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ACCOUNTING OUTLINEFrom Stickney & Weil Book

OVERVIEWFinancial Statements

1.

Balance Sheet: presents a snapshot of the investing and financing activities of a firmat a moment in timea. Assets

(1)Current Assets: cash and assets that a firm expects to turn into cash, sell, orconsume within approximately one year from the date on the b/s

(2)Noncurrent Assets: typically held and used for several years, include land,buildings, equipment, patents, and long-term investments in securities

b. Liabilities(1)Current Liabilities: obligations a firm expects to pay within one year(2)Noncurrent Liabilities: firms longer-term sources of funds

c. Shareholders Equity(1)

contributed capital: funds invested by shareholders for an ownership interest(2)retained earnings: earnings realized by a firm in excess of dividendsdistributed to shareholders since its formation

Assets = Liabilities + Shareholders Equity

2. Income Statement: presents the results of the operating activities of a firm for aspecific time period (i.e. one year), indicating the net income or earnings for that timeperiod i.e. the difference between revenues and expenses.a. Revenues: measure the inflows of assets (or reductions in liabilities) from selling

goods and providing services to customers.b. Expenses: measure the outflow of assets (or increases in liabilities) used in

generating revenues.3. Statement of Cash Flows: reports to net cash flows relating to operating, investing,

and financial activities for a period of time.a. Operating Activitiesb. Investing Activitiesc. Financing Activities

4. Notes: to help explain the f/s5. Opinion of CPA:Accounting Concepts, Principles, Assumptions, and Constraints (including the Big

Six)1. Qualitative Characteristics:

a. Relevancy: Information is relevant if it influences the actions of a decision maker.To be relevant, information must have predictive or feedback value and it must bepresented on a timely basis.

b. Reliability: Information must accurately depict (or at least fairly state) theconditions it is purported to represent. Accounting information is reliable to the

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extent it is verifiable, is a faithful representation and is reasonably free of errorand is unbiased (i.e. accountants are concerned with neutrality in presentation).

c. Comparability: Usefulness is enhanced if the f/s of an entity can be comparedwith other companies f/s.

d. Consistency: Use of the same accounting principles each year enhances the abilityto compare the f/s of the same company from year to year.2. Basic Assumptions:

a. Entity: A company is an economic unit separate and apart from its owners.b. Going Concern: We assume that t company will continue to operate indefinately.c. Monetary Unit: Everything is measured in money. We also assume that inflation

is insignificant and thus ignored.d. Periodicity: We cannot wait forever to issue financial information. Thus,

economic activities of a company are divided into artificial time periods (e.g.year, quarter, month) and f/s are issued based on the best estimates available at theend of the period).

3. Basic Principles:a.

Historical Cost: Assets should be recorded at their cost. (Cost = the valueexchanged at the time something is acquired. Typically, the exchange involvescash).

b. Revenue Recognition: Revenue is (generally) recorded when it is earned. Andrevenue is considered earned when the company has substantially accomplishedwhat it must do to be entitles to the benefits represented by the revenue (i.e. (1)earned, (2) measurable, and (3) is reasonably collectible). Often revenue isrecognized at the point of sale. E = MC2 (whether or not to recognize revenue issometimes difficult to determine under the accrual method).

c. Matching Principle: Costs incurred to generate revenues are expenses when therevenue is recognized. Efforts (expenses) should be matched withaccomplishments (revenues).

d. Full Disclosure Principle: Everything that is relevant must be disclosed in the f/sand accompanying footnotes (notes to the f/s). Example:Related Parties Disclosure:

1. must make disclosure of material related party transactions2. must makefull disclosure3. absent such a disclosure, assume parties to the transaction are conducting

the transaction at arms length basis4. Constraints:

a. Materiality/ Cost-Benefit: Relative significance, both quantitatively andqualitatively, must be considered. An item is material if its inclusion or omissionwould influence or change the judgment of a reasonable person. In short, if itdoesnt make a difference, it doesnt need to be disclosed.Cost-benefit relationship: The cost of making a particular measurement ordisclosure should not exceed the benefit derived from it.

b. Conservatism: Accounting measurements often take place in a context ofsignificant uncertainty. Possible errors should tend toward understatement, ratherthan overstatement, of assets and income. When in doubt, select the answer whichwill be least likely to overstate assets and income.

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c. Industry Practice: The peculiar nature of some industries and businessessometimes require departure from basic theory.

THE BALANCE SHEETAssets

1.

Recognitiona. the firm has acquired rights to its use in the future as a result of a past transaction(i.e. dont recognize executory Ks as assets) or exchange and

b. the firm can measure or quantify the future benefits with a reasonable degree ofprecision

2. Valuationa. Acquisition or Historical Cost: the amount of cash payment (or cash equivalent

value of other forms of payment) made in acquiring an asset.b. Current Replacement Cost: the current cost to replace it: entry value.c. Current Net Realizable Value: the net amount of cash (selling price less selling

costs) that a firm would receive currently if it sold each asset separately: exit

value.d. Present Value of Future net Cash Flows: the ability of an asset either to generatefuture net cash receipts or to reduce future cash expenditures. Must discount topresent value

3. Classificationa. Current Assets: cash and other assets that a firm expects to realize in cash or to

sell or consume during the normal operating cycle of the business, usually oneyear. Includes: cash, marketable securities held for short term, accounts and notesreceivable, inventories of merchandise, raw materials, supplies, work in process,and finished goods and prepaid operating costs, such as prepaid insurance andprepaid rent. EX of journalizing a prepayment:

DR Prepaid Rent $10,000CR Cash $10,000

to record prepayment of rent.

DR Rent Expense $5,000CR Prepaid Rent $5,000

amortize half the cost over half of the year because the rent was prepaid for the wholeyear.

b. Investments: long-term investments in securities in other firmsc. Property, Plant, and Equipment: Fixed Assets: tangible, long-lived assets used in a

firms operations over a period of years and generally not acquired for resale.Includes: land, buildings, machinery, automobiles, furniture, fixtures, computers,and other equipment. The b/s shows these items (except for land) at acquisitioncost less accumulated depreciation since the asset was acquired, unless the assetshave substantially declined in value since acquisition.

d. Intangible Assets: Includes: patents, trademarks, franchises, and goodwill.Accountants generally do not recognize expenditures that a firm makes in

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developing intangibles as assets because of the difficulty of ascertaining theexistence of future benefits. Accounting does, however, recognize specificallyidentifiable intangibles acquired in market exchanges from other entities as assets

Liabilities

1.

Recognition: a firm receives benefits or services and in exchange promises to pay theprovider of those goods or services a reasonably definite amount at a reasonablydefinite future time.

2. Valuation:a. most are monetary, requiring payments of specific amounts of cashb. but if the payment dates extend more than one year into the future, the liability

appears at the present value of the future cash outflows.c. some are nonmonetary i.e. delivery of goods or rendering services

3. Classificationa. Current Liabilities: obligation that a firm expects to pay or discharge during the

normal operating cycle of the firm, usually one year

b.

Long-Term Debt: obligations having due dates, or maturities, more than one yearafter the b/s date. Includes: bonds, mortgages, and similar debtc. Other Long-Term Liabilities: Includes: deferred income taxes and some

retirement obligations.

Shareholders Equity1. The residual interest2. Classification:

a. common stock: the amount that shareholders contribute directly for an interest inthe firm(1)par value(2)amounts contributed in excess of par value

b. retained earnings: earnings the firm subsequently realizes in excess of dividendsdeclared (earnings retained at beginning of period + net income for period dividends of period).

