting entries before recording the regular transactions of the next period. regular transactions of the next period.
Chapter 1-74
Summary of Reversing Entries (IF Used!)Summary of Reversing Entries (IF Used!)1. All accrual adjusting entries would be reversed.
2. 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
Chapter 1-75
Accounting Cycle SummarizedAccounting Cycle SummarizedAccounting Cycle SummarizedAccounting Cycle Summarized
1. Enter the transactions during the period in the journal.
2. Post from the journal to the ledger.
3. Prepare an unadjusted trial balance.
4. Prepare adjusting journal entries and post to the ledger.
5. Prepare a trial balance after adjusting (adjusted trial balance).
6. Optional--Prepare an Accountant’s Worksheet
7. Prepare the financial statements from the adjusted trial balance or the Accountant’s Worksheet
8. Prepare closing journal entries and post to the ledger.
9. Prepare a trial balance after closing (post-closing trial balance).
10.Optional--Prepare reversing entries and post to the ledger.
Chapter 1-76
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 3Homework for Ch. 3
Class Assignment Questions -- # 4, 10, 11, 12, 21, and 22 (page 111)Class Assignment Questions -- # 4, 10, 11, 12, 21, and 22 (page 111)
Homework -- Proprietary ProblemHomework -- Proprietary Problem A preformatted Excel worksheet is provided with some columns of A preformatted Excel worksheet is provided with some columns of
the Accountant’s Worksheet already completed. the Accountant’s Worksheet already completed. Required:Required:
a.) Complete the Accountant’s Worksheet a.) Complete the Accountant’s Worksheet using Excelusing Excel b.) Prepare an Income Statement, Retained Earnings Statement, b.) Prepare an Income Statement, Retained Earnings Statement, and ‘classified’ Balance Sheet and ‘classified’ Balance Sheet c.) Record in journal entry form the adjusting entriesc.) Record in journal entry form the adjusting entries d.) Record in journal entry form the closing entriesd.) Record in journal entry form the closing entries e.) Prepare a post-closing (aka. ‘after-closing’) trial balancee.) Prepare a post-closing (aka. ‘after-closing’) trial balance
Chapter 1-77
C H A P T E R C H A P T E R 44
INCOME STATEMENT AND INCOME STATEMENT AND RELATED INFORMATIONRELATED INFORMATION
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-78
1.1. Understand the uses and limitations of an income Understand the uses and limitations of an income statement.statement.
2.2. Prepare a single-step income statement.Prepare a single-step income statement.
3.3. Prepare a multiple-step income statement.Prepare a multiple-step income statement.
4.4. Explain how to report ‘special items’:Explain how to report ‘special items’:
a.) Discontinued operationsa.) Discontinued operations
b.) Extraordinary items. b.) Extraordinary items.
5.5. Explain “intraperiod tax allocation”.Explain “intraperiod tax allocation”.
6.6. Identify where to report earnings per share (EPS) Identify where to report earnings per share (EPS) information.information.
7.7. Prepare a retained earnings statement.Prepare a retained earnings statement.
8.8. Explain how to report other comprehensive income.Explain how to report other comprehensive income.
Summary of Chapter 4Summary of Chapter 4Summary of Chapter 4Summary of Chapter 4
Chapter 1-79
Evaluate past performance.
Income Statement (aka. “Operating Statement)Income Statement (aka. “Operating Statement)Income Statement (aka. “Operating Statement)Income Statement (aka. “Operating Statement)
Help assess the risk or uncertainty of achieving future cash flows.
Predicting future performance.
Usefulness
Chapter 1-80
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
Income StatementIncome StatementIncome StatementIncome Statement
“Quality” of Earnings
Chapter 1-81
Format of the Income StatementFormat of the Income StatementFormat of the Income StatementFormat 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
Sales revenueSales revenue
Fees earnedFees earned
Interest revenueInterest revenue
Dividend revenueDividend revenue
Rent revenueRent revenue
Examples of Revenue Accounts
Chapter 1-82
Format of the Income StatementFormat of the Income StatementFormat of the Income StatementFormat of the Income Statement
Expenses for the period:
Costs incurred to run the business and generate the revenue Gross DECREASE in Retained Earnings component of stockholders’ equity
Cost of goods soldCost of goods sold
Depreciation expenseDepreciation expense
Interest expenseInterest expense
Rent expenseRent expense
Salary expenseSalary expense
Examples of Expense Accounts
Chapter 1-83
Format of the Income StatementFormat of the Income StatementFormat of the Income StatementFormat of the Income Statement
Gains – – Increases in income from “peripheral” or Increases in income from “peripheral” or
incidental transactionsincidental transactions
Losses - Decreases in income from “peripheral” or - Decreases in income from “peripheral” or
incidental transactions.incidental transactions.
Sale of investment in Microsoft Sale of investment in Microsoft shares, shares,
Sale of old delivery truck, Sale of old delivery truck,
Impairment losses.Impairment losses.
Examples of Gains and Losses
Chapter 1-84
Single-Step FormatSingle-Step FormatSingle-Step FormatSingle-Step Format
The single-step The single-step statement has few statement has few categories or subtotals:categories or subtotals:
Income Statement (in thousands)
Revenues:
Sales 285,000$
I nterest revenue 17,000
Total revenue 302,000
Expenses:
Cost of goods sold 149,000
Selling expense 10,000
Administrative expense 43,000
I nterest expense 21,000
I ncome tax expense 24,000
Total expenses 247,000
Net income 55,000$
Earnings per share 0.75$
RevenuesRevenues
ExpensesExpenses
Net IncomeNet Income
Single- Single- StepStep
Single- Single- StepStep
Chapter 1-85
Multiple-Step FormatMultiple-Step FormatMultiple-Step FormatMultiple-Step Format
More categories More categories and subtotals than and subtotals than ‘single step’ format ‘single step’ format
More categories More categories and subtotals than and subtotals than ‘single step’ format ‘single step’ format
Income Statement (in thousands)
Sales 285,000$
Cost of goods sold 149,000
Gross profit 136,000
Operating expenses:
Selling expenses 10,000
Administrative expenses 43,000
Total operating expense 53,000
Income from operations 83,000
Other revenue (expense):
I nterest revenue 17,000
I nterest expense (21,000)
Total other (4,000)
I ncome bef ore taxes 79,000
I ncome tax expense 24,000
Net income 55,000$
Earnings per share 0.75$
1. Operating 1. Operating Section Section
1. Operating 1. Operating Section Section
2. Nonoperating 2. Nonoperating Section Section
2. Nonoperating 2. Nonoperating Section Section
3. Income tax 3. Income tax 3. Income tax 3. Income tax
Chapter 1-86
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 “Special” ItemsReporting “Special” ItemsReporting “Special” ItemsReporting “Special” Items
Chapter 1-87
Illustration: KC Corporation had after tax income from continuing operations of $5,000,000 in 2010. Prior to disposal, the restaurants operated at a pretax loss of $450,000 in 2010. 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:
Reporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued Operations
Income from continuing operations $5,000,000Discontinued operations: Loss from operations, net of $135,000 tax benefit
315,000 Loss on disposal, net of $81,000 tax benefit
189,000Net income $4,496,000
Total loss on discontinued operations
504,000Earnings per share:
Income from continuing operations $5.00
Discontinued operations .50
Net income $4.50
Chapter 1-88
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 Irregular ItemsReporting Irregular ItemsReporting Irregular ItemsReporting Irregular Items
Chapter 1-89
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.
YESYES
Reporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary Items
NONO
NONO
Chapter 1-90
Illustration: KC Corporation had after tax income from continuing operations of $4,000,000 in 2011. 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
Reporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary Items
Earnings per share: Income from continuing operations $4.00
Extraordinary gain .54 Net income $4.54
Chapter 1-91
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 inventoriesImpairment 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?
Items NOT Getting ‘Special’ (Separate) SectionItems NOT Getting ‘Special’ (Separate) SectionItems NOT Getting ‘Special’ (Separate) SectionItems NOT Getting ‘Special’ (Separate) Section
Chapter 1-92
Illustration of “Unusual Gains & Losses”Illustration of “Unusual Gains & Losses”Illustration of “Unusual Gains & Losses”Illustration of “Unusual Gains & Losses”
Chapter 1-93
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
ACCOUNTING CHANGESACCOUNTING CHANGES(Covered in more detail in Ch. 22)(Covered in more detail in Ch. 22)
ACCOUNTING CHANGESACCOUNTING CHANGES(Covered in more detail in Ch. 22)(Covered in more detail in Ch. 22)
Chapter 1-94
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
ACCOUNTING CHANGES ACCOUNTING CHANGES ACCOUNTING CHANGES ACCOUNTING CHANGES
Chapter 1-95
Arcadia HS, purchased equipment for $510,000 which was Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value 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 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), 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 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.with a salvage value of $5,000 at the end of that time.
Questions:Questions: What is the journal entry to correct the prior years’ What is the journal entry to correct the prior years’
depreciation?depreciation?
Prepare the journal entry in 2010 to record depreciation. Prepare the journal entry in 2010 to record depreciation.
No Entry No Entry RequiredRequired
Change in Estimate – An IllustrationChange in Estimate – An IllustrationChange in Estimate – An IllustrationChange in Estimate – An Illustration
Chapter 1-96
EquipmenEquipmentt
$510,000$510,000Accumulated depreciationAccumulated depreciation 350,000350,000
$160,000$160,000
Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example After 7 yearsAfter 7 years
Equipment cost Equipment cost $510,000$510,000
Salvage valueSalvage value - 10,000 - 10,000
Depreciable baseDepreciable base 500,000500,000
Useful life (original)Useful life (original) 10 years 10 years
Annual depreciationAnnual depreciation $ 50,000 $ 50,000 x 7 years = x 7 years = $350,000$350,000
First, establish First, establish remaining remaining
depreciable depreciable amount at date of amount at date of
change in change in estimate.estimate.
First, establish First, establish remaining remaining
depreciable depreciable amount at date of amount at date of
change in change in estimate.estimate.
Revised salvage value (5,000)Remaining depreciable amount
$155,000
Chapter 1-97
Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example After 7 yearsAfter 7 years
Remaining depreciable base $Remaining depreciable base $155,000155,000
Divide by remaining life 8 Divide by remaining life 8 yearsyears
New depreciation New depreciation $ $ 19,37519,375
Depreciation Depreciation Expense Expense
calculation for calculation for 2010.2010.
Depreciation Depreciation Expense Expense
calculation for calculation for 2010.2010.
Depreciation expense 19,375
Accumulated depreciation 19,375
Journal entry for 2010
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?
Chapter 1-98
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
Accounting ChangesAccounting ChangesAccounting ChangesAccounting Changes
Chapter 1-99
In 2011, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2010. In 2011, Hillboro makes the following entry to correct for this error (ignore income taxes).
Correction of Errors -- IllustratedCorrection of Errors -- IllustratedCorrection of Errors -- IllustratedCorrection of Errors -- Illustrated
Retained earnings 100,000
Accounts receivable100,000
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.
Chapter 1-100
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
Intraperiod Tax AllocationIntraperiod Tax Allocation
Chapter 1-101
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.
Earnings Per Share (EPS)(Ch. 16 provides detail coverage of EPS)
Earnings Per Share (EPS)(Ch. 16 provides detail coverage of EPS)
Net income - Preferred dividends
Weighted average number of shares outstanding
Chapter 1-102
Calculating EPS--An ExampleCalculating EPS--An Example
Compute EPS for 2009Compute EPS for 2009
Net Income $1,357,000; $50,000 cash dividend paid on preferred stockNet Income $1,357,000; $50,000 cash dividend paid on preferred stock Shares of common stock:Shares of common stock:
Issued and outstanding on January 1, 2009 = 500,000 sharesIssued and outstanding on January 1, 2009 = 500,000 sharesApril 1, 2009 -- issued additional 48,000 shares at $72. per shareApril 1, 2009 -- issued additional 48,000 shares at $72. per shareOctober 1, 2009 – 52,800 shares October 1, 2009 – 52,800 shares reacquiredreacquired and retired at $65. per share and retired at $65. per share
Calculate denominator (the ‘weighted-average’ common shares outstanding):Calculate denominator (the ‘weighted-average’ common shares outstanding):
500,000 (500,000 X 12/12)500,000 (500,000 X 12/12) 36,000 (48,000 X 9/12)36,000 (48,000 X 9/12) (13,200) (13,200) (52,800 X 3/12)(52,800 X 3/12) 522,800 Weighted Average Common Shares Outstanding522,800 Weighted Average Common Shares Outstanding
Calculate earnings per share: Calculate earnings per share: $2.50 EPS$2.50 EPS ($1,357,000 Net Income minus $50,000 Preferred Dividend)($1,357,000 Net Income minus $50,000 Preferred Dividend)
522,800 Weighted Average Common Shares Outstanding522,800 Weighted Average Common Shares Outstanding
Chapter 1-103
EPS IllustrationEPS IllustrationEPS IllustrationEPS Illustration
Chapter 1-104
Woods, Inc.Statement of Retained Earnings
For the Year Ended December 31, 2011
Balance, January 1 1,050,000$ Prior period adjustment - error correction (50,000) Balance, January 1 (restated) 1,000,000 Net income 360,000 Dividends (300,000) Balance, December 31 1,060,000$
Chapter 4-49
Woods, Inc.Statement of Retained Earnings
For the Year Ended December 31, 2011
Balance, January 1, as previously reported 1,050,000$ Prior period adjustment - error correction* (50,000) *Balance, January 1, as restated 1,000,000 Net income 360,000 Dividends (300,000) Balance, December 31 1,060,000$ * The prior period adjustment would be 'net of tax'
I llustration of Retained Earnings StatementI llustration of Retained Earnings StatementI llustration of Retained Earnings Statement
Chapter 1-105
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
Retained EarningsRetained EarningsRetained EarningsRetained Earnings
Chapter 1-106
Comprehensive Income -- includes all changes ll changes
in stockholders’ equity during a period except those in stockholders’ equity during a period except those resulting from investments by owners and dividends resulting from investments by owners and dividends paid to stockholderspaid 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 IncomeComprehensive Income
Chapter 1-107
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 IncomeComprehensive IncomeComprehensive IncomeComprehensive Income
Chapter 1-108
Comprehensive Income--IllustratedComprehensive Income--Illustrated
Illustration 4-19
A “Second” separate
income statement
Chapter 1-109
V. Gill I nc.
Combined Statement of Comprehensive I ncome
For the Year Ended December 31, 2010
Sales revenue 800,000$
Cost of goods sold 600,000
Gross profi t 200,000
Operating expenses 90,000
Net income 110,000
Unrealized holding gain, net of tax 30,000
Comprehensive income 140,000$
Comprehensive IncomeComprehensive Income
Combined income
statement
Chapter 1-110
Comprehensive IncomeComprehensive Income
Include as part of Statement of Stockholder’s EquityIllustration 4-20
Chapter 1-111
Comprehensive IncomeComprehensive Income
Balance Sheet PresentationIllustration 4-21
The AThe Accumulated Other Comprehensive Income ccumulated Other Comprehensive Income of $90,000 is of $90,000 is reported in the stockholders’ equity section of the Balance reported in the stockholders’ equity section of the Balance Sheet.Sheet.
Chapter 1-112
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).
GAAP vs. IFRS Differences
Chapter 1-113
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 4Homework for Ch. 4
Class Assignment Questions--#16 (skip ‘d’), 21, Class Assignment Questions--#16 (skip ‘d’), 21, 22, 23, 30, 37 (pages 158-159)22, 23, 30, 37 (pages 158-159)
Homework: (pages 167 and 175)Homework: (pages 167 and 175)
Prob. 4-7Prob. 4-7
Professional Research Assignment--using Professional Research Assignment--using FASB CodificationFASB Codification
Chapter 1-114
C H A P T E R C H A P T E R 55
BALANCE SHEET AND BALANCE SHEET AND STATEMENT OF CASH FLOWSSTATEMENT OF CASH FLOWS
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-115
1.1. Explain the uses and limitations of a Balance Sheet.Explain the uses and limitations of a Balance Sheet.
2.2. Identify the elements appearing on a Balance Sheet.Identify the elements appearing on a Balance Sheet.
3.3. Prepare a “classified” Balance Sheet.Prepare a “classified” Balance Sheet.
4.4. Identify balance sheet items requiring “disclosure” and Identify balance sheet items requiring “disclosure” and
various ways the required disclosure can be various ways the required disclosure can be
accomplished.accomplished.
5.5. Indicate the purpose and content of the Statement of Indicate the purpose and content of the Statement of
Cash Flows.Cash Flows.
6.6. Prepare a simply Statement of Cash Flows (Chapter 23 will Prepare a simply Statement of Cash Flows (Chapter 23 will
provide extensive coverage of the preparation of the provide extensive coverage of the preparation of the
Statement of Cash Flows).Statement of Cash Flows).
Summary of Chapter 5Summary of Chapter 5Summary of Chapter 5Summary of Chapter 5
Chapter 1-116
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)
Balance SheetBalance SheetBalance SheetBalance Sheet
Usefulness of the Balance Sheet
Chapter 1-117
Most assets and liabilities are reported at historical cost.
Use of judgments and estimates.
Many items of financial value are omitted.
Limitations of the Balance Sheet
Balance SheetBalance SheetBalance SheetBalance Sheet
Chapter 1-118
Three General Classifications
Assets, Liabilities, and Stockholders’ Equity
Companies further divide these classifications:
Classification in the Balance Sheet
Balance SheetBalance SheetBalance SheetBalance Sheet
Chapter 1-119
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.
Current Assets
Balance SheetBalance SheetBalance SheetBalance Sheet
Chapter 1-120
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.
Cash & Cash Equivalents
Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”
Chapter 1-121
Portfolios
Short-Term Investments
Type Valuation Classification
Held-to-Maturity
DebtAmortized
CostCurrent or
Non-current*
TradingDebt or Equity
Fair Value Current
Available- for-Sale
Debt or Equity
Fair ValueCurrent or
Non-current*
Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”
*The “Held-to-Maturity” and “Available-for-Sale” could be either Current Assets OR Non-Current Assets depending on “Management’s Intent”
Chapter 1-122
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
Receivables
Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”
Chapter 1-123
Accounts Receivable – Presentation OptionsCurrent Assets:Current Assets:
Cash Cash $ 346$ 346
Accounts receivableAccounts receivable 500 500
Less allowance for doubtful accountsLess allowance for doubtful accounts 25 25 475 475
Inventory Inventory 812812
Total current assets Total current assets $1,633$1,633
Current Assets:Current Assets:
Cash Cash $ 346$ 346
Accounts receivable, Accounts receivable, net of $25 allowancenet of $25 allowance 475475
Inventory Inventory 812812
Total current assets Total current assets $1,633$1,633
11
22
Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”
Chapter 1-124
Inventories
Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”
Questions: 1.) What is the proper valuation for Inventories? Answer: Lower-of-cost-or-market (LCM) 2.) Any required disclosure related to valuation method?
Answer:
Method of determining cost (e.g., FIFO or LIFO).
Chapter 1-125
insuranceinsurance
suppliessupplies
Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE
rentrent
advertisingadvertising
Prepayments often occur in regard to:Prepayments often occur in regard to:
Prepaid Expenses
Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”
Question: How can Prepaid Expenses be classified as a current asset (they will not be converted into cash within the next year or operating cycle if longer)?
Answer: They will be ‘consumed’ within the next year and will NOT require reduction in cash since already ‘paid for’.
Chapter 1-126
Current Assets - “Summary”
Balance Sheet
Current assets
Cash 285,000$
Short-Term I nvestments 140,000
Accounts receivable 777,000
I nventory 402,000
Prepaid expenses 170,000
Total current assets 1,774,000
Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”Balance Sheet – “Current Assets”
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.
