Appunti di "Financial Accounting", Appunti di Contabilità Finanziaria

Scarica Appunti di "Financial Accounting" e più Appunti in PDF di Contabilità Finanziaria solo su Docsity! INTRODUCTION TO ACCOUNTING -language of business: accounting -accounting is quite popular -accounting has existed since about 3000 B. C. -ACCOUNTING = information to understand reality / mapping the reality of a company -reports: investment/Financing (B/S) + Revenue/Expenses (Income Statement) + CashInflow/CashOutflow (Statement of Cash Flow) + contribution, dividends, investments (SSE) -return on investment: useful to understand if we want to make an investment -Father of accounting: he wanted that “a person should not go to sleep at night until the debits equaled the credits” -return on investment > cost of capital -inside: managers => managerial accounting -Regions: Europe, North America and Asia -for each region, we have other three different regions 1) wholesales 2) retail 3) digital -every company has a different type of accounting -outside: investors => financial accounting (IFRS or US/GAAP) -people with money can pay people with ideas; they have to meet somehow, thus there is a flow of money, but we have to have a feedback of the company -investors and management are the primary users of financial statements -the quantity and quality of accounting information that companies supply are determined by managers’ assessment of the benefits and costs of disclosure -conceptually, accounting amounts may reflect three elements: 1) economics (“How can we best report economic reality?”) :) 2) measurement errors :/ 3) bias (“How can we best report desired results?”) :( -accounting is of good quality when it faithfully capture underlying economics and helps in the assessment of growth, profitability and credit risk INTRODUCTION TO A NEW LANGUAGE -appreciate how business activities are captured by financial statements + understand the difference between cash and accrual accounting + overview of the 4 statements + explain how components of financial statements are linked together -every business starts with the business idea (start up) -> ask for money at the bank, then invest in my company (buy the machines, buy the raw material, pay the workers and if I am lucky, I will sell my stuff) -operating and investing activities (revenues and expenses) + financing activities (cash from loans, interest and loan repayments, cash from share issues) EXAMPLE - CHOCOLATE CAKE -two years period - ten cakes -financial activities: 1) 300 dollars me 2) 200 dollars you (10% of interest every year) -investing 500 dollars -SCF is necessary to tell the difference of money between time0 (birth of the company) and time1 (the amount of money owned by the company after one year) -assets (PP&E) (can be current or non-current) = liabilities (you/people not from the company) + Equity (me/people from the company) = initial capital from the company -BALANCE SHEET = reports a company’s financial position at a point in time 1) resources, namely what the company owns 2) sources of asset financing a) from stockholders - owner financing b) from banks or other creditors and suppliers - nonowner financing -Investing (assets) = nonowner financing (liabilities) + owner financing (equity) -the balance sheet reports the resources that the firm controls (assets) and the claims against the resources as of the balance sheet date -PROFIT AND LOSS (or income statement (I/S)) = difference between revenue and expenses (revenue-expenses) -EXPENSES = divided based on the nature 1) COGS (cost of goods sold) or depreciation 2) SGE (selling general expense) 3) Interest Expense 4) Taxes -Revenue-COGS = Gross Profit -STATEMENT OF CASH FLOW (SCF): 1) Operating activity => 500 dollars - 120 dollars 2) Investing => 500 dollars 3) Finance => 500 dollars -AT THE END OF THE FIRST YEAR, MY BALANCE WILL BE 380 DOLLARS -input = 500 dollars => at the end of the two years, there are 960 dollars (500 for us, the rest 460 dollars is the leftover) -deltaCash Flow = net income at the end of every year is 230 dollars -net income = it tells you if you are creating or destroying value -Income NOT EQUAL to cash flow -B/S = balance sheet = assets (cash + PPE gross (historical cost) + account receivable + accumulated depreciation + inventory) + liabilities (long-term debts) + equity (sheldholder money (share capital + retained earning (REt = REt-1 + NIt - divt) -div = money that the company earns if it is successful -PPE gross - acc. Depr. = net PPE -Income Statement = revenue (first line) + net income (last line) => in between there are expenses (-COGS (direct material + direct label + makination over head) -revenue-COGS = gross profit -gross profit-SG&A (selling general and accounting costs) = operating income -operating income-interest expenses-EBT-taxes = net income -Statement Cash Flow - Operating Cash Flow (money that comes after selling a product) - Investing Cash Flow - Financing Cash Flow -OCF + ICF (always negative) + FCF = changing in cash of the year -changing in cash + beginning balance cash = -Statement of Shareholder Equity = contributed capital (share capital) + retained earning (RE) -unearned revenue = potential revenue -cash flow is not the expense: 1) paid but could use more $ + exp. = PPE; prepaid 2) used but did not pay exp. + $ = interest payable; accrued expense; employee -cash inflow different than/not associated to revenue: 1) money is received, but not earned $ + revenue = unearned revenue 2) money is not received, but is earned revenue * $ = interest receivable -conservatism law = if there is a potential loss, you have to declare it; if you have a potential gain, you don’t have to declare it -Bad Debt Expense = expense that reviews the net income contra-asset account -ACCOUNTING FOR MERCHANDISING OPERATIONS -merchandising companies 1) buy and sell goods 2) the primary source of revenues is referred to as sale revenue or sales -cost of goods sold is the total cost of merchandise sold during the period -OPERATING CYCLE = the operating cycle of a merchandising company normally is longer than that of a service company -beginning inventory + purchase + cost of goods sold + ending inventory = cost of goods available for sale -why controlling inventory is important? 1) to ensure availability of inventory items 2) to prevent excessive accumulation of inventory items -the perpetual inventory system maintains a continuous record of Inventory changes 1) purchases and sales of inventory recorded directly to inventory account 2) Inventory purchases, freight, purchases returns and discounts are debited to the Inventory account 3) Costs of Goods Sold (COGS) is thus debited and Inventory is credited for each sale 4) periodic inventory counts are still required to ensure reliability 5) advantages: a) traditionally used for merchandise with high unit values b) shows the quantity and cost of the inventory that should be on hand at any time c) provides better control over inventories than a periodic system the periodic inventory system updates inventory records only periodically 1) Inventory purchases recorded as a debit to Purchases account 2) COGS is a calculation to the Income Statement 3) physical inventory is counted and verified periodically 4) under both periodic and perpetual inventory systems, physical counts of inventory are conducted at least once a year -perpetual vs periodic system 1) whether a company uses a perpetual inventory system or a periodic inventory system will depend on the nature of the business 2) a company that deals with high volumes of low value products may be more likely to use a periodic inventory system 3) a company that deals with low volumes of high value