1500-Accounting 2-Chp 6

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Department
Human Resources Management
Course
HRM 3430
Professor
Linda Love
Semester
Fall

Description
CHAPTER 1-INTRODUCTION Accounting is a process of: -classifying and recording -reporting and communicating; assembling information -interpreting and evaluating financial information Scorekeeping-Financial Accounting (chapters 2-6): managers can present themselves as intelligent,well-informed members of the management team; present information for external users (banks, customers, suppliers, shareholders, creditors); lots of standards; when a company publishes its income statement and its balance sheet it is engaged in scorekeeping; the company is reporting to shareholders and other interested parties how well or how bad it has preformed; these reports are about the past; an exercise in stewardship; investors and to a lesser extent creditors have allowed the company the use of their resources and the company must in turn report what it did with those resources and how well the investment has performed; with this information existing investors and creditors can make informed judgements about how advisable it is to continue and be investors and creditors or whether they should liquidate their holdings in this company and invest or lend somewhere else; balance sheet and income statement; how well the company has performed -investor: the holder of the shares of a company; limited liability company; (the shares that are listed on a stock exchange); these shares can be bought or sold at market prices by anyone -creditor: the holder of the company’s debt (notes or debentures); lower risk than shares and usually yield a lower return; they can be bought and sold in a public market, generally a specialized section of the stock market Attention Directing-Management Accounting (chapters 7-11): understand budgetary planning and control; managers are judged in part on their financial performance; on-going basis; flexibility; very prompt; Page 1 of 75 comparisons; cost benefit rather than standards; powerful model of business; management by exception; corrective action only becomes necessary when things have gone wrong that is, when there is an exception; a major part of organizational planning takes place through budget setting and budget approval processes; what the managers should be paying attention to; a company will go through a series of logical related steps to achieve its objectives: 1. Define the objectives 2. Make plans that would if achieved accomplish the objectives 3. Carry out the business operations in the plan 4. Measure the results of operations 5. Compare the results with the plans and the objectives 6a. If the objectives have been achieved move on to the next iteration 6b. If the objectives have not been reached instigate corrective action then move on to the next iteration Decision Making-Finance (chapters 12-15): managers need to know how to present the financial aspects of their business proposal; communication skills; investment opportunities; long and short term; support decision making or problem solving; decisions are the essence of business; should the cost be planned or actual?; short term decision making –cost driver; long term decision making –net present value; the financial implications of business choices decision making includes the following steps: 1. Specify the problem or decision as precisely as possible 2. Choose an appropriate decision technique 3. Gather information 4. Use the information and the technique to make the decision 5. Implement the decision 6. Evaluate the outcome “the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions” Page 2 of 75 Accounting, Various Streams: recording transactions is a routinized automated activity where the transaction data is automatically recorded and the accounting records on the computer are updated; once the data is recorded the next step is measurement; judgement is called for to decide the effect of a transaction; is the activity to which the transaction refers completed or is there some residual effect that needs to be recognized as a asset/liability in the balance sheet? (GAAP); finally the information needs to be communicated and the accountant will choose the most appropriate way to disclose the information to comply with the law, gaap, and the needs of external users of financial statements; once the accountant has prepared the statements the external auditor will review them and the records that support them; the auditor is employed by the shareholders to safe guard their interests; when the chips are down management probably has more influence on the decision than shareholders do Financial Accounting: external users; (auditing firm); recording transactions for measuring and disclosing Management Accounting: internal organizational activity that provides information to managers to assist them in their managerial activities including the planning and control cycle and also to support them in decision making Auditing: ensure compliance with rules Personal financial planning: applications to personal issues; (banks, consulting); make a list of assets and liabilities (a personal balance sheet); the difference between assets and liabilities is your personal wealth or equity; (how much to invest in your savings so that you can afford to retire); decisions are based on personal budgets and net present value techniques CHAPTER 2-FINANCIAL ACCOUNTING FOR SCOREKEEPING Page 3 of 75 International Financial Reporting Standards (IFRS): required January 2011 in Canada for most large enterprises; becoming the main financial reporting standard outside the US; US are also starting to accept International Financial Accounting Standards Board (IASB): Conceptual Framework -objective Supporting concepts include: -qualitative characteristics -elements of financial statements -recognition -measurement -presentation and disclosure Using Financial Statements to Assess Profitability -the dollar amounts of operating income and net profit after interest and taxes will be shown in the income statement and judging whether or not these are adequate requires that they be compared with the assets; in reporting income it is normal to show operating income separately from net income -operating income: revenues less the operating expenses incurred in earning the revenues; specifically excludes interest (a financing charge) and taxes (management has little control over); used to judge how well the assets of the business have been used; a comment on management efficiency -net income: is what is left after interest and taxes are deducted from operating profit; a measure of how well the company did for its shareholders; interest paid is an expense that largely depends on the company’s capital structure; a company financed entirely from equity capital will have no interest payments but a company financed with a large amount of debt will have a high level of interest expense; taxes are then deducted and what is left over is the profit available for the equity shareholders to enjoy Page 4 of 75 2 ways of comparing company income to the resources used to generate it: -return on assets/ratio of operating income to total assets: used to assess the extent to which the assets have been efficiently utilized by management; operating income ÷ total assets X100 -return on equity/ratio of net income to shareholder’s equity/return on capital employed/return on investment: used to assess the effectiveness of the company as an equity investment; net income ÷ shareholder’s equity X 100 Characteristics of Accounting Information based on (IASB): needs to be useful, not enough to say they are correct; there are many dimensions and each needs to be considered with two important criteria; relevance and reliability; information must be able to influence a decision or belief; relevant and reliable are in conflict with one another Relevance: predict the future; confirm what happened in the past; constraints; make sure it is useful not a waste (the organization has these assets, if you are leasing something it does not belong on the balance sheet –entity specific); information has to be able to influence a decision or a belief -predictive value: (information that causes a bank to decide whether or not to make a loan would be relevant to that lending decision; suppose a bank looks at the financial statements of a company and discovers that there is already an excessive amount of borrowing and that profits are low) –as a result it estimates that the chances of repayment of the proposed loan are low; the financial statements have provided relevant information; it would be of no use to the bank to get the financial statements after making the loan; to be relevant the information must be timely -feedback value: (an investor has shares in a company and when the directors send him the financial statements the investor is pleased to see that the company has made reasonable net income and has every sign of being well managed) –the statements were relevant to the investor in Page 5 of 75 supporting his belief that the directors were exercising good stewardship over the assets which they had been entrusted -entity specific: relates directly to the organization in question Reliable: free from bias and is accurate -information should be verifiable: (the value of the assets needs to be verified); if a number of competent experts look at a set of financial statements data they should agree on the accounting conclusions; (a transaction might be the purchase of some production machinery –most accountants would be able to agree that the money was spent and that it was spent on a long term asset –that indicates verifiability); (if those same accountants were to be asked over what period the asset should be amortized there could be a range of acceptable opinions because this is a judgement call –the amortization expense is less verifiable) -information should have representational faithfulness: correctness; the intention of financial statements is to represent various events by means of their monetary values; (if a company buys some production machinery for $25,000 cash and that was the whole transaction then it would be represented faithfully; if the company had traded in another machine with a realizable value of $10,000, the cash expenditure of $25,000 would not be represented faithfully –it would be better to record this transaction as the sale of the asset traded in for $10,000 and the cost of the new machine as being $35,000 -information should be neutral: information sends strong messages to shareholders and other users; it is appropriate to have a balanced view without a bias for either good or bad news; information should not be reported selectively because it presents the view that management wants to demonstrate; (if a company is being sued by a customer for a fault in a product sold by that company and at the same time the company is suing the supplier of the product for the same reason; an unbiased report would show both these legal actions and report the company’s expectations about the outcome –to show only one legal action or that the expected outcome is the success of one action and the failure of the other would be biased and lack neutrality Page 6 of 75 -information should be comparable: (income statements are comparable from the past); one of the requirements of financial reporting is that the company must report not only on the current year but also on the comparable data for the previous year; (if the company has changed one of its accounting practices between the two years such as changing the number of years over which a machine is amortized –the data is no longer comparable) -information should be consistent: accounting treatment of events should be consistent; where they are inconsistent the nature of the change should be reported so that users may make adjustments in their interpretations; (the reason that the accounting data about amortization is not comparable is that it is inconsistent between the two years) Objective of financial reporting: “provide financial information about the reporting entity that is useful to existing and potential investors, lenders and others creditors in making decisions about providing resources to the entity”; those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans or other forms of credit; only incorporated companies are required to report externally; a company is incorporated under either the federal or one of the provincial companies act -internal managers will receive internal reports on the financial dimension of their areas of responsibility; it would be unusual for internal managers to receive a balance sheet it is more likely they would receive a detailed statement of the expenses they have incurred and where appropriate the revenue they generated ;will be different from the general purpose financial statements in two respects: 1. they will only cover items that are under the direct control of those managers 2. they will be in much greater detail Canadian institute of chartered accountants: provisions about the treatment of financial statements; according to the CICA financial statements: Page 7 of 75 1. Are prepared for the use of actual and potential investors and creditors 2. Are for the use of those who make investing and lending decisions 3. Should assist users to predict future cash flows Stewardship: the legal requirement for providing all shareholders with financial statements has a purpose Divorce of ownership and control: the shareholders of the company do not take part in day to day management, they appoint directors to carry out the actual work of management; enable shareholders to assess whether or not the directors have exercised their stewardship of the company assets effectively Generally Accepted Accounting Principles (GAAP): Canadian GAAP and International GAAP (IFRS); are more guides to action than they are absolutes; some of them are in conflict so judgement needs to be used Accrual: match revenues and expenses; put things in the same period; when reporting resource flows through the income statement the objective is to capture the revenue generated and the expense incurred in a given period –this may be different from the timing of the related cash flow; reporting revenues and expenditures in the time period when the economic resource is created or used up; generates the recognition of assets (prepayments) and liabilities (utilities owed) for which there is no legal documentation but which cover the ends of accounting periods; replaces matching –necessitated by the periodicity concept; periodicity splits the life of the entity into successive 12 month periods; matching requires that the sales revenue realized in a period be reported in the same period and not in another; the expenses reported be those that are incurred in the year the sales were recognized Business Entity: relate to the enterprise you’re dealing with; (can’t recognize something that is leased; whatever the legal structure each business enterprise is considered to be a separate entity for accounting purposes; all the transactions relating to that entity must be recorded and Page 8 of 75 reported, and those transactions extraneous to the entity