Textbook Notes (363,074)
Canada (158,173)
Business (2,364)
BU387 (31)
Chapter 1-12

Accounting - Chapters 1-12 Complete Notes.doc

63 Pages
Unlock Document

Wilfrid Laurier University
Keith Whelan

Chapter One: The Canadian Financial Reporting Environment Accounting is the identification, measurement, and communication of financial information about economic entities to interested persons. Stakeholder What is at stake? Investors/creditors Investment/loan Management Job, bonus, reputation, salary increase, access to capital markets by company Securities commissions and stock Reputation, effective and efficient capital exchanges marketplace Analysts and credit rating agencies Reputation, profits Auditors Reputation, profits (companies are their clients) Standard Setters Reputation Various - The overall objective of financial reporting is to provide financial information that is useful to users and that is decision relevant. The statements should communicate information about: 1. The entity’s economic resources and claims to those resources 2. Changes in those resources and claims Sometimes financial statements are prepared with biased information to depict the company in its best light through aggressive financial reporting (opposite to conservative financial reporting). This process may involve overstating assets or net income, understating liabilities/expenses or carefully selecting note disclosures that emphasize positive events. Meeting financial analysts’ expectations and the fact that managers are often compensated based on the company’s net income are several reasons why bias in the financial statements may arise. Additionally, certain benchmarks may need to be met to comply with contracts that the company has (financial stability or liquidity ratios). A single set of general-purpose financial statements are prepared with the expectation that the majority of the stakeholder needs will be met. These statements are also expected to present the enterprise’s financial operations fairly. Accounting professions in various countries have tried to develop a set of standards that are generally accepted and universally practised. The common set of standards and procedures is called generally accepted accounting principles (GAAP). International GAAP is often referred to as International Financial Reporting Standards (IFRS). To be listed on a U.S. exchange, companies must follow U.S. GAAP or IFRS. Professional judgement plays an especially important role in private entity GAAP and IFRS. There cannot be a rule for every situation and therefore private entity GAAP and IFRS are based primarily on general principles rather than specific rules. The basic premise of this is that accountants with significant experience will be able to apply these principles appropriately to any situation. In a principles-based standard-setting system, the conceptual framework underlies the standards. Accountants either apply specific standards that are based on the conceptual framework, or it no specific standard exists, the accountant uses the conceptual framework and professional judgement to reason through to an answer. Ethical dilemmas are common in accounting. Management biases – either internally promoted (to maximize bonuses) or externally promoted (to meet analysts’ earning expectations) – are the starting point typically. These typically lead to an emphasis on the short term or long term results and place accountants in an environment of pressure. Some of the challenges facing accounting are globalization which leads to a requirement for international harmonization of standards, increased technology which results in the need for more timely information, and the move to a new economy resulting in a focus on measuring and reporting non-traditional assets that create value. An increased requirement for accountability is also a challenge which results in the creation of new measurement and reporting models that look at business reporting as a whole. Chapter Two: Conceptual Framework Underlying Financial Reporting Why is a conceptual framework necessary? 1. To by useful, standard setting should build on an established body of concepts and objectives. Useful and consistent standards can be additionally added over time. The result is a coherent set of standards and rules, as they have all been built upon the same foundation. 2. By referring to an existing framework, it should be possible to solve new and emerging practical problems more quickly. The following diagram shows an overview of a conceptual framework. At the first level, the objectives identify accounting’s goals and purposes: these are the conceptual framework’s building blocks. At the second level are the qualitative characteristics that make accounting information useful and the elements of financial statement (assets, liabilities, equity, revenues, expenses, gains and losses). At the third and final level are the foundational principles used in establishing and applying accounting standards. First Level: The “why” – goals and purposes of accounting OBJECTIVE S of financial reporting Second Level: Qualitative Characteristi Elements Bridge between of financial cs of statements accounting information Third Level: The Foundational Principles “how” - implementation Qualitative Characteristics of Useful Information Choosing an acceptable accounting method, the amount and types of information to be disclosed, and the format in which information should be presented involves determining which alternatives gives the most useful information for decision-making purposes. A) Fundamental Qualitative Characteristics 1. Relevance – accounting info must be capable of making a difference in a decision - helps users confirm or correct their previous expectations; has feedback/confirmatory value 2. Representational Faithfulness – reflects the underlying economic substance of an event/transaction - info that is representationally faithful is complete, neutral and free from material error or bias Completeness – statements should include all necessary information to portray underlying events Neutrality – information cannot be selected to favour one set of stakeholders over another - standard setters must also choose the best standards regardless of economic consequences Freedom from material error/bias – information must be reliable B) Enhancing Qualitative Characteristics 1. Comparability – information that has been measured and reported in a similar way is considered comparable (company to company or year-to-year) - comparability enables users to identify the real similarities and differences in