products may be more likely to use a perpetual inventory system -recording purchases: 1) made using cash or credit (on account) 2) normally record when goods are received from the seller 3) purchase invoice should support each credit purchase -Freight Costs: 1) FOB = free on board 2) FOB SHIPPING POINT (buyer pays freight costs) => ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller 3) FOB DESTINATION (seller pays freight costs) => ownership of the goods remains with the seller until the goods reach the buyer -freight costs incurred by the seller are an operating expense -purchaser may be dissatisfied because goods are damaged or defective, of inferior quality, or do not meet specifications 1) purchase return: return goods for credit if the sale was made on credit, or for a cash refund if the purchase was for cash 2) purchase allowance: may choose to keep the merchandise if the seller will grant a reduction from the purchase price -credit terms may permit buyer to claim a cash discount for prompt payment -advantages: 1) purchaser saves money 2) seller shortens the operating cycle by converting the accounts receivable into cash earlier -purchase discounts: 1) 2/10, n/30 => customers have 30 days to pay for a purchase but can receive a two percent discount if the entire purchase paid in full within ten days 2) 1/10 EOM => 1% discount if paid within the first ten days of the next month 3) n/10 EOM => net amount due within the first ten days of the next month -recording sales of merchandise 1) made using cash or credit (on account) 2) sales revenue, like service revenue, is recorded when the performance obligation is satisfied 3) performance obligation is satisfied when the goods are transferred from the seller to the buyer 4) sales invoice should support each credit sale -”Flip side” of purchase returns and allowances -contra-revenue account is Sales Revenue (debit) -sales not reduced (debited) because: 1) would obscure importance of sales returns and allowances as a percentage of sales 2) could distort comparisons -SALES DISCOUNT: 1) offered to customers to promote prompt payment of the balance due 2) contra-revenue account (debit) to Sales Revenue -determining cost of goods sold under a periodic system: 1) no running account of changes in inventory 2) ending inventory determined by physical count 3) cost of goods sold not determined until the end of the period -recording merchandising transactions 1) record revenues when sales are made 2) do not record cost of merchandise sold on the date of sale 3) physical inventory count determines a) cost of merchandise on hand b) cost of merchandise sold during the period 4) record purchases in Purchases account 5) purchase returns and allowances, purchase discounts, and freight costs are recorded in separate accounts 1 June Equipement 4,000 Accounts payable 4,000 4 June Purchases 4,500 Accounts payable 4,500 4 June Freight in 800 Cash 800 5 June Prepaid rent 9,000 Cash 9,000 6 June Accounts payable 900 Purchase R&A 900 8 June Accounts receivable 3,000 Sales revenue 3,000 13 June Accounts payable 1,800 Purchase discount 36 Cash 1,764 14 June Sales R&A 750 Accounts receivable 750 15 June Cash 10,000 Notes payable 10,000 20 June Cash 1,250 Unearned revenue 1,250 22 June Cash 1,114 Sales discounts 11 Accounts receivable 1,125 25 June Salary expense 2,500 Cash 2,500 30 June Dividends 1,500 Cash 1,500 ADJUSTING ENTRIES a. Depreciation expense 167 Accumulated depreciation 167 b. Rent expense 3.000 Prepaid rent 3,000 c. Interest expense 50 Interest payable 50 d. Salaries expense 5 days 500 Salaries payable 500 e. Utilities expense 350 Accounts payable 350 -DEFERRALS: 1) prepaid expenses: expenses paid in cash and recorded as assets before they are used or consumed 2) unearned revenues: revenues received in cash and recorded as liabilities before they are earned -ACCRUALS: 1) accrued revenues: revenues earned but not yet received in cash or recorded 2) accrued expenses: expenses incurred but not yet paid in cash or recorded INVENTORIES -three factors that contribute to fraudulent activity (fraud triangle) 1) opportunity 2) financial pressure 3) rationalization -fraud: 3 broad categories 1) asset misappropriation: any scheme that involves the theft or misuse of an organization’s assets 2) fraudulent statements: fabrication of an organization’s financial statements to make the company appear more or less profitable 3) corruption: any scheme in which a person uses his or her influence in a business transaction to obtain an unauthorized benefit contrary to that person’s duty to his or her employer -INTERNAL CONTROL: the organizational plan and all the related measures that a firm adopts to: 1) safeguard assets 2) enhance accuracy and reliability of accounting records 3) increase efficiency of operation 4) ensure compliance with laws and regulations -primary components of an internal control system 1) a control environment 2) risk assessment 3) control activities 4) information and communication 5) monitoring -PRINCIPLES OF INTERNAL CONTROL ACTIVITIES: characteristics of an efficient internal control system (Internal Auditing function) 1) establishment of responsibility a) control is most effective when only one person is responsible for a given task b) establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel 2) segregation of duties a) different individuals should be responsible for related activities b) the responsibility for record-keeping for an asset should be separate from the physical custody of that asset 3) documentation procedures a) companies should use prenumbered documents, and all documents should be accounted for b) employees should promptly forward source documents for accounting entries department 4) physical controls 5) independent internal verification 6) human source controls -limitations of internal control: 1) costs should not exceed benefit 2) human element 3) size of the business 4) most internal control measures can be circumvented or overcome 5) collusion is when two or more employees work as a team with the purpose to defraud the firm CHAPTER 8 - ACCOUNTING RECEIVABLES amounts due from individuals and other companies that are expected to be collected in cash 1) amounts owed by customers as a result of the sale of goods and services = accounts receivable 2) claims for which formal instruments of credit are issued as proof of debt = notes receivable 3) “nontrade” (interest, loans to officers, advances to employees, and income taxes receivable) -three accounting issues 1) recognising accounts receivable => when to record them as assets 2) valuing accounts receivable => what amount to put in the statement of financial position 3) disposing of accounts receivable => when to remove them from the assets -RECOGNITION 1) at the same moment as the recognition of the revenue 2) possible later decreases a) returns and allowances b) discounts 3) reported as an asset on the statement of financial position -VALUATION 1) reported at the amount the company thinks they will be able to collect 2) sales on account raise the possibility of accounts not being collected 3) valuation can be difficult because an unknown amount of receivables will become uncollectible -methods of accounting for uncollectible accounts 1) direct wire-off: losses recorded when confirmed a) no matching b) receivable not stated at net realisable value c) not acceptable for financial reporting 2) allowance method: losses estimated a) better matching b) receivable stated at net realisable value c) required by IFRS -DIRECT WIRE-OFF METHOD 1) account receivable removed from assets when it becomes uncollectible 2) loss of account is a result from making revenue on account => expense 