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Chapter 5-7

ACTG2010 Chapter 5-7.docx

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ACTG 2010
Douglas Kong

ACTG Chapter 5 Cash cycle: The cycle of investing cash in resources, providing goods and services to customers, and collecting cash from customers. Cash lag: The delay between the expenditure and receipt of cash. Inventory conversion period: The average length of time between receiving inventory from a supplier and selling it to the customer. Payables deferral period: Average number of days between receipt of goods and services from a supplier to payment of the supplier. Receivable conversion period: Average length of time between delivery of goods to a customer and receipt of cash. Inventory self-financing period: Average number of days between the date the inventory is paid for and the date that the inventory is sold to a customer. Same as the cash lag. Self-financing: Time paid since supplier was paid till when cash was collected. IFRS i). Unit of measure: Currency in which all an entity’s activities are classified. E.g., U.S dollar or even Canadian Dollar. Drawbacks of unit of measure include; it may not consider inflation, and human capabilities. ii). Entity concept: If there is a separate entity, there should be information that is provided for that entity alone. However, there are situations where owners of the entity can record their private personal transaction that do not relate to the business entity to affect the overall credibility of financial statements. Stakeholders may make wrong assumptions. Anil Chopra’s Nashco and Dimension Hospitality vs. his personal transactions (e.g., India Ticket) that are included in the same financial statement. iii). Going concern (A business will continue running): An entity that will be continuing its operations for the foreseeable future. In the event that an entity exists for a certain known duration of time (or is at risk of going out of business), all assets and liabilities become current. Creditors will demand loan repayment or supply payment in the current period (not the original long term commitment, they won’t allow payment deferrals on inventory). iv). Periodic reporting assumption: The entity reports financial information over periods of time that are shorter than the entities life (quarterly, annually). You now where an entity is headed based on these reports and the information is more useful for stakeholders if it is reported frequently. Cash flow statement can also be known as the changes in financial position. -Cash from operations: Any cash that an entity generates or uses from its day-to- day business activities. Cash involving current assets and current liability accounts. Cash from financing activities: Is that cash an entity raises from and pays to equity investors and lenders. Involving long-term assets. -Cash from investing activities: The cash an entity spends on buying capital assets and other long-term assets (also the cash that the entity receives from selling those assets). Cash involved with long-term liability and equity. -All three of these activities combine to create net cash flow. -Cash and cash equivalents include: i). Cash on hand and cash in bank accounts. ii). Short-term liquid investment: Investments that are easily converted to known amounts of cash with little risk that the amount of cash to be received would not change. These are investments maturing within 3 months. Government T-bills, money market fund (bank needs money to meet its deposits, very short term paper for borrowing where some interest is paid), commercial paper (entities like Loblaws need money for a short duration of time which would be paid back with interest). NOTE: Equity investments (Royal Bank Shares) cannot be included in cash or cash equivalents because their market values fluctuate. iii). Bank overdraft is a liability to the bank created when an entity has $20000 in its bank account and it writes cheque amounts exceeding the balance in its bank account. Line of credit is a loan amount provided by the bank at interest which becomes a liability for the institution owing the money. Cash and cash equivalents includes the money available from having a line of credit (included as a negative balance). -Repurchasing common shares from investors is when an entity (corporation) purchases shares back from investors for the purposes of -IFRS states that interest paid out can be treated as either operating activity or financing activity. Dividends are always financing activities. -Cash flow statements only reports statements involving cash. Cash flow from operations can be calculated in 2 ways: i). Indirect method: Adjusting net income for non-cash amounts and for operating flows not included in the calculation for net income. Used more widely by company’s even though IFRS allows the direct method. The method highlites the difference between income and cash flow. ii). Direct method: Cash collections and cash disbursements related to operations during a period. Only considers cash inflows and outflows. -When examining the indirect method, there are two types of adjustments that need to be made: i). Remove transactions and economic events that are included in the calculation of net income but do not effect the cash flow. Essentially taking out all the non-cash transactions. E.g., depreciation which does not involve cash, it’s just allocating the cost of a depreciating item to expense over its life. Since depreciation is a non-cash expense subtracted from net income, it must be added back to net income to eliminate it when calculating CFO. Hence non-cash items must be subtracted when calculating net income then must be added back when reconciling from net income to CFO. ii). Adjusting accrual