should be excluded; (the share capital will be recorded in respect of a company but other aspects of the shareholders wealth (personal assets) will not be included) Current Value/Constant Dollar: it is assumed that dollars received or spent at any time are exactly equivalent to dollars received or spent at any other time; where inflation is significant this is untrue; replaces historical cost but still exists –the price actually paid for an asset or an expense is objective and verifiable it is considered superior to other valuations and historical cost is the initial valuation of all transactions; (land can be revalued) Disclosure: do not hide anything if it relates to decision making; presentations in the statement might be misleading and this principle requires that any such situation be disclosed generally by way of a note accompanying the financial statements; (if the company is being sued by a customer the company may believe that the case will go in its favour and so there are no cost implications and no expenses to report in the financial statements however the possibility that the case could be decided against the company should be disclosed in the notes to the financial statements) Going Concern: do not assume the company will go bankrupt; value it on an ongoing basis; in the absence of information to the contrary the business will continue to exist; assets will have their value in use as assets of a viable business (restricted to their historical cost) rather than some fire-sale price that they would fetch in a forced sale situation –which would be an exit price Materiality: ignore items that do not have a material impact on decision making; financial statement data should only consist of items that are large enough and important enough to be material to their interpretation; trivial amounts may be ignored Neutrality/Conservatism: replaces conservatism; auditors; no biases; in calculating income and in valuing assets it requires that a somewhat biased approach be taken; (if there has been a reduction in the value of an asset that reduction is to be accounted for –shown as a loss; if there has been Page 9 of 75 an increase in the value of an asset its benefit should not be recognized until the benefit has been realized; present information free from bias as much as possible Periodicity: break up into quarters, monthly; usually 1 year in financial period; the life of a business is effectively unlimited; it does not die as a person would and may continue even though its shareholders pass away; partitioning this long life into yearly reports is a meaningful and useful exercise for the shareholders and other interested parties; without this companies would present no periodic reports and no one would know what was going on Recognition/Realization: (my truck that delivers or yours?; title doesn’t pass until someone signs); the point at which a transaction can be said to have happened; (the rules about exactly when a sale has been made or an asset required) Scorekeeping: The Financial Statements; all organizations provide general purpose financial statements to external users; which are sent annually to all shareholders as well as government agencies and stock exchanges; where accrual accounting is used cash flow reporting is replaced by reporting on wealth and changes in wealth; all 4 statements refer to past events rather than expectations about the future; prepared for the use of actual and potential investors and creditors; for use when making investing and lending decisions; to help predict future cash flows Income statement: flow/shareholders claim –details of operations for benefit of shareholders over the period; revenues, expenses and profits for a year; a period of time that is now completed (the previous fiscal year); prepared using the accrual concept of resource flows; during the normal course of trade over a year the company will engage in many transactions that affect the owner’s equity; every time a sale is made or every time an expense is incurred the owner’s equity rises or falls; the income statement summarizes all of these transactions over a one year reporting period and reports on their overall effect; because the income statement reports on events of a period of time it has been compared to a movie of a company; Page 10 of 75 although the income statement measures past income it is used by investors and creditors to make informed judgements about how much income the company is likely to make in future years; the net difference between the sales revenue generated and the total of all expenses is the net income or profit of the company for the year; Balance Sheet: stock/comprehensive –where does the company stand financially at the end of the period; assets, liabilities, and equities at the end of the year; snapshot or still photograph of the company at a point in time (usually the last day of the fiscal year); prepared using the accrual concept of resource flows; what the company owns; what the company owes; the owners financial interest claim on the company; assets, liabilities, and owners equity; to get an idea of the type and value of the company assets, the amount and repayment dates of the company liabilities and the net worth of the owner’s equity investment Statement of Owners Equity/Statement of Retained Earnings: flow/shareholders claim –summary of operations, how much of shareholders claim was distributed to them in the period; changes in owner’s equity; prepared using the accrual concept of resource flows; short statement that helps link the balance sheet and the income statement; one of the items on the balance sheet is retained earnings; retained earnings represent income made on behalf of the owner’s but that has not been distributed to them by way of dividend; the retained earnings at the beginning of a year are increased by any net income (from the income statement) and decreased by any dividends paid that year; the remaining balance appears on the balance sheet at the end of the year Cash Flow Statement/Statement of Changes in Financial Position: flow/comprehensive –in what ways and why did the balance sheet change over the period; changes in cash; only one that deals with cash flow; summarizes past cash inflows and outflows and shows their effect on the cash assets; supplements the balance sheet and the income statement; it reports on the various sources of cash (cash from operations, cash from borrowing, cash from selling assets, cash from raising equity investment) and the various uses of cash (operating losses, repaying debt, buying Page 11 of 75 assets, paying dividends); include this information to creditors and investors SampleSimpleFinancial Statements Didier Corporation Ltd. Balance Sheet: As at December 31, 2012 Current assets$200,000 Current liabil$110,000 Long-term liabilities 130,000 Long-term asset300,000 Total liabiliti240,000 Equity 260,000 Total liabilities Total assets $500,000 and equity $500,000 Didier Corporation Ltd. IncomeStatement:Year Ended December 31, 2012 Sales revenue $900,000 Operatingexpenses 800,000 Operatingincome 100,000 Interest expense $13,000 Incometaxes 22,000 35,000 Net income $ 65,000 39 -currentitems=withinayear -thingsthat vary=interestexpense andincometax The accounting equation: collecting, organizing and reporting financial information; measure how the company has been doing (income statement); show where it stands financially at the end of the period (balance sheet); summarize transactions with its owners (statement of retained earnings); summarize balance sheet changes (statement of cash flows); usually expressed in the form of debits and credits