3) bad debt expense XXX accounts receivable XXX -ALLOWANCE METHOD 1) the amount of uncollectible accounts receivable is estimated at the end of each accounting period 2) an allowance is created to reduce the value of the receivable and record the expense in the period of the sale 3) the account receivable is removed from the books when it becomes definitely uncollectible 4) bad debt expense XXX allowance for doubtful accounts XXX -PERCENTAGE OF SALES 1) focuses on the income statement 2) based on prior experience of the business 3) computed as a percentage of credit sales 4) ignores the current balance of the allowance account 5) the percentage used is adjusted as needed to reflect collection experience -PERCENTAGE-OF-RECEIVABLES 1) focuses on accounts receivable 2) computes the amount of allowance that should appear in the statement of financial position 3) aging schedule a) individual accounts receivable from specific customers are analysed according to the length of time they remain outstanding -CREDIT CARD SALES 1) they save retailers the cost of a credit department 2) the retailer is required to pay a fee (called a discount) to the credit card company for usage 3) they are treated as cash sales a) the bank issuing the card pays the seller immediately and collects the amount from the customer -NOTES RECEIVABLE 1) a promissory note is a written promise to pay a specified amount of money on demand or at a specific date 2) promissory notes may be used a) when individuals and companies lend or borrow money b) when amount of transaction and credit period exceed normal limits, or c) in settlements of accounts receivable -NOTES RECEIVABLE - RECOGNITION 1) a note receivable should be added to assets at the time of the transaction creating it (sale, loan, etc.) 2) it should remain in assets until a) the amount is collected from the marker a) contract price plus payments for architects’ fees, building permits, and excavation costs -EQUIPMENT: 1) all costs incurred in acquiring the equipment and preparing it for use 2) costs typically include a) purchase price b) sales taxes c) freight and handling charges d) insurance on the equipment while in transit e) assembling and installation costs f) costs of conducting trial runs -CAPITAL LEASES: 1) renting arrangements over a long period 2) capital leases are reported as assets, even though the company does not legally own the asset 3) equipment under lease XXX lease liability XXX -DEPRECIATION: 1) process of allocating the costs of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset 2) it is a process of cost allocation, not asset valuation 3) it applies to land improvement, and capital leases, not land a) depreciable, because the revenue-producing ability of asset will decline over the asset’s useful life 4) factors affecting depreciation a) cost (all expenditures necessary to acquire the asset and make it ready for intended use) b) useful life (estimate of expected period of use, based on nature of assets and intended use) c) residual value (estimate of asset’s value at the end of its useful life) 5) depreciation methods a) several methods to choose from i) straight-line method ii) units-of-activity method iii) declining-balance methods 6) presentation in income statement a) depends on the use of the asset i) depreciation of manufacturing plant and equipment => cost of goods sold ii) depreciation of store equipment => selling expenses iii) depreciation of office equipment => administrative expenses iv) depreciation of delivery trucks => friìeight out expense 7) depreciation for partial years a) fixed assets are not always purchased at the beginning of the fiscal year b) the first year of use, depreciation for the months when the asset is used in operations c) in the last year, depreciation for the remaining months of the useful life 8) depreciation and income taxes a) tax laws often do not require the taxpayer to the use the same depreciation method on the tax return that is used in preparing financial statements b) many corporations use i) straight-line in their financial statements to maximize net income ii) accelerated depreciation on their tax returns to minimize their income taxes 9) revising periodic depreciation a) depreciation expense based on estimations i) useful life ii) residual value b) during the useful life, these estimations may be revised c) new depreciation expense: 𝑛𝑒𝑡 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 − 𝑛𝑒𝑤 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 -COST MODEL vs REVALUATION MODEL 1) if the firm chooses the revaluation model a) plant assets must be revalued (up or down) to their value i) when fair value can be estimated ii) when book value differs significantly from fair value b) revaluation must be applied to all assets in a class of assets i) land, building, equipment, … c) assets that are experiencing rapid price changes must be revalued each year, otherwise less frequent revaluation is acceptable 2) revaluation model a) when asset revalued, accumulated depreciation is removed b) loss in value => income statement c) gain in value => other comprehensive income => equity, unit asset is sold -MAINTENANCE EXPENSES vs CAPITAL EXPENDITURES 1) maintenance expenses a) ordinary repairs to maintain the operating efficiency and productive life of the asset b) record in Maintenance Expense in the year it is incurred 2) capital expenditures a) additions and improvements b) costs incurred to increase the operating efficiency, productive capacity, or useful life of the asset c) add to the cost of the asset affected d) depreciate over remaining useful life of the asset -PLANT ASSET DISPOSAL 1) companies dispose of plant assets through a) sales b) retirement c) exchange for another asset 2) gain/loss on disposal in income statement in the year of the sale a) non-operating gain/loss b) extraordinary gains/losses do not exist under IFRS -SALE OF PLANT ASSETS 1) record depreciation up to the date of sale 2) compare the book value of the asset with the proceeds from the sale a) if proceeds > book value => gain on disposal Cash XXX Accumulated depreciation XXX Fixed asset XXX Gain on disposal XXX b) if proceeds < book value => loss on disposal Cash XXX Accumulated depreciation XXX Loss on disposal XXX Fixed asset XXX -RETIREMENT OF PLANT ASSETS 1) the firm gets no proceeds from the sale, it may even have to pay for the disposal Accumulated depreciation XXX Loss on disposal XXX Cash XXX Fixed asset XXX -NATURAL RESOURCES 1) natural resources a) natural gas and oil b) precious metals and gems c) coal, metals 2) Cost a) expenditure to acquire the resource and prepare it for its intended use 3) Depletion charge a) allocation of the cost to expense over the resource deposit’s useful life b) depletion per unit (𝑐𝑜𝑠𝑡 − 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒) 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑛𝑎𝑡𝑢𝑟𝑎𝑙 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 -INTANGIBLE ASSETS 1) rights, privileges, and competitive advantages that do not have physical substance 2) common types of intangibles a) patents b) copyrights c) franchises or licenses d) trademarks and trade names e) goodwill 3) useful name a) limited b) indefinite 2) represents a promise to pay a) sum of money at maturity date, plus b) periodic interest at a contractual (or stated) rate on the maturity amount (face value) 3) paper certificate, typically 1000 euros face value 4) interest payments usually made semi-annually 5) generally issued when the amount of capital needed is too large for one lender to supply -BOND PRICING 1) face (par) value and contractual interest rates are decided by issuing firm 2) bond price is decided by the