Accounting Procedures

Assets = Liabilities + EquityDR CR DR CR DR CR+ - - + - +

Revenue - ExpenseDR CR DR CR- + + -

1. dual effects of transactions (i.e. debit one account and credit another)2. T-accounts to accumulate the changes that take place in each b/s

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Asset Account

Beginning Balance

Increases DR Decreases CREnding Balance

Liability Account

Decreases DR

Beginning Balance

Increases CREnding Balance

Shareholders Equity Account

Decreases DR

Beginning Balance

Increases CREnding Balance

Temporary Accounts

Revenue

Decreases DR Increases CR (allhere except forcorrections,adjustments, andfinal transfer)

ExpenseIncreases DR (allhere except forcorrections,adjustments, andfinal transfer)

Decreases CR

Summary of what Account to Debit or Credit for Transactions

Debit (left-side) Transaction Credit (right-side)Increase Asset: Cash Issue Capital Stock at par

for Cash

Increase Ownership Equity

Account: Capital StockIncrease Asset: Cash Borrow Money on a Bank

LoanIncrease Liability:LoanPayable

Increase Asset: OfficeEquipment

Purchase Office Equipmentfor Cash

Decrease Asset: Cash

Decrease ShareholderEquity Account:RetainedEarnings

Issue a Stock Dividend Increase Shareholder EquityAccount: Capital Stock

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Decrease ShareholderLiability:Equity Account,Preferred Capital Stock

Redeem Preferred Stock byIssuance of Notes Payable

IncreaseNotes Payable

Decrease ShareholderEquity Account:Retained

Earnings

Pay for a Cash Dividend Decrease Asset: Cash

Decrease Liability:BondsPayable

Convertible BondsConverted to Capital Stock

Increase Shareholder EquityAccount: Capital Stock

Decrease Liability:Accounts Payable

Issue a Note Payable toSettle an Account Payable

Increase Liability:NotesPayable

Decrease Liability:Accounts Payable

Pay Cash on an AccountPayable

Decrease Asset: Cash

3. JournalizingDate Account Debited Amount Debited

Account Credited Amount CreditedExplanation of transaction or event being journalized

4. Posting: At periodic intervals (i.e. weekly or monthly), the accountant enters, orposts, transactions recorded in the general journal to the individual accounts in thegeneral ledger (T-Accounts)

5. Trial Balance Preparation: lists each of the accounts in the general ledger with itsbalance as of a particular date (i.e. lists debit balances or credit balances of allaccounts)

6. Adjust Trial Balancea. to correct if it doesnt balance (i.e. debits credits)b. to account for Depreciation and Bad Debts, etc.c. Close Entries (i.e. Expense and Revenue Accounts)d. now make a Post-Closing Trial Balance to reflect all the adjustments

7. Financial Statement PreparationPermanent Accounts:1. Asset2. Liability3. Shareholders Equity These are balanced at the end of the fiscal period (hence the name: Balance Sheet)Temporary Accounts:1. Revenue2. Expense (i.e. Cost of Goods Sold, Rent Expense, Depreciation Expense) These are closed at the end of the fiscal period the balances are then transferred to an Income Summary Account (Debit the Revenue

Accounts and Credit the Income Summary; Credit the Expense Accounts and Debitthe Income Summary)

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then this balance is transferred to the Shareholders Equity Account on the B/S (i.e.Credit Retained Earnings)

THE INCOME STATEMENTAccounting Methods

1.

Cash Basis:a. a firm recognizes revenues in the period when it receives cash from customersb. a firm reports expenses in the period when it makes cash expendituresc. Problems:

(1)does not adequately match the cost of the efforts required in generatingrevenues with those revenues

(2)unnecessarily postpones the time when the firm recognizes revenue. A firmshould recognize revenue when the firm has finished the difficult parts of thetransaction

d. users: lawyers, accountants, other professionals2. Accrual Basis:

a.

recognizes revenue when a firm sells goods or renders servicesb. costs of assets used lead to expenses in the period when the firm recognizes therevenues that the costs helped produce

c. Why good:(1)revenues more accurately reflect the results of sales activity(2)expenses more closely match reported revenues

d. users: business firms i.e. merchandising and manufacturing firms

Measurement Principles of Accrual Accounting1. Timing of Revenue Recognition:

a. Requirements:(1)a firm has performed all, or a substantial portion of, the services it expects to

provide(2)the firm has received cash, a receivable, or some other asset capable of

reasonably precise measurementb. most firms involved in selling goods and services recognize revenue at the time of

sale (delivery)c. if the firm makes the sale on account, past experience and an assessment of credit

standings of customers provide a basis for predicting the amount of cash the firmwill collect

d. in general, the firm will recognize revenue when it has no further significantuncertainty about the amount and timing of cash collection from the salestransaction.

2. Measurementof Revenuea. a firm measures the amount of revenue by the cash or cash-equivalent value of

other assets it receives from customersb. Uncollectible Accounts: if a firm expects not to collect some portion of the sales

for a period, it must adjust the amount of revenue recognized during that periodfor estimated uncollectible accounts arising from those sales. The adjustment

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occurs in the period when the firm recognizes revenue and not in the later periodwhen it identifies specific customers accounts as uncollectible.

c. Sales Discounts and Allowances: the firm must estimate these amounts and makeappropriate reduction, at the time of sale, in measuring the amount of revenue itrecognizes.

d.

Sales Returnse. Delayed Payments: for the period of sale, the firm recognizes as revenue only thepresent value, at the time of sale, of the amount it expects to receive

3. Timing of Expense Recognition: when do the benefits of an asset expire, leaving theb/s, and becoming expenses, entering the income statement as reductions in

shareholders equity?a. Criteria for Expense Recognition:

(1)if an asset expiration associates directly with a particular revenue, thatexpiration becomes an expense in the period when the firm recognizes therevenue. Matching cost expirations with revenues.

(2)if an asset expiration does not clearly associate with revenues, that expirationbecomes an expense of the period when the firm consumes the benefits of thatasset in operations.

b. Product Costs:(1)merchandising firm: inventory appears as an asset stated at acquisition cost on

the b/s. When the firm sells the inventory, the same amount of acquisitioncost appears as an expense (Cost of Goods Sold) on the income statement

(2)mfg firm: incurs costs as it changes the physical form of the goods itproduces: (1) direct material costs, (2) direct labor costs, and (3) mfg overheadcosts. These Product Costs (i.e. Work-in-Process Inventory and FinishedGoods Inventory) remain on the balance sheet as assets until the firm sells thegoods that they embody; then they become expenses.

c. Marketing Costs: expensed in the period when the firm uses their servicesd. Administrative Costs: Treated like marketing costs and expensed in the period

4. Measurement of ExpensesAccounting Procedures1. accumulate expenses of the period2. report theses expenses and revenue in the income statement3. after preparing the income statement at the end of the period, the accountant transfers

the balance in each revenue and expense account to the Retained Earnings Account:Closing the Revenue and Expense Accounts.

Retained Earnings (SE) Amount

Account with Debit Balance (SE), usually expense account Amount

Account with Credit Balance (SE) Amount

Retained Earnings (SE) Amount

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closing entries reduce the balances in all temporary accounts to zero. the former debit(credit) balances in temporary accounts become debits (credits) in the Retained EarningsAccount.

4. Journalizing for Revenues, Expenses, and Dividends:Asset (A) Increase or Liability (L) Decrease Amount

Revenue (SE) AmountTypical entry to recognize revenue

Expense (SE) AmountAsset (A) Decrease or Liability (L) Increase Amount

Typical entry to record expense

Retained Earnings (SE) AmountDividends Payable (L) Amount

Typical entry to record dividend declaration

Dividends Payable (L) AmountCash (A) Amount

Typical entry to record dividend payment

Contra Account (XA) accumulates amounts subtracted from the amount in anotheraccount.