Chapter 1-127
Generally consists of four types:
SecuritiesSecurities – Available for Sale; Hold-to-Maturity Debt Securities
Land held for investment, Long-term Notes Receivable
Special funds (e.g. Bond Sinking Fund)Special funds (e.g. Bond Sinking Fund)
Nonconsolidated subsidiariesNonconsolidated subsidiaries or affiliated companies.
Long-Term Investments
Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”
Chapter 1-128
Nonconsolidated Subs, Affiliated Nonconsolidated Subs, Affiliated
CompaniesCompanies Nonconsolidated Subs, Affiliated Nonconsolidated Subs, Affiliated
CompaniesCompanies
Investments:
I nvesment in ABC bonds 321,657 *
I nvestment in UC I nc. 253,980 *
Notes receivable 150,000
Land held f or speculation 550,000
Sinking f und 225,000
Pension f und 653,798
Cash surrender value 84,321
I nvestment in Uncon. Sub. 457,836
Total investments 2,696,592
Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”
Long-Term Investments
Special FundsSpecial Funds
Long-term Notes Receivable and Land Long-term Notes Receivable and Land held for Speculationheld for Speculation
Investments in bonds and stocks*Investments in bonds and stocks*
*“Held-to-Maturity” and “Available-for-Sale” Investments could be either Current Assets OR Long-Term Assets depending on “Management’s Intent”
Chapter 1-129
Property, Plant, and Equipment
Property, Plant, and Equip.
Building 1,375,778
Land 975,000
Machinery and equipment234,958
Capital leases 384,650
Leasehold improvements 175,000
Accumulated depreciation(975,000)
Total PP&E 2,170,386
Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”
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!
Chapter 1-130
Intangibles
Intangibles
Goodwill 2,000,000
Patents 177,000
Trademark 40,000
Franchises 125,000
Copyright 55,000
Total intangibles 2,397,000
Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”
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.
IFRS Valuation = Choice of Amortized Cost or FMV!
Chapter 1-131
Other Assets
Other assets
Prepaid pension costs 133,000
Def erred income tax 40,000
Total other 173,000
Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent Assets”Balance Sheet – “Noncurrent 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.
Chapter 1-132
“Obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities.”
Balance Sheet – “Current Liabilities”Balance Sheet – “Current Liabilities”Balance Sheet – “Current Liabilities”Balance Sheet – “Current Liabilities”
Current Liabilities
Notes payable* 233,450$
Accounts payable 131,800
Salaries payable 43,000
Unearned revenue 17,000
I ncome tax payable 23,400
Current maturities LT debt 121,000
Total current liabilities 569,650
* To be classified as a Current Liability, the Note Payable must be due within one year or operating cycle whichever is longer
Chapter 1-133
Balance Sheet – “Long-Term Liabilities”Balance Sheet – “Long-Term Liabilities”Balance Sheet – “Long-Term Liabilities”Balance Sheet – “Long-Term Liabilities”
Long- term liabilities
Long-term debt 979,500
Obligations capital lease 345,800
Def erred income taxes 77,909
Total long-term liabilities 1,403,209 Stockholders' equity
“Obligations that a company does not reasonably expect to liquidate within one year or the normal operating cycle whichever is longer.”
Long-Term Liabilities
All covenants and restrictions must be disclosed.
Chapter 1-134
Three parts, (1) Capital Stock,
(2) Additional Paid-In Capital, and
(3) Retained Earnings.
Balance Sheet – “Stockholders’ Equity”Balance Sheet – “Stockholders’ Equity”Balance Sheet – “Stockholders’ Equity”Balance Sheet – “Stockholders’ Equity”
Stockholders’ Equity
Chapter 1-135
Balance Sheet - FormatBalance Sheet - FormatBalance Sheet - FormatBalance Sheet - Format
Account Form
Chapter 1-136 LO 3LO 3
Report Form
Chapter 1-137
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
Ways to Accomplish Required DisclosureWays to Accomplish Required DisclosureWays to Accomplish Required DisclosureWays to Accomplish Required Disclosure
Chapter 1-138
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:
1. Where did the cash come from?
2. What was the cash used for?
3. What was the change in the cash balance?
Purpose of the Statement of Cash Flows
The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows
Chapter 1-139
Three different activities:
Operating,
Content and Format
The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows
Investing, Financing
Chapter 1-140
Three Categories of Cash Flows
The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows
OperatingOperatingOperatingOperating
Cash inflows and outflows from “day-in, day-out” normal operations.
InvestingInvesting**InvestingInvesting**
Cash inflows and outflows from purchase and later sale of non-current assets.
FinancingFinancingFinancingFinancing
Cash inflows and outflows from non-current liabilities and equity.
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.
*Investing activities is the investing activities of the COMPANY (NOT the Stockholders)
Chapter 1-141
The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows
IFRS classifies some cash flows differently than GAAP (we’ll look at the differences in Intermediate II)
Chapter 1-142
(1) comparative balance sheets,
(2) the current income statement, and
(3) selected transaction data.
Information Needed:
The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows
Class Problem on next page.
“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
Chapter 1-143
Information for Class ProblemInformation for Class Problem Paradise Consulting Company Paradise Consulting Company
Link to Solution for Ch. 5 Class Problem
Assets Dec. 31, 2010 Dec. 31, 2009 Inc. or (Dec.) Cash 22,000$ 13,000$ 9,000$ Accounts Receivable 106,000 88,000 18,000 Office Equipment 37,000 22,000 15,000 Accum. Depr. (17,000) (11,000) 6,000
Total Assets 148,000$ 112,000$
Liabilities and S.E. Salaries Payable 20,000$ 15,000$ 5,000$ Common Stock 100,000 80,000 20,000 Retained Earnings 28,000 17,000 11,000
Total Liabilities & S. E. 148,000$ 112,000$
Consulting Fees Earned 108,000$ Expenses: Salaries Expense 68,000$ Depreciation Expense 6,000 74,000
Net Income 34,000$
New office equipment was purchasde in 2010; none was soldDividends were paid in 2010
PREPARE THE STATEMENT OF CASH FLOWS
Income Statement for 2010
Chapter 1-144
Issuance of common stock to purchase assets.
Conversion of bonds into common stock.
Issuance of debt to purchase assets.
The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows
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:
Significant Noncash Activities
Chapter 1-145
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.
Usefulness of the Statement of Cash FlowsUsefulness of the Statement of Cash FlowsUsefulness of the Statement of Cash FlowsUsefulness of the Statement of Cash Flows
Without cash, a company will not survive.
Cash flow from Operations:
Would you lend money to the company?
Would you buy the new issue of equity securities?
Chapter 1-146
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.
Chapter 1-147
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Ratio indicates whether the company can pay off its current liabilities from its operations. A ratio near 1:1 is good.
Financial Liquidity
Net Cash Provided by Operating Activities
Average Current Liabilities
Current Cash to
Debt Coverage
Ratio
=
Chapter 1-148
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
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.
Financial Flexibility
Net Cash Provided by Operating Activities
Average Total Liabilities
Cash Debt Coverage
Ratio
=
What is going to happen to the company if it has to ‘liquidate its assets to repay its liabilities?
Chapter 1-149
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
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.
Free Cash Flow
Chapter 1-150
Ratio Analysis -- Rate of Return on AssetsRatio Analysis -- Rate of Return on AssetsRatio Analysis -- Rate of Return on AssetsRatio Analysis -- Rate of Return on Assets
Rate of Return on AssetsRate of Return on Assets measures a firm’s success in using assets measures a firm’s success in using assets to generate earnings. It is calculated based on dollar amounts from the to generate earnings. It is calculated based on dollar amounts from the Income Statement (CH. 4) and the Balance Sheet (this chapter).Income Statement (CH. 4) and the Balance Sheet (this chapter).
Rate of Return on Assets Rate of Return on Assets ==
Rate of Return on Assets Rate of Return on Assets ==
Rate of Return on Assets = 6.4% (Is 6.4% ‘good’? Compare it to Rate of Return on Assets = 6.4% (Is 6.4% ‘good’? Compare it to what?)what?)
Net IncomeNet Income Average Total AssetsAverage Total Assets
$51.6$51.6 $812.7 + 791.6 / 2$812.7 + 791.6 / 2
Chapter 1-151
The analyst obtains further insight into the behavior of The analyst obtains further insight into the behavior of Return of Assets by Return of Assets by disaggregatingdisaggregating it into components it into components of profit margin on sales and asset turnover as follows:of profit margin on sales and asset turnover as follows:
Net Income
Average Total Assets
Rate of Return on Assets
=
Net Income
Net Sales
Profit Margin on Sales
=
Net Sales
Asset Turnover
x
x Average Total Assets
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
“Pennies of profit on each dollar of
sales”
Grocery store vs. Fur salon
Ability to generate sales revenue
from use of assets
Grocery store vs. Fur Salon
Chapter 1-152
$64.2
($811.8 + 665.3) / 2
Rate of Return on Assets
=
$64.2
$420.1
Profit Margin on Sales
=
$420.1
Asset Turnover
x
x
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
8.7% 15.28% =
x
.569
($811.8 + 665.3) / 2
The analyst obtains further insight into the behavior of The analyst obtains further insight into the behavior of ROA by ROA by disaggregatingdisaggregating it into components of profit it into components of profit margin on sales and asset turnover as follows:margin on sales and asset turnover as follows:
Chapter 1-153
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 5Homework for Ch. 5
Class Assignment Questions #2, 6, 7, 21, 22, Class Assignment Questions #2, 6, 7, 21, 22, 28, 32, 36 (pages 239-241)28, 32, 36 (pages 239-241)
Homework: (pages 239-250)Homework: (pages 239-250)
CE 5-4 CE 5-4
Ex. 5-15Ex. 5-15
Prob. 5-1Prob. 5-1
Chapter 1-154
C H A P T E R C H A P T E R 66
ACCOUNTING AND THE ACCOUNTING AND THE
TIME VALUE OF MONEYTIME VALUE OF MONEY
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-155
1.1. Distinguish between simple and compound interest.Distinguish between simple and compound interest.
2.2. Use appropriate compound interest tables.Use appropriate compound interest tables.
3.3. Identify the ‘variables’ needed to solve time-value-of-money Identify the ‘variables’ needed to solve time-value-of-money problems.problems.
4.4. Draw Time-Line DiagramsDraw Time-Line Diagrams
5.5. Solve future and present value of single amount problems.Solve future and present value of single amount problems.
6.6. Solve future value of ordinary annuity problems.Solve future value of ordinary annuity problems.
7.7. Solve present value of ordinary and annuity due problems.Solve present value of ordinary and annuity due problems.
8.8. Calculate issuance price of bonds, prepare amortization Calculate issuance price of bonds, prepare amortization schedule, and record related journal entries.schedule, and record related journal entries.
Summary of Chapter 6Summary of Chapter 6Summary of Chapter 6Summary of Chapter 6
Chapter 1-156
Simple InterestSimple Interestvs.vs.
Compound InterestCompound Interest
Simple InterestSimple Interest Compound Interest• computed by adding
the interest earned in one period to the amount on which interest is computed in future periods
• principal sum stays the same from period to period
Chapter 1-157
Simple Interest IllustratedSimple 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?
Time Rate Principal Interest Simple
yearsX 3360
360
100
8 $10,000
The total that Marshall will receive is $12,400.($10,000.00 principal + $2,400. SIMPLE interest)
$800 times 3 years = $2,400 total interest
Chapter 1-158
Compound Interest IllustratedCompound 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?
The total that Sanchez will receive is $12,597.($10,000. principal + $2,597. COMPOUND interest)
Beginning "Compound
Year Investment Interest Earned" "Ending Investment"
1 $10,000 $ 800 $10,800
2 10,800 864 11,664
3 11,664 933 12,597
Most business situations use Compound Interest
Chapter 1-159
Time Value of MoneyTime Value of Money
1.) Two slides illustrating the IMPACT of time 1.) Two slides illustrating the IMPACT of time value of money in “value of money in “Investing for Investing for RetirementRetirement” situations” situations
2.) “Let’s Make a Deal” (Illustration of 2.) “Let’s Make a Deal” (Illustration of importance of considering TIMING of cash importance of considering TIMING of cash flow, not just dollar amount of cash flow)flow, not just dollar amount of cash flow)
3.) “Time-line diagrams” and my ‘formula’3.) “Time-line diagrams” and my ‘formula’ slides for time-value-of-moneyslides for time-value-of-money
Chapter 1-160
Example #1—Investing for RetirementExample #1—Investing for Retirement
If you invest $10,000 TODAY to earn interest If you invest $10,000 TODAY to earn interest at 20% compound annual interest rate, at 20% compound annual interest rate, what total dollar amount will you have what total dollar amount will you have when you are ready to retire 30 YEARS when you are ready to retire 30 YEARS FROM NOW?FROM NOW?
Answer = Answer = $2,373,763.
Chapter 1-161
Example #2—Investing for RetirementExample #2—Investing for Retirement
If you invest $200 per month starting today (at If you invest $200 per month starting today (at age 45), that earns 20% compounded age 45), that earns 20% compounded annually, you would have invested a total of annually, you would have invested a total of $48,000 by age 65. At 65, when you retire, $48,000 by age 65. At 65, when you retire, you would have $494,402. you would have $494,402.
If you had started saving $200 per month at If you had started saving $200 per month at age 40 (and thus invested $12,000 extra over age 40 (and thus invested $12,000 extra over those 5 years), how much would you have at those 5 years), how much would you have at age 65?age 65?
Answer = Answer = $1,249,278
Quote from Albert Einstein:
“The most awesome power of the universe is that
of COMPOUND INTEREST”
Chapter 1-162
(I’ll tell you what’s behind each of the three (I’ll tell you what’s behind each of the three doors before you have to pick!)doors before you have to pick!)
Let’s Make a DealLet’s Make a Deal
Chapter 1-163
DOOR # 1DOOR # 1
TODAY, I’LL GIVE YOU $10. TODAY, I’LL GIVE YOU $10.
Chapter 1-164
DOOR #2DOOR #2
THREE YEARS FROM TODAY, I PROMISE TO THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $10. GIVE YOU $10.
Chapter 1-165
DOOR #3DOOR #3
THREE YEARS FROM TODAY, I PROMISE TO THREE YEARS FROM TODAY, I PROMISE TO GIVE YOU $12.60.GIVE YOU $12.60.
Chapter 1-166
SUMMARYSUMMARY
DOOR #1 = TODAY GET $10.DOOR #1 = TODAY GET $10. DOOR #2 = GET PROMISE OF $10 TO BE DOOR #2 = GET PROMISE OF $10 TO BE
RECEIVED 3 YEARS FROM NOWRECEIVED 3 YEARS FROM NOW DOOR #3 = GET PROMISE OF $12.60 TO BE DOOR #3 = GET PROMISE OF $12.60 TO BE
RECEIVED 3 YEARS FROM NOWRECEIVED 3 YEARS FROM NOW
Which Door “Don’t” You Want? WHY?Which Door “Don’t” You Want? WHY?
Assuming 8% COMPOUND, annual interest; do you Assuming 8% COMPOUND, annual interest; do you want Door #1 OR Door #3?want Door #1 OR Door #3?
Chapter 1-167
Three Components of Interest:
“Pure” Rate of Return
Expected Inflation Rate
Credit Risk Rate
Choosing an Appropriate Interest RateChoosing an Appropriate Interest Rate
Chapter 1-168
1.) 1.) Future ValueFuture Value of of ((Single Present AmountSingle Present Amount))
• Now 1 2 3Now 1 2 3
• $10. ?$10. ?
F = P (Factor: n=3, i (8%), Table 6-1 on page 309)F = P (Factor: n=3, i (8%), Table 6-1 on page 309)
F = $10. (1.25971)F = $10. (1.25971)
F = $12.60F = $12.60
YOU DO NOT HAVE TO USE THE FORMULAS IN THE TEXTBOOK, YOU DO NOT HAVE TO USE THE FORMULAS IN THE TEXTBOOK, YOU CAN USE ‘MY FORMULAS’ IF YOU WISH!!!YOU CAN USE ‘MY FORMULAS’ IF YOU WISH!!!
Chapter 1-169
Time Periods (‘n’ rows) and Interest Rate Column (‘i)Time Periods (‘n’ rows) and Interest Rate Column (‘i)
• When using tables, the left-hand column refers to When using tables, the left-hand column refers to the number of interest compounding periods (n)the number of interest compounding periods (n)
• The columns on the tables are the interest rate per The columns on the tables are the interest rate per compounding period (i)compounding period (i)• Interest can, of course, be paid on a quarterly or Interest can, of course, be paid on a quarterly or
semiannual basis semiannual basis • To use the tables in these cases, it is necessary to:To use the tables in these cases, it is necessary to:
• (a) divide the annual interest rate by the number of (a) divide the annual interest rate by the number of compounding periods in the year to find the compounding periods in the year to find the appropriate interest rate column (i)appropriate interest rate column (i)
• (b) multiply the number of compound interest periods (b) multiply the number of compound interest periods in one year by the number of yearsin one year by the number of years to find (n) to find (n)
Chapter 1-170
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?
The company will have $1,082,430 at the end of the year.
Example ofExample of Future Value Future Value ofof(Single Present Amount)(Single Present Amount)
Put “time-line diagram” on the board.
F = P (factor, n = 4; i=2%; Table 6-1 page 308))
F = $1,000,000 times 1.08243
F = $1,082,430
Chapter 1-171
2.) 2.) Present ValuePresent Value of of ((Single Future AmountSingle Future Amount))
•
• Now 1 2 3Now 1 2 3• ? $12.60? $12.60
P = F (Factor: n=3; i (8%); Table 6-2 on page 311)P = F (Factor: n=3; i (8%); Table 6-2 on page 311)
P = $12.60 (.79383)P = $12.60 (.79383)
P = $10.P = $10.
Chapter 1-172
Example of aExample of a Present ValuePresent Value ofof(Single Future Amount)(Single Future Amount)
Don Smith wants to have $2,000 at the end of three Don Smith wants to have $2,000 at the end of three years. How much must he invest today in a 5 years. How much must he invest today in a 5 percent investment (annual compound interest) to percent investment (annual compound interest) to achieve this goal? 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 .86384
P = $1,728
Don must invest $1,728 today to have the $2,000 he will need at the end of three years.
Chapter 1-173
AnnuitiesAnnuitiesAnnuitiesAnnuities
(1) Periodic payments or receipts (called rents) of the same amount each period,
(2) Same-length interval between such rents, and
(3) Same interest rate applies to all the rents.
Annuity requires:
Ordinary annuity - rents occur at the end of each period.
Annuity Due - rents occur at the beginning of each period.
Two Type
s
Chapter 1-174
3.) 3.) Future ValueFuture Value of anof an ““Ordinary”Ordinary” AnnuityAnnuity
• Now 1 2 3Now 1 2 3
• $10 $10 $10$10 $10 $10• ??• FFa = A (Factor: n=3; i (8%); Table 6-3 on page 313)a = A (Factor: n=3; i (8%); Table 6-3 on page 313)
Fa = $10 (3.24640)Fa = $10 (3.24640)
Fa = $32.46Fa = $32.46
Chapter 1-175
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.
Fa = A (factor, n=5; i=8%; Table 6-3, Page 313)
The required annual payment to the fund is $1,705.