ASSETS=LIABILITIES + OWNERS EQUITY Assets (OWN): the sum of the value of everything that the company owns Liabilities (CLAIM): the sum of all the debt claims on the company; (the sum of all the specific promises the company has made to pay to outsiders in the future) Page 12 of 75 Owner’s equity (CLAIM): total value of the owner`s financial claim on the company; always equal to the net assets of the company; made of retained earnings and contributed capital -transactions that involve an exchange of assets and/or liabilities of equal value do not change the net assets of the company and so do not alter owner’s equity -transactions that result in an increase in the net assets of the company result in an equal increase in owner’s equity -transactions that result in a decrease in the net assets of the company result in a matching decrease in owner’s equity SAMPLE TRANSACTIONS: 1. The owners invested $25,000 in the company (double entry) -assets have increased by $25,000 -liabilities are unchanged -owner’s equity has increased by $25,000 because the owners parted with some resources which they let the company have -the source of that $25,000 was the owners investment; the company not only has $25,000 it also has an obligation to the owners to account for the $25,000 they have invested -it is not a debt that needs to be repaid but the company is responsible for using the resources for long term benefit of the owners Assets Liabilities Owners equity 25000 0 25000 2. The company borrowed $10,000 from the bank -assets have increased by $10,000 -liabilities have increased by $10,000 -owner`s equity is unchanged Assets Liabilities Owners equity 35000 10000 25000 Page 13 of 75 3. The corporation bought some inventory (goods for resale) for $8000, which they paid for in cash -Assets (inventory) have increased by $8000 -Assets (cash) have decreased by $8000 -Liabilities are unchanged -owner’s equity is unchanged; there was no change in the net worth of the company Assets Liabilities Owners equity 35000 10000 25000 4. The company bought inventory (goods for resale) at a cost of $5000. The vendor allows 30 days credit on the amount owing -assets (inventory) have increased by $5000 -liabilities have increased by $5000 Assets Liabilities Owners equity 40000 15000 25000 5. The company sold inventory to a customer for $7000 in cash, the inventory had cost the company $4000 -this is an exchange transaction where the value received ($7000 in cash) is greater than the value surrendered ($4000 of inventory); the difference represents an increase in the net assets of the business –this $3000 is added to the owners equity -increases in net assets that arise from regular operations are by definition increases in the owner’s equity in the business Assets Liabilities Owners equity 43000 15000 28000 6. The company sold inventory to a customer on credit for $9000, the inventory cost the company $6000 Page 14 of 75 -the $9000 sale is represented by money owed to the company by the customer, a decision has to be made as to what point in time this sale will be recognized -gaap will recognize this as a completed sale and so will recognize the $3000 increase in assets at the time of the sale -the $3000 profit will be added to owner’s equity Assets Liabilities Owners equity 46000 15000 31000 7. The customer who had bought the goods for $9000 on credit paid for them -an asset ($9000 owed to the company by the customer) has been exchanged for an asset of the same monetary value ($9000 in cash) -there is no increase in the net assets and therefore no increase in the owner’s equity -the company had already recognized the $3000 increase in owner’s equity when the sale was made –as a general rule the benefit of a sale is recognized when the sale is made which is not necessarily when the money is received Assets Liabilities Owners equity 46000 15000 31000 8. The company paid for the inventory it bought on credit ($5000) -Assets (cash) have decreased by $5000 -Liabilities have decreased by $5000 -there is no change in the owner’s equity because there is no change in the net assets Assets Liabilities Owners equity 41000 10000 31000 9. The company paid in cash interest of $100 on the bank loan Page 15 of 75 -assets (cash) have decreased by $100 resulting in net assets having decreased by $100 -owner’s equity has also fallen by $100 this is because the outflow of $100 has not resulted in the acquisition of an asset rather it measures an expense; an expense may be thought of as what happens when an asset expires and becomes worthless -in this case the benefit is that the company was allowed the use of a loan for a period of time -expenses occur in many situations (payment of salaries and wages, rent of premises, fire insurance premiums); the effect of incurring the expense is to reduce owner’s equity Assets Liabilities Owners equity 40900 10000 30900 10. The owners decided to declare themselves a dividend (a cash payment out of profits); they paid themselves $1000 in cash -assets (cash) have decreased by $1000 resulting in net assets having decreased by $1000 -owner’s equity has fallen by $1000 Assets Liabilities Owners equity 39900 10000 29900 ASSETS-LIABILITIES=OWNERS EQUITY -the left hand side is net assets the net value obtained after the total claims of the debt holders are subtracted from the total value of the assets -if any transaction that affects the valuation of total assets or total liabilities such as there is a difference between the 2 changes, then the valuation of owners equity must also be adjusted to maintain the accounting equation -the income statement, the statement of retained earnings and the cash flow statement are each summaries of changes in different parts of the Page 16 of 75 accounting equation over a period of time always respecting the rule that owners equity is adjusted to reflect changes in net assets The accounting equation: Self St Problem 3 (page 68) Bombardier Inc. reported operating income of $1,700 million and net income of $391 million for the year ended January 31, 2002. the company’s total assets were $27,753 million and owners’ equity was $4,090 million as at January 31, 2002. Required: How much were the total liabilities as at January 31, 2002? LIABILITIES ASSETS = = ? $27,753 OWNERS ’ EQUITY= $4,090 42 Assets-OwnersEquity Page 17 of 75 The accounting equation: Self St Problem 4 (page 69) Bombardier Inc. reported operating income of $246 million and a net loss of $89 million for the year ended January 31, 2004. the company’s total assets were $25,569 million and liabilities totalled $22,319 million as at January 31, 2004. Required: How much were the total owners’ equity as at January 31, 2004? ASSETS = LIABILITIES $25,569 = 22,319 OWNERS’ EQUITY= ? 