revenue and expenses so that only cash flows are reflected. We can change accrual revenues and expenses to cash by adjusting for changes over a period in the non-cash working capital accounts on the balance sheet (A/R, A/P, W/P, essentially the current assets and liabilities. -Increasing depreciation expense would not increase CFO because you already subtracted depreciation when calculating net income. To reconcile from net income to CFO, you are adding the amount of depreciation which balances out depreciation to 0. -Gains: The amount by which the selling price of an asset is greater than its net book value. These are subtracted from net income to determine CFO. -Losses: The amount by which the selling price of an asset is less than its net book value. These are added to net income to determine CFO. -Future (deferred) income taxes: Differences between how taxes are calculated for accounting purposes versus how they are calculated for taxation authorities These are added/subtracted from net income to determine CFO. -Writeoffs or writedowns of assets: Occurs when an asset’s book value is decreased to reflect a decline in market value that is not supported by a transaction. These are added to net income to determine CFO. Value of a Sony Bravia TV for example, bought for 5000 but three years later is worth only $800. -Liquidity is the ability to convert short-term assets into cash. It is important to evaluate to see whether an entity can meet its current operations. Current assets, current liabilities and shares of public companies. -Solvency is the ability of the entity to pay its debts as they come due. You should be able to meet your obligations as they fall due (it is a long-term concept). -CFO if regular and predictable, is an important source of liquidity because it represents a reliable source of cash for meeting obligations. -Limit to the current ratio introduced in chapter 2 was determining liquidity because it only measures the current assets and current liabilities (it is static since the balance sheet is measured on a particular day). -Operating cash flows to current liabilities ratio is the cash from operations divided by the average current liabilities. The advantage is it shows how cash generated over time is used by the entity to pay off its short-term obligations (this is not static concept, so long as CFO is able to meet the average current liabilities (sufficient cash must be generated on an ongoing basis). A ratio value less than 1 would indicate the company not having sufficient CFO to meet average current liabilities. -Negative CFO may result when a business has started and the business is in its growth stage because (acquiring additional inventory and capital assets). But negative CFO prolonged may dry up external sources of cash. For example, in the short run, a loan could be taken to facilitate the temporary shortfall in cash. But in the long run, there may not be an inexhaustible source of money that the company can receive. Lenders will offer money at interest rates which depend on the risk the lenders are in with investments. -Free cash flow: Cash from operations minus capital expenditures (capX). Capital expenditure is the reinvestment in business for long-term assets (maintaining machines, or purchasing watches). -IFRS requires a separate cash flow statement while GAAP does not. GAAP does require cash flow information recorded separately in notes. -GAAP requires interest and received to be recorded as part of CFO. IFRS allows entities to classify interest payments as CFO or financing activities or interest received as CFO or investing activities. -Ending balance=beginning balance+changes ACTG Chapter 6 Changes in purchasing power: There are 2 things inflation and currency exchange. -Internal controls: Ensure an entity achieve its objectives. In an accounting context, internal controls address the reliability of an accounting system’s information and protect an entity’s assets from loss, theft, and inappropriate use. Poor internal controls can lead to significant losses. -Segregation of duties: Ensuring that people who handle an asset are not also responsible for record keeping for that asset. -Bank reconciliation: Explains differences between an entity’s accounting records and tis bank account. -Receivables: Amounts owing to an entity. Usually cash but they could also be goods or services. Receivables are generally current assets but if the receivable is long term, then it would be put into noncurrent asset. -Selling of credit is done in the industry since it is done by other entities (normal business practice). If the credit amount is not paid upon the end of a certain term, then the creditor may charge interest. There are even situations where the lender may need write-off the credit offered (generally a small percentage of all transactions). -Customers may not receive the goods and services, demand a refund, or merely not pay the supplier, which are some of the reasons suppliers may not get paid. To combat this, suppliers offer incentives such as 2% rebate if goods and services that are paid off well in advance of the due date (pay in 10 days even though there is a 30 day payment), or even no interest to paid for certain duration of time (instead of having to write-off the receivables). -Net realizable value: Represents the estimated amount of cash that would be collected out of receivables. This would be a useful way to see how the entity is managing its receivables, credit and general cash flow (since it represents the amount of cash that would be received). IFRS reports receivables on B/S as net realizable value. - For the stewardship and to measure managers performance, the cash collected, how much credit has been given (sales given on credit), discount offered to