Adjusting Entries:1. Salaries and wages earned by employees2. Interest that has accrued3. Recognition of Accrued Revenues and Receivables4. Recognition of Accrued Expenses and Payables5. Allocation of Prepaid Operating Costs6. Recognition of Depreciation7. Valuation of Liabilities8. Correction of Errors

ACCRUAL ACCOUNTING ON THE INCOME STATEMENTAccrual Basis for Mfg1. a mfg firm incurs 3 types of costs to convert raw materials into finished products:

a. direct material (or raw material)b. direct laborc. mfg overhead

2. most mfg firms recognize revenue at the time they sell the goods; until they sell thegoods, it treats mfg costs as product cost assets and accumulates them in inventoryaccountsa. The Raw Materials Inventory Account: includes the cost of raw materials

purchased but not yet transferred to production. When the mfg begins to use raw

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materials in production departments, it transfers the cost of the materials from theRaw Materials Inventory Account to the Work-in-Process Inventory Account

b. The Work-in-Process Inventory Accountaccumulates (with debits) the cost of rawmaterials transferred from the raw materials storeroom, the cost of direct laborservices used, and the mfg overhead costs incurred. When the firm completes

mfging, it reduces (with credits) the balance in the Work-in-Process account andincreases (with debits) the balance in the Finished Goods Inventory.c. The Finished Goods Inventory Accountincludes the total mfg cost of units

completed but not yet sold. The sale of mfged goods to customers results in atransfer of their cost from the Finished Goods Inventory Account to the expenseaccount Cost of Goods Sold.

3. however, selling and administrative costs are period expensesAccrual Basis for other Types of Businesses1. Revenue Recognition:

a. the firm has provided all or a substantial portion of the services it expects toperform for customers, andb. is able to measure the amounts of revenues and expenses (that is, cash inflows andcash outflows) with reasonable precision.

2. Measurement :a. the revenues must equal the present value of the amount of cash a firm expects to

receive from customers for goods or services sold, andb. expenses must equal the amount of cash a firm has expended or expects to expend

to generate the revenues.3. Firms sometimes recognize revenues and expenses before the sale or delivery of a

product. This is typically when the firm has Ked with a particular customer, agreedon a selling price, and performed substantial work to create the product.

4. Income Recognition Before the Sale:a. Long-Term Contractors:b. Percentage-of-Completion Method: recognizes a portion of the K price as revenue

during each accounting period of construction. It bases the amount of revenue,expense, and income on the proportion of total work performed during theaccounting period. It measures the proportion of total work performed during theaccounting period either from engineers estimates of the degree of completion orfrom the ratio of costs incurred to date to the total costs expected for the entire K.As the contractor recognizes portions of the k price as revenue, it recognizes equalportions of the total estimated k costs as expenses.

c. Completed K Method: Postpone revenue recognition until they complete theconstruction project and its sale.

d. Forest Products Companies: Because of the aging of products process, cannotsatisfy the criteria for revenue recognition until time of sale. A proper matchingof expenses with revenues requires that these firms capitalize, as part of the agingassets, all expenditures made (maintenance, storage) during the aging process.Such costs become expenses at the time of sale, when the firm recognizesrevenues.

5. Income Recognition After the Sale:

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a. Insurance Companies: Recognize revenues and expenses at each period ofinsurance coverage. Insurance companies must, however, match against thisrevenue each period a portion of the ultimate cash outflow to satisfy claims.

b. Franchisors: When substantial uncertainty exists at the time of sale regarding theamount that (or timing or both) of cash or the cash equivalent value of other assets

that a firm will ultimately receive from customers, the firm delays the recognitionof revenues and expenses until it receives cash. Such sellers recognize revenue atthe time of cash collection using either the installment method or the cost-recovery-first method. These methods attempt to match expenses with revenues.

c. Installment Method: Can use this method when you cannot make reasonablycertain estimates of cash collection. recognizes revenue as the seller collects partsof the selling price in cash. This method recognizes as expenses each period thesame portion of the cost of the good or service sold as the portion of total revenuerecognized.

d. Cost-Recovery-First Method: When the seller has substantial uncertainty aboutthe amount of cash it will collect, it can also use this method. This method

matches the costs of generating revenues dollar for dollar with cash receipts untilthe seller recovers all such costs. Expenses match revenues in each period untilthe seller recovers all costs. Only when cumulative cash receipts exceed totalcosts will profit (that is, revenue without any matching expenses) appear in theincome statement.

Revenue and Expense RecognitionCash Basis

Period Revenue Expense Income1 $ 1,000 $1,600 ($600)

2 1,000 4,000 (3,000)

3 2,000 4,000 (2,000)4 4,000 -------- 4,000

5 4,000 -------- 4,000

Total $12,000 $9,600 $2,400

Percentage of Completion

Period Revenue Expense Income1 $ 2,0001 $1,600 $ 400

2 5,0002 4,000 1,000

3 5,000 4,000 1,000

4 ------ ------ -------

5 ------ ------ -------Total $12,000 $9,600 $2,400

1 $1,600/$9,600 x $12,0002 $4,000/$9,600 x $12,000

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Completed K Method

Period Revenue Expense Income1 $----- $----- $-----

2 ----- ------- ------

3 12,000 9,600 2,400

4 ------- ------ -----5 ------- ------ ------

Total $12,000 $9,600 $2,400

Installment Method

Period Revenue Expense Income1 $ 1,000 $ 8003 $ 200

2 1,000 800 200

3 2,000 1,6004 400

4 4,000 3,2005 800

5 4,000 3,200 800

Total $12,000 $9,600 $2,400

Cost Recovery First Method

Period Revenue Expense Income1 $ 1,000 $1,000 $ 0

2 1,000 1,000 0

3 2,000 2,000 0

4 4,000 4,000 0

5 4,000 1,600 2,400

Total $12,000 $9,600 $2,400

Format and Classification net income is gross income minus extraordinary gains and losses1. Income from Continuing Operations: revenues, gains, expenses, and losses from the

continuing areas of business activity2. Income, Gains, and Losses from Discontinued Operations: alerts f/s reader that the

firm does not expect this source of income to continue3. Extraordinary Gains and Losses:

a. it is unusual in natureb. it is infrequent in occurrence

4. Adjustments for Changes in Accounting Principles: disclose effects of the changes oncurrent and previous years net income

5. Earnings per Share: must be disclosed in order to receive an Unqualified Opinionfrom an accountant

3 $1,000/$12,000 x $9,6004 $2,000/$12,000 x $9,6005 $4,000/$12,000 x $9,600

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Compound Interest1. Future Value (Table 1): what is $1 today going to be worth in the future, assuming a

given interest rate of r with interest compounding over a given number of periods?F = P(1+r)n

EX: Deposit $1 in an IRA or 401(k)

A BRetirement Age 60 60

Age at Date of Deposit 40 22

Years Interest is Earned 20 38

Interest Rate Assumed 7% 7%

Value of $1 at RetirementDate

$3.87 $13.08

for A: F = 1(3.86968)for B: F = 1(13.07927)

2. Present Value (Table 2): if you have to wait to get your money, what is $1 in thefuture worth today, assuming a given interest rate with interest compounding over agiven number of periods? P = F(1+r)-n

3. Annuitiesa. Future Value (Table 3): if you take a stream of annuity payments and invest them

at a given interest rate, what will they aggregate to at some point in the future? i.e.if we put in $1 a year for X number of periods, what will that annuity grow to bythe end of the period? (FV of the annuity)

b. Present Value (Table 4): whats an annuity of $1 over a certain number of years ata given interest rate worth today (PV of the annuity)

what lenders look at when deciding how much interest to charge:1. pure return: that the lender wants2. inflation concerns: if high-inflation times, higher interest rate to account for it

(because the value of the dollar is eroded). Lender must take length of loan intoconsideration when determining inflation component of interest rate (because it iseasier to make assumptions about interest rates for one year than for ten)

3. credit risk: lender will have a higher interest rate for a company that is a start up,etc.

LIQUID ASSETS: CASH, MARKETABLE SECURITIES, AND RECEIVABLES

Cash1. Cash Inclusions and Valuation: Easily convertible into cash i.e. demand deposits,savings accounts, cods (compensating balances must be kept in a separate balancefrom Cash) Compensating Balances: when the lender asks for the borrower to keep some cash

in the bank without earning interest as part of the loan. For example, Bank willloan Co. $50 million and Bank requires Co. to keep in their Cash Account, at alltimes, a $3 million balance. So available Cash to Co. is only $47 million. (SEC

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requires disclosing the existence of compensating balances or other restrictions onCash).