economic phenomena 2. Verifiability – knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction 3. Timeliness – information must be available to decision makers before it loses its ability to influence their decisions 4. Understandability – users need to have reasonable knowledge of business and financial accounting matters in order to understand the information in financial statements but this information must also be of sufficient quality and clarity that is allows reasonably informed users to see its significance Materiality – info is material if including it or leaving it out would influence the judgement of a reasonable person (qualitative factors must be considered in determining materiality as well) Cost vs. Benefit – the costs of providing the information must be weighed against the benefits that can be had from using the information - costs may be from auditing, processing, collecting info, distributing, analysis etc. Elements of Financial Statements - there are many elements that users expect to find on the financial statements, including assets, liabilities, equity, revenues, expenses, gains, and losses - there are also subcategories such as noncurrent assets, cash, inventory etc. Assets 1. They involve present economic resources 2. The entity has a right or access to these resources where others do not In order for something to be an asset, the entity must provide evidence that it represents an economic resource and then link itself to that resource. In other words, the entity must first prove that the item has economic value and then that the entity may lay claim to or access that value. Economic resources are defined to thing that are scarce and capable of producing cash flows where teh right to access is an enforceable right. Using the example of land: a) Present economic resource: the land and plant represent a present resource; the entity may sell or use the property now and the property is not freely available to all so it has economic value (someone would pay to acquire the property) b) Right or access that others do not have: the entity has sole ownership of the property since it holds legal title. It therefore is connected to this specific economic resource and may lay claim to it Liabilities 1. They represent an economic burden or obligation 2. The entity has a present obligation (which is enforceable) Constructive Obligations are obligations that arise through past or present practice that signals that the company acknowledges a potential economic burden (warranty for defective products). Equity/Net Assets is a residual interest in the assets of an entity that remains after deducting its liabilities Revenues are increases in economic resources, either by inflows or other enhancements of an entity’s assets or by settlement of its liabilities Expenses are decreases in economic resources, either by outflows or reductions of assets of by the incurrence of liabilities Gains are increases in equity from an entity’s peripheral or incidental transactions Losses are decreases in equity from an entity’s peripheral or incidental transactions Comprehensive Income includes net income and all other changes in equity except for owners’ investments/distributions. In the new comprehensive income statement, the following would be included as “other comprehensive income”: - unrealized holding gains and losses on certain securities - certain gains and losses related to foreign exchange instruments - gains and losses related to certain types of hedges - other Foundational Principles Recognition/Derecognit Measurement Presentation and ion Disclosure 1. Economic entity 5. Periodicity 10. Full disclosure 2. Control 6. Monetary unit 3. Revenue recognition 7. Going concern and realization 8. Historical cost 4. Matching 9. Fair value Recognition/Derecognition Recognition deals with the act of including something on the entity’s balance sheet / income statement. Elements of financial statements have historically been recognized when: 1. they meet the definition of an element (ex. liability) 2. they are probable 3. They are reliably measurable Derecognition deals with the act of taking something off the balance sheet / income statement. 1. Economic Entity Assumption This assumption allows us to identify an economic activity with a particular unit of accountability. This helps accountants determine what to include or recognize in a particular set of financial statements. The consolidated financial statements are prepared from the perspective of the economic entity which allows the company to recognize and group together the assets, liabilities, and other financial statement elements that are under the parent’s control into one set of statements. 2. Control Control is important in determining which entities to consolidate and include in the financial statements. 1. There is power to direct the entity’s activities. In order to include the entity in the consolidated financial statements, the reporting entity must be able to make strategic decisions for the entity. 2. Only one entity has the power to direct the activities of the entity in question. Control prevents the sharing of power. 3. Power need not be exercised or absolute. 4. The reporting entity should have access to the benefits from the entity. 3. Revenue Recognition and Realization 1. Risks and rewards have passed or the earnings process is substantially complete 2. Measurability is reasonably certain 3. Collectibility is reasonably assured 4. Matching Accounting attempts to match costs with the revenues that they produce. GAAP requires that a rational and systematic allocation policy be used to establish exactly how much of a contribution is made to each period. The cost of a long term asset must be allocated over all accounting periods during which the asset is used because the asset contributes to revenue generation throughout its useful life. Costs are often classified into product costs and period costs. Product costs such as material, labour, and overhead attach to the product and are carried into future periods as inventory (if not sold) since inventory meets the definition of an asset. Period costs such as officers’ salaries and other administrative expenses are recognized immediately, even though the benefits associated with these costs occur in the future, because the costs do not meet the definition of an asset. Measurement Elements are recognized in the financial statements if they meet the definition of elements and are measurable (amounts may be reasonably estimated). 