44 The accounting equation: Self St Problem 4 (page 69) Bombardier Inc. reported operating income of $246 million and a net loss of $89 million for the year ended January 31, 2004. the company’s total assets were $25,569 million and liabilities totalled $22,319 million as at January 31, 2004. Required: b) What was the return on assets for the year? Operating Income / Total assets = $246 / $25,569 = 0.96% or approx 1% c) What was the return on equity for the year? Net Income / Owners’ Equity = ($89) / $3,250 = negative = -2.73% or approx -3% 36 CHAPTER 3-THE INCOME STATEMENT The income statement: periodicity means chopping up the companies’ operations into one year sub periods so that shareholders and others can receive ongoing reports of how well the company performed; reports changes in wealth over a period of time; the net effects of revenues the company has generated and expenses it has incurred; expenses are deducted from revenues to leave the bottom line which is a figure of net income or profit; if the expenses exceed the revenues a loss will be reported; both revenues and expenses are calculated according to the matching principle –that is only the revenues earned in the period (no Page 18 of 75 matter when the money was received) and the expenses that were consumed in the period (no matter when they were paid for) are counted; this idea of matching is effected through accrual –moving revenues and expenses from one period to another to reflect real resource flows; accrual/matching is the principle difference between the income statement and a list of payments and receipts; summarizes all the operating revenues and expenses to show the operating income and from that interest and taxes are deducted to calculate the net income; revenues, expenses, and time periods are matched with one another through the use of accruals; the main parts of an income statement are: Revenues Less COGS –what it cost to create revenue; not all companies but manufacturing and retail industry; what is actually sold; physical presence Leaving Gross profit/margin Less Operating expenses –(cogs, rental expenses, amortization on a building, employee wages); not related to the sale you made; 2 types: cogs & not cogs Leaving Operating profit –everything but interest and tax expense Less Interest expense and tax expense – interest depends on level of debt; don’t judge management on interest; tax is discretionary Leaving Net income Revenues –sale of goods and services: revenues are resources that flow into the company; they increase the value of the company and hence increase the owners equity; arise mostly as a result of selling goods or services to customers; the most straightforward situation is where the entire transaction is completed within a year (the goods are sold, the cash is collected and all obligations under the contract of sale are completed Page 19 of 75 within the calendar year –in this simple situation the sale would be recognized in the year; a retail store that sells on a cash basis or there is a sign on a door that reads no refunds or exchanges); less straightforward situations will occur where some aspect of a transaction falls outside the year –the matching principle requires that an accrual be made to move a part of the transaction forward or backward in time; other non sale situations that give rise to revenues (interest revenues from bank deposits, GICs, rent revenues, commission revenues) Gross profit ratio: gross profit (margin) is the difference between revenues and the direct costs of goods sold; controlled by monitoring the gross profit ratio=gross profit ÷ salesX100 Operating profit: what is left after the operating expenses have been deducted from the gross profit; the profit before the interest and tax; should be lower than the above ratio; controlled by monitoring the operating profit as % of sales=operating profit ÷ salesX100 Net income: what is left over after interest expense and income taxes are deducted from the operating profit; belongs to shareholders; don’t compare net income to sales Revenue Recognition/Realization: when the revenues are recognized as realized; date establishes when the profit on the transaction will be recorded as earned; situations: -goods physically exchanged for cash: cash increases, revenue increases on balance sheet; sale is realized at that time -goods sold on credit: accounts receivable increases; sale at the time of change of legal ownership -goods subject to warranty or return: accrued liability increases, warranty expense decreases; make an allowance -goods or services over a period of time: accounts receivable/cash increases, liability increases; prorate the sale recognition Page 20 of 75 -2milliontotal -paid500,000 =1.5million Matching (Accrue)–Cost of Goods Sold: when an income statement for a year is prepared the operating expenses have to be matched to the year; expenses are resources that were used up during a period; in the same way that we recognize revenue when it is earned, not when the cash comes in; we recognize expense when it is used up not when the cash is paid; once the sales recognition issue is settled we have to accrue (match) the related expenses; the most common accrual is of credit sales –credit terms are for 30 days after which the invoice value is payable in full; the resource flow that the accounting/matching process is most interested in locating is the period when the goods were sold –when legal ownership of the goods passes from seller to buyer; the revenues for the sale of all goods sold in a given year will be recognized as revenues of that year even if they have not been paid for –if the customer fails to pay the matching principle requires us to recognize this possibility even if at the time we are preparing the income statement we do not have all the information to know which customers will prove problematic; we would therefore accrue an allowance for bad debts based on past experiences –that would create an expense (bad debt expense) that is matched with the time period; some sales are incomplete when initially made (a publisher sells books to bookstores but the bookstore has a right to return some or all of the shipment if the books don’t sell as well as expected –to take credit for all the sales at the time of delivery would be misleading so a percentage of Page 21 of 75 expected returns has to be held back in reporting sales); (if the sale of a new car has a warranty of 3 years or 50,000 km, while the full value of the car as sold may be treated as revenue, the expected costs to be incurred under warranty should be treated as an expected future payment but a current expense and matched by making it an expense in the same year the sale was recorded); in both examples the invoice and cash received may be an overstatement of the eventual net sales revenue; what would the sales revenue be for the accounting year if we had full knowledge of all the eventual outcomes? In the absence of full knowledge we make reasonable assumptions and in cases of doubt we exercise conservatism so that revenues are not over-reported EXAMPLE of RR in the retail industry: -peter’s press a bookstore prepares its income statement for the 12 months ended December 31 each year -during the current year a total of $550,000 has been banked from cash sales to customers -during November a customer took a large number of books on credit for $10,000, by December 31 that order has still not been paid for -peter’s press will recognize sales revenue of $560,000 for the year -the cogs for $560,000 must be recognized as an expense and the possibility that the $10,000 still owed may not be recovered has to be recognized –if the manager thinks there is a 50% chance of nonpayment then $5000 will be reported as a bad debts expense EXAMPLE of RR in the service industry: -fanatical fitness prepares its income statement for the 12 months ended December 31 each year -at the start of 2011 the club showed an amount of $100,000 on its balance sheet as a liability for memberships received in 2010 but continued into 2011 -during 2011 fanatical received 1,500,000 in cash for annual memberships Page 22 of 75 -at the end of 2011 there were a total of 250,000 worth of continuing memberships that would carry on until sometime into 2012 -in 2011 fanatical fitness will recognize 1,350,000 as revenues as follows: -memberships paid for in 2010 and expired in 2011 100,000 -add memberships received in 2011 1,500,000 -deduct memberships expiring in 2012 250,000 Expenses: opposite of revenues; decrease equity; in measuring net