2. Cash Control and Management: Internal controls to prevent theft or embezzlementMarketable Securities

1.

Classification of Securities: Current asset as long as the firm (1) can readily convertthem into cash and (2) intends to do so when it needs cash, usually within one year ofthe date of the b/s

2. Valuation of Securities at Acquisition: recorded at acquisition cost:DR Marketable Securities $10,300

CR Cash $10,300

3. Valuation of Securities after Acquisition:a. Debt Held to Maturity: firm has the intent and ability to hold to maturity; shown

on b/s as amount based on amortized acquisition cost

DR Investment Securities $1,150CR Cash $1,150

To record purchase of securities (at cost, which included a $1,000 par value, $50broker fee and $100 premium)

DR Interest Expense $50CR Investment Securities $50

this is amoritizing the security. it will mature in 3 yrs so amortize $50/yr to bring it to theultimate yield of $1,000. in the meantime, it is earning interest

b. Trading Securities: shown on the b/s at market value; changes in the market valueare reported each period in income

12/28/19x3DR Marketable Securities $400,000

CR Cash $400,000To record acquisition of trading securities.

12/31/19x3DR Marketable Securities $35,000

CR Unrealized Holding Gain on Trading Securities (Inc.St.) $35,000To revalue trading securities to market value and recognize an unrealized holdinggain in income. (realize as income because as a brokerage firm, securities are like yourinventory)

1/3/19x4DR Cash $48,000

CR Marketable Securities $435,000CR Realized Gain on Sale of Trading Securities (Inc.St.) $ 45,000

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To record the sale of trading securities at a gain.

c. Securities Available for Sale: shown on the b/s at market value; changes in themarket value do not affect reported income until the firm sells the securities

11/1/19x3DR Marketable Securities $400,000CR Cash $400,000

To record acquisition of securities available for sale.

12/31/19x3DR Marketable Securities $35,000

CR Unrealized Holding Gain on Securities Available for Sale (SE) $35,000To revalue securities available for sale to market value and record unrealized gain(unrealized holding gain is a component of retained earnings and recorded on the b/s: donot want to muck up income statement if trading securities is not your business as in

trading securities is for brokerage firms).

8/15/19x4DR Cash $480,000

CR Marketable Securities $400,000CR Realized Gain on Sale of Securities Available for Sale (Inc.St.) $80,000

To record the sale of securities available for sale at a gain based on acquisition cost.

Recording a Loss on Marketable SecuritiesDR Unrealized Loss on Decrease in Market Value

Securities Available for Sale (SE) below Book Value

CR Marketable Securities Decrease in MarketValue belowBook Value

DR Cash Proceeds of Sale

DR Realized Loss on Sale Plug Amountof Securities Availablefor Sale (Inc.St.)

CR Marketable Securities Acquisition Cost

Accounts ReceivableThe sum of all individual customers net balances, reduced by the amounts of estimateduncollectible accounts, sale discounts, and sales returns and allowances. The chargeagainst income for expected uncollectible amounts, sale discounts, and sales returns andallowances preferably occurs in the period when the sales occur

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Sale of Goods on AccountDR Accounts Receivable selling price

CR Sales Revenue selling price

Collection of Cash from Customers

DR Cash amount collectedCR Accounts Receivable amount collected

1. Uncollectible Accounts:a. Direct Write-Off Method:

(1)recognizes losses form uncollectible accounts in the period when a firmdecides that specific customers accounts are uncollectible

DR Bad Debt Expense (Inc. St.) actual amount uncollectibleCR Accounts Receivable (L) actual amount uncollectible

(2)shortcomings:(a)does not usually recognize the loss from uncollectible accounts in the

period in which the sale occurs and the firm recognizes revenue(b)provides firms with an opportunity to manipulate earnings each period by

deciding when particular customers accounts become uncollectible(c) the mount of accounts receivable on the balance sheet under the direct

write-off method does not reflect the amount a firm expects to collect incash

(3)GAAP does not allow firms to use the direct write-off method for financialreporting when they have significant amounts of expected uncollectibleaccounts and when the selling firm, such as a retail store, can reasonablypredict them.

(4)Firms must, however, use the direct write-off method for income tax reportingpurposes. Tax allows firms to claim a deduction for bad debts only when theycan demonstrate that particular customers will not pay.

b. Allowance Method:(1)when a firm can estimate with reasonable precision the amounts of

uncollectibles, GAAP requires the allowance method for uncollectibles

DR Bad Debt Expense (Inc. St.) estimated uncollectible amountCR Allowance for Uncollectible Accounts (XE) estimated

uncollectible amount

(2)when a firm judges particular customers accounts to be uncollectible, itwrites off the account (credit) and debits the contra asset account: Allowancefor Uncollectible Accounts

DR Allowance for Uncollectible Accounts (XE) actual uncollectible amountCR Accounts Receivable (L) actual uncollectible

amount

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(3)the write-off of specific customers accounts using the allowance method doesnot affect income. The income effect occurs in the year of the sale, when thefirm provides for estimated uncollectible accounts

(4)two methods:(a)

percentage-of-sales method for estimating uncollectibles: if cash salesoccur in a relatively constant proportion to credit sales, the accountant canapply the estimated uncollectible percentage, proportionately reduced, tothe total sales for the period

(b)aging-of-accounts-receivable method for estimating uncollectibles:estimates the amount or receivables the firm expects not to collect;classifies each customers account as to the length of time the account hasbeen uncollected. assign an estimate as to what portion is going to beuncollected. the more current the receivable is, the lower the probabilitythat it is uncollectible.

total A/R Current 30-60 days 60-90 daystotal A/R $45,000 $29,000 $15,000 $1,000

uncollectibleestimate

2% 5% 10%

allowance foruncollectibleaccounts

$1,430 $ 580 $ 750 $ 100

DR Bad Debt Expense (Inc. St.) $1,430CR Allowance for Uncollectible Accounts (XE) $1,430

to record estimate for uncollectible accounts.

when determining estimated uncollectible percentages, take into account:1. the type of industry: for example, some companies, like hospitals, are

notorious for having a/r in the 60-90 days range2. the companys historical experience in valuation allowances

(c)specific identification method: if you know something about a specificcompanys account that they owe you i.e. on the brink of chapter 11 and youare concerned that they may never be able to pay you, supplement the numberyou come up with in the aging-of-accounts methodwith an additionalallowance identified with a specific troubled customer.

2. Sales Discounts: the amount of ales discounts made available to customers appears asan adjustment in measuring net sales revenue

3. Sales Return and Allowances: The selling firm debits a revenue contra (SalesAllowances) during the period of sale for expected returns so as to report correctly theamount of cash it expects to collect form each periods sales

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Notes Receivable1. Calculation of Interest Revenue

Interest = Base (Principal or Face) x Interest Rate x Elapsed Time

2.

Accounting for Interest-Bearing Notes Receivable

6/30DR Notes Receivable 3,000

CR Accounts ReceivableS Co. 3,000

8/31DR Cash 3,060

CR Notes Receivable 3,000CR Interest Revenue 60

entry upon collection at maturity

but if accounting period was 1 month and the note has not been paid yet7/31DR Interest Receivable 30

CR Interest Revenue 30($3,000 x 12 x 30/360 = $30)

and upon collection at maturity8/31DR Cash 3,060

CR Notes Receivable 3,000CR Interest Receivable 30CR Interest Revenue 30

INVENTORIES: THE SOURCE OF OPERATING PROFITS

Beginning Inventory + AdditionsWithdrawals = Ending Inventory

Costs Included in Inventory at Acquisition1. Components of Inventory Cost: mfg firm inventory costs are (1) direct materials, (2)

direct labor, and (3) mfg overhead. An mfg firm debits all production costs to Work-in-Process Inventory: full absorption costing.

2. The Purchase Transaction: a firm should record purchases in the formal accountingrecords when legal title to the goods passes from seller to buyer (watch out for buy-back options in purchase Ks and potential abuses).