5. Periodicity Assumption This assumption implies that an enterprise’s economic activities can be divided into artificial time periods. These time periods vary, but the most common are one month, one quarter or one year. The shorter the time period, the more difficult it becomes to determine the proper net income for the period. 6. Monetary Unit Assumption This assumptions means that money is the common denominator of economic activity and is an appropriate basis for accounting measurement and analysis. It implies that the monetary unit is the most effective way of expressing to interested parties changes in capital and exchanges of goods and services. 7. Going Concern Assumption This is the assumption that a business enterprise will continue to operate for the foreseeable future. The only time when the assumption does not apply is when there is intent to liquidate the company’s net assets and cease operations or cease trading in the company’s shares or when the company has no realistic alternative but to liquidate or cease operations. 8. Historical Cost Principle Transactions are initially measured at the amount of cash that was paid or received. 1. It represents a value at a point in time 2. It results from a reciprocal exchange (2-way exchange) 3. The exchange includes an outside party 9. Fair Value Principle GAAP has increasingly called for the use of standardized fair value measurements in the financial statements. Fair value is an exit price (a price to sell/transfer). If an entity has a manufacturing facility that is integrated into its other facilities, the entity might successfully argue that the facility has synergistic value and is worth more to the specific entity. However, the market would generally value the facility based on what it was worth without the entity-specific synergies. Someone buying the facility would not have access to these entity-specific synergies and so would not attribute any excess value to them. Presentation and Disclosure 10. Full Disclosure Principle Anything that is relevant to decisions should be included in the financial statements. The principle recognizes that the nature and amount of information included in financial reports reflects a series of judgemental trade-offs. The trade-offs aim for information that is detailed enough to disclose matters that make a difference to users, but also condensed enough to make the information understandable. Five Elements to be Included in MD&As: 1. The company’s vision, core businesses, and strategy 2. Key performance drivers 3. Capabilities (capital/other resources) to achieve the desired results 4. Results (historical and prospective) 5. Risks that may shape and/or affect the achievement of results Financial Engineering – the process of legally structuring a business arrangement or transaction so that it meets the company’s financial reporting objective Chapter Three: The Accounting Information System Permanent Accounts – asset, liability, and equity accounts (B/S); left open Temporary Accounts – revenue, expense, and dividend accounts; periodically closed Adjusting Entries – entries that are made at the end of an accounting period to bring all accounts up to date on an accrual accounting basis so that correct financial statements can be prepared Four Financial Statements 1. Balance Sheet 2. Income Statement 3. Statement of Cash Flows 4. Statement of Retained Earnings / Statements of Changes in Shareholders’ Equity There is also a statement of comprehensive income which can be a part of the income statement. The Accounting Cycle 1. Identification and measurement of transactions and other events 2. Journalizing (general journal, cash receipts/disbursement journals etc.) 3. Posting (GL monthly, subsidiary ledgers usually daily) 4. Trial Balance Preparation 5. Adjustments (accruals, prepayments, estimated items) 6. Adjusted Trial Balance 7. Statement Preparation 8. Closing (temporary accounts) 9. Post-Closing Trial Balance 10. Reversing Entries (optional) Types of Adjusting Entries Prepayments Accruals 1. Prepaid Expenses – expenses paid 3. Accrued Revenues – revenues in cash and recorded as assets before earned but not yet received in cash or they are used or consumed recorded 2. Unearned Revenues – revenues 4. Accrued Expenses – expenses received in cash and recorded as incurred but not yet paid in cash or liabilities before they are earned recorded Closing Entries Interest Revenue 800 Sales 400,000 Cost of Goods Sold 316,000 Salary Expense 20,000 Ad Expense 52,600 Income Summary 12,200 Income Summary 12,200 - to close the account Retained Earnings 12,200 Chapter Four: Reporting Financial Performance The business model can be broken down into three distinct types of activities: 1. Financing – obtaining cash funding, often by borrowing, issuing shares, or retaining profits 2. Investing – using the funding to buy assets and invest in people 3. Operating – utilizing the assets and people to earn profits The balance sheet aims to capture the financing and investing activities. The income statement aims to capture the operating and performance-related activities. The cash flow statement looks at the interrelationship between the activities. The income statement is used by investors and creditors to: 1. Evaluate the enterprise’s past performance and profitability - by examining revenues, expenses, gains, and losses, users can see how the company performed and compare the company’s performance with its competitors 2. Provide a basis for predicting future performance - information about past performance can be used to determine important trends 3. Help assess the risk or uncertainty of achieving future cash flows - information on the various components of income highlights the relationships among them and can be used to assess the risk of not achieving a particular level of cash flows in the future The income statement provides feedback and predictive value, which help stakeholders understand the business. Quality of Earnings – the nature of the content and the way it is presented - the emphasis is on ensuring that the information is unbiased, reflects reality, and is transparent and understandable - an additional focus is on whether the earnings are sustainable Earnings Management – the process of targeting certain earnings levels (whether current or future) an then working backwards to determine what has to be done to ensure that these targets are met - these activities have a negative effect on the quality of earnings Gains – increases in equity (net assets) from peripheral or incidental transactions of an entity - doesn’t include those resulting from revenues or investment by owners Losses – decreases in equity (net