market (potential creditors) 3) bond prices are affected by a) time to maturity b) credit rating of issuer c) contractual interest rate and other bond features 4) bond prices are expressed as a percentage of face value -BOND ISSUE: 1) issued at face (par) value: Cash 100 Bonds payable 100 2) issued at a premium (i.e. contractual interest rate exceeds market interest rate): Cash 105 Bonds payable 105 3) issued at a discount (i.e. contractual interest rate lower than market interest rate): Cash 97 Bonds payable 97 -INTEREST ON BONDS - ISSUED AT FACE VALUE 1) interest payment: Interest expense XX Cash XX 2) year-end adjustment: Interest expense XX Interest payable XX -INTEREST ON BONDS - ISSUED AT A PREMIUM 1) Interest payment: Interest expense XX Cash XX 2) amortisation of premium diminishes cost of borrowing: Bond payable Dr XX Interest expense Dr XX 3) Interest expense = contractual interest payment - premium amortisation -AMORTISATION: straight line method results in periodic interest expense of the same amount in each interest period t -CARRYING VALUE: face value of the bonds adjusted for premium amortised up to the date of retirement -INTEREST ON BONDS - ISSUED AT A DISCOUNT 1) Interest payment: Interest expense XX Cash XX 2) amortisation of discount increases cost of borrowing: Interest expense Dr XX Bond payable Cr XX 3) Interest expense = contractual interest payment + discount amortisation -BOND REDEMPTION (I.E. BUY BACK) 1) at maturity: Bond payable XX Cash XX Premium/discount entirely amortised 2) before maturity Bond payable* XX Cash XX Gain on bond redemption XX *carrying value: face value of the bonds adjusted for premium/discount amortised up to the date of retirement -how efficiently does the firm use its current liabilities and current assets? 1) working capital = current assets - current liabilities 2) working capital turnover = 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 -does the firm generate enough profit to pay the interest on its debt? 1) times interest earned = 𝑖𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 CHAPTER 11 - CORPORATIONS: ORGANISATION, SHARE TRANSACTIONS, DIVIDENDS, & RETAINED EARNINGS -characteristics that distinguish corporations from proprietorships and partnerships 1) separate legal existence 2) limited liability of shareholders 3) transferable ownership rights 4) ability to acquire capital 5) continuous life 6) corporate management 7) government regulations 8) additional taxes -PROPRIETORSHIP: 1) generally owned by one person 2) often small service-type businesses 3) owner receives any profits, suffers any losses, and is personally liable for all debts -PARTNERSHIP: 1) owned by two or more persons 2) often retail and service-type business 3) generally unlimited personal liability 4) partnership agreement -CORPORATION: 1) ownership divided into shares 2) separate legal entity organized under state corporation law 3) limited liability -formation of a corporation: 1) file application with government agency in the jurisdiction in which incorporation is desired 2) government grants charter 3) shareholders elect the board of directors 4) the board sets policies (by-laws), appoint the officers, and elects a chairperson 5) the board also designates the chief executive officer (CEO) -ownership rights of shareholders 1) vote in election of board of directors and on actions that require shareholder approval 2) share the corporate earnings through receipt of dividends 3) keep the same percentage ownership when new shares are issued 4) share in assets upon liquidation (after creditors) in proportion to their holdings. This is called a residual claim -share issue 1) authorised shares a) charter indicates the maximum number of shares that a corporation is authorised to issue 2) the general assembly of shareholders must approve the declaration of a dividend 3) stated dividend on preference shares must be paid in full before any dividend is paid to common shareholders 4) three relevant dates for dividends: a) declaration date b) date of record: to identify persons/entities that will receive the dividends c) payment date -SHARE DIVIDENDS: 1) proportional distribution of a corporation’s own shares to its shareholders 2) do not change total shareholder’s equity 3) a stock dividend is a transfer to retained earnings to contributed capital 4) valued at the market value of the shares on the declaration date -small share dividends do not alter the market value of outstanding shares -SHARE SPLITS: 1) increase in the number of authorised, issued, and outstanding shares a) it is a reduction in the par value 2) the market value is usually affected proportionately 3) a 5-for-1 share split e.g. means that the company will have five times as many shares outstanding after the split as it had before. Each share’s par value will be divided by five 4) no accounting recording needed -RETAINED EARNINGS: 1) is the accumulation of net income that a company has retained for use in the business 2) increase with net income and decrease with a net loss 3) part of the shareholders’ claim on the total assets of the corporation 4) a debit balance in retained earnings is a deficit -STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY: 1) most companies prepare a statement of changes in shareholders’ equity, which is more comprehensive than a statement of retained earnings 2) reports changes in all categories of equity during the period a) share transactions b) dividends c) effects of treasury share transactions -how profitably does the firm use the money invested by common shareholders? 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟′𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 -how much of its profits does the firm pay in dividends? 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑑𝑒𝑐𝑙𝑎𝑟𝑒𝑑 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 CHAPTER 12 - INVESTMENTS -corporations generally invest in debt or share securities for one of three reasons 1) corporation may have excess cash 2) to generate earnings from investment income 3) for strategic reasons -ACCOUNTING FOR DEBT INVESTMENTS 1) purchase of bonds Investment in bonds XX Cash XX (cost includes all expenditures necessary to acquire these investments: price paid plus brokerage fees (commissions) 2) Interest revenue a) carrying value of the bond x interest rate x portion of the year the bond is outstanding -SALE OF BOND INVESTMENT: buyer of the bonds must pay the seller the accrued interest revenue Cash XX Investment in bonds XX Interest revenue XX Gain on sale of bond investment XX -revenue is vanity, profit is sanity, cash is reality! -usefulness of the Statement of Cash Flows 1) provides information to help assess a) firm’s ability to generate future cash of flows b) firm’s ability to pay its obligations and dividends c) reasons for difference between net income and change in cash account d) cash investing and financing transactions during the period -classification 1) operating activities a) cash inflows i) from sale of goods and services ii) from interest and dividends received b) cash outflows i) to suppliers for inventory ii) to employees for services iii) to government for taxes iv) to lenders for interest v) to others for expenses 2) investing activities a) cash outflows i) to purchase property, plant and equipment ii) to purchase investments in debt or shares of other firms iii) to make loans to other firms b) cash inflows i) from sale of property, plant and equipment ii) from sale of investments in debt or shares of other firms iii) from collection of notes receivable 3) financing activities a) cash inflows i) from issuance of common shares ii) from issuance of long-term debt (bonds and