Example ofExample of Future ValueFuture Value of anof an ““Ordinary Annuity”Ordinary Annuity”
$10,000 = A (5.86660)
A = $10,000/5.86660 = $1,705
Put “time-line diagram” on the board
Chapter 1-176
4.) 4.) Present ValuePresent Value of an of an ““Ordinary”Ordinary” AnnuityAnnuity
• Now 1 2 3Now 1 2 3
• ? $10 $10 $10? $10 $10 $10
Pa = A (Factor: n = 3; i (8%), Table 6-4 on page 315)Pa = A (Factor: n = 3; i (8%), Table 6-4 on page 315)
Pa = $10 (2.57710)Pa = $10 (2.57710)
Pa = $25.77Pa = $25.77
Chapter 1-177
Example ofExample of Present ValuePresent Valueof anof an “ “Ordinary Annuity”Ordinary Annuity”
Cathy Crosby sold a piece of property and is to receive Cathy Crosby sold a piece of property and is to receive three equal annual payments of $5,000 beginning one three equal annual payments of $5,000 beginning one year from today. What is the present value of this sale if year from today. What is the present value of this sale if the current interest rate is 4 percent, compounded the current interest rate is 4 percent, compounded annually? annually?
The present value of the $5,000 annuity stream is $13,875
Put “time-line diagram” on the board
Pa = A (factor, n=3; i=4%; Table 6-4 on page 314)
Pa = $5,000 times 2.77509
Pa = $13,875
Chapter 1-178
5.) 5.) Present ValuePresent Value of an of an “Annuity Due”“Annuity Due”
Periodic rents occur at the BEGINNING of the period.
Now 1 2 3Now 1 2 3• $10 $10 $10$10 $10 $10• ??
Pad = A (Factor: n = 3; i (8%), Table 6-5 on page 317)Pad = A (Factor: n = 3; i (8%), Table 6-5 on page 317)
Pad = $10 (2.78326)Pad = $10 (2.78326)
Pad = $27.83Pad = $27.83
Chapter 1-179
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?
Example ofExample of Present ValuePresent Value of an of an “Annuity Due”“Annuity Due”
Example ofExample of Present ValuePresent Value of an of an “Annuity Due”“Annuity Due”
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 3.44371
Pad = $16,529,808
The present value of the $4.8 million annuity stream is $16,529,808
Chapter 1-180
Rents begin after a specified number of periods.
Deferred AnnuitiesDeferred AnnuitiesDeferred AnnuitiesDeferred Annuities
0 1 2 3 4 19 20
100,000
100,000
100,000. . . . .
Future ValuePresent Value
-You are NOT Responsible for Deferred Annuities
Chapter 1-181
Bond Certificateat Face (“Maturity”) Value
Bond Certificateat Face (“Maturity”) Value
Bond Issue Date
Bond Selling Price (CASH)
Corporation Bond Investors
Bonds Payable Liability--Bonds Payable Liability--Issue DateIssue Date
Chapter 1-182
Bond Issue Date
Bond Interest Payments (CASH)
Bond Interest PaymentsCorporation Investors
Cash Interest Payment = Principal × Cash Interest Rate ×
Time
Cash Interest Payment = Principal × Cash Interest Rate ×
Time
Bonds Payable--Bonds Payable--Interest PaymentsInterest Payments
Chapter 1-183
Bond Issue Date
Bond Face Value (CASH)
at Maturity Date
Bond Maturity
Date
Corporation Investors
Bonds Payable--Bonds Payable--Maturity DateMaturity Date
Chapter 1-184
Selling Price of Bonds PayableSelling Price of Bonds Payable
The selling price of a bond is determined by the The selling price of a bond is determined by the “market” based on the “market” based on the time value of moneytime value of money..
Two Cash Flows to be paid:Two Cash Flows to be paid: $12,000 annual cash interest payments$12,000 annual cash interest payments $200,000 cash payment at maturity$200,000 cash payment at maturitytoday 1 2 3……….10 today 1 2 3……….10
interest payments .
$12,000 $12,000 $12,000.........$12,000
$ ?$200,000 Principal Payment Selling
Price = $?
Chapter 1-185
Illustration--Bonds Payable Issued at “Discount”Illustration--Bonds Payable Issued at “Discount”
XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The bonds XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The bonds pay interest annually on December 31. The market rate of interest on 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.bonds of a similar default risk is 10% on the date the bonds are issued.
Requirements:Requirements:1.) Calculate the issuance (selling price) of the bonds:1.) Calculate the issuance (selling price) of the bonds:
a.) Using ‘formulas’a.) Using ‘formulas’b.) Using “PV” function in Excelb.) Using “PV” function in Excel
2.) Prepare an amortization table for the 10 interest payments 2.) Prepare an amortization table for the 10 interest payments
3. Prepare the required "journal entry" to record:3. Prepare the required "journal entry" to record: a.) The issuance of the bonds payable on January 2, 2008a.) The issuance of the bonds payable on January 2, 2008 b.) The first annual interest payment on Dec. 31, 2008 (USING THEb.) The first annual interest payment on Dec. 31, 2008 (USING THE EFFECTIVE INTEREST METHOD—EFFECTIVE INTEREST METHOD—NOTNOT STRAIGHT LINESTRAIGHT LINE----
TO TO AMORTIZE THE BOND DISCOUNT)AMORTIZE THE BOND DISCOUNT) c.) The retirement of the bonds on the maturity datec.) The retirement of the bonds on the maturity date
LinkLink to Excel worksheet with Solutions to Class Problem to Excel worksheet with Solutions to Class Problem
Chapter 1-186
Future value of a Future value of a single present single present amountamount
Present value of a Present value of a single future amountsingle future amount
Solving for other Solving for other unknowns (i.e., ‘n’ the unknowns (i.e., ‘n’ the number of interest number of interest periods and ‘i’ the periods and ‘i’ the interest rate per interest rate per interest period)interest period)
Single Dollar Single Dollar AmountsAmounts AnnuitiesAnnuities
Future value of Future value of ordinaryordinary annuity annuity
Future value of Future value of annuity dueannuity due* (NOT * (NOT Responsible for this one)Responsible for this one)
Present value of Present value of ordinaryordinary annuity annuity
Present value of Present value of annuity dueannuity due
Solving for other unknowns (i.e., Solving for other unknowns (i.e., ‘n’ the number of interest periods; ‘n’ the number of interest periods; ‘i’ the interest rate per interest ‘i’ the interest rate per interest period); ‘A’ the annuity amount)period); ‘A’ the annuity amount)
* * Your textbook does NOT provide a Your textbook does NOT provide a Table for Future Value of an Table for Future Value of an Annuity Due (and we are NOT Annuity Due (and we are NOT going to create the Table)going to create the Table)
Summary of Time Value of Money Situations You Summary of Time Value of Money Situations You Are Responsible ForAre Responsible For
Summary of Time Value of Money Situations You Summary of Time Value of Money Situations You Are Responsible ForAre Responsible For
Chapter 1-187
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.
Deferred Annuities(That You are NOT Responsible For)(That You are NOT Responsible For)
Deferred Annuities(That You are NOT Responsible For)(That You are NOT Responsible For)
0 1 2 3 4 19 20
100,000
100,000
100,000. . . . .
Future ValuePresent Value
Chapter 1-188
Class Assignment Review Questions and Homework Class Assignment Review Questions and Homework for Ch. 6for Ch. 6
Class Assignment Questions #3, 4, 6, 9, 17 Class Assignment Questions #3, 4, 6, 9, 17 (skip ‘b’), 18 (page 295)(skip ‘b’), 18 (page 295)
Homework: (pages 297-301)Homework: (pages 297-301)
Ex. 3; Prob. 2 (skip ‘b’); and Ex. 3; Prob. 2 (skip ‘b’); and
Proprietary Problem on next slide (similar to Proprietary Problem on next slide (similar to class problem--BUT Market interest rate on class problem--BUT Market interest rate on date bonds were issued for the homework is date bonds were issued for the homework is 4%)4%)
Chapter 1-189
Proprietary Ch. 6 Homework ProblemProprietary Ch. 6 Homework Problem
XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The XYZ Co. issues $200,000 of 6%, 10-year bonds on January 2, 2008. The bonds pay interest annually on December 31. The market rate of bonds pay interest annually on December 31. The market rate of interest on bonds of a similar default risk is interest on bonds of a similar default risk is 4%4% on the date the on the date the bonds are issued.bonds are issued.
Requirements:Requirements:1.) Calculate the issuance (selling price) of the bonds:1.) Calculate the issuance (selling price) of the bonds:
a.) Using ‘formulas’a.) Using ‘formulas’b.) Using “PV” function in Excelb.) Using “PV” function in Excel
2.) Prepare an amortization table for the 10 interest payments 2.) Prepare an amortization table for the 10 interest payments
3. Prepare the required "journal entry" to record:3. Prepare the required "journal entry" to record: a.) The issuance of the bonds payable on January 2, 2008a.) The issuance of the bonds payable on January 2, 2008 b.) The first annual interest payment on Dec. 31, 2008 (USING THE b.) The first annual interest payment on Dec. 31, 2008 (USING THE EFFECTIVE INTEREST METHOD—EFFECTIVE INTEREST METHOD—NOTNOT STRAIGHT LINESTRAIGHT LINE--TO --TO AMORTIZE THE BOND PREMIUM)AMORTIZE THE BOND PREMIUM) c.) The retirement of the bonds on the maturity datec.) The retirement of the bonds on the maturity date
Chapter 1-190
C H A P T E R C H A P T E R 77
CASH AND RECEIVABLESCASH AND RECEIVABLES
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-191
What is cash?What is cash?
Reporting cashReporting cash
Petty cash fund Petty cash fund
Bank reconciliationBank reconciliation
CashCash ReceivablesReceivables
Recognition and Recognition and valuation of accounts valuation of accounts receivablereceivable
Recognition and Recognition and valuation of notes valuation of notes receivablereceivable
Disposition of accounts Disposition of accounts and notes receivableand notes receivable
Ratio analysisRatio analysis
Impairment of long-term Impairment of long-term receivable (loans) receivable (loans)
Cash and Receivables -- Summary of Chapter 7Cash and Receivables -- Summary of Chapter 7Cash and Receivables -- Summary of Chapter 7Cash and Receivables -- Summary of Chapter 7
Chapter 1-192
What about ‘posted-dated checks’, IOUs, postage stamps--are they included in Cash?
What is Cash?What is Cash?What is Cash?What is Cash?
Cash Examples: coins, currency, checking accounts, money orders, certified checks, cashier’s checks, personal checks, and savings accounts.
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!
Chapter 1-193
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’.
Reporting CashReporting CashReporting CashReporting Cash
Restricted Cash
Bank OverdraftsWhen 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.
Chapter 1-194
Used to pay small amounts for miscellaneous expenses.
The Imprest Petty Cash System (part of The Imprest Petty Cash System (part of Internal Control System over Cash)Internal Control System over Cash)
1. Record $300 transfer of funds to petty cash to establish the petty cash fund:
Petty Cash 300
Cash 300
2. 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.
Chapter 1-195
The Imprest Petty Cash System The Imprest Petty Cash System (Continued)(Continued)
Office Supplies Expense 42
Postage Expense 53
Entertainment Expense 76
Cash Over and Short 2
Cash 173
3. Custodian receives a company check to replenish the fund.
IF material--adjusting entry needed at end of accounting period for any unreplenished disbursements in the petty cash fund.
Chapter 1-196
Bank Bank ReconciliationReconciliation
Schedule explaining any differences between the bank’s and the company’s records of cash.
Reconciling Items:
1. Deposits in transit.
2. Outstanding checks.
3. Bank charges and credits.
4. 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
Chapter 1-197
Bank Reconciliation -- Example Bank Reconciliation -- Example (Also journal entries based on (Also journal entries based on
completed reconciliation)completed reconciliation)
Chapter 1-198
Completed Bank ReconciliationCompleted Bank Reconciliation
Chapter 1-199
Cash 780Nov. 30
Bank service charge expense 18
Accounts receivable 220
Accounts payable
180
Interest revenue
600
Journal Entries for Bank Reconciliation ExampleJournal Entries for Bank Reconciliation Example
Cash 238
Chapter 1-200
ReceivablesReceivablesReceivablesReceivables
Written promises to pay a sum of money on a specified future date.
Claims held against customers and others for money, goods, or services.
Oral promises of the customer to pay for goods and services
sold.Accounts Accounts
Receivable Receivable (aka.“Trade (aka.“Trade Receivable”)Receivable”)
Accounts Accounts Receivable Receivable (aka.“Trade (aka.“Trade Receivable”)Receivable”)
Notes Notes ReceivableReceivable
Notes Notes ReceivableReceivable
Chapter 1-201
Non-tradeNon-trade Receivables (i.e., Misc. Receivables)1. Advances to officers and employees.
2. Advances to subsidiaries.3. Deposits to cover potential damages or losses.4. Deposits as a guarantee of performance or payment.5. Dividends and interest receivable.6. Claims against:
a) Insurance companies for casualties sustained.b) Defendants under suit.c) Governmental bodies for tax refunds.d) Common carriers for damaged or lost goods.e) Creditors for returned, damaged, or lost goods.f) Customers for returnable items (crates, containers,
etc.).
ReceivablesReceivablesReceivablesReceivables
Chapter 1-202
Accounts ReceivablesAccounts ReceivablesAccounts ReceivablesAccounts Receivables
““Trade Discounts”Trade Discounts”
Reductions from the list price
Not recognized in the accounting records
Customers are billed net of trade discounts
““Trade Discounts”Trade Discounts”
Reductions from the list price
Not recognized in the accounting records
Customers are billed net of trade discounts
10 % Discount
for Wholesale
rs
Chapter 1-203
Accounts ReceivablesAccounts ReceivablesAccounts ReceivablesAccounts Receivables
““Cash DiscountsCash Discounts””
(aka. Sales Discounts)(aka. Sales Discounts)
Inducements for prompt Inducements for prompt paymentpayment
““Cash DiscountsCash Discounts””
(aka. Sales Discounts)(aka. Sales Discounts)
Inducements for prompt Inducements for prompt paymentpayment 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?
Chapter 1-204
GAAP specifically excludes from present value considerations “receivables arising from transactions with customers in the normal courseof business which are due in customary trade terms not exceeding approximately one year.”
Non-recognition of Interest on Accounts Receivable
Accounts ReceivablesAccounts ReceivablesAccounts ReceivablesAccounts Receivables
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”)
Chapter 1-205
Current Assets:
Cash 346$
Accounts receivable 500 Less: Allowance for doubtful accounts (25) 475
Inventory 812
Prepaids 40
Total current assets 1,673
Fixed Assets:
Office equipment 5,679
Furniture & fixtures 6,600
Less: Accumulated depreciation (3,735)
Total fixed assets 8,544 Total Assets 10,217$
Assets
Accounts ReceivableAccounts ReceivableAccounts ReceivableAccounts Receivable
What is the NRV of the accounts receivable on the partial Balance Sheet above?
Chapter 1-206
Allowance MethodAllowance Method
Losses are Estimated:Percentage-of-sales (aka. “income statement approach”)Percentage-of-receivables/”aging” (aka. “balance sheet approach”)GAAP
Methods of Accounting for Uncollectible Accounts
Direct Write-OffDirect Write-OffTheoretically undesirable:
No matchingReceivable not stated at net realizable valueNot GAAP
Valuation of Accounts ReceivableValuation of Accounts ReceivableValuation of Accounts ReceivableValuation of Accounts Receivable
Chapter 1-207
Percentage of Sales (income statement approach):
Summary
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.
Uncollectible Accounts ReceivableUncollectible Accounts ReceivableUncollectible Accounts ReceivableUncollectible Accounts Receivable
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.
Chapter 1-208
Class ExampleClass Example
The Ex., Why, Zee Company began operations on Jan. 1, The Ex., Why, Zee Company began operations on Jan. 1, 2008.2008.
Record journal entries for the following:Record journal entries for the following: MonthlyMonthly sales on account of $20,000 sales on account of $20,000 MonthlyMonthly estimated bad debts of 1% of sales on account estimated bad debts of 1% of sales on account Write off of John Jones’s individual account receivable for Write off of John Jones’s individual account receivable for
$150 when it ultimately proves uncollectible.$150 when it ultimately proves uncollectible. Write off of Janice Smith’s individual account receivable for Write off of Janice Smith’s individual account receivable for
$280 when it ultimately proves uncollectible$280 when it ultimately proves uncollectible Unexpectantly recover the amount due from Mr. Jones when he Unexpectantly recover the amount due from Mr. Jones when he
sends to Ex., Why, Zee Company a check for $150.sends to Ex., Why, Zee Company a check for $150. Collect $175,000 of Accounts Receivable (in addition to the Collect $175,000 of Accounts Receivable (in addition to the
above $150 from Mr. Jones)above $150 from Mr. Jones) At December 31, 2008 year-end, the adjusting entry to revise At December 31, 2008 year-end, the adjusting entry to revise
Allowance account to the current estimated balance of $1,400.Allowance account to the current estimated balance of $1,400.
LinkLink to the Solution for Bad Debt Accounting to the Solution for Bad Debt Accounting
Chapter 1-209
Recording of Recording of NotesNotes Receivable ReceivableRecording of Recording of NotesNotes Receivable Receivable
Short-Term Note
Long-Term
Record at Face Value, set up Allowance
Record at Present Value*of cash expected to be
collectedInterest Rates
Stated cash interest rate = Market rate
Stated rate interest rate > Market rate
Stated rate interest rate < Market
rate
Note Issued at
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
Chapter 1-210
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?
Non (or Zero)-Interest-Bearing NoteNon (or Zero)-Interest-Bearing NoteNon (or Zero)-Interest-Bearing NoteNon (or Zero)-Interest-Bearing Note
0 1 3 3
$0 $0 Interest$0
$10,000 Principal
i = 9%
n = 3
Chapter 1-211
P = F (factor)P = $10,000 x .77218P = $7,721.80
Zero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing Note
PV of Principal
Chapter 1-212
Journal Entries for Zero-Interest-Bearing note
Present value of expected future cash flows ($10,000. principal and zero interest) = $7,721.80
Date Account Title Debit Credit
J an. yr. 1 Notes receivable 10,000.00
Discount on notes receivable 2,278.20
Cash 7,721.80
Dec. yr. 1 Discount on notes receivable 694.96
I nterest revenue 694.96
($7,721.80 x 9%)
Zero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing Note
Chapter 1-213
Zero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing Note
Chapter 1-214
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?
Unrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing Note
0 1 2 3
1,000 1,000 Interest$1,000
$10,000 Principal
i = 12%
n = 3
Chapter 1-215
Pa = A (factor)Pa = $1,000 x 2.40183 Pa = $2,402
Unrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing Note
PV of INTEREST
Chapter 1-216
P = F (factor)P = $10,000 x .71178P = $7,118
Unrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing Note
PV of PRINCIPAL
Total present value = $9,520 ($2,402 + $7,118)Interest Principal
Chapter 1-217
Journal Entries
Date Account Title Debit Credit
Beg. yr. 1 Notes receivable 10,000
Discount on notes receivable 480
Cash ($2,402 + $7,118) 9,520
End. yr. 1
($9,520 x 12%)
Unrealistically LowUnrealistically Low Interest-Bearing NoteInterest-Bearing NoteUnrealistically LowUnrealistically Low Interest-Bearing NoteInterest-Bearing Note
Cash 1,000
Discount on notes receivable 142
Interest revenue1,142
Chapter 1-218
Unrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing NoteUnrealistically Low Interest-Bearing Note
Chapter 1-219
Notes Received for Property, Goods, or ServicesNotes Received for Property, Goods, or ServicesNotes Received for Property, Goods, or ServicesNotes 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:
1. No interest rate is stated, or
2. Stated interest rate is unreasonable, or
3. Face amount of the note is materially different from the current cash sales price.
Chapter 1-220
IllustrationIllustrationIllustrationIllustration
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 35,247Discount on Notes Receivable ($35,247 - $20,000)
15,247Land
14,000Gain 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.