assets) from peripheral or incidental transactions of an entity - doesn’t include those that results from expenses or distributions to owners Sale of investments, sale of plant assets, settlement of liabilities and writeoffs of assets are types of gains/losses. Other Comprehensive Income – made up of certain specific gains and losses that may be required to be presented separately on the income statement (below net income) and includes unrealized gains/losses on certain securities - this is closed out to a balance sheet account that is often referred to as Accumulated Other Comprehensive Income as an equity account on the Balance Sheet The distinction between gains and revenue depends largely on how the enterprise’s ordinary or typical business activities are defined. If McDonald’s sells a hamburger, it is recording a revenue. If they sell a deep fryer, any excess of the selling price over the book value would be recorded as a gain. Having income statement elements shown in full detail allows decision makers to better assess whether a company does indeed generate cash flows from its normal ongoing core business activities and whether it is getting better or worse at it. Single-Step Income Statement – only two main groupings are used: revenues and expenses Multi-Step Income Statement – separates operating transactions and non- operating transactions and matches costs and expenses with related revenues A study of the trend in gross profits may show how successfully a company uses its resources; it may also be a basis for understanding how profit margins have changed as a result of competition. Disclosing income from operations highlights the difference between regular and irregular or incidental activities. Disclosure of operating earnings may help in comparing different companies and assessing their operating efficiencies. Income Statement Sections 1. a) Continuing Operations - sales/revenues - cost of goods sold - selling expenses - administrative expenses b) Non-Operating - other revenues and gains - other expenses and losses c) Income Tax 2. Discontinued Operations - material gains/losses resulting from the disposition of a part of the business (net of taxes) 3. Extraordinary Items 4. Other Comprehensive Income - other gains/losses not required by primary sources of GAAP - includes all other changes in equity that don’t relate to shareholder transactions (net of taxes) Presentation of Expenses: Nature vs. Function 1. Nature - depreciation, purchases of materials, transport costs, employee benefits - this method tends to be more straightforward since no allocation of costs is required between functions 2. Function - cost of sales, distribution costs, administrative costs, and other - this method requires more judgement since costs such as payroll and amortization are allocated between functions - at a minimum, this method requires that cost of sales be presented separately from other costs Currently, income measurement follows a modified all-inclusive approach. This approach indicates that most items, even irregular ones, are recorded in income. Some exceptions include: 1. Errors in the income measurement of prior years 2. Changes in accounting policies that are applied retrospectively Discontinued Operations include components of an enterprise that have been disposed of or are classified as ‘held for sale.’ Companies may discontinue operations as part of a downsizing strategy to improve their operating results, to focus on core operations, or even to generate cash flows. Assets Held for Sale - if the component is not yet disposed of, an additional condition must be met before the transaction can be given a different presentation on the income statement - this condition is that the assets relating to the component must be considered to be ‘held for sale’ Assets are considered to be held for sale when all of the following criteria is met: - there is an authorized plan to sell - the asset is available for immediate sale in its current state - there is an active program to find a buyer - sale is probable within one year - the asset is reasonably priced and actively marketed - changes to the plan are unlikely When an asset is held for sale, regardless of whether it meets the definition of a discontinued operation, the asset is remeasured to the lower of its carrying value and fair value less its cost to sell. If the value of an asset that has been written down later increases, the gain can be recognized up to the amount of the original loss. Once an asset has been classified as held for sale, no further depreciation is recognized. Ex. During the current year, the electronics division lost $300,000 (net of tax). DG estimates that it can sell the business at a loss of $500,000 (net of tax). Under IFRS, the assets and liabilities would be presented as held for sale and classified as current assets and liabilities. Income from continuing operations $20,000,000 Discontinued Operations Loss from operation of discontinued department (net of tax) $300,000 Loss from disposal of electronics division (net of tax) 500,000 800,000 Net income $19,200,000 Extraordinary Items – material, nonrecurring items that are significantly different from the entity’s typical business activities - they are presented separately on the income statement in order to provide enough detail to have predictive value 1. Must be infrequent 2. Must be atypical of the company’s normal business activities 3. Must not depend mainly on decisions or determinations by management or owners Extraordinary items are shown net of taxes in a separate section in the income statement, usually just before net income. Unusual Gains and Losses – not typical of everyday business activities or do not occur frequently - include writedowns of inventories and gains/losses from fluctuations on foreign exchange - normally part of income from continuing operations Often enough, estimates that were originally made in good faith must be changed. Changes in Estimates are accounted for in the period of change if they affect only that period, or in the period of change and future periods if the change affects both. Ex. Assume DP Materials has consistently estimated its bad debt expense at 1% of credit sales. In 2010, Dp’s controller determines that the estimate of bad debts for the current year’s credit sales must be revised upward to 2%, or double the previous year’s percentage. Using 2% results in a bad debt charge of $240,000. The expense is recorded as follows: Bad Debt Expense 240,000 Allowance for Doubtful Accounts 240,000 The entire change is included in the 2010 income because