notes) b) cash outflows i) to shareholders as dividends ii) to redeem long-term debt iii) to repurchase common shares (treasury shares) -significant non-cash activities 1) although they don’t involve cash inflows or outflows, they must be disclosed a) direct issuance of common shares to purchase assets b) conversion of bonds into common shares c) direct issuance of debt to purchase assets d) exchanges of plant assets 2) companies report these activities in either a separate note or supplementary schedule to the financial statements -two formats for the operating activities 1) direct method a) presents each type of cash inflow and outflow (inflows from sales, outflows to employees, outflows to suppliers, etc.) b) provides better information … but almost never used 2) indirect method a) reconciles Net Income with Cash flows from operating activities b) easier to prepare … and used by most firms -preparing the statement of cash flows 1) compute increases and decreases during the year for each item of the statement of financial position 2) explain and classify each of the differences 3) reconcile with the increase / decrease in cash -summary of Conversion to Net Cash Provided by Operating Activities - Indirect Method -FREE CASH FLOW = how much cash is available for new investments? 𝑐𝑎𝑠ℎ 𝑝𝑟𝑜𝑣𝑖𝑑𝑒𝑑 𝑏𝑦 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 − 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 -TIMES INTEREST EARNED (CASH BASIS) = does the firm generate enough cash flows to cover interest payments? 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 CHAPTER 14 - FINANCIAL STATEMENT ANALYSIS -need for comparative analysis 1) every item reported in a financial statement has significance 2) various analytical techniques are used to evaluate the significance of financial statement data -analysing financial statements involves 1) characteristics a) liquidity b) profitability c) solvency 2) comparison bases a) intracompany b) industry averages c) intercompany 3) tools of analysis a) horizontal b) vertical c) ratio -horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time 1) purpose is to determine the increase or decrease that has taken place 2) commonly applied to the statement of financial position, income statement, and retained earnings statement b) ratios include the profit margin, asset turnover, return on assets, return on ordinary shareholders’ equity, earnings per share, price-earnings, and payout ratio 3) solvency: measure the ability of the company to survive over a long period of time a) debt to total assets and b) times interest earned are two ratios that provide information about debt-paying ability -SUMMARIES OF RATIOS 1) liquidity ratios 2) profitability ratios 3) solvency ratios SUMMARIES FROM THE BOOK - CHAPTER 1 - ACCOUNTING IN ACTION -ACCOUNTING = consists of three basic activities 1) it identifies the economic events relevant to its business 2) it records those events in order to provide a history of its financial activities 3) it communicates the economic events of an organisation to interested users -a vital element in communicating economic events is the accountant’s ability to analyse and interpret the reported information -analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data -who uses our data? 1) INTERNAL USERS (managers who plan, organise, and run the business) a) managerial accounting provides internal reports to help users make decisions about their companies 2) EXTERNAL USERS (individuals and organisations outside a company who want financial information about the company) a) Investors (owners): use accounting information to make decisions to buy, hold, or sell ownership shares of a company b) Creditors (i.e., suppliers and bankers): use accounting information to evaluate the risks of granting credit or lending money c) financial accounting provides economic and financial information for investors, creditors, and other external users -TAXING AUTHORITIES = want to know whether the company complies with tax laws -REGULATORY AGENCIES = want to know whether the company is operating within prescribed rules -CUSTOMERS = are interested in whether a company will continue to honour product warranties and support its product lines -LABOUR UNIONS = want to know whether the companies have the ability to pay increased wages and benefits to union members -the standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics -there are three primary accounting standard-setting bodies 1) the International Accounting Standards Board (IASB) 2) the Financial Accounting Standards Board (FASB) 3) the International Financial Reporting Standards (IFRS) a) generally uses one of two measurement principles, the historical cost principle or the fair value principle -RELEVANCE = financial information is capable of making a difference in a decision -FAITHFUL REPRESENTATION = the numbers and descriptions match what really existed or happened - they are factual -HISTORICAL COST PRINCIPLE (or cost principle) = dictates that companies record assets at their cost -FAIR VALUE = assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability); may be more useful than historical cost for certain types of assets and liabilities -MONETARY UNIT ASSUMPTION = requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables accounting to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle -an economic entity can be any organisation or unit in society -ECONOMIC ENTITY ASSUMPTION = requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities -PROPRIETORSHIP = a business owned by one person; usually only a relatively small amount of money (capital) is necessary to start in business as a proprietorship; the owner (proprietor) receives any profits, suffers any losses, and is personally liable for all debts of the business -PARTNERSHIP = a business owned by two or more persons associated as partners; like a proprietorship, for accounting purposes the partnership transactions must be kept separate from the personal activities of the partners -CHART OF ACCOUNTS = lists the accounts and the account numbers that identify their location in the ledger; the numbering system that identifies the accounts usually starts with the statement of financial position accounts and follows with the income statement accounts -the purpose of transaction analysis is first to identify the type of account involved, and then to determine whether to make a debit or a credit to the account -TRIAL BALANCE = a list of accounts and their balances at a given time; proves the mathematical equality of debits and credits after posting; may also uncover errors in journalizing and posting; is useful in the preparation of financial statements; prepared in three steps 1) list the account titles and their balances 2) total the debit and credit columns 3) prove the equality of the two columns -ATTENTION = the trial balance does not prove that the company has recorded all transactions or that the ledger is correct CHAPTER 3 - ADJUSTING THE ACCOUNTS -TIME PERIOD ASSUMPTION = accountants divide the economic life of a business into artificial time periods -periodically in order to assess their financial condition and results of operations. Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods -FISCAL YEAR = accounting time period that is one year in length -ACCRUAL-BASIS ACCOUNTING = companies record transactions that change a company’s financial statements in the periods in which the events occur; is therefore in accordance with International Financial Reporting Standards (IFRS) -CASH-BASIS ACCOUNTING = companies record revenue when they receive cash -when a company agrees to perform a service or sell a product to a customer, it has a performance obligation -REVENUE RECOGNITION PRINCIPLE = requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied -EXPENSE RECOGNITION PRINCIPLE (matching principle) = dictates that efforts (expenses) be matched with results (revenues) -ADJUSTING ENTRIES = ensure that the revenue recognition and expense recognition principles are followed; necessary because 1) some events are not recorded daily because it is not efficient to do so 2) some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions 3) some items may be unrecorded -adjusting entries are required every time a company prepares financial statements -every adjusting entry will include one income statement account and one statement of financial position account -adjusting entries => classified as 1) deferrals a) prepaid expenses (expenses paid in cash before they are used or consumed) b) unearned revenues (cash received before services are performed) 2) accruals a) accrued revenues (revenues for services performed but not yet received in cash or recorded) b) accrued expenses (expenses incurred but not yet paid in cash or recorded) ADJUSTING ENTRIES FOR DEFERRALS -TO DEFER = to postpone or delay => deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged -PREPAID EXPENSES (or prepayments) = when companies record payments of expenses that will benefit more than one accounting period; prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies); the expiration of these costs does not require daily entries, which would be impractical and unnecessary -an adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account -USEFUL LIFE = period of service; because a building is expected to be of service for many years, it is recorded as an asset, rather than an expense, on the date it is acquired; to follow the expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset’s useful life -DEPRECIATION = process of allocating the cost of an asset to expense over its useful life; allocation concept, not a valuation concept; allocates an asset’s cost to the periods in which it is used; does not attempt to report the actual change in the value of the asset -CONTRA ASSET ACCOUNT = keeps track of the total amount of depreciation expense taken over the life of the asset; is offset against an asset account on the statement of financial position -ACCUMULATED DEPRECIATION - EQUIPMENT = it discloses both the original cost of the equipment and the total cost that has been expensed to date -BOOK VALUE = difference between the cost of any depreciable asset and its related accumulated depreciation -the purpose of depreciation is not valuation but a means of cost allocation -depreciation expense identifies the portion of an asset’s cost that expired during the period -UNEARNED REVENUE = when a customer pays for products or services in advance of their receipt, this payment is recorded by a business as unearned revenue. Also referred to as “advance payments” or “deferred revenue” unearned revenue is mainly used in accrual accounting -the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account ADJUSTING ENTRIES FOR ACCRUALS -the adjusting entry for accruals will increase both a statement of financial position and an income statement account -ACCRUED REVENUES = revenues for services performed but not yet recorded at the statement date -an adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account -without the adjusting entry, assets and equity on the statement of financial position and revenues and net income on the income statement are understated -ACCRUED EXPENSES = expenses incurred but not yet paid or recorded at the statement date -an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account -without this adjusting entry, liabilities and interest expense are understated, and net income and equity are overstated SUMMARY OF BASIC RELATIONSHIPS -each adjusting entry affects one statement of financial position account and one income statement account THE ADJUSTED TRIAL BALANCE AND FINANCIAL STATEMENTS -after a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts => adjusted trial balance -the purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments -because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements -companies can prepare financial statements directly from the adjusted trial balance -some companies use an alternative treatment: 1) when a company prepays an expense, it debits that amount to an expense account 2) when it receives payment for future services, it credits the amount to a revenue account -PREPAID EXPENSES = become expired costs either through the passage of time (e.g., insurance) or through consumption (e.g., advertising supplies) -it may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient -the framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital -RELEVANCE = accounting information has relevance if it would make a difference in a business decision; information is considered relevant if it provides information that has predictive value -MATERIALITY = a company-specific aspect of relevance -REVERSING ENTRY = exact opposite of the adjusting entry made in the previous period; use of reversing entries is an optional bookkeeping procedure; it is not a required step in the accounting cycle -CORRECTING ENTRIES = only at the end of an accounting period; whenever they discover an error; must be posted before closing entries -it is possible to reverse the incorrect entry and then prepare the correct entry -CLASSIFIED STATEMENT OF FINANCIAL POSITION = groups together similar assets and similar liabilities, using a number of standard classifications and sections -INTANGIBLE ASSETS = many companies have long-lived assets that do not have physical substance yet often are very valuable -PROPERTY, PLANT AND EQUIPMENT = assets with relatively long useful lives that a company is currently using in operating the business -DEPRECIATION = practice of allocating the cost of assets to a number of years -ACCUMULATED DEPRECIATION ACCOUNT = shows the total amount of depreciation that the company has expensed thus far in the asset’s life -LONG-TERM INVESTMENTS = are generally 1) investments in ordinary shares and bonds of other companies that are normally held for many years 2) non-current assets such as land or buildings that a company is not using in its operating activities -CURRENT ASSETS = assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer -OPERATING CYCLE = average time that it takes to purchase inventory, sell it on account, and then collect cash from customers -except where noted, we will assume that companies use one year to determine whether an asset or liability is current or non-current -on the statement of financial position, companies usually list these items in the reverse order in which they expect to convert them into cash -NON-CURRENT LIABILITIES = obligations that a company expects to pay after one year -CURRENT LIABILITIES = obligations that the company is to pay within the coming year or its operating cycle, whichever is longer -LIQUIDITY = ability to pay obligations expected to be due within the next year -companies make a reversing entry at the beginning of the next accounting period; each reversing entry is the exact opposite of the adjusting entry made in the previous period; the recording of reversing entries is an optional step in the accounting cycle -the use of reversing entries does not change the amounts reported in the financial statements CHAPTER 5 - ACCOUNTING FOR MERCHANDISING OPERATIONS -MERCHANDISING COMPANIES = they buy and sell merchandise rather than perform services as their primary source of revenue => merchandising companies that purchase and sell directly to consumers are called