income we try to match the expenses with the revenues of the accounting period; the cash flow may not be a perfect guide to the resource flow we want to recognize –have to make the same adjustments of shuffling expenses from one period to another to get a good match; include items incurred directly in relation to the sale of goods (cogs in a retail store or the cost of manufacturing the goods sold in a production plant) –in respect of these direct costs we can see the link between the revenue generating process and the associated costs incurred and matching the two is relatively straightforward; expenses include operating costs of the company other than cogs (wages, rent, utilities) Cost of Goods Sold & Inventory: when a company purchases inventory for resale the transaction is revenue neutral; one asset (cash or its equivalent) has been exchanged for another asset (inventory) of equal value –as long as they still have the inventory no change in equity occurs; when the inventory is sold it creates revenue and it also reduces the asset inventory; this reduction in inventory value is recorded as an expense called cost of goods sold; where goods are of relatively small individual value simpler systems that do not capture cost of goods sold as the sale takes place may be used in these situations the cogs is found indirectly; the goods purchased during the year are added to the opening inventory and then the closing inventory is deducted –the balance is the cost of goods sold; gross profit or margin to sales ratio is one way that the control of cogs is carried out; the relationship between the cogs and the selling Page 23 of 75 price is known, the gross profit/margin should be precise –if the actual gross margin is lower than expected something has gone wrong (spoilage, theft, temporary selling price reductions); the cost convention tells us that inventory is recorded at a cost in the first instance; if inventory becomes impaired in some way then the conservatism convention tells us that its value should be reduced; if some of the inventory deteriorates and becomes unsellable the value of the inventory should be written down to reflect this and the amount of the write-down becomes an expense; the inventory may also lose value for reasons external to the organization; when inventory is bought it is an asset; until it is used it will appear on the balance sheet as an asset recorded at cost; if market value falls below cost the inventory value will be reduced to market value; when it has been sold it will be recorded in the income statement as an expense and it will no longer appear on the balance sheet as an asset Overhead expenses: in addition to cogs expenses also include overhead costs (wage and salary expenses; payroll related expenses –employers’ pension plan and employment insurance contributions; establishment expenses –taxes, rent, utilities, repairs; marketing expenses –advertising, sales, commissions; research and development and financing expenses – interest); the matching process is done indirectly; most of these overhead expenses cannot be directly linked to any particular revenues and instead they are more linked to the passage of time; matching for these expenses is done by matching the time period to when the revenues were earned rather than to the revenues themselves; in general we use accruals to adjust cash payments to reflect the resource flows and to match expenses to time periods; if the company has incurred an expense but not yet paid for it, add the accrued expense to the payments; if the company has paid for an expense but not yet used it, deduct the prepaid amount from the payments EXMAPLE of accrued expenses: -twin sisters restaurant prepares financial statements annually to December st 31 each year Page 24 of 75 -on January 2011 the restaurant owed 800 for electricity used in 2010 but not yet paid for -during 2011 twin sisters paid 12 monthly electricity bills for a total of 5200 -as at December 31 there was an unpaid electricity bill of 600 for the month to December 15 -cash paid in 2011 5200 -deduct owed from 2010 800 -add unpaid bill to December 15 2011 600 -add accrued usage from December 16 to December 31 2011 300 =Electricity expense for 2011 is 5300 -this expense of 5300 is matched to the consumption of electricity during 2011 -the balance sheet as at December 31 2011 will show a liability of 900 (600 billed but not paid and 300 accrued) for electricity used but not yet paid for -for the most part the electricity bills paid in the year will be for electricity consumed in the year therefore they are expenses for the current year; at the end of the year there may be an unpaid invoice for electricity and that invoice should be included as part of the current years expense -the last invoice of the year may only cover consumption up to December 15 as recorded by the meter reading; electricity consumed between December 16 and 31 should be estimated and accrued so that it becomes an expense of the current year -assuming the same process was carried out at the end of the previous year the electricity expense reported this year would not include the amount owed at the start of the year EXAMPLE of prepaid expenses: -twin sisters restaurant prepares financial statements annually to December st 31 each year -on January 1 2011 the restaurants balance sheet showed a payment in advance for rent of 1250 –this represents the rent for may 2014 the last Page 25 of 75 month of the five year lease and was paid on June 1 2009 at the beginning of the 5 year lease -during 2011 twin sisters made 12 annual rent payments of 1250 each for a total of 15000 -cash paid for rent during 2011 15,000 -add rent paid in advance at start of year 1250 -deduct rent paid in advance at end of year 1250 Rent expense for 2011=15000 -rent expense of 15000 will appear in the income statement for 2011 and rent paid in advance of 1250 will appear as an asset in the balance sheet at the end of 2011 -sometimes the adjustment will go the other way and the expense has to be reduced by the amount of the prepayment Amortization (Depreciation): when a long term asset (a piece of machinery) is bought the historical cost principle implies that no expense has yet occurred; the asset cash has been exchanged for the asset machinery both having equal value; over time the machine will be used in the operations of the business and eventually it will become worn out and worthless; although the asset is long term its life is not infinite; over the span of its useful life it is necessary that the cost be written off as expense in some orderly fashion; the most straightforward way to calculate amortization is to assume that the net cost is to be written off in equal annual instalments; any anticipated salvage or sale value will be deducted from the cost and the balance divided by the number of years the asset is expected to be in operation to arrive at the annual expense; (if someone buys a truck for 100,000 and on day 1 the company has exchanged an asset (cash) worth 100,000 for another asset (the truck) also worth 100,000 the transaction neither creates a revenue or expense –as time goes by the asset truck will be used up and the 100,000 eventually will all become expense; amortization will allocate the 100,000 to the periods to which it should be matched); (if the company intends to the truck for 4 years and then sell it for 24,000 the amount that needs to be amortized is Page 26 of 75 76,000 (100,000-24,000) –this will be spread over the four years as a 19,000 amortization expense each year (76,000÷4); in the balance sheet the truck will be reported as having a cost of 100,000 