it reflects decisions made and information available in the current year and no future periods are affected by the change. Intraperiod Tax Allocation – procedure of allocating tax balances within a period Used for the following items: (1) income from continuing operations, (2) discontinued operations, (30 extraordinary items, and (4) other comprehensive income Assume that SCTE has income before income tax and discontinued operations of $250,000 and a gain from the sale of one of its operations of $100,000. The income tax rate is assumed to be 40%. Income before income tax and discontinued operations $250,000 Income tax 100,000 Income before discontinued operations 150,000 Gain from sale of discontinued operations net of applicable taxes of (40,000) 60,000 Net income $210,000 Earnings per Share (EPS) = Net Income – Preferred Dividends Weighted Average Number of Common Shares Outstanding Lancer Inc. reports net income of $350,000 and declares and pays preferred dividends of $50,000 for the year. The weighted average number of common shares outstanding during the year is 100,000 shares. EPS is $3.00 as calculated below: EPS = $350,000 – 50,000 = $3.00 100,000 Retained Earnings Statement For the Year Ended December 31, 2011 Balance, January 1, as reported $1,050,000 Correction for understatement of net income in prior period (inventory error) (net of taxes of $35,000) 50,000_ Balance, January 1, as adjusted 1,100,000 Add: Net income 360,000_ 1,460,000 Less: Cash dividends $100,000 Less: Stock dividends 200,000 300,000_ Balance, December 31 $1,160,000 Gaubert Inc. decided in March 2010 to change from FIFO method of valuing inventory to the weighted average method. If prices are rising, cost of sales would be higher and ending inventory lower for the preceding period: Retained earnings, Jan 1, 2010, as previously reported $120,000 Cumulative effect on prior years of retrospective application of new inventory costing method (net of $9,000 tax) 14,000_ Adjusted balance of retained earnings, Jan 1, 2010 $106,000 The journal entry would be: Taxes Receivable 9,000 Retained Earnings 14,000 Inventory 23,000 Comprehensive Income = Net income + Other Comprehensive Income Statement of Income and Comprehensive Income For the Income and Comprehensive Income For the Year Ended December 31, 2010 Sales revenue $800,000 Cost of Goods Sold 600,000 Gross Profit 200,000 Operating Expenses 90,000 Net Income 110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000 Comprehensive income 140,000 V. Gill Inc. Balance Sheet at as December 31, 2010 (Shareholders’ Equity Section) Shareholders’ Equity Common shares $300,000 Retained earnings 160,000 Accumulated other comprehensive income 90,000 Total Shareholders’ Equity $550,000 The accumulated other comprehensive income is reported in the shareholders’ equity section of the balance sheet as shown above. Chapter Five: Financial Position and Cash Flows The balance sheet is useful for analyzing the company’s liquidity, solvency, and financial flexibility. Liquidity looks at the amount of time that is expected to pass until an asset is realized or until a liability is paid. Solvency refers to an enterprise’s ability to pay its debts and related interest. Financial flexibility measures the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. Limitations of the Balance Sheet: - many assets and liabilities are stated at their historical cost –the information may be less relevant in comparison to what the current fair value would be - judgements and estimates are used in determining many of the items reported in the balance sheet - the balance sheet necessarily leaves out many items that are of relevance to the business but cannot be recorded objectively Monetary Assets – either money itself or claims to future cash flows that are fixed and determinable in amounts and timing - their carrying values are more representative of reality as they normally are close to the amount of cash that the company will receive in the future (ex. Notes receivable) - also includes liabilities that require future cash outflows that are fixed and determinable in amounts and timing (notes payable and long-term debts) Non-Monetary Assets – their value in terms of a monetary unit are not fixed - ex. Inventory, PP&E, certain investments, and intangibles - these assets are often recorded at their historical cost which doesn’t reflect their true value Financial Instruments – contracts between two or more parties – often marketable or tradable - easy to measure; ex. Cash, investments in other companies, contractual rights to receive/deliver cash Current Assets – cash and other cash assets that will ordinarily be realized within one year from the date of the balance sheet or within the normal operating cycle in the cycle is longer than a year Cash and Cash Equivalents – cash, demand deposits, and short-term highly liquid investments - readily convertible into known amounts of cash and have an insignificant risk of changing in value Short-Term Investments are valued at cost/amortized cost or fair value - those measured at cost are written down when impaired Inventories are valued at the lower of cost and net realizable value, with cost being determined using a cost formula such as FIFO, weighted average cost, or specific identification. It is important to disclose these details as it helps users understand the amount of judgement that was used in measuring the asset. Ex. Inventories (in thousands of USD) Raw materials and supplies 6,308 Work-in-process 30,445 Finished goods 256 Provision for excess inventory (2,471) Provision for non-completion of product inventory (3,735) 30,803 Less: Long-term inventory, net of provisions 19,170 11,633 The company may classify some of its inventory as long-term. Inventory is generally presented as a current asset since it will generally be sold within a year. Prepaid Expenses – current assets that are expenditures already made for benefits (usually services) that will be received within one year or the operating cycle (whichever is longer) Long-term investments are usually presented on the balance sheet just below current assets in a separate section called “Investments.” Long-term investments carried at other than fair value must be written down when impaired. Property, Plant and Equipment – tangible capital assets used in ongoing business operations to generate income - ex. Land, buildings, machinery, furniture, tools - generally carried at their cost or amortized costs (land isn’t typically depreciated) - IFRS allows an option to carry them at fair value using a revaluation or fair value