Chapter 1-221
Illustration (recording fair value option)Illustration (recording fair value option)Illustration (recording fair value option)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
Chapter 1-222
Disposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition 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:
1. Borrow using receivables as collateral for the loan
2. Sale of receivables -- a sale occurs only if the seller surrenders control of the receivables to the buyer.
Chapter 1-223
On April 1, 2010, Prince Company assigns $500,000 of itsaccounts receivable to the Third National Bank as collateral for a $300,000 loan due July 1, 2010. 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).
Illustration of Secured Borrowing Illustration of Secured Borrowing Illustration of Secured Borrowing Illustration of Secured Borrowing
Instructions:
a) Prepare the April 1, 2010, journal entry for Prince Company.
b) 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.
c) On July 1, 2010, Prince paid Third National all that was due from the loan it secured on April 1, 2010.
Chapter 1-224
Date Account Title Debit Credit
(a) Cash 290,000
Finance Charge 10,000
Notes Payable 300,000
($500,000 x 2% = $10,000)
(b) Cash 350,000
Accounts Receivable 350,000
(c) Notes Payable 300,000
I nterest Expense 7,500
Cash 307,500
(10% x $300,000 x 3/ 12 = $7,500)
Illustration of Secured Borrowing - ContinuedIllustration of Secured Borrowing - Continued Illustration of Secured Borrowing - ContinuedIllustration of Secured Borrowing - Continued
Which category of Cash Flow (Operating or Financing) for ‘a’ and ‘c’?
Chapter 1-225
Sale WithoutWithout RecourseThe ‘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
Sales of ReceivablesSales of ReceivablesSales of ReceivablesSales of Receivables
Sale WithWith RecourseSeller guarantees payment to purchaser
Estimated liability (“Recourse Obligation”) for possible uncollectible accounts set up)
Chapter 1-226
Sales of Receivables -- Sales of Receivables -- WITHOUTWITHOUT RECOURSE RECOURSESales of Receivables -- Sales of Receivables -- WITHOUTWITHOUT RECOURSE 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’) 460,000
Due from Factor (the ‘holdback’ of 5% of $500,000) 25,000
Loss on Sale of Receivables (3% x $500,000) 15,000
Accounts Receivable 500,000
Chapter 1-227
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:
Sales of Receivables -- Sales of Receivables -- WITH WITH RECOURSERECOURSESales of Receivables -- Sales of Receivables -- WITH WITH RECOURSERECOURSE
Cash 460,000Due from factor (“holdback”) 25,000Loss on Sale of Receivables (3% of $500,000 plus the Recourse Liab.) 21,000 Accounts Receivable 500,000 Recourse Liability (Crest would have to ‘make good’ if bad 6,000 debts proved to be abnormally high)
Chapter 1-228
General rules in classifying receivables are:1. Segregate the different types of receivables that a
company possesses, if material.
2. Appropriately offset the valuation accounts (Allowances) against the proper receivable accounts.
3. Determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer.
4. Disclose any loss contingencies that exist on the receivables.
5. Disclose any receivables designated or pledged as collateral.
6. Disclose all significant concentrations of credit risk arising from receivables.
Presentation of ReceivablesPresentation of ReceivablesPresentation of ReceivablesPresentation of Receivables
Chapter 1-229
Ratio Analysis of ReceivablesRatio Analysis of ReceivablesRatio Analysis of ReceivablesRatio 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”
Chapter 1-230
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.
Impairment of ReceivablesImpairment of Receivables
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.
Chapter 1-231
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
Chapter 1-232
Illustration: Computation of Impairment Loss
Recording Impairment Losses
Bad Debt Expense 12,437
Allowance for Doubtful Accounts 12,437
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 (2.48685) 12,431 87,563
LOSS ON IMPAIRMENT $12,437
Chapter 1-233
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.
Chapter 1-234
Background - Background - Example: Subprime loan crisis
Beyond the subprime loans was the practice of securitization
Chapter 1-235
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 7Homework for Ch. 7
Class Assignment Questions # 1, 4, 5, 8, 11, 15, Class Assignment Questions # 1, 4, 5, 8, 11, 15, 16, 19, 21, 28 (pages 358-359)16, 19, 21, 28 (pages 358-359)
Homework (pages 359-371):Homework (pages 359-371):
BE7-1BE7-1
Ex. 7-16 (part ‘b’ only), Ex. 7-17 (part ‘a’ only), Ex. 7-16 (part ‘b’ only), Ex. 7-17 (part ‘a’ only), Ex. 7-27Ex. 7-27
Prob. 7-2, Prob. 7-12 Prob. 7-2, Prob. 7-12
Chapter 1-236
C H A P T E R C H A P T E R 88
VALUATION OF INVENTORIES: VALUATION OF INVENTORIES:
A COST-BASIS APPROACHA COST-BASIS APPROACH
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-237
Why Inventory is so ImportantWhy Inventory is so Important
INVENTORIES—just another specific asset we will INVENTORIES—just another specific asset we will cover—right???cover—right??? Answer = WRONG!!! UNDERSTAND.Answer = WRONG!!! UNDERSTAND. 1. Very important asset if firm sells a product1. Very important asset if firm sells a product (GM, Wal-Mart, Dell Computers)(GM, Wal-Mart, Dell Computers) 2. Results in biggest EXPENSE on Income Statement!2. Results in biggest EXPENSE on Income Statement! 3. Buy for $200 from vendor, sell to customer for $1803. Buy for $200 from vendor, sell to customer for $180
—how are we doing?—how are we doing? 4. Buy from catalog for $80 (which is less than $82 4. Buy from catalog for $80 (which is less than $82
charged by local vendor). Then pay $6. shipping chargecharged by local vendor). Then pay $6. shipping charge—how are we doing?—how are we doing?
Chapter 1-238
Importance of Inventories (cont’d.)Importance of Inventories (cont’d.)
55. . Run out of inventory and production line shuts down. How we Run out of inventory and production line shuts down. How we doing? (“Just-in-Time” inventory levels)doing? (“Just-in-Time” inventory levels)
66. . Obsolete/overstocked inventory on hand. How are we Obsolete/overstocked inventory on hand. How are we doing?doing?
77. “More efficient supply chain” (EDI)—let supplier access . “More efficient supply chain” (EDI)—let supplier access your computer inventory records to determine when and how your computer inventory records to determine when and how much to ship to you—good idea?much to ship to you—good idea?
88. Inventory returns by customers to us and from us back to . Inventory returns by customers to us and from us back to vendors—how are we doing?vendors—how are we doing?
99. Cash discounts for prompt payment—good idea? . Cash discounts for prompt payment—good idea?
1010. . Inventory errors—common? Any impact on Financial Inventory errors—common? Any impact on Financial Statements?Statements?
Chapter 1-239
1.1. Identify major classifications of inventory for merchandising company Identify major classifications of inventory for merchandising company and a manufacturing company.and a manufacturing company.
2.2. Distinguish between perpetual and periodic inventory systems.Distinguish between perpetual and periodic inventory systems.
3.3. Identify the effects of inventory errors on the current year’s and Identify the effects of inventory errors on the current year’s and following year’s financial statements.following year’s financial statements.
4.4. Understand the items to include as inventory cost (all reasonable and Understand the items to include as inventory cost (all reasonable and necessary costs of acquiring the inventory and getting it ready for necessary costs of acquiring the inventory and getting it ready for sale).sale).
5.5. Describe and compute inventory and cost of goods sold expense for Describe and compute inventory and cost of goods sold expense for the various inventory cost flow methods (Specific Identification, FIFO, the various inventory cost flow methods (Specific Identification, FIFO, LIFO, Weighted-Average Cost).LIFO, Weighted-Average Cost).
6.6. Identify the major advantages and disadvantages of the various Identify the major advantages and disadvantages of the various inventory cost flow methods.inventory cost flow methods.
7.7. Explain the significance and use of a LIFO reserve.Explain the significance and use of a LIFO reserve.
8.8. Explain the dollar-value LIFO method.Explain the dollar-value LIFO method.
Summary of Chapter 8Summary of Chapter 8Summary of Chapter 8Summary of Chapter 8
Chapter 1-240
Classification of InventoriesClassification of InventoriesClassification of InventoriesClassification of Inventories
MerchandiserMerchandiser
Merchandise Merchandise InventoryInventory
ManufacturerManufacturer
Raw MaterialsRaw Materials
Work in ProcessWork in Process
Finished GoodsFinished Goods
or
Chapter 1-241
Inventory Cost FlowInventory Cost FlowInventory Cost FlowInventory Cost Flow
Chapter 1-242
IMPORTANT ‘FORMULA’ TO UNDERSTANDIMPORTANT ‘FORMULA’ TO UNDERSTANDIMPORTANT ‘FORMULA’ TO UNDERSTANDIMPORTANT ‘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)
Chapter 1-243
‘‘Formula’ Formula’ Inputs Inputs for Ending Inventoryfor Ending Inventory‘‘Formula’ Formula’ Inputs Inputs for Ending Inventoryfor 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)
Chapter 1-244
Systems for maintaining inventory recordsSystems for maintaining inventory records Perpetual systemPerpetual system oror Periodic systemPeriodic system
Systems for maintaining inventory recordsSystems for maintaining inventory records Perpetual systemPerpetual system oror Periodic systemPeriodic system
Perpetual SystemPerpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts (cash discounts) are credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for each sale.
4. 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.
Chapter 1-245
Systems for maintaining inventory recordsSystems for maintaining inventory records Perpetual systemPerpetual system oror Periodic systemPeriodic system
Systems for maintaining inventory recordsSystems for maintaining inventory records Perpetual systemPerpetual system oror Periodic systemPeriodic system
Periodic SystemPeriodic System
1. Purchases of merchandise are debited to “Purchases”.
2. Ending Inventory determined by physical count.
3. 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
Chapter 1-246
Perpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An Illustration
Festive Company had the following transactions during the current year.
Record these transactions using the Perpetual and Periodic systems.
Chapter 1-247
Perpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An IllustrationPerpetual vs. Periodic -- An Illustration
Inventory 5,400 Cash (or Accounts Payable) 5,400
Accounts Receivable 7,200 Sales Revenue 7,200
Cost of Goods Sold Expense (600 x $6.) 3,600
Inventory 3,600
No entry necessary to adjust inventoryThe Inventory account shows the correct ending balance of $2,400 ($600 bb + $5,400 bought - $3,600 sold)
Purchases 5,400 Cash (or Accounts Payable) 5,400
Accounts Receivable 7,200 Sales Revenue 7,200
NO Entry
Inventory (ending per count) 2,400Cost of Goods Sold Expense (plug) 3,600 Purchases 5,400 Inventory (beginning) 600
Illustration:
Chapter 1-248
Errors in Measuring Ending InventoryErrors in Measuring Ending Inventory
Misstatements in inventory will cause errors in the Misstatements in inventory will cause errors in the following areas: following areas: Income StatementIncome Statement
Cost of Goods Sold, Gross Profit, Taxes, Net IncomeCost of Goods Sold, Gross Profit, Taxes, Net Income Balance SheetBalance Sheet
Inventory, Retained EarningsInventory, Retained Earnings Because the ending inventory of one period Because the ending inventory of one period
becomes the beginning inventory of the next becomes the beginning inventory of the next period, ending inventory errors affect period, ending inventory errors affect twotwo accounting periods accounting periods (two Income Statements but only (two Income Statements but only one Balance Sheet).one Balance Sheet).
Chapter 1-249
Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6. As Reported As CorrectedAs Reported As Corrected
Year 1 Year 2 Year 1 Year 2Year 1 Year 2 Year 1 Year 2
Sales Sales 100 100 100 100
C of G. Sold:C of G. Sold:
Begin. Inv.Begin. Inv. 12 12 12 12
+Purchases+Purchases 58 58 58 58
Gds. Avail.Gds. Avail. 70 70 70 70
- Ending Inv. - Ending Inv. 16 16 1010
=C. of G. Sold=C. of G. Sold 54 60 54 60
Gross Profit 46Gross Profit 46 4040
• What were the effects of the error on the Yr. 1 Financial Statements:
Income Statement? Balance Sheet?
Chapter 1-250
Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6.Ex: In Yr. 3 we find that Yr. 1 ending inv. was overstated by $6. As Reported As CorrectedAs Reported As Corrected
Year 1 Year 2 Year 1 Year 2Year 1 Year 2 Year 1 Year 2
Sales Sales 140 140 140 140
C of G. Sold:C of G. Sold:
Begin. Inv.Begin. Inv. 1616 1010
+Purchases+Purchases 74 74 74 74
Gds. Avail.Gds. Avail. 90 84 90 84
- Ending Inv. - Ending Inv. 1616 8 8** 1010 8 8**
=C of G. Sold=C of G. Sold 54 82 60 76 54 82 60 76
Gross Profit 46Gross Profit 46 58 58 4040 6464
• *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?
Chapter 1-251
What was the effect of OVERSTATING the Year 1 What was the effect of OVERSTATING the Year 1 ending inventory by $6? (ignore taxes)ending inventory by $6? (ignore taxes)
Sales
Begin. Inventory
+ Purchases
Goods Avail. 4 Sale
- Ending Inventory
Cost of Goods Sold
Gross Profit
Net Income
Ret. Earn, end. Bal.
Year 1 Year 2No effect
No effect
No effect
No effect
Overstated $6
Understated $6
Overstated $6
Overstated $6
Overstated $6
No effect
Overstated $6
No effect
Overstated $6
No effect
Overstated $6
Understated $6
Understated $6
No effect (why?)
Does Bal. Sheet Balance?
Does Bal. Sheet
Balance?
Chapter 1-252
Accounting for Purchase (Cash) DiscountsAccounting for Purchase (Cash) DiscountsAccounting for Purchase (Cash) DiscountsAccounting for Purchase (Cash) Discounts
Purchases 10,000 Accounts Payable 10,000
Accounts Payable 4,000
Cash 3,920
Accounts Payable 6,000 Cash 6,000
Accounts Payable 9,800
Accounts Payable 3,920 Cash 3,920
Accounts Payable 5,880Purchase Discounts Lost (‘stupidity exp.) 120 Cash 6,000
* $4,000 x 2% = $80
*
** $10,000 x 98% = $9,800
**
Purchase Discounts 80
Purchases 9,800
Using the Periodic System
Chapter 1-253
We’ll illustrate the calculations then discuss which inventory cost flow method is ‘correct’!
Cost Flow Assumption Adopted
does NOT need to be the same as the
Physical Movement of Goods
Cost Flow Assumption Adopted
does NOT need to be the same as the
Physical Movement of Goods
FIFO
Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?
LIFO
Weight-Average Cost
Specific Identification
Chapter 1-254
HAPPY HARRY’S USED CARSHAPPY HARRY’S USED CARS
Purchase 1965 VW Beetle for $400.Purchase 1965 VW Beetle for $400. Purchase 2009 Rolls Royce for $350,000.Purchase 2009 Rolls Royce for $350,000.
Inventory Count at year end = 1 carInventory Count at year end = 1 car What is Cost of Ending Inventory?What is Cost of Ending Inventory? What is Cost of Goods Sold Expense?What is Cost of Goods Sold Expense?
What is the only inventory “costing” What is the only inventory “costing” method that makes any sense?method that makes any sense? SPECIFIC IDENTIFICATION!SPECIFIC IDENTIFICATION!
Chapter 1-255
Specific Identification MethodSpecific Identification Method
Units in the ending inventory are identified as coming from specific purchases
Inventory Data Inventory Data
June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $ 800$ 800 6 6 PurchasePurchase 220 units 220 units @ $12.50@ $12.50 2,7502,750 2525 PurchasePurchase 200 units 200 units @ $14.00@ $14.00 2,8002,800
Goods available 4 saleGoods available 4 sale 500 units 500 units $6,350$6,350
Sales Sales 280 units 280 units On hand June 30 On hand June 30 220 units220 units
Specific Identification Method
$3,620Cost of goods sold2,730Less June 30 inventory
$6,350Cost of goods avail. for sale
Specific Identification Method
980 70 units @ $14.00
1,250100 units @ $12.50
$2,730220 units at cost of
$ 500 50 units @ $10.00
Chapter 1-256
Specific IdentificationSpecific 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?
Chapter 1-257
FIFOFIFO
FIFO = First-In, First-OutFIFO = First-In, First-Out
First COSTS into inventory are the first COSTS out of inventory:First COSTS into inventory are the first COSTS out of inventory:
QuestionQuestion: Where are the costs going when they leave : Where are the costs going when they leave inventory?inventory?
AnswerAnswer = To COST OF GOODS SOLD EXPENSE on the Income = To COST OF GOODS SOLD EXPENSE on the Income StatementStatement
Thus under FIFO--The first (earliest) costs into inventoryThus under FIFO--The first (earliest) costs into inventory are are transferred to Cost of Goods Sold Expense when inventory items transferred to Cost of Goods Sold Expense when inventory items are sold. are sold.
Thus under FIFO--The last (most recent) inventory purchase Thus under FIFO--The last (most recent) inventory purchase COSTSCOSTS remain in ending inventory. ENDING INVENTORY IS WHAT YOU remain in ending inventory. ENDING INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF GOODS SOLD EXPENSE!GOODS SOLD EXPENSE!
Chapter 1-258
FIFO/LIFO ComparisonFIFO/LIFO Comparison(My Simple Example)(My Simple Example)
FIFOFIFO LIFOLIFO
Beg.Beg. 1 unit @ $3. Beg.1 unit @ $3. Beg. 1 unit @ $3.1 unit @ $3.
Purchases: Purchases:Purchases: Purchases:
1 unit @ $4. 1 unit @ $4.1 unit @ $4. 1 unit @ $4.
1 unit @ $5. 1 unit @ $5.1 unit @ $5. 1 unit @ $5.
1 unit @ 1 unit @ $6.$6. 1 unit @ 1 unit @ $6.$6.
Available $18. Available $18.Available $18. Available $18.
1 unit End.Inv1 unit End.Inv. ?. ? 1 unit End.Inv 1 unit End.Inv. ? . ?
3 units CofGS ? 3 units CofGS ?3 units CofGS ? 3 units CofGS ?
Chapter 1-259
FIFO FIFO (My Simple Example)(My Simple Example)
FIFOFIFO Beg.Beg. 1 unit @ $3.1 unit @ $3.
Purchases:Purchases: $12 Cost of Goods Sold Expense$12 Cost of Goods Sold Expense 1 unit @ $4. 1 unit @ $4. 1 unit @ $5.1 unit @ $5. 1 unit @ 1 unit @ $6.$6. Available Available $18. $18.1 unit End Inv1 unit End Inv. - 6.. - 6. 3 units CofGS $12.3 units CofGS $12.
Chapter 1-260
First-In, First-Out (FIFO) Method 200 units @ $14.00 from purchase of June 25 $2,800 20 units @ $12.50 from purchase of June 6 250
220 units in Ending Inventory at a cost of $3,050
First-In, First-Out (FIFO) MethodFirst-In, First-Out (FIFO) MethodAn IllustrationAn 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 Inventory Data
June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $ 800$ 800
6 6 PurchasePurchase 220 units 220 units @ $12.50@ $12.50 2,7502,750
2525 PurchasePurchase 200 units 200 units @ $14.00@ $14.00 2,8002,800
Goods available 4 saleGoods available 4 sale 500 units 500 units $6,350$6,350
Sales Sales 280 units 280 units
On hand June 30 On hand June 30 220 units220 units
$3,300Cost of goods sold (plug)3,050Less June 30 inventory (calculate)
$6,350Cost of goods avail. for sale
Chapter 1-261
LIFOLIFO
LIFO = Last-In, First-OutLIFO = Last-In, First-Out
Last COSTS into inventory are the first COSTS out of inventory:Last COSTS into inventory are the first COSTS out of inventory:
QuestionQuestion: Where are the costs going when they leave : Where are the costs going when they leave inventory?inventory?