purchases, and how may returns are accepted can also be assess managers performance. -Tax authorities allow you to pay taxes based net realizable valuable (which has been adjusted for provision). -Direct write-off method: When the management is almost sure that a particular receivable would not be collected. It can be written off. The journal entry would be debit bad debt expense and credit accounts receivable. -Matching is the process of reporting expenses in the same period as revenue for those expenses is simultaneously recorded (expenses are recorded as soon as revenue is reported). -Allowance for uncollectable accounts (bad debt provision): A contra asset account representing the amount of receivable that management estimates that would not be collected. Together, accounts receivable and allowance for uncollectable accounts offers the net realizable value. -Percentage of receivables method (managers estimate at the end of the period amount of receivable that would not be collected). They create an AFUA where A/R is taken to net realizable amount after taking the provisions at the end of the period. This is also known as the balance sheet approach. This takes the balance sheet report. -Managers can manipulate net income figures for various purposes. For example, by increasing the allowance for bad debt receivable, the managers could use the overall low net income to show how the poorly the previous managers performed. Then subsequently, decrease bad debt percentage to boost the overall net income figure to earn their bonus. A precise estimate of NRV may not be needed in the credit sale approach where it a precise measure of this value is essential for the A/R approach. -Aging schedule: A technique that estimates uncollectible A/R based on the amount of time they are unpaid. Historical information is used to offer assumptions about the future provisions that should undertaken for bad debt, however, the future is uncertain and these past figures may not be the most reliable source. -Economic slowdown may cause the percentage of bad debt expense to increase. While economic expansion may result in customers paying (so many factors). -Companies following IFRS must provide note on change in AFUA percentage. -Percentage of credit sales method: Some portion of credit sales would not be collected that are known as bad debt. The journal entry that would be recorded, debit bad debt expense and credit AFUA. The difference between both methods is that we are using a income statement approach since sales are an income statement account. -GAAP does not require disclosure of details for allowance for uncollectable/doubtful debt. If banks have provided loans, they may require this information. But this information is not generally available for most stakeholders which makes it difficult to assess stewardship. -The direct writeoff method under accrual accounting is not acceptable since revenues are not matched to expenses. -As for bad debt, a provision account can also be made for future returns (goods sold but expected to be returned by customers). Contra revenue account is called allowance for sales return. If estimated returns are not recorded, revenue and A/R is being overstated. When customers return the product, sales return would be debited and allowance for sales return would be credited (THIS IS TO RECORD ESTIMATED SALES RETURNS). This is related to the income statement not balance sheet! -Long-term receivables are on the noncurrent asset side of the balance sheet. -Hidden reserves: The undisclosed accounting choices with which managers can manage earnings and other financial information with the intention of pursuing self interest (they could increase the allowance for uncollectable accounts this year, managers could state that a more conservative stance and then decrease it for next year to increase net income). Hidden reserves are dependent on managers estimations. -Violation or covenant (Stringent regulations and conditions imposed/stipulated by the bank while lending monies to the customer): In loan agreement from banks, there are certain clauses (current ratio should not go below a certain number, A/R should be received within 90 day). The bank can ask for the money due immediately. -Estimates for sales returns or warranties can also be used as hidden reserves. -A problem with the current ratio is that all current assets are not necessarily liquid. A better measure is the quick or acid test ratio since it excludes less liquid assets. Quick assets include, cash & cash equivalents, marketable securities (financial asset that can be bought/sold immediately in the bond/stock market), and receivables. The higher the quick ratio, the better. For every dollar of liabilities, there is a certain number at quick assets. The number is useful if you can compare it to similar businesses in that industry or if there are years worth of quick ratios for the company (compare between the years). -Inventory has some raw materials, some goods under preparation (work in progress), and finished products (it should be taken out of current assets when finding the quick ratio for liquidity purposes, also prepaid has already been paid for even though the benefit has been received yet, it not easily to convert to cash, hence not included in the quick ratio). -Account receivables turnover ratio is as credit sales/average accounts receivables (average of beginning balance A/R and ending balance A/R). It is useful in assessing liquidity and how well credit sales are being managed in the period. The higher this number the better. -Average collection period of A/R: 365/Accounts receivables turnover ratio. This assess the number of days it actually takes to collect all of the money. Althou
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