method Intangible Assets – capital assets that have no physical substance; usually have a higher degree of uncertainty about their future benefit - patents, copyrights, franchises, goodwill, trademarks, trade names, etc. - recorded at cost and are divided into two groups: those with infinite and finite lives Other Assets vary widely in practice. These may include ‘Future Income Tax Assets’ (deferred income taxes). When a company buys an asset, it is allowed to deduct the cost of the asset from future taxable income. This represents a benefit, which is tax effected and recognized on the balance sheet. Current Liabilities – obligations that are due within one year from the date of the balance sheet or within the operating cycle, where this is longer Working Capital = Total Current Assets – Total Current Liabilities - the net amount of a company’s relatively liquid resources Long-Term Liabilities – obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead are payable at some later date - future income tax liabilities (deferred income taxes) are future amounts that the company owes to the government for income taxes Owners’ Equity is typically divided into four parts: 1. Capital Shares 2. Contributed Surplus - ex. Gains from certain related party transactions 3. Retained Earnings - undistributed earnings 4. Accumulated Other Comprehensive Income Additional Information Reported 1. Contingencies – material events that have an uncertain outcome 2. Accounting Policies – explanations of the valuation methods that are used or the basic assumptions that are made for inventory valuations, amortization methods, investments in subsidiaries, etc. 3. Contractual Situations – explanations of certain restrictions or covenants that are attached to specific assets, or more likely, liabilities 4. Additional Detail – expanded details on specific balance sheet line items 5. Subsequent Events – important events that happened after the balance sheet data were compiled Contingency – an existing situation in which there is uncertainty about whether a gain or loss will occur and that will finally be resolved when one or more future events occur or fail to occur - gain contingencies include tax operating loss carry-forwards - loss contingencies relate to litigation against the company, environmental issues, or possible tax assessments Cash Flow Statement – allows users to assess the enterprise’s capacity to generate cash and cash equivalents and its needs for cash resources Classifications of the Cash Flow Statement: 1. Operating Activities – the enterprise’s main revenue producing activities and all other activities that are not related to investing or financing 2. Investing Activities – the acquisitions and disposals of long-term assets and other investments that are not included in cash equivalents 3. Financing Activities – activities that result in changes in the size and composition of the enterprise’s equity capital and borrowing Indirect Method of Presenting Cash Flows from Operating Activities - begins with net income and reconciliation to cash Direct Method - presents the following information in the operations portion: - cash received from customers - cash paid to suppliers and employees - interest paid/received - taxes paid - other Net income provides a long-term measure of a company’s success or failure, but cash is a company’s lifeblood. Without cash, a company will not survive. Financial Liquidity Current Cash Debt Coverage Ratio = Net Cash Provided by Operating Activities Average Current Liabilities The higher this ratio is, the less likely it is that the company will have liquidity problems. A ratio of at least 1:1 is good because it indicates that the company can meet all of its current obligations from internally generated cash flow. Cash Debt Coverage Ratio = Net Cash Provided by Operating Activities Average Total Liabilities A more long-run measure that provides information on financial flexibility. Indicates a company’s ability to repay its liabilities from net cash provided by operating activities without having to liquidate the assets that it uses in its operations. Chapter Six: Revenue Recognition Price Risk – risk that the price of an asset will change Sales agreements normally specify that is being given up and what is being acquired: Acquired – consideration or rights to the consideration; amount, nature and timing are agreed upon Given Up – goods/services (nor or in the future); details regarding delivery are agreed upon Concessionary Terms are terms that are more lenient than usual and are meant to induce sales. These may create additional obligations or may reflect the fact that the risks and rewards or control has not yet passed to the customer. They create additional recognition and measurement uncertainty. Ex. Selling on credit, sales to riskier customers, shipping at a later date, extended warranties. Contract Law - contract establishes the point in time when legal title passes (entitlement/ownership under law) - when the customer takes physical possession of the goods straight away, legal title would normally pass at this point FOB Shipping Point – title passes at the point of shipment FOB destination – title passes when the asset reaches the customer Constructive Obligation – an obligation that is created through past practice or by signalling something to potential customers; often enforceable under law - if a customer has a past history of accepting all returns after their “30 day period” they effectively have an obligation to accept customer returns for any reason at any time since an expectation has been created Revenue – an inflow of economic benefits (cash, receivables, other consideration) arising from ordinary activity Revenues are realized when goods and services are exchanged for cash. Realization is the process of converting noncash resources and rights into money. This is referred to as the cash-to-cash cycle. Two views on how to account for revenues: 1. Earnings Approach - focuses on the earnings process and how a company adds value 2. Contract-Based Approach - focuses on contractual rights and obligations created by contracts Earnings Approach - seen primarily as in income statement approach to accounting for revenues - focus is on measuring revenues and costs and recognizing revenues when earned Revenues are recognized when: - performance is substantially complete - collection is reasonable assured Performance occurs when an entity can measure the revenue (and costs) and when it has substantially accomplished what it must do to be entitled to the benefits of the revenues. Performance is