AnswerAnswer = To COST OF GOODS SOLD EXPENSE on the Income = To COST OF GOODS SOLD EXPENSE on the Income StatementStatement
Thus under LIFO--The last (most recent purchase) costs into Thus under LIFO--The last (most recent purchase) costs into inventoryinventory are transferred to Cost of Goods Sold Expense when are transferred to Cost of Goods Sold Expense when inventory items are sold. inventory items are sold.
Thus under LIFO--The first (earliest) inventory purchase (including Thus under LIFO--The first (earliest) inventory purchase (including beginning inventorybeginning inventory) ) COSTSCOSTS remain in ending inventory. remain in ending inventory. ENDING ENDING INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU INVENTORY IS WHAT YOU WANT TO CALCULATE; THEN YOU CAN “PLUG” COST OF GOODS SOLD EXPENSE!CAN “PLUG” COST OF GOODS SOLD EXPENSE!
Chapter 1-262
FIFO/LIFO ComparisonFIFO/LIFO Comparison(My Simple Example)(My Simple Example)
FIFOFIFO LIFOLIFO
Beg.Beg. 1 unit @ $3. Beg.1 unit @ $3. Beg. 1 unit @ $3.1 unit @ $3.
Purchases: Purchases:Purchases: Purchases:
1 unit @ $4. 1 unit @ $4.1 unit @ $4. 1 unit @ $4.
1 unit @ $5. 1 unit @ $5.1 unit @ $5. 1 unit @ $5.
1 unit @ 1 unit @ $6.$6. 1 unit @ 1 unit @ $6.$6.
Available $18. Available $18.Available $18. Available $18.
1 unit End.Inv1 unit End.Inv. ?. ? 1 unit End.Inv 1 unit End.Inv. ? . ?
3 units CofGS ? 3 units CofGS ?3 units CofGS ? 3 units CofGS ?
Chapter 1-263
LIFO LIFO (My Simple Example)(My Simple Example)
LIFOLIFOBeg.Beg. 1 unit @ $3.1 unit @ $3.
Purchases:Purchases: 1 unit @ $4.1 unit @ $4. 1 unit @ $5.1 unit @ $5. 1 unit @ 1 unit @ $6.$6.Available $18.Available $18.1 unit End. Inv. 1 unit End. Inv. - 3.- 3.__ 3 units CofGS $15.3 units CofGS $15.
$3 Ending Inventory
$15 Cost of Goods Sold Expense
Chapter 1-264
Last-In, First-Out (LIFO) MethodLast-In, First-Out (LIFO) MethodAn IllustrationAn Illustration
Ending inventory is priced using the earliest
purchases (Including Beg. Inventory)
Inventory Data Inventory Data
June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $800$800
6 6 PurchasePurchase 220 units 220 units @ $12.50@ $12.50 2,7502,750
2525 PurchasePurchase 200 units 200 units @ $14.00@ $14.00 2,8002,800
Goods available 4 saleGoods available 4 sale 500 units 500 units $6,350$6,350
Sales Sales 280 units 280 units
On hand June 30 On hand June 30 220 units220 units
$3,800Cost of goods sold2,550Less June 30 inventory
$6,350Cost of goods avail. for sale
Last-In, First-Out (LIFO) Method 80 units @ $10.00 from June 1 inventory $ 800 140 units @ $12.50 from purchase of June 6 1,750
220 units in Ending Inventory at a cost of $2,550
© Royalty Free C Squared Studios/ Getty Images
Chapter 1-265
Inventory is priced at the weighted
average cost of the goods available
for sale during the period
Inventory Data Inventory Data
June 1 June 1 InventoryInventory 80 units80 units @ $10.00@ $10.00 $800$800
6 6 PurchasePurchase 220 units 220 units @ $12.50@ $12.50 2,7502,750
2525 PurchasePurchase 200200 units units @ $14.00@ $14.00 2,8002,800
Goods available 4 saleGoods available 4 sale 500 units 500 units $6,350$6,350
Sales Sales 280280 units units On hand June 30 On hand June 30 220220 units units
Cost of Goods Available for Sale ÷ Units Available for Sale = Weighted-Average Unit Cost $6,350 ÷ 500 units = $12.70
Ending Inventory = 220 units @ $12.70 = $2,794
$3,556Cost of goods sold2,794Less June 30 inventory
$6,350Cost of goods avail. for sale
© Royalty Free C Squared Studios/ Getty Images
Weighted-Average Cost MethodWeighted-Average Cost Method
Chapter 1-266
Impact of Inventory Impact of Inventory CostingCosting Methods Alternatives Methods Alternatives
Which method would you chose if it were your company? WHY?
Limit your choices to just FIFO or LIFO!
Chapter 1-267
LIFO “LIQUIDATION”LIFO “LIQUIDATION”LIFO “LIQUIDATION”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, 2010. Will a LIFO Liquidation accomplish the CEO’s goal and save your job? Legal? Ethical?
LIFO Inventory existing at December 1, 2010
From 2007 8,000 pounds at $4. $32,000
From 2008 10,000 pounds at $6. 60,000
From 2009 7,000 pounds at $9. 63,000
From 2010 5,000 pounds at $10. 50,000
30,000 $205,000
Chapter 1-268
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.
LIFO Liquidation (Continued)LIFO Liquidation (Continued)LIFO Liquidation (Continued)LIFO Liquidation (Continued)
Chapter 1-269
Select Select FIFOFIFO Method Method(In a period of Rising Prices)(In a period of Rising Prices)
• Practical Advantages:Practical Advantages:• Higher net income (and earnings per share) in a Higher net income (and earnings per share) in a
period of rising prices. Higher stock price?period of rising prices. Higher stock price?• Which also may mean higher bonus for Which also may mean higher bonus for
management and/or increase in value of the management and/or increase in value of the shares of stock (and stock options) they own!shares of stock (and stock options) they own!
• Theoretical AdvantageTheoretical Advantage::• Ending inventory on balance sheet is closest to Ending inventory on balance sheet is closest to
current values = realistic view of inventorycurrent values = realistic view of inventory
• DISADVANTAGES:DISADVANTAGES:• “ “Phantom FIFO Profit”--does not provide a good Phantom FIFO Profit”--does not provide a good matching of current costs and revenuesmatching of current costs and revenues
• Pay higher taxes to government than LIFOPay higher taxes to government than LIFO
Chapter 1-270
Select Select LIFOLIFO Method Method (In a period of Rising Prices) (In a period of Rising Prices)
• Practical Advantages:Practical Advantages:• Pay less income taxes in a period of rising prices Pay less income taxes in a period of rising prices
(thus keep more cash—rather than pay it to IRS)(thus keep more cash—rather than pay it to IRS)• Opportunity to ‘manage income’ (LIFO Liquidation)Opportunity to ‘manage income’ (LIFO Liquidation)
• Theoretical Advantage:Theoretical Advantage:• Best suited for the income statement because it Best suited for the income statement because it
matches revenues and cost of goods soldmatches revenues and cost of goods sold
• DISADVANTAGESDISADVANTAGES::• Lower net incomeLower net income• ‘ ‘Terrible’ current balance sheet value of inventory, Terrible’ current balance sheet value of inventory, particularly during a prolonged period of price particularly during a prolonged period of price increases and decreasesincreases and decreases
Chapter 1-271
Each Year, Can you switch ‘back and forth’ from One Each Year, Can you switch ‘back and forth’ from One Inventory Costing Method to Another ???Inventory Costing Method to Another ???
NONO -- the -- the Consistency conceptConsistency concept requires requires that companies use the same accounting methods from that companies use the same accounting methods from year to year. The consistency assumption allows year to year. The consistency assumption allows financial statement users to compare the company’s financial statement users to compare the company’s current year’s results with those of prior years.current year’s results with those of prior years.
This does NOT mean a company can never change This does NOT mean a company can never change accounting methods. We covered changes in accounting methods. We covered changes in Accounting Principles back in Chapter 4 —Accounting Principles back in Chapter 4 —Retrospectively go back and change the prior years’ Retrospectively go back and change the prior years’ financial statements to make them comparable with the financial statements to make them comparable with the method used in the current year.method used in the current year.
(Note: A change from FIFO to LIFO does NOT result in (Note: A change from FIFO to LIFO does NOT result in restating prior years’ financial statements)restating prior years’ financial statements)
Chapter 1-272
Can you Get the “Best of Both Worlds” (FIFO on Can you Get the “Best of Both Worlds” (FIFO on ‘books’ and LIFO on the Corporate Tax ‘books’ and LIFO on the Corporate Tax
Return)????Return)????
NO, because of LIFO CONFORMITY RULE—passed by NO, because of LIFO CONFORMITY RULE—passed by Congress:Congress:
If a company uses LIFO forIf a company uses LIFO fortax purposes, the IRS requirestax purposes, the IRS requiresthe same method for financialthe same method for financialreporting (i.e., ‘the books’)reporting (i.e., ‘the books’)
What will happen if the U.S. switches to IFRS—which does NOT allow LIFO?
Chapter 1-273
Remaining “Miscellaneous” Topics in Ch. 8Remaining “Miscellaneous” Topics in Ch. 8
““Perpetual” calculations of Inventory for Perpetual” calculations of Inventory for FIFO and LIFO (vs. “Periodic” calculations FIFO and LIFO (vs. “Periodic” calculations previously illustrated)previously illustrated)
LIFO ReserveLIFO Reserve ““Dollar Value LIFO (vs. ‘specific units’ LIFO Dollar Value LIFO (vs. ‘specific units’ LIFO
calculations previously illustrated)calculations previously illustrated)
Chapter 1-274
Perpetual Calculations Compared to Periodic Perpetual Calculations Compared to Periodic Calculations – An IllustrationCalculations – An Illustration
Perpetual Calculations Compared to Periodic Perpetual Calculations Compared to Periodic Calculations – An IllustrationCalculations – 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 $4.40
26,400
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)
Chapter 1-275
First-In, First-Out (FIFO) -- PeriodicFirst-In, First-Out (FIFO) -- PeriodicFirst-In, First-Out (FIFO) -- PeriodicFirst-In, First-Out (FIFO) -- Periodic
FIFO -- Periodic Method (previously FIFO -- Periodic Method (previously covered)covered)
2,000 @ $4.75 $9,500 4,000 @ $4.40 17,600
$27,100
27,100
$16,800
Chapter 1-276
First-In, First-Out (FIFO) -- PerpetualFirst-In, First-Out (FIFO) -- Perpetual
FIFO -- Perpetual MethodFIFO -- Perpetual Method
Note: FIFO Perpetual always will yield the same Ending Inventory and Cost of Goods Sold as FIFO Periodic
Chapter 1-277
Last-In, First-Out (LIFO) -- PeriodicLast-In, First-Out (LIFO) -- PeriodicLast-In, First-Out (LIFO) -- PeriodicLast-In, First-Out (LIFO) -- Periodic
LIFO -- Periodic Method (previous LIFO -- Periodic Method (previous covered)covered)
2,000 @ $4.00 $8,0004,000 @ $4.40 17,600
$25,600
25,600
$18,300
Chapter 1-278
Last-In, First-Out (LIFO) -- PerpetualLast-In, First-Out (LIFO) -- Perpetual
LIFO -- Perpetual LIFO -- Perpetual MethodMethod
Note: LIFO Perpetual can result in different answer than LIFO Periodic
Chapter 1-279
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
Special Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFO
LIFO ReserveLIFO Reserve
Chapter 1-280
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”)
Special Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFO
Dollar-Value LIFODollar-Value LIFO
Chapter 1-281
Special Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFO
Dollar-Value LIFO ProcessDollar-Value LIFO Process1st 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
Chapter 1-282
Dollar-Value LIFO -- IllustratedDollar-Value LIFO -- Illustrated
Chapter 1-283
Class Assignment Review Questions and Homework Class Assignment Review Questions and Homework for Ch. 8for Ch. 8
Class Assignment Questions #1, 3, 6, 7, 8, 16, Class Assignment Questions #1, 3, 6, 7, 8, 16, 18 (skip ‘c’), 19, 20 (pages 413-414)18 (skip ‘c’), 19, 20 (pages 413-414)
Homework (pages 415-422):Homework (pages 415-422):
BE 4, 5BE 4, 5
Ex. 17, 25Ex. 17, 25
Chapter 1-284
C H A P T E R C H A P T E R 99
INVENTORIES: INVENTORIES:
ADDITIONAL VALUATION ISSUESADDITIONAL VALUATION ISSUES
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-285
1.1. Describe and apply the lower-of-cost-or-market Describe and apply the lower-of-cost-or-market rule.rule.
2.2. Discuss accounting issues related to purchase Discuss accounting issues related to purchase commitments.commitments.
3.3. Estimating ending inventory using the gross Estimating ending inventory using the gross profit method.profit method.
4.4. Determine ending inventory by applying the Determine ending inventory by applying the retail inventory method.retail inventory method.
5.5. Inventory ratios.Inventory ratios.
Summary of Chapter 9Summary of Chapter 9Summary of Chapter 9Summary of Chapter 9
Chapter 1-286
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.
A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)
LCM
Chapter 1-287
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 Refinements to Replacement Cost: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).
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Conservatism ConceptConservatism Concept
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Conservatism ConceptConservatism Concept
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.
Chapter 1-288
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM) Historical cost = $100. Historical cost = $100.
Replacement cost at end of Year 1= $80 Replacement cost at end of Year 1= $80
Year 1Year 1
LCM Write down:LCM Write down:
Loss on Inventory 20Loss on Inventory 20
Inventory 20Inventory 20
(from $100 to $80) (from $100 to $80)
Conservative for Year 1?:Conservative for Year 1?:
Income StatementIncome Statement Loss of $20 Loss of $20 will lower Net Incomewill lower Net Income
Balance SheetBalance Sheet Asset Inventory Asset Inventory reduced to $80.reduced to $80.
Year 2Year 2 If Sell for $200 at beginning of Year 2:If Sell for $200 at beginning of Year 2:
Accounts Rec. 200Accounts Rec. 200 Sales Revenue 200Sales Revenue 200 Cost of Good Sold 80Cost of Good Sold 80 Inventory 80Inventory 80
Conservative for Year 2?:Conservative for Year 2?: Income Statement shows ‘income’ of Income Statement shows ‘income’ of
$120. What would the income have $120. What would the income have been IF the ‘conservative’ LCM had been IF the ‘conservative’ LCM had NOT been followed in Year 1?NOT been followed in Year 1?
(CAN “CONSERVATISM CONCEPT” (CAN “CONSERVATISM CONCEPT” Possibly Lead to “BIG BATH” Possibly Lead to “BIG BATH” Accounting????)Accounting????)
LCM over Two Years – Ignoring Ceiling or Floor LCM over Two Years – Ignoring Ceiling or Floor RefinementsRefinements
Chapter 1-289
NotNot<<
CostCost MarketMarket
Ceiling = NRVCeiling = NRV
ReplacementCost
ReplacementCost
Floor =NRV less Normal
Profit Margin
Floor =NRV less Normal
Profit MarginGAAPLCM
GAAPLCM
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)
NotNot>>
““Market” number to use to Market” number to use to compare to cost will be the compare to cost will be the MIDDLE number of the three MIDDLE number of the three market numbersmarket numbers
Chapter 1-290
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)
How LCM Works – An IllustrationHow LCM Works – An Illustration
Individual Items BasisIndividual Items Basis
Chapter 1-291
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)
How LCM Works – An IllustrationHow LCM Works – An IllustrationIndividual Items, Major Categories, Total Individual Items, Major Categories, Total
InventoryInventory
Individual Items method is most ‘conservative’ of the Individual Items method is most ‘conservative’ of the three three
Chapter 1-292
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)
Recording LCM – Journal Entry
Ending inventory (cost) $ 415,000 Ending inventory (LCM—Individual items)350,000Adjustment to LCM $ 65,000
Inventory (or Allowance on inventory) 65,000
Loss on inventory 65,000
Inventory 65,000Cost of goods sold 65,000
Two possible ways to record ‘write-down’Two possible ways to record ‘write-down’
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.
Chapter 1-293
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.
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)
Extending LCM to Purchase “Commitments”
Chapter 1-294
Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)Lower-of-Cost-or-Market (LCM)
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
Purchase CommitmentsPurchase Commitments
When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.
Inventory 7,000,000 Estimated Liability on Purchase Commitments 3,000,000 Cash 10,000,000
Chapter 1-295
Estimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit Method
(1) Provides an estimate of ending inventory for management and auditor.
(2) Uses past gross profit percentages in calculation.
(3) A single blanket gross profit rate may not be representative.
(4) Only acceptable for interim (generally quarterly) reporting purposes.
Chapter 1-296
Estimating Inventory--Gross Profit MethodEstimating Inventory--Gross Profit MethodEstimating Inventory--Gross Profit MethodEstimating 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.
*It is possible the gross profit percent could be a *It is possible the gross profit percent could be a percentage ‘mark-up on cost’ (A method for Cost percentage ‘mark-up on cost’ (A method for Cost
Accounting)Accounting)
Beginning Inventory $ 60,000Beginning Inventory $ 60,000
Purchases + Purchases + 200,000200,000
Cost of Goods Available for Sale $260,000Cost of Goods Available for Sale $260,000
Estimated Cost of Goods Sold Exp. Estimated Cost of Goods Sold Exp. - 196,000 (70% x $280,000 - 196,000 (70% x $280,000 Sales)Sales)
Estimated Cost of Ending Inventory $64,000Estimated Cost of Ending Inventory $64,000
Chapter 1-297
Astaire Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May.
Instructions:
Compute the estimated inventory at May 31, assuming that the gross profit is 25% of net sales.
I nventory, May 1 160,000$ Purchases (gross) 640,000 Freight- in 30,000 Sales 1,000,000 Sales returns 70,000 Purchase discounts 12,000
Estimating Inventory -- Gross Profit Method Another Estimating Inventory -- Gross Profit Method Another IllustrationIllustration
Estimating Inventory -- Gross Profit Method Another Estimating Inventory -- Gross Profit Method Another IllustrationIllustration
Chapter 1-298
Solution to the 2nd IllustrationCompute the estimated inventory assuming gross profit is 25% of net sales
Estimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit MethodEstimating Inventory -- Gross Profit Method
Inventory, May 1 $ 160,000
Purchases (gross) 640,000
Purchase discounts (12,000)
Freight-in 30,000 658,000
Cost of Goods Available for Sale $ 818,000
Estimated Cost of Goods Sold (75% of $930,000*) (697,500)
Estimated ending inventory, May 31 $ 120,500
Sales (at selling price) $1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000*
Chapter 1-299
Retail Inventory MethodRetail Inventory MethodRetail Inventory MethodRetail Inventory Method
A method used by retailers:
1.) To estimate ending inventory without a physical count
2.) As a ‘check’ to compare to the physical inventory ‘count’
(1) the total cost and retail value of goods purchased,
(2) the total cost and retail value of the goods available for sale, and
(3) the sales for the period.
Requires retailers to keep records of:
Some companies refine the retail method by computing inventory separately by departments or class of merchandise
Chapter 1-300
Fuque Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2011.