and from that cost the accumulated amortization to date will be deducted; at the end of year 1 the written down value will be 81,000 (100,000-19,000); at the end of year 2 the written down value will be 62,000 (81,000-19,000)...at the end of year 4 the written down value will be 24,000 (43,000-19,000) and at this point a number of things could happen, the truck could be sold as per the original plan and if so the 24,000 realized will be an exact match for the written down value and there will be no effect on the income statement – over the 4 years 76,000 of expired cost is written off as amortization expense with the expectation that the truck will be sold at the end of 2013 for 24,000; or possibly the truck could be sold for a higher amount (40,000) which would result in a gain on sale of 16,000 or the truck could be sold for less at 20,000 and result in a loss of sale of 4000; gains and losses have to be brought into the income statement as revenues and expenses respectively but really they are an admission that the original amortization estimate was incorrect) -declining balance amortization: applies a constant percentage rate to each year’s written down value; the effect is a higher amortization charge in the earlier years of the assets life and lower rates in later years; (if the truck were to be amortized using a rate of 30% on the declining balance it would be 30,000 in year one (30% of 100,000), 21,000 in year 2 (30% of 70,000), 14,700 in year 3 (30% of 49,000) and 10,300 in year 4 (30% of 34,300) with numbers rounded to the nearest hundred) -amortization on the basis of use: (if it is assumed that the truck will run 500,000 km over its life then the rate of $0.152 per km could be charged as amortization (0.152 is the 76,000 net cost divided by 500,000km); the effect would be to charge amortization expense according to how heavily the truck was used each year Bad debt expense: when sales are made on credit there is some uncertainty as to whether or not the customers will pay –most will pay Page 27 of 75 eventually but some turn into bad debts; when looking at revenue recognition we made it clear that the sales should be recognized when the legal title of the goods is passed to the customer; good matching requires that we recognize an estimated amount of bad debt expense related to those sales in the same year that the sales are recognized; bad debt will be an estimate relating to future events of which the precise details are unknown; past history is often a good guide to the amount of bad debt expense that would be prudent to recognize; (if the bad debts have worked out to be around 2% of all unpaid accounts each year for the past 10 years recognition of bad debt expense in the amount of 2% of the current years accounts receivable would be prudent and reasonable –we do that by creating a bad debt expense of 2% of the accounts receivable and a matching allowance for doubtful debts); there is a difference between the bad debt expense and most other expenses –the majority of expenses are identified because there is a transaction involved, a payment for the expense; this transaction is then adjusted through the accruals process to represent the actual resource flow that should be recognized as expense; in the case of bed debt there is no transaction; we create the expense without any payment being involved; to recognize an expense in the absence of a payment requires that we create an allowance for doubtful debts on the balance sheet; the allowance for doubtful debts is a contra asset account and is deducted from the accounts receivable to which it refers –by doing this it reduces the accounts receivable to their net realizable value; in the next accounting period when the actual bad debts come to light they can be written off by deducting them from the bad debt provision; we can adjust the accounts receivable to accommodate the actual bad debts discovered without making any additional expenses in the income statement of the current year (good matching) EXAMPLE: -mikes motor shop is preparing its annual financial statement for its first year for December 31 2010 Page 28 of 75 -mike has made a list of the money owed to him by customers; there are a total of 125 on the list and the total amount of outstanding invoices is 27,000 -looking down on the list he can identify 3 problem customers whose accounts total 2000; one has gone bankrupt, one has skipped town, and one has complained that the work wasn’t done properly and refuses to pay -mike thinks it would be prudent to assign 2% of the remaining receivables as an allowance for doubtful debts -mikes 2010 income statement: -3 customers who are specifically identified as bad debt expense 2000 -2% on the balance of receivables (2% X (27,000-2000)=500 -bad debt expense for 2010 as per the income statement=2500 -mikes 2010 balance sheet: -accounts receivables (net of the 2000 of specific bad debts written off) 25,000 -deduct allowance for doubtful debts 500 Net realizable value=24,500 -at the end of January 2011 mikes accounts receivable amount to 30,000; 2 customers have defaulted upon their obligations and failed to pay for work amounting to 400 that was done in 2010; this 400 can be taken away from the allowance for doubtful debts without further recourse to the income statement or the balance sheet -mikes 2011 balance sheet: -accounts receivable prior to recognizing bad debts 30,000 -deduct allowance for doubtful debts (no change from dec 2010) 500 Net realizable value=29,500 -the 400 of identified bad debts is then removed from both the receivables and the provision -mikes 2011 balance sheet: Page 29 of 75 -accounts receivable after recognizing bad debts (30,000-400) 29,600 -deduct allowance for doubtful debts (500-400) 100 Net realizable value=29,500 Operating income: operating expenses are deducted from revenues to reveal the operating income of the organization; measure of how well the organization did in its chosen line of business; operating manager is responsible for this; monitored through the use of ratios: -gross profit ratio/gross profit to sales ratio: the gross profit (revenues less cost of goods sold) expressed as a percentage of the revenues; in managing retail outlets this is a critical control number and is carefully checked against expectations and against what the competition is earning -return on sales ratio/operating profit to sales ratio: the operating profit (revenues less both cost of goods sold and operating expenses) expressed as a percentage of revenues; useful measure of overall performance for every company -return on assets ratio: operating income ÷ operating assets (frequently taken to be the total assets); to get a sense of how much the operating profit is in relation to the assets employed Net income: financing charges (interest expense) are deducted from the operating income as are income taxes and the result is the net income of the company -net income to sales ratio: net income ÷ sales X100; how much of each sale’s dollars remain as income -return on equity ratio/return on shareholder’s equity ratio: net income ÷ shareholder’s equity X 100; net income can be compared with the owners equity to give the return on shareholder’s equity ratio Page 30 of 75 Page 31 of 75 Retained earnings: accumulation of past profits less losses less dividends; appears on the balance sheet as part of owners equity; a recognition that net income has been made but that net income has not been paid out to its ultimate owners –the shareholders; if nothing were ever given to the shareholders then retained earnings would be the accumulated net income of the company from its