achieved when: a) The risks and rewards are transferred and/or the earnings process is substantially complete b) Measurability is reasonably assured When an entity sells goods, there is often one main act or critical event in the earnings process that signals substantial completion or performance. Some uncertainty remains, but its level is acceptable and revenues can be recognized under accrual accounting. Substantial completion normally occurs in business that sell goods at point of delivery. This is generally when the risks and rewards of ownership pass. If the earnings process has a critical event, it is often referred to as a discrete earnings process. Product Earnings Process – plant vines, fertilize/protect, harvest, ferment, bottle, ship, collect $$$ When services are provided, the focus is on performance of the service. The accounting is more complex where the earnings process has numerous significant events (continuous earnings process). Service Earnings Process – obtain client, plan audit, perform interim work on controls, attend inventory count, perform year-end work, sign audit report, bill client, collect $$$ An example of a discrete earnings process for a service would be a maintenance inspection on a car. The service is offered on the spot and is completed in a very short time. The critical event is when the mechanic hands over the inspected car and the bill. Long-term contracts such as construction contracts, may invoice the purchased at intervals, as various points in the project are reached. These invoices are referred to as billings. Two methods of accounting for long-term construction and other service contracts are generally recognized: 1. Percentage-of-Completion Method - revenues and gross profit are recognized each period based on the construction progress 2. Completed-Contract Method - revenues and gross profit are recognized only when the contract is completed - makes most sense to use when the service consists of a single significant event The method that best matches the revenues to be recognized to the work performed should be used. - If performance requires many ongoing acts (a continuous earnings process), the percentage-of-completion method should be used as long as the company is able to measure the transaction - The completed-contract method should be used when performance consists of a single act (a discrete earnings process) or as a default method when there is a continuous earnings process but the progress toward completion is not measurable Enforceable Rights – buyer has the legal right to require specific performance on the contract - seller has the right to require progress payments that may provide evidence of the buyer’s ownership interest A continuous sale occurs as the work progresses, and revenue should be recognized accordingly. Contract-Based Approach - the contract-based approach reflects a more recent view of revenue recognition - the emphasis is on the balance sheet and on measuring the rights and obligations under sales contracts - recognizes revenues when these rights and obligations change Under this approach, revenue is recognized when: - the entity becomes party to the contract - the contractual rights are collectible/measurable - the performance obligation is measurable Net Contract Position – the net amount of the contractual rights and obligations Ex. A plumber agrees to provide plumbing services to a customer for $500 cash payable within 30 days. Once the agreement is agreed upon by both parties, the plumber has a contractual right to receive $500 and a contractual performance obligation to provide the plumbing service. At inception of contract: Contractual Rights/Obligations 500 Contractual Rights/Obligations 500 The contractual right to receive cash becomes an AR and is contingent upon performing the service. Technically, no receivable exists until the service is performed. When Service Provided (assume related costs to provide the service are $250) Contractual Rights/Obligations 500 Payroll Expense 250 Revenues 500 Cash 250 If services were provided over time, the revenue recognition would likewise be spread out over time, using the percentage-of-completion method. Measurement Uncertainty – results from an inability to measure the transaction of parts of the transaction; due potentially from the following reasons: a) inability to measure the consideration b) inability to measure related costs c) inability to measure the outcome of the transaction itself (sales contingent on future event etc.) The alternative revenue recognition treatments are available when there is measurement uncertainty: a) Do not record a sale if it is not measurable b) Record the sale, but attempt to measure and accrue an amount relating to the uncertainty as a cost or reduced revenues Measuring Parts of a Sale - ex. the phone and wireless access are separate units for accounting purposes - ideally, the relative fair value method would be used - the fair value of each item is determined and then the purchase price is allocated based on the relative fair values - alternatively, the residual fair value method could be used – the fair value of the undelivered item is subtracted from the overall purchase price; the residual value is then used to value the delivered item Ex. Google Inc. sells a product and a service bundled together. Assume that the separate deliverables meet the GAAP criteria for treatment as separate units. The fair value of the product is $100 and the fair value of the service is $200. In order to make the sale, Google sold the bundle at a discount for $250. Under the fair value method, the amount that is allocated to the product would be $83.88 and the value attributed to the service would be $166.67. If the residual value method is used, the service would be valued at $200 and the product at $50. Fair Value Fair Value Residual Residual Method Method Method Method Calculation Allocation Calculation Allocation Product 100__ x $83.33 (250 – 200) $50 250 (100 + 200) Service 200___ x $166.67 (250 – 50) $200 250 (100 + 200) Total $250 $250 Sometimes contracts become onerous – the contract is no longer profitable to the company. Consideration should be given to remeasuring the contract and reflecting a loss in the income statement. Collectibility - at the point of sale, if it is reasonably sure that collection of the receivable will ultimately occur, revenues are recognized - alternatively, when collectability cannot be reasonably assured, revenues cannot be recognized In some distribution arrangements, the vendor retains legal title to the goods. In such cases, the point