Retail Inventory Method – An IllustrationRetail Inventory Method – An IllustrationRetail Inventory Method – An IllustrationRetail Inventory Method – An Illustration
COST RETAILBeg. inventory, Oct. 1 52,000$ 78,000$ Purchases 272,000 423,000 Freight in 16,600 Purchase returns 5,600 8,000 Additional markups 9,000 Markup cancellations 2,000 Markdowns (net) 3,600 Normal spoilage 10,000 Sales 390,000
Prepare a schedule computing estimated ending inventory following the conventional retail method (lower of average cost or market)
Chapter 1-301
Retail Inventory - LCM MethodRetail Inventory - LCM MethodRetail Inventory - LCM MethodRetail Inventory - LCM Method
Cost to COST RETAIL Retail %
Beg. inventory 52,000$ 78,000$ Purchases 272,000 423,000 Freight in 16,600 Purchase returns (5,600) (8,000) Markups, net 7,000
Current year additions 283,000 422,000 Goods available for sale 335,000 500,000 67.00% Markdowns, net (3,600)
Normal spoilage (10,000) Sales (390,000) Estimated Ending inventory at retail 96,400$
Estimated Ending inventory at Cost:96,400$ x 67.00% = 64,588$
Conventional Retail at Lower of Cost or Market
==//
To calculate ending inventory at ‘cost’ – move To calculate ending inventory at ‘cost’ – move “markdowns, net” up with markups (and thus included in “markdowns, net” up with markups (and thus included in cost to retail percentage)cost to retail percentage)
Chapter 1-302
Accounting standards require disclosure of:
Presentation and AnalysisPresentation and AnalysisPresentation and AnalysisPresentation and Analysis
Presentation:
(1) composition of the inventory,
(2) financing arrangements, and
(3) costing methods employed.
Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory.
Ratio Analysis:
Chapter 1-303
Ratios -- Inventory Ratios -- Inventory Turnover &Turnover &Average Days to Sell InventoryAverage Days to Sell InventoryRatios -- Inventory Ratios -- Inventory Turnover &Turnover &Average Days to Sell InventoryAverage Days to Sell Inventory
Average Days to Sell = = 365 days / 7.5 times = 48.7 days
INVENTORY TURNOVER -- Measures the number of times on average a company sells the inventory during the period.
Is 48.7 days supply of inventory on hand too little or Is 48.7 days supply of inventory on hand too little or too much? What would you compare the 48.7 days too much? What would you compare the 48.7 days
to?to?
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.
Chapter 1-304
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.
Summary of IFRS vs. GAAP Summary of IFRS vs. GAAP Differences Related to InventoriesDifferences Related to Inventories
Chapter 1-305
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 9Homework for Ch. 9
Class Assignment Questions #1, 2, 6, 9, 10, 15, Class Assignment Questions #1, 2, 6, 9, 10, 15, 17, 18 (page 468)17, 18 (page 468)
Homework (pages 469-479):Homework (pages 469-479):
BE 1, 2, 3, 5, 6, 7, 9BE 1, 2, 3, 5, 6, 7, 9
Prob. 6Prob. 6
Chapter 1-306
C H A P T E R C H A P T E R 1010
ACQUISITION AND DISPOSITION OF ACQUISITION AND DISPOSITION OF
PROPERTY, PLANT, AND EQUIPMENTPROPERTY, PLANT, AND EQUIPMENT
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-307
1.1. What should be included in the asset classification of property, What should be included in the asset classification of property, plant, and equipment?plant, and equipment?
2.2. Understand the “capitalize” as asset or expense decision.Understand the “capitalize” as asset or expense decision.
3.3. Identify the costs to include in initial acquisition of property, plant, Identify the costs to include in initial acquisition of property, plant, and equipment.and equipment.
4.4. Describe the accounting problems associated with self-constructed Describe the accounting problems associated with self-constructed assets – including ‘interest capitalization’.assets – including ‘interest capitalization’.
5.5. Describe the accounting treatment for costs subsequent to Describe the accounting treatment for costs subsequent to acquisition (post-acquisition expenditures).acquisition (post-acquisition expenditures).
6.6. Describe the accounting treatment for the disposal of property, Describe the accounting treatment for the disposal of property, plant, and equipment.plant, and equipment.
Summary of Chapter 10Summary of Chapter 10Summary of Chapter 10Summary of Chapter 10
Chapter 1-308
“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.
Property, plant, and equipment includes land, buildings, and equipment (machinery, furniture, tools).
Three Major characteristics include:
Property, Plant, and Equipment ASSETSProperty, Plant, and Equipment ASSETSProperty, Plant, and Equipment ASSETSProperty, Plant, and Equipment ASSETS
Chapter 1-309
““Capitalize” as Asset or ExpenseCapitalize” as Asset or Expense
Asset (Asset (benefit more than current period)benefit more than current period)
Ppd. Ins. Del. Truck Coal Mine PatentPpd. Ins. Del. Truck Coal Mine Patent
Expenditure Expenditure vs.vs.
Ins. Exp. Depr. Exp.Ins. Exp. Depr. Exp. DepletionDepletion AmortizationAmortization Exp. Exp.Exp. Exp.
Expense Expense (benefit just the current period)(benefit just the current period)
Chapter 1-310
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 = Value at Historical Cost (Subsequently to be depreciated—except for Land)
Acquisition of PP&EAcquisition of PP&E(Recorded at Cost or Fair Market Value?)(Recorded at Cost or Fair Market Value?)
Acquisition of PP&EAcquisition of PP&E(Recorded at Cost or Fair Market Value?)(Recorded at Cost or Fair Market Value?)
U.S. GAAP states: “property, plant, and equipment should not be written up to
reflect appraisal, market, or current values which are above cost.”
U.S. GAAP states: “property, plant, and equipment should not be written up to
reflect appraisal, market, or current values which are above cost.”
IFRSIFRS allows either Historical Cost OR Fair Market Value (If allows either Historical Cost OR Fair Market Value (If Fair Value is selected--property, plant, or equipment must Fair Value is selected--property, plant, or equipment must be REVALUED TO CURRENT VALUE regularly)be REVALUED TO CURRENT VALUE regularly)
Chapter 1-311
Acquisition of PP&E – What Costs to Include in Acquisition of PP&E – What Costs to Include in Acquisition Cost?Acquisition Cost?
ALL REASONABLE AND NECESSARY COST OF ACQUIRING ALL REASONABLE AND NECESSARY COST OF ACQUIRING THE ASSET AND GETTING IT READY FOR ITS INTENDED USE THE ASSET AND GETTING IT READY FOR ITS INTENDED USE SHOULD BE ADDED TO THE ASSET.SHOULD BE ADDED TO THE ASSET.
WHY?:WHY?:
MATCHING (If expenditure is related to the asset and the MATCHING (If expenditure is related to the asset and the ‘benefits’ from the expenditure will be obtained over 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, then the cost should be spread over the life of the asset (i.e., matched with the revenue being life of the asset (i.e., matched with the revenue being generated by using the asset over its life).generated by using the asset over its life).
Or is the above ‘hogwash’ that doesn’t provide ‘relevant’ Or is the above ‘hogwash’ that doesn’t provide ‘relevant’ information to help financial statement readers make better information to help financial statement readers make better
decisions?decisions?
If you are considering lending money to Ford Motor If you are considering lending money to Ford Motor Company (or buying their stock) does the depreciated cost Company (or buying their stock) does the depreciated cost of Ford’s Dearborn, Michigan factory—built in 1955--of any of Ford’s Dearborn, Michigan factory—built in 1955--of any
relevancy to you?relevancy to you?
Chapter 1-312
Includes all costs to acquire land and ready it for use. Costs
typically include:
Cost of Land Cost of Buildings
Cost of Land and BuildingsCost of Land and BuildingsCost of Land and BuildingsCost of Land and Buildings
(1) closing costs, such as title to the land, attorney’s fees, and recording fees;
(2) costs of grading, filling, draining, and clearing;
(3) assumption of any liens, mortgages, or encumbrances on the property; and
(4) the purchase price;
(5) Additional land improvements that have an indefinite life.
Includes all costs related directly to acquisition or
construction. Costs include:
(1) materials, labor, and overhead costs incurred during construction;
(2) professional fees and building permits.
What about Interest Cost What about Interest Cost incurred on funds incurred on funds
borrowed to finance borrowed to finance construction of the construction of the
building?building?
Chapter 1-313
Include all costs incurred in acquiring the equipment and preparing it for use.
Costs typically include:
Cost of Equipment
(1) purchase price,
(2) freight and handling charges
(3) insurance on the equipment while in transit,
(4) cost of special foundations if required,
(5) assembling and installation costs, and
(6) costs of conducting trial runs.
Cost of EquipmentCost of EquipmentCost of EquipmentCost of Equipment
Chapter 1-314
Self-Constructed Assets
Cost of Self-Constructed AssetsCost of Self-Constructed AssetsCost of Self-Constructed AssetsCost of Self-Constructed Assets
Costs typically include:
(1) Materials and direct labor
(2) Overhead can be handled in two ways:
1. Assign no fixed overhead
2. Assign a portion of all overhead to the
construction process.
Companies use the second method extensively.
What about Interest Cost incurred on funds What about Interest Cost incurred on funds borrowed to finance construction of the building, borrowed to finance construction of the building,
bridge, submarine? bridge, submarine?
Chapter 1-315
Three approaches have been suggested to account for the interest incurred in financing the construction.
Interest Costs During ConstructionInterest Costs During Construction
Capitalize Capitalize NO interest NO interest
during during constructionconstruction
It’s Interest It’s Interest ExpenseExpense
Capitalize actual Capitalize actual debt financing debt financing costs incurred costs incurred
during construction during construction (with modification)(with modification)
Capitalize all Capitalize all financing costs financing costs incurred during incurred during
constructionconstruction
BOTH “Debt” and BOTH “Debt” and “Equity” costs of “Equity” costs of
financing financing constructionconstruction
GAAPGAAP
$ 0$ 0 $ ?$ ?
Should Financing Costs During Construction Should Financing Costs During Construction be Capitalized as part of the Cost of the be Capitalized as part of the Cost of the
Asset?Asset?
IFRS recently changed their rules to parallel U.S.IFRS recently changed their rules to parallel U.S.
GAAP—as part of the ‘convergence project’GAAP—as part of the ‘convergence project’
Chapter 1-316
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:
1. Qualifying assets.
2. Capitalization period.
3. Amount to capitalize.
Interest Costs During ConstructionInterest Costs During Construction
Chapter 1-317
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).
Qualifying Assets:
Interest Costs During ConstructionInterest Costs During Construction
Chapter 1-318
Capitalization Period:
Interest Costs During ConstructionInterest Costs During Construction
Begins when:
1. Expenditures for the asset have begun.
2. Interest costs are being incurred.
Ends when:
The asset is substantially complete and ready for use.
Chapter 1-319
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)
Interest Costs During Construction-- IllustratedInterest Costs During Construction-- Illustrated
Actual Expenditures:
J anuary 1, 2011 $100,000
April 30, 2011 150,000
November 1, 2011 300,000
December 31, 2011 100,000
Total expenditures $650,000
All other general debt existing on Jan. 1, 2011:
$500,000, 14%, 10-year bonds payable
$300,000, 10%, 5-year note payable
11
Chapter 1-320
Interest Costs During Construction-- IllustratedInterest Costs During Construction-- Illustrated
WeightedWeighted Average
Actual Capitalization Accumulated
Date Expenditures Period Expenditures*
J an. 1 100,000$ 12/ 12 100,000$
Apr. 30 150,000 8/ 12 100,000
Nov. 1 300,000 2/ 12 50,000
Dec. 31 100,000 0/ 12 -
650,000$ 250,000$
Step 3-Compute weighted-average accumulated expenditures*
Step 1-Determine whether asset qualifies for capitalization of interest = YES
Step 2-Determine the capitalization period = Jan. 1, 2011 to Dec. 31, 2011
Chapter 1-321
Interest Costs During Construction-- Illustrated
$24,000 interest ($200,000 @ 12% interest rate of specific debt)$24,000 interest ($200,000 @ 12% interest rate of specific debt)
+ 6,250 interest ($50,000 @ 12.5%+ 6,250 interest ($50,000 @ 12.5%** weighted-average rate on other debt) weighted-average rate on other debt)
$30,250$30,250 Total Interest to Capitalize Total Interest to Capitalize
Step 4 - Compute the Interest to Capitalize on the $250,000 weighted-average expenditures:
Journal entry to Capitalize InterestEquipment 30,250
Interest expense 30,250
All other debt:All other debt:
$500,000 14% $70,000$500,000 14% $70,000
++300,000300,000 10% + 10% +30,00030,000
Total $800,000 $100,000Total $800,000 $100,000
Weighted-average interest Weighted-average interest rate on all other debtrate on all other debt
$100,000 interest$100,000 interest
$800,000 principal$800,000 principal12.5%12.5%**
Chapter 1-322
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.
Other Issues in Recording Acquisition of PP&EOther Issues in Recording Acquisition of PP&EOther Issues in Recording Acquisition of PP&EOther Issues in Recording Acquisition of PP&E
Chapter 1-323
““Contributions” of PP&EContributions” of PP&E““Contributions” of PP&EContributions” 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.
Chapter 1-324
Basket Purchase AllocationBasket Purchase Allocation(aka. “Joint Cost” Allocation Situation)(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 $5,000,000 cost between the land and building?
First However—”Don’t lose site of the forest for the trees”
Amount %Fair market value of building 6,000,000$ 75%Fair market value of land 2,000,000 25%Total fair market value 8,000,000$ 100%
Cost % AllocationAssign to building 5,000,000$ 75% 3,750,000$ Assign to land 5,000,000 25% 1,250,000
100% 5,000,000$
Chapter 1-325
Post-Acquisition ExpendituresPost-Acquisition ExpendituresPost-Acquisition ExpendituresPost-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.
“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.
To capitalize post-acquisition costs, one of the following conditions must be present:
Chapter 1-326
Post-Acquisition ExpendituresPost-Acquisition Expenditures
Costs that Are ExpensedThe 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.
Account Title Debit CreditMaintenance Expense 200 Cash 200
Chapter 1-327
Post-Acquisition ExpendituresPost-Acquisition Expenditures
Costs that Are Capitalized—”Improvement”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.
Account Title Debit CreditEquipment 5,000 Cash 5,000
Chapter 1-328
Post-Acquisition ExpendituresPost-Acquisition Expenditures
Costs that Costs that “Extend the Life”“Extend the Life” of an Asset of an AssetThe 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.
Account Title Debit CreditAccumulated Depreciation - Equipment 8,000 Cash 8,000
Chapter 1-329
Disposition of PP&EDisposition of PP&EDisposition of PP&EDisposition 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.
Chapter 1-330
SALESALE of PP&E Assets of PP&E AssetsSALESALE of PP&E Assets of PP&E Assets
Ottawa Corporation owns machinery that cost $20,000
when purchased on July 1, 2007. 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, 2010. The machinery is sold on
September 1, 2011, for $10,500.
Journal Entries on September 1, 2011Journal Entries on September 1, 2011
Depreciation expense ($2,400 x 8/12) 1,600
Accumulated depreciation 1,600
Cash 10,500 Accumulated depreciation 10,000*
Machinery 20,000Gain on sale 500
** $8,400 + $1,600 = $10,000$8,400 + $1,600 = $10,000
Chapter 1-331
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.
Involuntary ConversionInvoluntary Conversion of PP&E of PP&EInvoluntary ConversionInvoluntary Conversion of PP&E of PP&E
Chapter 1-332
Summary of Gain and Loss Recognition on Summary of Gain and Loss Recognition on Exchanges Exchanges of Non-Monetary Assetsof Non-Monetary Assets
Summary of Gain and Loss Recognition on Summary of Gain and Loss Recognition on Exchanges Exchanges of Non-Monetary Assetsof Non-Monetary Assets
The FASB recently changed from a ‘similar’/’dissimilar’ method of The FASB recently changed from a ‘similar’/’dissimilar’ method of recording exchanges of non-monetary assets to an ‘economic recording exchanges of non-monetary assets to an ‘economic substance’ approach that parallels IFRS handling of non-monetary substance’ approach that parallels IFRS handling of non-monetary asset exchanges.asset exchanges.
Chapter 1-333
Accounting for Accounting for Exchanges of PP&E that Have Exchanges of PP&E that Have Commercial (Economic) SubstanceCommercial (Economic) Substance
Accounting for Accounting for Exchanges of PP&E that Have Exchanges of PP&E that Have Commercial (Economic) SubstanceCommercial (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.
Equipment ($6,000 FMV of asset given up, plus $7,000 cash paid) 13,000Accumulated Depreciation—Equipment 4,000Loss on Disposal of Equipment ($8,000 book value vs. $6,000 FMV) 2,000 Equipment -- old 12,000
Cash 7,000
Journal Entry to Record Exchange of Non-Monetary Journal Entry to Record Exchange of Non-Monetary AssetAsset
How would the journal entry have been different if the FMV of the used How would the journal entry have been different if the FMV of the used machine traded was $11,000?machine traded was $11,000?
Gain on Disposal of $3,000; and Equipment acquired Gain on Disposal of $3,000; and Equipment acquired $18,000$18,000
Chapter 1-334
Exchanges that Exchanges that Lack Commercial (Economic) Lack Commercial (Economic) SubstanceSubstance
Exchanges that Exchanges that Lack Commercial (Economic) Lack Commercial (Economic) SubstanceSubstance
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.
Chapter 1-335
Practice Problem on Non-Monetary Exchanges Practice Problem on Non-Monetary Exchanges of PP&Eof PP&E
CA 10-5 (page 533) as example of exchange of CA 10-5 (page 533) as example of exchange of non-monetary assetsnon-monetary assets
LinkLink to Solution to Solution
Chapter 1-336
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.
Miscellaneous Problems
Disposition of Plant AssetsDisposition of Plant AssetsDisposition of Plant AssetsDisposition of Plant Assets
Chapter 1-337
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 10Homework for Ch. 10
Class Assignment Questions #1, 2, 7, 8, 10, 12, Class Assignment Questions #1, 2, 7, 8, 10, 12, 16 (pages 515-516)16 (pages 515-516)
Homework (pages 519-530):Homework (pages 519-530):
Ex. 5, 16, 23Ex. 5, 16, 23
Prob. 9Prob. 9
Chapter 1-338
C H A P T E R C H A P T E R 1111
DEPRECIATION, IMPAIRMENTS, DEPRECIATION, IMPAIRMENTS, AND DEPLETIONAND DEPLETION
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-339
1.1. Explain the concept of depreciation.Explain the concept of depreciation.
2.2. Identify the factors involved in the depreciation Identify the factors involved in the depreciation process.process.
3.3. Compare activity, straight-line, accelerated, and Compare activity, straight-line, accelerated, and MACRS methods of depreciation.MACRS methods of depreciation.
4.4. Explain the accounting issues related to asset Explain the accounting issues related to asset impairment.impairment.
5.5. Explain the accounting procedures for depletion of Explain the accounting procedures for depletion of natural resources.natural resources.
6.6. Explain how to report property, plant, equipment, Explain how to report property, plant, equipment, and natural resources on the financial statements.and natural resources on the financial statements.
Summary of Chapter ElevenSummary of Chapter ElevenSummary of Chapter ElevenSummary of Chapter Eleven
Chapter 1-340
Allocating costs of long-term assets:
P&E (this chapter) = Depreciation expense
Intangibles (Ch. 12) = Amortization expense
Natural resources (this chapter) = Depletion
expense
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.
Depreciation = Cost AllocationDepreciation = Cost AllocationDepreciation = Cost AllocationDepreciation = Cost Allocation
Chapter 1-341
Factors Involved in the Depreciation CalculationFactors Involved in the Depreciation CalculationFactors Involved in the Depreciation CalculationFactors Involved in the Depreciation Calculation
1) 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)
2) What is the asset’s ESTIMATED useful life?