3. Merchandise Purchases Adjustments: The accounting should debit or credit alladjustment costs (i.e. transporting and handling the goods, cash discounts, goodsreturned, and other adjustments of the invoice price) to the Merchandise Inventoryaccount. Frequently, the accountant uses adjunct (accumulates additions to another

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account) and contra (accumulates subtractions from another account) accounts forthese adjustments to provide a more complete analysis of the cost of purchases (i.e.Purchase Discounts, Freight-in, Purchase Returns, and Purchase Allowancesaccounts).

4.

General Rule: any cost incurred directly in preparing an asset for its intended use (forsale) generally becomes a part of the cost of that asset. There are two main categories:a. product costs: all the costs associated with your inventory (getting it ready for

intended use)b. period costs: costs incurred as part of ongoing operations:

(1)these are expensed in the current period (i.e. rent) or(2)if the costs will extend beyond many periods, capitalize these costs and, in

subsequent periods, amortize or depreciate them over their useful life (i.e. abuilding)

Basis for Inventory Valuation

1.

Acquisition Cost Basis: values units in inventory at their historical cost until sold.Gains or losses are realized (show up in income) upon final disposition.2. Current Cost Basis:

a. Replacement Cost (Entry Value): the amount a firm would have to pay to acquirethe item at that time (assumes a fair market).

b. Net Realizable Value (Exit Value): the amount that a firm could realize as awilling seller in the ordinary course of business.

3. Lower-of-Cost-or-Market Basis (LCM): the smaller of acquisition cost or marketvalue, with market value generally measured as replacement cost. This is aconservative accounting policy because (1) it recognizes losses from decreases inmarket value before the firm sells goods, but it does not record gains from increasesin market value before a sale takes place; and (2) inventory figures on the balancesheet are never greater, but may be less, than acquisition cost. This results inreporting unrealized holding losses but delays reporting unrealized holding gains untilthe firm sells the goods.a. step 1: determine what the designated market value is:

(1)look at what the replacement costis (generally, we will take this number)(2)but if the replacement cost is higher than the net realizable value (estimated

selling price less costs of completion and disposal), we wont take thereplacement cost

(3)or if the net realizable value minus the normal profit margin (generallymeasured as a percentage of selling price) is higher than the replacement cost,we wont take the replacement cost

(4)select the amount that is the middle of the 3 (NRV, Replacement Cost, NRVNormal Profit Margin) this becomes the designated market value

b. step 2: compare designated market value with the costand select the lower of thetwo this number gets carried as inventory value on the b/s

c. step 3: journal entry to write down to the designated market vale (cost = $25;designated market value = $20):

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Direct MethodDR Cost of Goods Sold $5

CR Inventory $5

Indirect Method

DR Loss on Market Decline of Inventory $5CR Allowance (XE) $5

4. Standard Cost: a predetermined estimate of what items of manufactured inventoryshould cost

5. GAAP Basis for Inventory Valuation: GAAP requires loser of cost or market forinventory, which implies that accounting uses market values when inventory hasfallen below cost. Computing market value requires both replacement cost and netrealizable value amounts.

Timing of Computations

1.

Periodic Inventory System:a. the ending inventory figure results from the firms making a physical count ofunits on hand at the end of an accounting period and multiplying the quantity onhand by the cost per unit.

b. the firm then uses the inventory equation to calculate the withdrawals thatrepresent the cost of goods sold, an expense.

c. makes no entry for withdrawals (COGS) until it counts and costs the inventory onhand at the end of the accounting period.

d. any losses from shrinkage (i.e. losses due to breakage, theft, evaporation, andwaste) appear in the COGS amount.

Beginning Inventory + PurchasesEnding Inventory = Cost of Goods Sold

EX: sales during a year amounted to $165,000:DR Cash and A/R $165,000

CR Sales $165,000Sales recorded throughout the year

At the end of the year, the firm takes a physical count and assigns costs (using alower-of-cost-or-market) to ending inventory. This results in an ending inventoryof $20,000. Subtracting this amount from the $119,000 cost of goods available forsale yields COGS of $99,000:

DR Cost of Goods Sold $99,000CR Merchandise Inventory $99,000

COGS recognized under a periodic system

2. Perpetual Inventory System:a. calculates and records cost of goods sold whenever a firm takes an item from

inventory

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b. this requires a constant tracing of costs as items move into and out of inventoryc. computes goods expected to be remaining in the ending inventory after each

acquisition or withdrawal

Beginning Inventory + PurchasesWithdrawals = Ending Inventory

DR A/R $800CR Sales $800

DR COGS $475CR Merchandise Inventory $475

3. Periodic v. Perpetual Systems:a. periodic system:

(1)costs less to use because less accounting computations(2)likely to be cost effective when being out of stock is not extremely costly,

when there is a large volume of items with a small value per unit, or when

items are hard to steal or pilfer.b. perpetual system:(1)provides useful information not provided by the periodic system(2)cost-effective when there is a small volume of high-value items or when

running out of stock is costly.

Cost Flow Assumptions

Beginning Inventory + Net Purchases = COGS + Ending Inventory

1. FIFO:a. first in first out: assigns the costs of the earliest units acquired to the withdrawals

and assigns the costs of the most recent acquisitions to the ending inventoryb. conforms to good business practice in managing physical flows, especially in the

case of items that deteriorate or become obsoletec. COGS expense tends to be out-of-date because FIFO assumes that the earlier

purchase prices of the beginning inventory and the earliest purchases becomeexpenses.

d. When purchase prices rise, FIFO usually leads to the highest reported net incomeof the three methods, and when purchase prices fall, it leads to the smallest.

2. LIFO:a. last in first out: assigns the cost of the latest units acquired to the withdrawals and

assigns the costs of the oldest units to the ending inventoryb. firms are increasingly using LIFO because of tax purposes: results in a higher cost

of goods sold, a lower reported periodic income, and lower current income taxesthan FIFO or Weighted Average (LIFO Conformity Rule: if you use LIFO fortaxes, must use if for its financial reports to shareholders)

c. When purchase prices have been rising and inventory amounts increasing, LIFOproduces b/s figures usually much lower than current costs.

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d. LIFOs COGS figure closely approximates current costs; b/s amount for endinginventory contains some very old costs (SEC requires firms using LIFO todisclose the amounts at which LIFO inventories would appear if the firm had usedFIFO or current cost).

e. results in the least fluctuation in reported income in businesses in which sellingprices tend to change as purchase prices of inventory items changef. LIFO Layers: in any year when purchases exceed sales, the quantity of units ininventory increases. The amount added to inventory for that year is called a LIFOinventory layer(1)EX: firm purchases 100 Xs a year and sells 98 Xs a year. After 4 years, the

costs of the 8 unsold units are the costs of Xs 1 and 2, 101 and 102, 201 and202, and 301 and 302.

(2)dipping into LIFO layers: if inventory quantities decline, the older, lowercosts per units of prior years LIFO layers leave the b/s and become expenses:results in a lower COGS as well as larger reported income and larger incometaxes in that period.

(3)LIFO permits firms to defer taxes as long as they do not dip into LIFO layersg. LIFO b/s: LIFO usually leads to a b/s amount for inventory so much less than

current costs that it may mislead readers of f/s3. Weighted Average:

a. the firm calculates the average of the cost of all goods available for sale (or use)during the accounting period, including the cost applicable to the beginninginventory.

b. resembles FIFO more than LIFO in its effects on the f/s. When inventory turnsover rapidly, the weighted average inventory cost flow provides amounts virtuallyidentical to FIFOs amounts.