of delivery is therefore not proof of full performance. This specialized method of marketing for certain types of products uses what is known as a consignment. Under this arrangement, the consignor (ex. a manufacturer) ships merchandise to the consignee (ex. a dealer), who acts as an agent for the consignor in selling the merchandise. Both consignor and consignee are interested in selling: the consignor to make a profit, the consignee to make a commission on the sales. Earnings Approach - the consignee accepts the merchandise and agrees to exercise due diligence (care) in looking after the inventory and selling it - when the merchandise is sold, cash received from customers is then remitted to the consignor by the consignee, after deducting a sales commission and any chargeable expenses - revenue is only recognized after the consignor receives notification of the sale - for the entire time of the consignment, the merchandise is carried as the consignor’s inventory and is separately classified as Merchandise on Consignment; it is not recorded in the consignee’s books - upon sale of the merchandise, the consignee has a liability for the net amount that is must remit to the consignor See page 338 for an example Contract-Based Approach - both parties have rights and obligations - consignor has the right to nay consideration once the inventory is sold to a 3rd party customer - consignor has obligation to provide inventory for display purposes and pay a percentage of the consideration upon sale to a third party (selling commission) - consignee is the one selling the service; agrees to display and sell consignor’s goods for a commission - the consignee must measure the value of the rights and obligations up front; measurement uncertainty is here since the revenue is contingent upon making a sale - if no sale is made, then no service revenue will be earned - the journal entries for the consignor would be essentially the same as under the earnings approach assuming the contract with the customer is entered into at the same time as the control of the goods passes to the customer Percentage-of-Completion Method Earnings Approach - the percentage-of-completion method recognizes revenues, costs, and gross profits as progress is made toward completion on a long-term contract - in order to apply the percentage-of-completion method, there has to be a basis/standard for measuring the progress toward completion at particular interim dates - measuring progress toward completion requires significant judgement - the various measures (costs, labour hours, product produced etc.) are identified as inputs or outputs - input measures (costs, labour hours worked) measure the efforts that have been devoted to a contract - output measures (tonnes produced, km of a highway completed) measure results - neither of these measures can be applied to all long-term projects, so the measure needs to be carefully tailored to the circumstances (judgement is essential) Formula for Percentage of Completion, Cost-to-Cost Basis – Earnings Approach Percent Complete = Costs incurred to date___ = Percent complete Most recent estimate of total costs Formula for Total Revenue to be Recognized to date - Earnings Approach (or gross profit) Revenue to be Recognized to Date = Percent Complete x Estimated Total Revenue Formula for Amount of Current Period Revenue, Cost-to-Cost Basis – Earnings Approach (or gross profit) Current Period Revenue = Revenue to be recognized to date - Revenue recognized in prior periods Ex. To illustrate the percentage-of-completion method, assume that Hardhat Ltd. Has a contract starting in July 2011 to construct a 4.5M bridge that is expected to be completed in October 2013 at an estimated cost of 4M. 2011 2012 2013 Costs to date 1,000,000 2,916,000 4,050,000 Estimated costs to complete 3,000,000 1,134,000 - Progress billings during the year900,000 2,400,000 1,200,000 Cash collected during the year 750,000 1,750,000 2,000,000 The percent complete would be calculated as follows: 2011 2012 2013 Costs incurred to date Contract price 4,500,000 4,500,000 4,500,000 Less estimated cost: Costs to date 1,000,000 2,916,000 4,050,000 Estimated costs to complete 3,000,000 1,134,000 -_ Estimated total gross profit 500,000 450,000 450,000 Percent Complete 25% 72% 100% (1,000,000) (2,916,000) (4,050,000) 2011 2012 2013 Cost of Construction: Construction in process 1,000,000 1,916,000 1,134,000 Materials, Cash, Payables etc. 1,000,000 1,916,000 1,145,000 Progress Billings: Accounts Receivable 900,000 2,400,000 1,200,000 Billings on Const. In Process 900,000 2,400,000 1,200,000 Collections: Cash 750,000 1,750,000 2,000,000 Accounts Receivable 750,000 1,750,000 2,000,000 See pages 342–343 for Percentage of Completion: Revenue and Gross Profit by Year - Earnings Approach Calculation of Unbilled Contract – Earnings Approach Amount at Dec 31, 2011 Contract revenue recognized to date: 4M * (1M / 4M) $1,125,000 Billings to date 900,000 Unbilled revenue 225,000 See page 344 for a financial statement presentation of the previous data. Comparison of Gross Profit Recognized – Earnings Approach Percentage-of-Completion Completed-Contract 2011 $125,000 - 2012 199,000 - 2013 126,000 450,000 See page 346 for a financial statement using the completed contract method – earnings approach. Losses on Long-Term Contracts Earnings Approach 1. Loss in Current Period on a Profitable Contract - occurs when there is a significant increase in the estimated total contract costs during construction but the increase doesn’t eliminate all profit on the contract - under the percentage-of-completion method only, the increase in the estimated cost requires an adjustment in the current period for the excess gross profit that was recognized on the project in prior periods - this adjustment is recorded as a loss in the current period because it is a change in accounting estimate 2. Loss on an Unprofitable Contract - cost estimates at the end of the current period may indicate that a loss will result once the contract is completed - under both the percentage of completion and completed-contract methods, the entire loss that is expected on the contract must be recognized in the current period 1. Loss in Current Period Ex. On Dec 31, 2012, Hardhat estimates the costs to complete the bridge contract at $1,468,962 instead of $1,134,000. Assuming all other data are the same as before, hardhat would calculate the percent complete and recognize the loss as follows: Cost to date (12/31/12) 2,916,000 Estimated
More Less

Related notes for BU387

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.