(Estimated useful life of an asset often differs from its
physical life (obsolescence to consider)).
3) 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)
4) Which method of cost allocation is best?
(Methods listed on next slide)
Chapter 1-342
Depreciation - Methods of Cost AllocationDepreciation - Methods of Cost AllocationDepreciation - Methods of Cost AllocationDepreciation - Methods of Cost Allocation
The profession requires the depreciation method employed be “systematic and rational.” Examples include:
(1) Activity method (units of use or production).
(2) Straight-line method.
(3) Sum-of-the-years’-digits.*
(4) Declining-balance method.
(5) Group and composite methods.
(6) Hybrid or combination methods.
Accelerated Accelerated methodsmethods
Special methodsSpecial methods
* * Some textbooks no longer cover the ‘sum-of-Some textbooks no longer cover the ‘sum-of-the-years-digits’ method of depreciation.the-years-digits’ method of depreciation.
We will also cover “MACRS” depreciation method used for tax We will also cover “MACRS” depreciation method used for tax purposespurposes
Chapter 1-343
Activity Method of DepreciationActivity Method of DepreciationActivity Method of DepreciationActivity Method of Depreciation
First: Calculate depreciation rate per unit: $500,000 cost - $50,000 estimated salvage value 30,000 hours estimated useful life
Second: Calculate depreciation amountMultiply actual usage (assume 4,000 hours) during the period times the $15. rate = $60,000 depreciation
FactsFacts
$15.$15.
Chapter 1-344
Straight-Line Depreciation MethodStraight-Line Depreciation MethodStraight-Line Depreciation MethodStraight-Line Depreciation Method
Calculate straight-line depreciation:
FactsFacts
Cost - Estimated Salvage ValueCost - Estimated Salvage Value
Estimated Useful Life in YearsEstimated Useful Life in Years
$500,000 - $50,000$500,000 - $50,000
5 Years5 Years
$90,000$90,000
Chapter 1-345
“Accelerated” Depreciation Methods(Sum-of-the-Years’-Digits)
“Accelerated” Depreciation Methods(Sum-of-the-Years’-Digits)
FactsFacts
FirstFirst: Calculate ‘fraction’ for the current year: Calculate ‘fraction’ for the current year
Numerator is number of years of estimated life Numerator is number of years of estimated life remaining as of the beginning of the yearremaining as of the beginning of the year
Denominator is “sum” of the ‘digits’ in the asset’s life Denominator is “sum” of the ‘digits’ in the asset’s life (e.g., for a 5-year estimated life, the denominator of the (e.g., for a 5-year estimated life, the denominator of the fraction would be 15 (1 + 2 + 3 + 4 + 5) OR “n(n+1) / 2”fraction would be 15 (1 + 2 + 3 + 4 + 5) OR “n(n+1) / 2”
Second:Second: Calculate depreciation by multiplying fraction Calculate depreciation by multiplying fraction times the (cost minus the estimated salvage value)times the (cost minus the estimated salvage value)
First year: 5 times ($500,000 - $50,000) = First year: 5 times ($500,000 - $50,000) = $150,000 $150,000 1515
Chapter 1-346
“Accelerated” Depreciation Methods(Sum-of-the-Years’-Digits)
“Accelerated” Depreciation Methods(Sum-of-the-Years’-Digits)
Sum-of-the-Years’-Digits--All Five Years
Chapter 1-347
“Accelerated” Depreciation MethodsAccelerated” Depreciation Methods(Declining Balance)(Declining Balance)
“Accelerated” Depreciation MethodsAccelerated” Depreciation Methods(Declining Balance)(Declining Balance)
FactsFacts
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
Chapter 1-348
“Accelerated” Depreciation MethodsAccelerated” Depreciation Methods(Declining Balance)(Declining Balance)
“Accelerated” Depreciation MethodsAccelerated” Depreciation Methods(Declining Balance)(Declining Balance)
Double-Declining-Balance MethodFirst: 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)!!
Chapter 1-349
MACRS (depreciation for tax return purposes) differs from
GAAP in three respects:
1. a mandated tax life, which is generally shorter than the
economic life;
2. 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
3. an assigned salvage value of zero.
Modified Accelerated Cost Recovery Modified Accelerated Cost Recovery SystemSystem
(MACRS)(MACRS)
Chapter 1-350
Modified Accelerated Cost Recovery Modified Accelerated Cost Recovery SystemSystem
(MACRS)(MACRS)
* “Built-in” automatic switch to straight-line method
Chapter 1-351
Modified Accelerated Cost Recovery SystemModified Accelerated Cost Recovery System(MACRS) -- An Illustration(MACRS) -- An Illustration
Assume that, on 1/1/X1, MILO acquired equipment with an estimated useful life of four (4) yearswith no salvage value at a cost of $850,000. The depreciation schedule for tax and books shows
20X1 20X2 20X3 20X4 TOTALDepreciation for tax purposes--accelerated 340,000 250,000 170,000 90,000 850,000Depreciation for book purposes--straight-line 212,500 212,500 212,500 212,500 850,000Excess ("deficit") of tax vs. book depreciation 127,500 37,500 (42,500) (122,500) 0
Assume that book income before taxes for the same four years was as follows:
20X1 20X2 20X3 20X4Book Income before taxes 350,000 370,000 420,000 650,000
ASSUME THAT THE INCOME TAX RATE FOR EACH YEAR WAS 35%
Link to Income Tax Journal Entry for all four years.
Chapter 1-352
Special Depreciation MethodsSpecial Depreciation MethodsSpecial Depreciation MethodsSpecial Depreciation Methods
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).
(Commonly used in a Specific Industry [e.g., Utilities])
Chapter 1-353
Special Depreciation Issues Special Depreciation Issues
(1) 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)
(2) 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.]
(3) 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 Of what value is depreciated book value to the
financial statement reader?????financial statement reader?????
Chapter 1-354
Natural resources, often called wasting assets, include petroleum, natural gas, minerals, and timber.
DepletionDepletionDepletionDepletion
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)
Chapter 1-355
Depletion Calculation -- An IllustrationDepletion Calculation -- An IllustrationDepletion Calculation -- An IllustrationDepletion Calculation -- An Illustration
Total cost – Est. salvage valueTotal cost – Est. salvage value
Total estimated units availableTotal estimated units available= Depletion cost per unit= Depletion cost per unit
Units extracted x Cost per unitUnits extracted x Cost per unit = Depletion= Depletion
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:First: Calculate the depletion rate per board foot of Calculate the depletion rate per board foot of timbertimber
$9,000,000 Cost - $ -0-$9,000,000 Cost - $ -0-
3,000,000 board feet3,000,000 board feet= $3. Depletion per board foot= $3. Depletion per board foot
Second:Second: Calculate the depletion dollar amount for the Calculate the depletion dollar amount for the periodperiod
700,000 board feet extracted X $3. = $2,100,000700,000 board feet extracted X $3. = $2,100,000
Chapter 1-356
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!
Depletion -- Miscellaneous IssuesDepletion -- Miscellaneous IssuesDepletion -- Miscellaneous IssuesDepletion -- Miscellaneous Issues
Chapter 1-357
Presentation of Property, Plant, Equipment, and Presentation of Property, Plant, Equipment, and Natural ResourcesNatural Resources
(Including Disclosures)(Including Disclosures)
Presentation of Property, Plant, Equipment, and Presentation of Property, Plant, Equipment, and Natural ResourcesNatural Resources
(Including Disclosures)(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.
DisclosurDisclosureses
Chapter 1-358
ImpairmentsImpairmentsImpairmentsImpairments
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:
a. Decrease in the market value of an asset (e.g., sub-prime mortgages held as an investment).
b. Adverse change in legal factors or in the business climate.
c. 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).
d. A forecast that demonstrates continuing losses associated with an asset.
Chapter 1-359
Measuring ImpairmentsMeasuring Impairments Measuring ImpairmentsMeasuring Impairments
o Review events for possible impairment.
o If the review indicates impairment, apply (under U.S. GAAP) the following TWO step process*:
1) The “recoverability test” -- If the sum of the expected future net cash flows (NOT (NOT discounted)discounted) from the long-lived asset is less than the book value of the asset, an impairment has occurred.
2) 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 present value of expected future net cash flowsnet cash flows).**IFRS uses only the 2IFRS uses only the 2ndnd step, thus resulting in more step, thus resulting in more
impairment losses being recorded (more conservative impairment losses being recorded (more conservative approach)approach)
Chapter 1-360
Impairment FlowchartImpairment Flowchart
Note that U.S. GAAP does NOT Note that U.S. GAAP does NOT permit ‘restoration’ of permit ‘restoration’ of impairment loss on assets impairment loss on assets held for use. IFRS does permit held for use. IFRS does permit ‘restoration’ if subsequent ‘restoration’ if subsequent events indicate the loss has events indicate the loss has been reversed.been reversed.
Chapter 1-361
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.
Cost of equipment 9,000,000$
Accumulated depreciation to date 1,000,000
Expected future net cash flows (undiscounted) 7,000,000
Fair value (discounted future cash flows) 4,400,000
Impairments IllustratedImpairments IllustratedImpairments IllustratedImpairments Illustrated
Cost of equipment 9,000,000$
Accumulated depreciation to date 1,000,000
Expected future net cash flows (undiscounted) 7,000,000
Fair value (discounted future cash flows) 4,400,000
Questions to answer on next slideQuestions to answer on next slide
Chapter 1-362
Impairments IllustratedImpairments 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 3,600,000 Accumulated depreciation 3,600,000 ($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 1,100,000 Accumulated depreciation 1,100,000 ($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
Chapter 1-363
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&EU.S. GAAP vs. IFRS -- PP&E
SimilaritiesSimilarities
Chapter 1-364
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.
U.S. GAAP vs. IFRS -- PP&EU.S. GAAP vs. IFRS -- PP&E
DifferencesDifferences
Chapter 1-365
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 11Homework for Ch. 11
Class Assignment Questions # 1, 2, 3, 5, 10, 13, Class Assignment Questions # 1, 2, 3, 5, 10, 13, 14, 16, 17, 31, 33 (pages 568-569)14, 16, 17, 31, 33 (pages 568-569)
Homework (pages 571-576):Homework (pages 571-576):
Ex. 5, 18, 21, 25 Ex. 5, 18, 21, 25
Chapter 1-366
C H A P T E R C H A P T E R 1212
I N T A N G I B L E A S S E T SI N T A N G I B L E A S S E T S
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-367
1.1. Describe the characteristics of intangible assets.Describe the characteristics of intangible assets.
2.2. Identify the costs to capitalize for intangible assets.Identify the costs to capitalize for intangible assets.
3.3. Describe the types of intangible assets.Describe the types of intangible assets.
4.4. Explain the procedure for amortizing ‘definitive-lived’ Explain the procedure for amortizing ‘definitive-lived’ intangible assets.intangible assets.
5.5. Explain the accounting issues related to intangible-asset Explain the accounting issues related to intangible-asset impairments.impairments.
6.6. Explain the conceptual issues related to goodwill.Explain the conceptual issues related to goodwill.
7.7. Describe the accounting procedures for recording goodwill.Describe the accounting procedures for recording goodwill.
8.8. Identify the conceptual issues and accounting for research and Identify the conceptual issues and accounting for research and development costs and similar costs.development costs and similar costs.
9.9. Indicate the financial statement presentation of intangible Indicate the financial statement presentation of intangible assets and related items.assets and related items.
Summary of Chapter 12Summary of Chapter 12Summary of Chapter 12Summary of Chapter 12
Chapter 1-368
CharacteristicsCharacteristics ofof Intangible Assets Intangible Assets CharacteristicsCharacteristics ofof Intangible Assets Intangible Assets
Intangible Assets:
(1) Are long-lived, lack physical existence, and are not financial instruments
(2) Get their value from their exclusive legal/economic rights.
Two Types of Intangibles and Accounting Treatment
Patents
Copyrights
Franchises or licenses
Trademarks or trade names
Goodwill (has ‘unique’ 2-step impairment test)
Definitive (Limited) Life
Amortize & 2-step Impair.Test
Indefinite Life
Do NOT Amortize and 1-step Impair. Test
Chapter 1-369
Recording Acquisition of Intangible AssetsRecording Acquisition of Intangible AssetsRecording Acquisition of Intangible AssetsRecording 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.
Chapter 1-370
Accounting for Intangibles -- A SummaryAccounting for Intangibles -- A SummaryAccounting for Intangibles -- A SummaryAccounting for Intangibles -- A Summary
Chapter 1-371
Intangibles with Intangibles with DefinitiveDefinitive Life Life(Amortize and 2-step Impairment Test)(Amortize and 2-step Impairment Test)
Intangibles with Intangibles with DefinitiveDefinitive Life Life(Amortize and 2-step Impairment Test)(Amortize and 2-step Impairment Test)
FranchiseFranchise (or licenselicense) with a limited life should be amortized to expense over the life of the franchise.
CopyrightCopyright is granted for the life of the creator plus 70 years. Amortize over estimated useful life -- which may be shorter than legal life.
Customer listsCustomer lists, order or production backlogs, and both contractual and non-contractual customer relationships. Amortize over estimated useful life.
PatentPatent 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.)
Chapter 1-372
Impairment of Impairment of DefinitiveDefinitive-Life Intangibles-Life IntangiblesImpairment of Impairment of DefinitiveDefinitive-Life Intangibles-Life Intangibles
Same as the 2-step impairment for PP&E assets in Chapter 11.
1. ‘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.
2. ‘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?
Chapter 1-373
Presented below is information related to a copyright owned by Carmello Company at December 31, 2010.
Cost 8,600,000$
Book value 4,300,000
Expected future net cash flows (not discounted) 4,000,000
Fair value (present value of future cash flows) 3,200,000
Impairment of Impairment of DefinitiveDefinitive-Life Intangible Asset-Life Intangible Asset(An Illustration)(An Illustration)
Impairment of Impairment of DefinitiveDefinitive-Life Intangible Asset-Life Intangible Asset(An Illustration)(An Illustration)
The copyright has a remaining useful life of 10 years.
(a) Perform step-1 -- the ‘recoverability test’ (is an impairment loss indicated)?
(b) Perform step-2 -- the ‘fair value test’ to determine the dollar amount of the impairment loss to record.
(c) Prepare the journal entry to record the impairment loss at December 31, 2010.
Chapter 1-374
Impairment of Impairment of DefinitiveDefinitive-Life Intangible Asset-Life Intangible Asset(An Illustration)(An Illustration)
Impairment of Impairment of DefinitiveDefinitive-Life Intangible Asset-Life Intangible Asset(An Illustration)(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.
Loss on impairment 1,100,000
Copyrights 1,100,000
Undiscounted expected future cash flow 4,000,000$
Book value (aka. 'carrying value') 4,300,000
Asset is Impaired (300,000)$
Fair Value Test: What is the dollar amount of the impairment loss to be recorded? Prepare journal entry.Fair value test:
Book value 4,300,000$
Fair value (Discounted f uture cash flows) 3,200,000
Loss on I mpairment (1,100,000)$
Chapter 1-375
Intangibles with Intangibles with IndefiniteIndefinite Life Life(Do (Do NOTNOT amortize; 1-step Impairment Test) amortize; 1-step Impairment Test)
Intangibles with Intangibles with IndefiniteIndefinite Life Life(Do (Do NOTNOT amortize; 1-step Impairment Test) amortize; 1-step Impairment Test)
TrademarkTrademark or trade nametrade name has legal protection for indefinite number of 10-year renewal periods.
Franchise with an indefinite lifeFranchise with an indefinite life should be carried at cost and not amortized.
“Purchased” Goodwill 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.
Chapter 1-376
Impairment of Impairment of Indefinite-LifeIndefinite-Life Intangibles (Other Intangibles (Other than Goodwill)than Goodwill)
Impairment of Impairment of Indefinite-LifeIndefinite-Life Intangibles (Other Intangibles (Other than Goodwill)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.
Chapter 1-377
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.
Impairment of Impairment of IndefiniteIndefinite-Life Intangibles (Other -Life Intangibles (Other than Goodwill -- An Illustration)than Goodwill -- An Illustration)
Impairment of Impairment of IndefiniteIndefinite-Life Intangibles (Other -Life Intangibles (Other than Goodwill -- An Illustration)than Goodwill -- An Illustration)
‘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
Loss on impairment 1,000,000
Franchise asset 1,000,000
Journal Entry to Record Impairment Loss
Chapter 1-378
GoodwillGoodwill
Goodwill Goodwill is evidenced when a company has ‘excess is evidenced when a company has ‘excess earnings’ (i.e., the company’s rate of return on assets earnings’ (i.e., the company’s rate of return on assets is greater than the industry average). is greater than the industry average).
GoodwillGoodwill can be attributed to a number of different can be attributed to a number of different reasons (e.g., skilled labor force, great management reasons (e.g., skilled labor force, great management team, superior product quality, excellent customer team, superior product quality, excellent customer service, etc.)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 overover 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)?
Chapter 1-379
Marshall Co. pays $400,000 cash to purchase the net assets of Tractorling Company--whose Balance Sheet is
presented below.
Recording Goodwill -- An IllustrationRecording Goodwill -- An IllustrationRecording Goodwill -- An IllustrationRecording Goodwill -- An Illustration
The FAIR VALUE of Tractorling’s Net Assets are
Chapter 1-380
Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)
Remember that Goodwill is C > FMV of NA acquired
Chapter 1-381
Marshall Co.’s Journal Entry to record purchase of Tractorling
Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)Recording Goodwill -- An Illustration (Continued)
What will be the accounting in the future for the Goodwill Asset now on Marshall’s financial statements?
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!
Goodwill of $50,000 = $400,000 Cost - $350,000 FMV of Net Assets Acquired
Chapter 1-382
““Negative” GoodwillNegative” Goodwill(Cost < FMV of Net Assets Acquired)(Cost < FMV of Net Assets Acquired)
““Negative” GoodwillNegative” Goodwill(Cost < FMV of Net Assets Acquired)(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.
Chapter 1-383
Impairment of GoodwillImpairment of GoodwillImpairment of GoodwillImpairment of Goodwill
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.
‘Different’ two-step process used to test Goodwill for impairment
Chapter 1-384
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 $50,000 for Goodwill):
Cash 60,000$
Receivables 200,000
I nventory 190,000
Property, plant, and equipment, net 2,550,000
Goodwill 50,000
Less: Liabilities (2,700,000)
Net assets 350,000$ *
Impairment of Goodwill -- An IllustrationImpairment of Goodwill -- An IllustrationImpairment of Goodwill -- An IllustrationImpairment of Goodwill -- An Illustration
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.
Chapter 1-385
Impairment of Goodwill -- An IllustrationImpairment of Goodwill -- An Illustration(Continued)(Continued)
Impairment of Goodwill -- An IllustrationImpairment of Goodwill -- An Illustration(Continued)(Continued)
Fair valueBook value, net of goodwill
I mplied goodwill
Book value of goodwill
Loss on impairment
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.
Loss on impairment 15,000 Goodwill 15,000
$ $ 335,000335,000300,000300,00035,00035,00050,00050,000
$ $ (15,000)(15,000)
Step 2: Calculate and record journal entry for the impairment of Goodwill.
Chapter 1-386
Impairment of Goodwill -- An IllustrationImpairment of Goodwill -- An Illustration(Continued)(Continued)
Impairment of Goodwill -- An IllustrationImpairment of Goodwill -- An Illustration(Continued)(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).