Example:1/1/96 Beginning Inventory of 1,000 units @ $ 5 per unit1/10/96 Purchase Inventory 200 units @ $ 8 per unit1/15/96 Sale 500 units @ $12 per unit1/20/96 Purchase 300 units @ $ 6 per unit1/31/96 Ending Inventory: 1,000 units @ $? per unit

need to solve for: (1) Cost of Ending Inventory, (2) COGS, and (3) Gross Profit on Sale

the inventory

equation

FIFO LIFO Weighted Average

Beginning Inventory $5,000 $5,000 $5,000

+ Purchases $3,400 $3,400 $3,400

= Goods Availablefor Sale

$8,400 $8,400 $8,400

- Ending Inventory $5,900 $5,600 $5,000

= Cost of GoodsSole

$2,500 $2,800 $3,400

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the gross profit

equationFIFO LIFO Weighted Average

Sales $6,000 (500 x $12) $6,000 $6,000

- Cost of GoodsSold

$2,500 $2,800 $3,400

= Gross Profits $3,500 $3,200 $2,600 Determining Ending Inventory in the above chart:

1. FIFO:a. 500 units sold came from the first 500 units in inventoryb. so 1,000 x $5 = $5,000 becomes 500 x $5 = $3,500c. total of 1,000 units remaining: what remains are the ones that most recently

came in: 1,000 = $5,900 (300 x $6, 200 x $8, and the 500 x $5).2. LIFO:

a. last units in (from the 20th and 10th) are the first outb. take off the 300 x $6 and the 200 x $8c. what is left is the 1,000 at $5 = $5,000

3. Weighted Average:a. add all units and divide by total cost of inventory to get average cost:b. $5.60/unitc. 1,000 x $5.60 = $5,600

DR Cost of Goods Sold (Inc. St.) $2,500 (FIFO)CR Inventory (A) $2,500

DR Cost of Goods Sold $2,800 (WA)CR Inventory $2,800

DR Cost of Good Sold $3,400 (LIFO)CR Inventory $3,400

Identifying Operating Margin and Holding Gains1. conventionally reported gross margins (sales minus cost of goods sold) comprises:

a. an operating margin, andb. a realized holding gain (or loss)

2. operating margin: the difference between the selling price of an item and itsreplacement cost at the time of sale.

3. realized holding gain: the difference between the current replacement cost of an itemand its acquisition cost FIFO recognizes most of the realized holding gain in computing income each

period LIFO does not recognize most of the unrealized holding gain in the income

statement.4. unrealized holding gain: the difference between the current replacement cost of the

ending inventory and its acquisition cost. This does not appear in the incomestatement.

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unrealized holding gains are higher under LIFO than under FIFO because earlierpurchases with lower costs remain in ending inventory under LIFO.

5. the sum of the operating margin plus all holding gains (realized and unrealized),economic profit, is the same under FIFO and LIFO.

6. total increase in wealth for a period includes both realized and unrealized holdinggains.

PLANT, EQUIPMENT, AND INTANGIBLE ASSETS: THE SOURCE OFOPERATING CAPACITY

Acquisition of Plant AssetsSelf-Constructed Asset: The capitalization of interest into plant assets during constructionreduces otherwise reportable interest expense and thereby increases income duringperiods of construction. In later periods, the plant will have higher depreciation charges,reducing income i.e. a portion of the interest expense for borrowing associated withbuilding that is being built for longer than 1 year can be included in the cost of thebuilding: Co. borrows $3 million: the interest is added to the cost of the building. It takes

2 years to build the building: borrowing went from $0 to $3 million. Average borrowingwas $1.5 million per year: record interest. At the end of the firs year, interest cost is$150,000, so instead of debiting the Interest Expense Account:

DR Bldg $150,000CR Interest Payable $150,000

stop capitalizing costs once the asset is ready for intended use. The subsequent InterestCosts are Expensed as a period cost.

Costs Subsequent to Acquisition

DepreciationPurpose of Depreciation: to systematically allocate the cost of an asset to the periods ofits useful life.1. depreciation is a process of cost allocation: as the firm uses the asset in each

accounting period, it treats a portion of the cost of the asset as the cost of the servicereceived and recognizes the cost as an expense of the period (costs leave the b/s andgo onto the income statement as debits)

2. return of capital: a firm attempts to earn both a return ofcapital and a return oncapital. Before a firm can earn a return on capital (as measured by accounting profits),it must recover all costs. Depreciation allows for a return of the cost of the asset, nomore, no less.

3. depreciation is not a decline in valueIssues in Depreciation Accounting measuring the depreciable basis of the asset estimating its useful life deciding on the pattern of expiration of asset cost over the useful service life1. Depreciable Basis of Plant Assets: Cost Less Salvage Value:

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a. historical cost accounting bases depreciation charges on the acquisition cost of theasset less the estimated residual valuethe amount the firm will receive when itretires the asset from service

b. estimating salvage value: estimated proceeds on the disposition of an asset less allremoval and selling costs; for buildings, assume a zero salvage value

2.

Pattern of Expiration of Costs: a firm must do one of the followinga. accelerated depreciationb. straight line depreciationc. decelerated depreciation (GAAP wont allow this one)d. expense immediatelye. no depreciation

Depreciation Methods1. Straight-Line (Time) Method:

a. financial reporting most commonly uses this methodb. divides the cost of the asset, less any estimated salvage value, by the number of

years of its expected life, to arrive at the annual depreciation.

Annual Depreciation = Cost Less Estimated Salvage Value/Estimated Life in Years

2. Production or Use (Straight-Line Use) Method: when the rate of usage varies overperiods and when the firm can estimate the total usage of an asset over its life, thefirm can use this method, based on actual production or usage during the period.

Depreciation Cost per Unit = Cost Less Estimated Salvage Value/Est # of Units

3. Accelerated Depreciation:a. the earning power of some plant assets decline as they grow olderb. these cases justify this method, which recognizes larger depreciation charges in

early years and smaller depreciation charges later(1)Declining-Balance Method: depreciation charge results from multiplying a

fixed rate time the net book value of the asset (cost less accumulateddepreciation but without subtracting salvage value) at the start of each period.The depreciation stops when net book value reaches salvage value. The resultis a declining periodic charge for depreciation throughout the life of the asset.

(2)Sum-of-the-Years-Digits Method: the depreciation charge results fromapplying a fraction, which decreases from year to year, to the cost lessestimated salvage value of the asset

(3)Modified Accelerated Cost Recovery System for Income Tax Reporting:(MACRS)

4. Factors in Choosing the Depreciation Method: can pick a different method for taxreporting and for financial reporting.a. Tax Reporting: the firm should try to maximize the present value of the

reductions in tax payments from claiming depreciation. When tax rates stayconstant over time, earlier deductions have greater value than later ones: leastand latest rule.

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b. Financial Reporting: firms seek an income statement that realistically measuresthe expiration of the assets benefits and provides a reasonable pattern of costallocation. Financial statements should report depreciation charges based onreasonable estimates of asset expirations. Most firms use the straight-line forfinancial reporting.

5.

Accounting for Periodic Depreciation:a. In recording depreciation, most firms credit a contra-asset account, AccumulatedDepreciation. This leaves the acquisition cost of the asset.

b. Book Value: the difference between the balance of an asset account and thebalance of its accumulated depreciation account.

DR Depreciation Expense (Inc. St.) $1,500CR Accumulated Depreciation (XE) $1,500

6. Changes in Periodic Depreciation:a. periodically, a firm will reestimate the useful life and salvage value of an asset.b.

no adjustment for the past misestimate is made, but the firm spreads the remainingundepreciated balance less the new estimate of salvage value over the newestimate of the remaining service life of the asset.

Example: Cost $120Salvage Value ($ 20)

Depreciable Base $100

Estimated Useful Life of 5 yrs: 5/$100 = $20 of Depreciation per year:

Year Beg. Dep. Base Dep. for Year End of Year Dep. Base1 $100 $20 $802 $80 $20 $60

Then, in the 3rd year, the Estimated Useful Life has been re-evaluated to be only 4 years.So now we have a Depreciable Base of $60 and only 2 years left. 2/$60 = $30 ofDepreciation for each remaining year:

Year Beg. Dep. Base Dep. for Year End of Year Dep. Base3 $60 $30 $304 $30 $30 $05

Repairs and Improvements1. Repairs and Maintenance:

a. Repairs: the costs of restoring as assets service potential after breakdowns orother damage

b. Maintenance: routine costs such as for cleaning and adjusting.c. Expenditures for these items do not extend the estimated service life or otherwise

increase productive capacity beyond the firms original expectations for the asset.