inception date and conversely if all the net income is paid to shareholders as dividends each year then retained earnings would be zero; the amount paid as dividends is most likely to be some of the net income but not all of it; the directors like to give shareholders back something on their investment but prudence dictates that they not give it all and as a result retained earnings on the balance sheet tends to get larger each year Page 32 of 75 -statement of retained earnings: required report for companies; picks up the opening balance of retained earnings in the balance sheet at the start of the year and adds in the net income for the year, it then deducts dividends paid and any other transactions that reduce retained earnings; the remaining balance is the retained earnings at the end of the year; companies may only pay dividends out of net income (current net income) or retained earnings (accumulated undistributed net income); other considerations (cash availability and the need for investment funds) mean that the dividend payout is substantially less than the maximum that is legally distributable -dividend payout ratio: dividend ÷ net income X100; the relationship of the dividend to the net income for the period Earnings per share: net income ÷ #common shares; investors will want to know how much earnings their shares made; at the end of either the income statement or the statement of retained earnings most companies will report this; statistic widely used by analysts when they attempt to value shares; a shares intrinsic value is the earnings a company makes on behalf of that share; the greater the number of shares in existence (for a given amount of net income) the less each one is worth; even though earnings may not be paid out as a dividend it is assumed that plowing the profits back into the company will have beneficial long term growth effects and will eventually result in larger dividends being paid to shareholders; many companies reward their employees with the issue of shares or options to buy shares instead of cash; issuing shares dilutes the EPS for all shareholders; the existence of obligations to issue new shares at some future date will also reduce the EPS -fully diluted earnings per share: net income + interest saved on conversion ÷ # of shares potentially in issue; to ensure full disclosure; this is the EPS that would exist if all the extra shares were issued Page 33 of 75 Double entry system: has built in checks and balances; standard system used all over the world for bookkeeping Total of debits=total of credits A=L+SE Page 34 of 75 Page 35 of 75 Page 36 of 75 Page 37 of 75 Page 38 of 75 Page 39 of 75 CHAPTER 4-THE BALANCE SHEET (1) The balance sheet: is laid out in the same was as the accounting equation which is the fundamental model for recording and reporting transactions; when deciding the dollar amounts that will go on the balance sheet the assets must be owned in the first place and then they must be valued; the assets (the left hand side of the equation) are listed and totalled; the liabilities and the equities (the right hand side of the equation) are listed and totalled; the two totals are agreed to show that the accounting equation is in balance; a list showing a point in time what a company owns, what it owes and what owners equity remains; the assets that are the most readily realizable are listed first and at the end of the list are the assets that the company will be realizing either not at all or only after a long delay; the liabilities are listed with those that are immediately payable first and those with a long timeline last; ordering of the assets and liabilities helps the user to assess the liquidity of the company and the probability of the company being unable to pay its debts; the dollar values that appear on the balance sheet are those that are recognized by the accounting equation when transactions occur (the historical cost); this will give a fair idea of their value but there are at least 2 problems with the historical cost: -transactions are an incomplete record of the events that are important to the company, there are plenty of events that make the company richer or poorer but that are not captured by transactions and so go unrecorded (actions by competitors, unusual successes or failures of the company’s activities); -it sometimes misrepresents the value of assets or liabilities; the true value of an asset or liability may be under or over stated by its historical cost and the accounting concept of conservatism is a major influence on how we deal with such issues; if historical cost of an asset is higher than its value in use, conservatism requires that we reduce the historical cost to a more reasonable amount and if historical cost of a liability is an understatement conservatism requires that we increase it to its likely actual future cost; assets that are undervalued and liabilities that Page 40 of 75 are overvalued by the historical cost approach are not increased which is an application of conservatism Assets Everything a company owns Current assets: Realizable within one year Cash Available immediately Short term investments Realizable quickly Accounts receivable Collectable within 2 months Inventory Saleable and therefore convertible into receivables within a couple of months Long term assets Those that will be used indefinitely in the course of operating the business Total assets: when the assets are added together the total represents all the assets the company has control over; the total is used by analysts to get an objective measure of the size of the company; the greater the total assets the larger the company and so greater the profit it should make; the main issues for financial statement readers are existence: established by physical inspection and counting (auditors will attend when the company staff counts the inventory at year end), ownership: established by looking at the paper trail (registration documents for a car show and who the owner is and the auditor would expect to see them) and basis of valuation: assets are normally valued at their original cost less any amortization, the auditor would check that the amortization rate is reasonable considering the nature of the asset; anything that is valuable and is owned by the business; in order for the asset to appear in the balance sheet it must have been acquired at a measurable cost because of the historical cost basis used in valuation Total current assets: one year or less; are expected to be going through a continuous process of realization and replacement always shown on the balance sheet; are valued conservatively –they are valued at the lower of their cost or their market value because they are going to be realized all Page 41 of 75 the current assets are stated at cost or at realizable or exit values –what they are expected to bring in when as expected, they are disposed of; this contrasts with long term assets where the historical cost is more dominant in the valuation; showing the total of current assets facilitates the calculation of the liquidity ratios which compare the current assets against the current liabilities they have to pay; realization means different things in respect of different assets; showing the total of current assets facilitates the calculation of the liquidity ratios which compare the current assets against the current liabilities they have to be; cash is always taken to be a current asset because it may be spent immediately; realization of receivables means collection of the money owed; realization of inventory means using it in the m
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