Chapter 1-387
Summary of Impairment TestsSummary of Impairment TestsSummary of Impairment TestsSummary of Impairment Tests
Chapter 1-388
Research and Development (R&D) CostsResearch and Development (R&D) CostsResearch and Development (R&D) CostsResearch 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.
Chapter 1-389
Start-up costs for a new operation.
Initial operating losses.
Advertising costs.
Other Costs Similar to R & D CostsOther Costs Similar to R & D CostsOther Costs Similar to R & D CostsOther Costs Similar to R & D Costs
Expensed as Incurred
“Industry exception”
Some computer software development costs are capitalized -- see next slide.
Chapter 1-390
Accounting for Computer Software CostsAccounting for Computer Software CostsAccounting for Computer Software CostsAccounting for Computer Software Costs
1. 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.
2. Once technological feasibility is established (when the company has completed a detailed program design or a working model), then subsequent development costs are capitalized.
Capitalize or Part of Research & Development Expense (R&D):
Reporting Software Costs:
Unamortized software costs. The total amount charged to expense The amounts, if any, written down to net realizable value.
Chapter 1-391
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 and RPresentations of Intangibles and R&&DDPresentations of Intangibles and RPresentations of Intangibles and R&&DD
Chapter 1-392
Presentations of IntangiblesPresentations of IntangiblesPresentations of IntangiblesPresentations of Intangibles
Chapter 1-393
Presentations of RPresentations of R&&D CostsD CostsPresentations of RPresentations of R&&D CostsD Costs
Chapter 1-394
1.1. Long-term investmentsLong-term investments1. 1. Investment in a subsidiary Investment in a subsidiary companycompany
2. 2. TimberlandTimberland
3. 3. Cost of engineering activity Cost of engineering activity required to advance the design of required to advance the design of a product to the manufacturing a product to the manufacturing stage.stage.
4. 4. Lease prepayment Lease prepayment
5. 5. Cost of equipment obtained Cost of equipment obtained under a capital lease.under a capital lease.
6. 6. Cost of searching for applications Cost of searching for applications of new research findings.of new research findings.
ItemItemItemItem Reported AsReported AsReported AsReported As
Review Question Review Question Review Question Review Question
Indicate how items on the list below would generally be reported in the financial statements.
2.2. Natural resourcesNatural resources
3.3. R & D expenseR & D expense
4.4. Prepaid rentPrepaid rent
5.5. PP&E (Chapter 21 PP&E (Chapter 21 covers Leases)covers Leases)
6.6. R & D expense R & D expense
Chapter 1-395
7.7. ExpenseExpense7. 7. Cost incurred in the formation of Cost incurred in the formation of a corporation.a corporation.
8. 8. Operating losses incurred in the Operating losses incurred in the start-up of a business. start-up of a business.
9. 9. Training costs incurred in start-up Training costs incurred in start-up of new operation. of new operation.
10. 10. Purchase cost of a franchise.Purchase cost of a franchise.
11. 11. Goodwill generated Goodwill generated internally.internally.
12. 12. Cost of testing in search of Cost of testing in search of product alternatives.product alternatives.
ItemItemItemItem Reported AsReported AsReported AsReported As
Review Question (Continued)Review Question (Continued)Review Question (Continued)Review Question (Continued)
Indicate how items on the list below would generally be reported in the financial statements.
8.8. Operating lossOperating loss
9.9. ExpenseExpense
10.10. IntangibleIntangible
11.11. Not recordedNot recorded12.12. R & D expenseR & D expense
Chapter 1-396
13.13. IntangibleIntangible13. 13. Goodwill acquired in the Goodwill acquired in the purchasepurchase of a business. of a business.
14. 14. Cost of developing a Cost of developing a patent.patent.
15. 15. Cost of purchasing a Cost of purchasing a patent frompatent from an inventor. an inventor.
16. 16. Legal costs incurred in Legal costs incurred in securing asecuring a patent. patent.
ItemItemItemItem Reported AsReported AsReported AsReported As
Review Question (Continued)Review Question (Continued)Review Question (Continued)Review Question (Continued)
Indicate how items on the list below would generally be reported in the financial statements.
14.14. R & D ExpenseR & D Expense
15.15. IntangibleIntangible
16.16. IntangibleIntangible
Chapter 1-397
17. 17. Cost of purchasing a Cost of purchasing a copyright.copyright.
18. 18. Research and Research and development costs.development costs.
19. 19. Cost of developing a Cost of developing a trademark.trademark.
20. 20. Cost of purchasing a Cost of purchasing a trademark.trademark.
ItemItemItemItem Reported AsReported AsReported AsReported As
Review Question (Continued)Review Question (Continued)Review Question (Continued)Review Question (Continued)
Indicate how items on the list below would generally be reported in the financial statements.
17. Intangible17. Intangible
18.18. R & D ExpenseR & D Expense
19.19. ExpensedExpensed
20.20. IntangibleIntangible
Chapter 1-398
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 12Homework for Ch. 12
Class Assignment Questions # 3, 4, 8, 9, 12, 23, Class Assignment Questions # 3, 4, 8, 9, 12, 23, 24 (pages 619-620)24 (pages 619-620)
Homework (pages 622-626):Homework (pages 622-626):
Ex. 3, 4, 13, 14Ex. 3, 4, 13, 14
Chapter 1-399
C H A P T E R C H A P T E R 1313
CURRENT LIABILITIES AND CURRENT LIABILITIES AND CONTINGENCIESCONTINGENCIES
Intermediate Accounting13th Edition
Kieso, Weygandt, and Warfield
Chapter 1-400
1. Describe the nature, type, and valuation of current liabilities.
2. Explain the classification issues of short-term debt expected to be refinanced.
3. Identify types of employee-related liabilities.
4. Identify the criteria used to account for and disclose gain and loss contingencies.
5. Explain the accounting for different types of loss contingencies.
6. Indicate how to present and analyze liabilities and contingencies.
Summary of Chapter 13Summary of Chapter 13Summary of Chapter 13Summary of Chapter 13
Chapter 1-401
What is a Liability?What is a Liability?What is a Liability?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’)
Chapter 1-402
What is a Current Liability?What is a Current Liability?What is a Current Liability?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 LiabilitiesAccounts 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.
Chapter 1-403
Balances owed to others for goods, supplies, or
services purchased on open account.
Accounts Payable (trade accounts payable)
Accounts PayableAccounts PayableAccounts PayableAccounts Payable
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.
Chapter 1-404
Written promises to pay a certain sum of money
on a specified future date.
Notes Payable
Notes PayableNotes PayableNotes PayableNotes Payable
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).
Chapter 1-405
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, 2010. Golden’s accounting year ends on December 31. Prepare journal entries related to the note.
Notes Payable -- “Notes Payable -- “Interest-BearingInterest-Bearing Note” Illustrated Note” IllustratedNotes Payable -- “Notes Payable -- “Interest-BearingInterest-Bearing Note” Illustrated Note” Illustrated
Golden Inc.’s Journal Entries for 2009 and 2010
6/1/09 Cash 50,0006/1/09 Cash 50,000 Note Payable 50,000Note Payable 50,000
12/31/09 Interest Expense 1,75012/31/09 Interest Expense 1,750 Interest Payable 1,750Interest Payable 1,750
5/31/105/31/10 Note Payable 50,000 Note Payable 50,000
Cash 50,000Cash 50,000Interest Expense 1,250Interest Expense 1,250Interest Payable 1,750Interest Payable 1,750
Chapter 1-406
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, 2010--the maturity date. Golden’s accounting year ends on December 31.
Notes Payable -- “Notes Payable -- “Zero-Interest-BearingZero-Interest-Bearing Note” Note” IllustratedIllustrated
Notes Payable -- “Notes Payable -- “Zero-Interest-BearingZero-Interest-Bearing Note” Note” IllustratedIllustrated
6/1/09 Cash 47,0006/1/09 Cash 47,000 Discount on Note Payable 3,000Discount on Note Payable 3,000
12/31/09 Interest Expense 1,75012/31/09 Interest Expense 1,750
Note Payable 50,000Note Payable 50,000
Discount on Note Payable Discount on Note Payable 1,7501,750
Discount on Note Payable 1,250Discount on Note Payable 1,250 5/31/10 Interest Expense 1,2505/31/10 Interest Expense 1,250
Note Payable 50,000Note Payable 50,000 Cash 50,000Cash 50,000
Golden Inc.’s Journal Entries for 2009 and 2010
Chapter 1-407
The Discount on Notes Payable is a contra liability account to Notes Payable.
Notes Payable -- “Notes Payable -- “Zero-Interest-BearingZero-Interest-Bearing Note” Note” IllustratedIllustrated
Notes Payable -- “Notes Payable -- “Zero-Interest-BearingZero-Interest-Bearing Note” Note” IllustratedIllustrated
What ‘interest rate’ did Golden actual pay on the “zero-interest-bearing note?
Answer: 6.4% $3,000 interest/$47,000 cash received
Golden’s Dec. 31, 2009 Balance Sheet Golden’s Dec. 31, 2009 Balance Sheet (partial)(partial)
Current liabilities:Current liabilities:
Notes Payable $50,000Notes Payable $50,000
Less: Discount on Notes Payable 1,250Less: Discount on Notes Payable 1,250* * $48,750 $48,750
((** $1,250 = $3,000 original balance less $1,750 $1,250 = $3,000 original balance less $1,750 amortized to interest expense on Dec. 31, 2009) amortized to interest expense on Dec. 31, 2009)
Chapter 1-408
Exclude debts maturing in next year from current
liabilities IF maturing liabilities are to be:
Debts Maturing in Next Year NOT requiring Use of Debts Maturing in Next Year NOT requiring Use of Current Asset to “Pay it off”Current Asset to “Pay it off”
Debts Maturing in Next Year NOT requiring Use of Debts Maturing in Next Year NOT requiring Use of Current Asset to “Pay it off”Current Asset to “Pay it off”
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.
Chapter 1-409
Debts Expected to be Refinanced
Mgmt. Intends of Refinance
Demonstrates Ability to Refinance
Actual Refinancing after balance sheet date but
before issue date
Financing Agreement Noncancellable with Capable
Lenderor
YEYESS
YESYES
Classify as Current Liability
NNOO
NONO
Exclude Debt from Current Liabilities and Reclassify as LT Debt
Current Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be Refinanced
Chapter 1-410
Current Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be Refinanced
On December 31, 2010, Alexander Company had $1,200,000 of
short-term debt in the form of notes payable due February 2,
2011. 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.
Chapter 1-411
Alexander Company
Balance Sheet (Partial)
December 31, 2010
Current liabilities:
Notes payable
Long-term debt:
Notes payable refinanced
Total liabilities
Current Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be Refinanced
$ 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.
Chapter 1-412
Current Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be RefinancedCurrent Obligations Expected to be Refinanced
Actual Refinancing of Short-Term Debt
Chapter 1-413
Amount owed by a corporation to its
stockholders as a result of board of directors’
authorization.
(Chapter 15 in Intermediate Accounting II)
Dividends PayableDividends PayableDividends PayableDividends Payable
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.
Chapter 1-414
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).
Customer Deposits
Customer DepositsCustomer DepositsCustomer DepositsCustomer Deposits
May be classified as current or long-term depending on the circumstances.
Chapter 1-415
Payment received before delivering goods or rendering services (e.g., Magazine Publisher)
Unearned RevenuesUnearned RevenuesUnearned RevenuesUnearned Revenues
Unearned and Earned Revenue Accounts
Chapter 1-416
The publishers of “Fly Fishing for Carp”“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.
Unearned Revenues -- An IllustrationUnearned Revenues -- An IllustrationUnearned Revenues -- An IllustrationUnearned Revenues -- An Illustration
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)
Chapter 1-417
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.
Sales Taxes PayableSales Taxes PayableSales Taxes PayableSales Taxes Payable
(a) Accounts receivable 31,800Sales 30,000Sales tax payable ($30,000 x 6% = $1,800) 1,800
(b) Cash 20,670Sales ($20,670 1.06 = $19,500) 19,500Sales tax payable 1,170
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.
Chapter 1-418
Corporations must prepare a corporate
income tax return* and compute the income
tax payable resulting from the operations of
the current period.
Income Tax PayableIncome Tax PayableIncome Tax PayableIncome Tax Payable
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]
Chapter 1-419
Amounts owed to employees for salaries or wages are reported as a current liability (i.e., “Salaries Payable”)
EmployeeEmployee Payroll Related Current LiabilitiesPayroll Related Current LiabilitiesEmployeeEmployee Payroll Related Current LiabilitiesPayroll Related Current Liabilities
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.)
EmployerEmployer Payroll Related Current Payroll Related Current LiabilitiesLiabilities Payroll Taxes incurred by Employer:
FICA & Medicare (matching employee withholding) Unemployment Taxes (State & Federal)
Chapter 1-420
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.
Payroll -- Current Liability ( An Illustration)Payroll -- Current Liability ( An Illustration)Payroll -- Current Liability ( An Illustration)Payroll -- Current Liability ( An Illustration)
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 entryJournal entry to record salaries and wages paidto record salaries and wages paid
Journal entry to record employer payroll Journal entry to record employer payroll taxestaxes Payroll tax expense 1,245
F.I.C.A taxes payable 765 Federal unemployment tax payable 80 State unemployment tax payable 400
Employees’ take-home pay of $7,827 vs. $11,245 payroll cost to Employees’ take-home pay of $7,827 vs. $11,245 payroll cost to Employer!Employer!
Chapter 1-421
Accrue for Compensated AbsencesAccrue for Compensated Absences Current Liability Current Liability
Accrue for Compensated AbsencesAccrue for Compensated Absences Current Liability 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 Accrue = Spread expense throughout the year; not
all recorded as expense when paid!all recorded as expense when paid!
Chapter 1-422
“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.”
ContingenciesContingenciesContingenciesContingencies
Chapter 1-423
Gain ContingenciesGain ContingenciesGain ContingenciesGain Contingencies
Typical GAIN Contingencies are:
1. Possible receipts of monies from gifts and donations.
2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favorable outcome.
4. Tax loss carryforwards (Chapter 19).Gain contingencies are usually not recorded. (Why not?)
Disclosed only if probability of receipt is high.
Chapter 1-424
Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies
The likelihood that the future event will confirm the incurrence of a loss and a liability can range from probable to remote.
Loss Contingency ‘May” be Recorded
Three degrees of probability:
Probable.
Reasonably possible.
Remote.
Chapter 1-425
AccountingProbability
Accrue
Disclose
Ignore
Probable
ReasonablyPossible
Remote
Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies
Chapter 1-426
Cone Inc. is involved in a lawsuit at December 31, 2010. Prepare the December 31 entry, if any, assuming:
(a) it is probable that Cone will be liable for $900,000
(b) 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
Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies
(b) No entry is necessary. Disclosure required.
(c) No entry or disclosure is necessary.
Do you believe that Loss Contingencies would be a Do you believe that Loss Contingencies would be a difficult or easy area to audit? difficult or easy area to audit?
Chapter 1-427
Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies
Note the first item listed below as a “Loss Contingency” that Note the first item listed below as a “Loss Contingency” that Usually is Accrued—but does Usually is Accrued—but does NOTNOT result in a result in a liabilityliability being being
recorded!recorded!
Chapter 1-428
Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies
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.
Litigation, Claims, and Assessments
Time period in which the action occurred.
Probability of an unfavorable outcome.
Ability to make a reasonable estimate of the
loss.
Chapter 1-429
Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies
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.
Environmental Liabilities
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.
Chapter 1-430
Loss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental LiabilitiesLoss 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.
Chapter 1-431
Loss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental Liabilities(An Illustration)(An Illustration)
Loss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental Liabilities(An Illustration)(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 .62092).
Drilling platform 620,920
Asset retirement obligation
620,920
Journal Entry to records this Asset Retirement Obligation Journal Entry to records this Asset Retirement Obligation
(ARO)(ARO)
Over the next five years: (1) the $620,920 Drilling Over the next five years: (1) the $620,920 Drilling Platform Asset will be depreciated AND (2) interest Platform Asset will be depreciated AND (2) interest needs to be recognized as the ARO Liability ‘grows’ needs to be recognized as the ARO Liability ‘grows’ until it is $1,000,000 in five years.until it is $1,000,000 in five years.
Chapter 1-432
Loss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental Liabilities(An Illustration)(An Illustration)
Loss Contingencies -- Environmental LiabilitiesLoss Contingencies -- Environmental Liabilities(An Illustration)(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
124,184Wildcat 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%) 62,092 Asset retirement obligation 62,092Similar entries would be made each year--based on an amortization Similar entries would be made each year--based on an amortization
schedulescheduleIf the actual cost to demolish the drilling platform differs If the actual cost to demolish the drilling platform differs from the ARO liability amount--the difference is recorded from the ARO liability amount--the difference is recorded
as a gain or loss.as a gain or loss.
Chapter 1-433
Loss ContingenciesLoss ContingenciesLoss ContingenciesLoss Contingencies
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
Self-Insurance ‘reserves’ (“cookie jars”) have been improperly used in the past by management to ‘manage earnings’
Chapter 1-434
Companies should disclose certain other contingent liabilities.
1. Guarantees of indebtedness of others.
2. Obligations of commercial banks under “stand-by letters of
credit.”
3. Guarantees to repurchase receivables (or any related property)
that have been sold or assigned.
Disclosure Requirements for ContingenciesDisclosure Requirements for ContingenciesDisclosure Requirements for ContingenciesDisclosure Requirements for Contingencies
Disclosure should include:
Nature of the contingency.
An estimate of the possible loss or range of loss.
Chapter 1-435
Disclosure Requirements for ContingenciesDisclosure Requirements for Contingencies(An Illustration)(An Illustration)
Disclosure Requirements for ContingenciesDisclosure Requirements for Contingencies(An Illustration)(An Illustration)
Disclosure of Loss Contingency through Litigation
Chapter 1-436
Balance Sheet Presentation of Current LiabilitiesBalance Sheet Presentation of Current LiabilitiesBalance Sheet Presentation of Current LiabilitiesBalance Sheet Presentation of Current Liabilities
Chapter 1-437
Ratio AnalysisRatio AnalysisRatio AnalysisRatio 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 Liabilities Current
Ratio
=
Cash + Marketable Securities + Net Receivables
Current Liabilities
Acid-Test Ratio
(aka. “Quick Ratio”)
=
Chapter 1-438
Costner Company has been operating for several years, and on December 31, 2010, presented the following balance sheet.
Ratio Analysis -- An IllustrationRatio Analysis -- An IllustrationRatio Analysis -- An IllustrationRatio Analysis -- An Illustration
Balance Sheet (in thousands)
Assets
Cash 40,000$
Accounts recievables, net 75,000
I nventories 95,000
Plant assets, net 220,000
Total assets 430,000$
Liabilities and Equity
Accounts payable 70,000$
Mortgage payable 140,000
Common stock, $1 par 160,000
Retained earnings 60,000
Total liabilities and equity 430,000$
Compute the current ratio:
$210,000
70,000
=3.0 to 1
Compute the acid-test ratio:
$115,000
70,000
=1.64 to 1
““Window Dressing”!!!!!!Window Dressing”!!!!!!
Chapter 1-439
Class Assignment Review Questions and Class Assignment Review Questions and Homework for Ch. 13Homework for Ch. 13
Class Assignment Questions #1, 3, 7, 9, 13, 20, Class Assignment Questions #1, 3, 7, 9, 13, 20, 21, 22, 26, 30 (page 669)21, 22, 26, 30 (page 669)
Homework (pages 668-673):Homework (pages 668-673):
CE 13-1, CE 13-2CE 13-1, CE 13-2
Ex. 1, 2, 8, 13Ex. 1, 2, 8, 13