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Therefore, accounting treats these expenditures as expenses for the period inwhich they are made.

d. when an accountant is in doubt about whether something is a repair orimprovement, she will be conservative and call it a repair.

2. Improvements: make an asset perform better than before. Because the expenditureimproves the assets service potential, accounting treats such an expenditure as anasset acquisition. Therefore, the firm can capitalize on the asset by debiting a newasset account or the existing asset account.

Impairment of Assets1. Accounting does not permit assets whose values have declined substantially to remain

on the b/s at amortized acquisition cost2. if the decline in value is so drastic that the expected future cash flows from the asset

have declined below book value, the asset is impaired3. the firm writes down the book value of the asset to its then-current fair value, which

is the market value of the asset or, if the firm cannot assess the market value, the

expected net present value of the future cash flows.

DR Accumulated Depreciation $10DR Apartment Bldg (new valuation) $ 4DR Loss on Impairment $11

CR Apartment Bldg (original cost) $25

Retirement of Assets1. when a firm retires a long-lived asset, it may be by sale to another entity2. the firm must then record an entry to bring the depreciation up to date3. when a firm retires an asset from service, it removes the cost of the asset and the

related amount of accumulated depreciation from the books.a. the firm records the amount received from the sale, a debit, andb. the amount of net book value removed from the books, a net credit.c. these two differ from each other. The excess of the proceeds received on

retirement over the book value is a gain or loss

selling an asset at book value:DR Cash $2,000DR Accumulated Depreciation $3,000

CR Equipment $5,000

selling for more than book value:DR Cash $2,300DR Accumulated Depreciation $3,000

CR Equipment $5,000CR Gain on Retirement of Equipment $ 300

recognizes that past depreciation charges have been too large gain appears on the income statement after closing entries, it increases Retained Earnings

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the gain restores to Retained Earnings the excess depreciation charged in the pastselling for less than book value:DR Cash $1,500DR Accumulated Depreciation $3,000

DR Loss on Retirement of Equipment $ 500CR Equipment $5,000 recognizes that past depreciation charges have been too small loss appears on the income statement after closing entries, it decreases Retained Earnings the loss reduces Retained Earnings for the shortfall in depreciation charged in the

past, in effect increasing depreciation charges all at once

Wasting Assets and Depletion1. Full Costing: capitalizes the costs of all explorations (both successful and

unsuccessful) so long as the expected benefits from the successful explorations will

more than cover the cost of all explorations2. Successful Efforts Costing: capitalizes the costs of only the successful efforts; thecosts of the unsuccessful exploration effects become expenses of the period

3. Amortize what is capitalized: usually using the units-of-production depletion methodIntangible Assets and Amortization lacks physical existence has a high degree of uncertainty concerning future benefits1. Research & Development: GAAP requires immediately expensing such costs

a. the future benefits are too uncertain to warrant capitalizationb. writing them off as soon as possible is more conservative

2. Software Development Costs:begin development technological feasibility commercial production

a. all costs incurred from beginning of development until technological feasibilityare expensed.

b. all costs from time of technological feasibility until commercial production arecapitalized(as Software Costs) because, at this point, the company has a productof future economic benefit. Must also Amortize these costs: amortize according to units of software the company is planning to sell instead

of its useful life: EX: $1 million in Software Costs; predict you will sell 100,000 units; so

amortize as $10/unit.c. all costs after commercial production are inventory costs room for manipulation:

1. when do you reach technological feasibility?2. how do you estimate the number of units the company will probably sell?

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3. Patents:a. acquire by acquisition: capitalize the cost (Asset on the B/S) and amortize over

the shorter of:(1)the remaining legal life or(2)its estimated economic life

can in no event exceed 40 years (but new rules may change this)b. acquire by internal research & development: expense4. Advertising: common practice to expense even though GAAP now allows

capitalization and amortization. Expense because:a. expensing advertising costs is more conservative than capitalizing themb. it is too difficult to quantify the future effects and timing of benefits derived from

these costs5. Goodwill (if internally developed, expense all costs associated with it, but if

purchasing a company:)a. goodwill arises when one company purchases another company or an operating

unit from another company

b.

accounting measures goodwill as the difference between the amount paid for theacquired company as a whole and the sum of the current values of its identifiablenet assets, less its liabilities.

c. goodwill appears on the f/s of the company making the acquisitiond. capitalizee. amortize for the lesser of its useful life or 40 years. (proposed new max. of 20 yrs)f. to determine:

(1)Co. A purchases Co. B for $350,000(2)determine the fmv of all the identifiable assets that have been acquired:

$262,000(3)determine the difference between fmv and purchase price ($350,000 -

$262,000) $88,000: this is the goodwill(4)Debit Goodwill Account (A)

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LIABILITIES

Basic Issues1. LiabilityRecognition:

a. the obligation involves a probable future sacrifice of resources at a specified ordeterminable date and the firm can measure, with reasonable precision, the cash

equivalent value of resources needed to satisfy the obligationb. the firm has little or no discretion to avoid the transferc. the transaction or event giving rise to the entitys obligation has already occurred

2. Contingencies: Potential Obligations:a. a firm should recognize an estimated loss from a contingency in the accounts only

if the contingency meets both of the following:(1)information available before issuance of the f/s indicates that it is probable

that an asset has been impaired or that a liability has been incurred, and(2)the amount of the loss can be reasonably estimated if the amount of the liability is a range, use the lower end of the range

b. notes to the f/s must disclose significant contingencies even if not included in thef/s themselves (disclose but dont accrue)

if contingency is probable and the amount of loss can be reasonably estimated, record theliability in the period in which the event occurred:DR Loss from Environmental Spill $5 million

CR Est. Liability for Environmental Cleanup $5 million

and when you start paying the cleanup costs:DR Est. Liability $X

CR Cash $X

if you recorded the $5 million in PV but payments will be made over 20 years, whathappens as the years go by (because youll be making more than $5 million inpayments)? each year, look at the PV of the remaining liability and record an entry in thatcurrent estimate in the new PV:

DR Interest Expense $XCR Est. Liability for Environmental Cleanup $X

3. Liability Valuation: liabilities appear on the b/s at the present value of payments afirm expects to make in the future, using the historical interest rate

4. Liability Classification:a. current liabilities: fall due within the operating cycle, usually one year (dont

discount to PV)b. noncurrent liabilities: fall due later (record at PV)

Current Liabilities1. Accounts Payable to Creditors2. Short-Term Notes and Interest Payable3. Wages, Salaries, and other Payroll Items

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4. Income Taxes Payable5. Deferred Performance Liabilitiesbefore performance:DR Cash $200,000

CR Advances from Customers $200,000

after performance:DR Advances from Customers $200,000

CR Performance Revenue $200,000

warranty:DR A/R $280,000DR Warranty Expense $ 11,200

CR Sales $280,000CR Estimated Warranty Liability $ 11,200

To record sales and estimated liability for warranties on items sold.recognize the warranty expense in the period when the firm recognizes revenue, eventhough it will make the repairs in a later period: match warranty expense with associatedrevenue.

Long-Term Liabilities1. Procedures for Recording Long-Term Liabilities:

a. borrower initially records a long-term liability at the cash value the borrowerreceives in return for promising to make future payments

b. the book value of the borrowing at any time equals the present value of all thethen-remaining promised payments using the historical market interest rateapplicable at the time the firm originally incurred the liability

c. finding the market interest rate implied by the receipt of a given amount of cashnow in return for a series of promised future repayments requires a process calledfinding the internal rate of return which is the interest rate that discounts aseries of future cash flows to its present value.

d. retiring long-term liabilities:(1)debits the liability account for its current book value(2)credits cash(3)recognizes any difference as gain (when book value exceeds cash

disbursement) or loss (when cash disbursement exceeds book value) onretirement of debt.

2. Mortgages and Notes3. Ks and Long-Term Notes: Interest Imputation:

a. GAAP requires that all long-term monetary liabilities, including those carrying noexplicit interest, appear on the b/s at the present value of the future cash payments

b. there is an imputed interest ratec. there are two ways to compute the present value of the liability and the amount of

imputed interest:

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(1)base interest rate on market value of asset: uses the market value of the assetacquired as a basis for computing the present value of the liability.

(2)use of market interest rate to establish market value of asset and present valueof note: to find the present value of the note, the firm would discount thepayments using the interest rate it would have to pay for a similar loan in the

open market at the time that it acquired the equipment4. BondsSTATEMENT OF CASH FLOWS

Introduction1. b/s: portrays financial condition or financial position2. income statement: portrays the results of operation i.e. the relationship of revenues

and expenses3. but neither the b/s nor the income statement describes the movement/changes in that

most critical of assetsCash

Purposes1. to provide information about cash receipts and cash payments during a period2. to summarize the operating, investing, and financing activities of a company3. answers the following questions:

a. where did cash come from?b. what was cash used for?c. what was the change in the cash balance?

Classifications1. Operating Activities: transactions that enter into determination of net income (e.g.

sales to customers, collection of receivables from customers, payment to suppliersand employees, payment of interest and income taxes).a. make adjustments to reconcile net earnings to net cash from operating activities

i.e. depreciation and amortization are non-cash expenses, so no money is goingout: add back non-cash transactions.

b. but, A/R and Inventory may have gone up: the company may have used resourcesto increase these non-cash assets: subtract the additional investment in non-cashcurrent assets.

cash flows associated with current assets and current liabilities2. Investing Activities: transactions that involve acquiring and disposing of noncurrent

assets, investing in and selling securities, and making loans to and collecting on loansfrom other companies (it is not unusual for growing companies to have a negativecash flow from investing activities). cash flows associated with noncurrent assets

3. Financing Activities: transactions that involve (1) obtaining capital from owners byissuing equity securities, paying dividends to owners, repurchasing equity securitiesfrom owners, or (2) borrowing money from creditors and repaying the amountsborrowed. cash flows associated with noncurrent liabilities and shareholders equity

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Balance Sheet

Current Assets (O) Current Liabilities (O)

Noncurrent Assets(I)

Noncurrent Liabilities(F)

Shareholders Equity (F)

VALUATION ISSUES1. Salvage Value (what can the asset be sold for at salvage)? $302. Net Book Value (acquisition cost less accumulated depreciation) $403. Future Revenue (what will the total future revenue be i.e. $100/yr

for 15 years) (the Marketing Fool Method because it disregards expensesassociated with the asset and PV considerations) $1,500

4. Capitalization of Earnings:a.

Historical earnings for one year capitalized at a specified rate ofreturn e.g. assume net earnings of $60/yr and buyer requires a 20%rate of return (Net earnings divided by required rate of return)$60/20% $300

b. Historical earnings for multiple years capitalized at a specific rateof return e.g. assume average net earnings over past 4 years andassume that the buyer requires a 20% rate of return (Average netearnings divided by required rate of return) $50/20% $250

c. Projectedearnings at a specified rate of return e.g. assume projectednet earnings of $75 per year and buyer requires a 20% rate of return(Projected net earnings divided by required rate of return) $75/20% $375

5.

Projected Discounted Cash Floss: assume projected cash flows oversome number of years in the future and discount that amount at an appropriatediscount rate (e.g. PV of annuity of $75 for 30 years discounted at 20%; seeTable 4: 4.97894 x $75) $374

KEY RATIOS1. Earnings per Share: (EPS) Net Income/Weighted Average Number of Shares

Outstanding: given the net earnings per share basic (earnings of the company dividedby weighted average of shares without taking account of dilution resulting fromcommon stocks equivalent i.e. disregard stock options) and diluted (assume stockoptions have been converted, thus increasing the denominator of this ratio)

2. Price Earnings Ratio

: (PE Ratio) Market Price of Stock/EPS: the higher the ratio is,the more excited investors are (associated with Income Statements)3. Dividend Yield: Dividends per Share/Market Value per Share: if the Co. doesnt pay

dividends, the ratio is 0.4. Book Value per Share: (from B/S) Shareholders Equity/Common Shares Outstanding

at Yearend: if you own 1 share of the Co, this ratio tells you what that share is worth(Shareholders Equity is Net Book Value)

5. Price to Book Value per Share: Market Value per Share/Book Value per Share

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if a Co. pays no dividends but has a high PE Ratio: people are willing to spend a highmultiple of earnings for stock because think the Co. will have significant growth

if a Co. pays good dividends but have low PE Ratios it is because the market thinksprospects of future growth are not that favorable

cannot infer anything about earnings form the Price per Share alone

MARKET DATAIndexes1. Dow Jones Industrial: 30 largest stocks traded on the NYSE2. Nasdaq: historically smaller stocks, but no longer the case3. Standard & Poors 500: 500 large companies generally traded on the NYSE: more

broad reading of the overall market than the Dow4. NYSE Composite: all the shares traded on the NYSE5. Russell 2,000: Small Cap Index: smaller companies with lower market value.THE ACCOUNTING BUSINESS1. The Accounting Profession:

a. Independence: must be neutral i.e. dont own stock in the company you areauditing.

b. R.U.L.E.S.:a. Rates (hourly rate)b. Utilization (number of billables you can get out of an associate)c. Leverage (how many people can you get working for you so when you bill

then out and you only pay them a fraction of that, the better for the persongetting the profits?)

d. Expenses (historically, at accounting firms, 1/3 revenue supportsinfrastructure i.e. rent expense, and now technology costs as well; 1/3 goes topay staff; 1/3 to the partners)

e. Speed: (of billing and collecting)2. Responsibilities of the Auditor:

a. with respect to the GAAP f/s, express and opinion as to the fairness of the f/s (notthat theyre accurate) based on the auditing procedures

b. with respect to the other information, read to make sure not inconsistent with f/s3. Types of Audit Opinions:

a. Unqualified: . . . in accordance with GAAP(1) intro paragraph: tells the reader that the auditor has audited the f/s and

reinforces that the f/s are the responsibility of the companys managementand states that the auditors responsibility is to express an opinion based ontheir audits

(2) scope paragraph: auditor tells the world what they have done i.e. did theirwork in accordance with generally accepted auditing standards:(a)purposes of obtaining reasonable assurance about whether f/s are free of

material misstatement (not saying if accurate)(b)test basis: look at evidence supporting the amounts and the disclosure of

the f/s

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(c) look at the accounting principles that the company has chosen and thesignificant estimates

(3) opinion paragraph: gets to the point: in our opinion, the f/s fairly presents thefinancial position in all material respects and are in conformity with GAAP

b. Qualified: . . . except for . . .: rarec.

Adverse: . . . not in accordance with GAAP: very unusuald. Disclaimer: . . . we express no opinion.

4. Audit Procedures:a. evaluate internal control systemb. inspect thingsc. external communications i.e. confirm that a client has received goods, that

balances are accurate at the bank, etcd. meaningful analytic review: do all the increases and decreases make sense?

5. Managements Financial Responsibility:a. they are responsible for everything in the financial report because they prepare the

f/s

b.

information outside the f/s must be consistent with the f/sc. warn readers that preparing financial report entails making judgment callsd. acknowledge role to set up internal accounting controls: reasonable insurance that

f/s are free of material misstatements and that assets are safe-guardede. makes reference to the fact that the independent auditors are appointed by the bd.

and then annually, the bd votes on the auditors and the shareholders also vote(ratification)

6. Auditing Committee:a. end to be outside directorsb. lots of judgments to be made (so lots of lawyers)c. meet periodically, typically 2-4 times a year, to meet with the auditorsd. audit committee and top management get involved when key accounting policies

must be made i.e. when there are new procedurese. if there is an internal audit department, the internal audit director reports to the

audit committee (independence from management)7. Fraud

a. dont do itb. collusion delays detection