RETAILERS; merchandising companies that sell to retailers are known as WHOLESALERS -the primary source of revenues for merchandising companies is the sale of merchandise, often referred to simply as SALES REVENUE or SALES -a merchandising company has two categories of expenses 1) cost of goods sold: a) total cost of merchandise sold during the period b) directly related to the revenue recognized from the sale of goods 2) operating expenses -OPERATING CYCLES 1) the operating cycle of a merchandising company ordinarily is longer than that of a service company 2) the purchase of merchandise inventory and its eventual sale lengthen the cycle -FLOW OF COSTS 1) beginning inventory plus the cost of goods purchased is the cost of goods available for sale 2) as goods are sold, they are assigned to cost of goods sold => those goods that are not sold by the end of the accounting period represent ending inventory 3) companies use one of two systems to account for inventory: a) a perpetual inventory system (companies that sell merchandise high unit values) i) companies keep detailed records of the cost of each inventory purchase and sale ii) these records, continuously show the inventory that should be on hand for every item iii) under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs iv) advantages of the perpetual system (1) provides better control over inventories than a periodic system (2) the company can count the goods at any time to see whether the amount of goods actually on hand agrees with the inventory records (3) managers of some small business still find that they can control their merchandise and manage day-to-day operations using a periodic inventory system b) a periodic inventory system i) companies do not keep detailed inventory records of the goods on hand throughout the period ii) instead, they determine the cost of goods sold only at the end of the accounting period (that is, periodically) iii) at that point, the company takes a physical inventory count to determine the cost of goods on hand iv) how to determine the cost of goods sold under a periodic inventory system (1) determine the cost of goods on hand at the beginning of the accounting period (2) add to it the cost of goods purchased (3) subtract the cost of goods on hand at the end of the accounting period -companies record sales revenue when the performance obligation is satisfied -the performance obligation is satisfied when the goods transfer from the seller to the buyer -sales may be made on credit or for cash -a business document should support every sales transaction, to provide written evidence of the sale. Cash register documents provide evidence of cash sales -a sales invoice provides support for a credit sale -the original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price, and other relevant information -the seller makes two entries for each sale 1) the first entry records the sale: the seller increases (debits) Cash (or Accounts Receivable, if a credit sale), and also increases (credits) Sales Revenue 2) the second entry records the cost of the merchandise sold: The seller increases (debits) Cost of Goods Sold, and also decreases (credits) Inventory for the cost of those goods 3) as a result, the Inventory account will show at all times the amount of inventory that should be on hand -for internal decision-making purposes, merchandising companies may use more than one sales account -on its income statement presented to outside investors, a merchandising company normally would provide only a single sales figure—the sum of all of its individual sales accounts. This is done for two reasons 1) providing detail on all of its individual sales accounts would add considerable length to its income statement 2) most companies do not want their competitors to know the details of their operating results -SALES RETURNS AND ALLOWANCES 1) “flip side” of purchase returns and allowances, which the seller records as sales returns and allowances 2) these are transactions where the seller either accepts goods back from the buyer (a return) or grants a reduction in the purchase price (an allowance) so the buyer will keep the goods 3) what happens if the goods are not returned but the seller grants the buyer an allowance by reducing the purchase price? In this case, the seller debits Sales Returns and Allowances and credits Accounts Receivable for the amount of the allowance. An allowance has no impact on Inventory or Cost of Goods Sold 4) Sales Returns and Allowances is a contra revenue account to Sales Revenue => it means that it is offset against a revenue account on the income statement -SALES DISCOUNTS 1) the seller may offer the customer a cash discount - called by the seller a sales discount - for the prompt payment of the balance due 2) is based on the invoice price less returns and allowances, if any 3) the seller increases (debits) the Sales Discounts account for discounts that are taken 4) like Sales Returns and Allowances, Sales Discounts are a contra revenue account to Sales Revenue. Its normal balance is a debit -COMPLETING THE ACCOUNTING CYCLE 1) adjusting entries a) a merchandising company generally has the same types of adjusting entries as a service company; however, a merchandiser using a perpetual system will require one additional adjustment to make the records agree with the actual inventory on hand b) a merchandising company that uses a perpetual system will take a physical count of its goods on hand. The company’s unadjusted balance in Inventory usually does not agree with the actual amount of inventory on hand. The perpetual inventory records may be incorrect due to recording errors, theft, or waste. Thus, the company needs to adjust the perpetual records to make the recorded inventory amount agree with the inventory on hand. This involves adjusting Inventory and Cost of Goods Sold -CLOSING ENTRIES 1) a merchandising company, like a service company, closes to Income Summary all accounts that affect net income 2) in journalizing, the company credits all temporary accounts with debit balances, and debits all temporary accounts with credit balances -SUMMARY OF MERCHANDISING ENTRIES -FORMS OF FINANCIAL STATEMENTS 1) Income Statement (I/S): a primary source of information for evaluating a company’s performance a) income statement presentation of sales i) begins by presenting sales revenue ii) it then deducts contra revenue accounts (sales returns and allowances and sales discounts) from sales revenue to arrive at net sales b) Inventory is less close to cash than accounts receivable because the goods must first be sold and then collection made from the customer CHAPTER 6 - INVENTORIES -two important steps in the reporting of inventory at the end of the accounting period 1) classification of inventory based on its degree of completeness 2) determination of inventory amounts -CLASSIFYING INVENTORY 1) in a merchandising company, inventory consists of many different items, characterised by a) they are owned by the company b) they are in a form ready for sale to customers in the ordinary course of business 2) merchandisers need only one inventory classification, merchandise inventory, to describe the many different items that make up the total inventory 3) in a manufacturing company, some inventory may not yet be ready for sale 4) inventory classified in three categories a) finished goods: manufactured items that are completed and ready for sale b) work in process: that portion of manufactured inventory that has been placed into the production process but is not yet complete c) raw materials: basic goods that will be used in production but have not yet been placed into production 5) by observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management’s production plans 6) many companies have significantly lowered inventory levels and costs using just-in- time (JIT) inventory methods => Under a just-in-time method, companies manufacture or purchase goods only when needed for use -DETERMINING INVENTORY QUANTITIES 1) all companies need to determine inventory quantities at the end of the accounting period 2) if using a perpetual system, companies take a physical inventory for two reasons a) to check the accuracy of their perpetual inventory records b) to determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft 3) companies using a periodic inventory system take a physical inventory for two different purposes: a) to determine the inventory on hand at the statement of financial position date b) to determine the cost of goods sold for the period 4) determining inventory quantities involves two steps: a) taking a physical inventory of goods on hand i) at the end of the accounting period ii) involves actually counting, weighing, or measuring each kind of inventory on hand iii) an inventory count is generally more accurate when goods are not being sold or received during the counting iv) companies often “take inventory” when the business is closed or when business is slow b) determining the ownership of goods i) goods in transit: should be included in the inventory of the company that has legal title to the goods ii) consigned goods: In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods -INVENTORY COSTING 1) Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale 2) after a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold -SPECIFIC IDENTIFICATION 1) if a company can positively identify which particular units it sold and which are still in ending inventory, it can use the specific identification method of inventory costing 2) Specific identification requires that companies keep records of the original cost of each individual inventory item 3) the reality is, however, that this practice is still relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost flow assumptions, about which units were sold -COST FLOW ASSUMPTION 1) assume flows of costs that may be unrelated to the physical flow of goods 2) there are two methods a) First-in, first-out (FIFO) i) the earliest goods purchased are the first to be sold ii) the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold iii) under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed b) average-cost i) allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred ii) the average-cost method assumes that goods are similar in nature iii) iv) the company then applies the weighted-average unit cost to the units on hand to determine the cost of the ending inventory 3) there is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods 4) to demonstrate the two cost flow methods, we will use a periodic inventory system. We assume two periodic system a) many small companies use periodic rather than perpetual systems b) very few companies use perpetual FIFO or average-cost to cost their inventory and related cost of goods sold 5) the cost of goods sold in formula in a periodic system is (Beginning Inventory + Purchase) - Ending Inventory = Cost of Goods Sold -FINANCIAL STATEMENT AND TAX EFFECTS OF COST FLOW METHODS 1) either of the two cost flow assumptions is acceptable for use 2) the reasons companies adopt different inventory cost flow methods are varied, but they usually involve one of three factors: a) income statement effects i) however, the ending inventories and the costs of goods sold are different. This difference is due to the unit costs that the company allocated to the cost of goods sold and to ending inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes ii) In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues iii) In a period of rising prices, FIFO reports a higher net income than average-cost iv) If prices are falling, the results from the use of FIFO and average-cost are reversed. FIFO will report the lower net income and average-cost the higher b) statement of financial position effects i) a major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost ii) conversely, a shortcoming of the average-cost method is that in a period of inflation, the costs allocated to ending inventory may be understated in terms of current cost -most important element = opportunity => opportunities occur when the workplace lacks sufficient controls to deter and detect fraud -second factor = financial pressure => employees sometimes commit fraud because of personal financial problems caused by too much debt, or they might commit fraud because they want to lead a lifestyle that they cannot afford on their current salary -third factor = rationalization => in order to justify their fraud, employees rationalize their dishonest actions -INTERNAL CONTROL = process designed to provide reasonable assurance regarding the achievement of objectives related to operations, reporting, and compliance; it consists of all the related methods and measures adopted within an organization to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance with laws and regulations; it has five primary components 1) a control environment (or “tone at the top”): to make it clear that the organization values integrity + unethical activity will not be tolerated 2) risk assessment: identify and analyze the various factors that create risk for the business and must determine how to manage these risks 3) control activities: design policies and procedures to address the specific risks faced by the company 4) information and communication: capture and communicate all pertinent information both down and up the organization, as well as communicate information to appropriate external parties 5) monitoring: monitored periodically for their adequacy -PRINCIPLES OF INTERNAL CONTROL ACTIVITIES: these activities are the backbone of the company’s efforts to address the risks it faces, such as fraud; heavily influenced by the size and nature of the company; six principles 1) Establishment of responsibility a) assign responsibility to specific employees b) control is most effective when only one person is responsible for a given task c) if only one person has operated the register, the shift manager can quickly determine responsibility for the shortage d) establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel 2) Segregation of duties a) two common application i) different individuals should be responsible for related activities ii) the responsibility for recordkeeping for an asset should be separate from the physical custody of that asset b) the work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee 3) Documentation procedures a) documents provide evidence that transactions and events have occurred b) companies should establish procedures for documents i) companies should use prenumbered documents, and all documents should be accounted for => prenumbering helps to prevent a transaction from being recorded more than once, or conversely, from not being recorded at all ii) the control system should require that employees promptly forward source documents for accounting entries to the accounting department c) this control measure helps to ensure timely recording of the transaction and contributes directly to the accuracy and reliability of the accounting records 4) Physical controls a) physical controls relate to the safeguarding of assets and enhance the accuracy and reliability of the accounting records 5) Independent internal verification a) involves the review of data prepared by employees b) to obtain maximum benefit from independent internal verification: i) companies should verify records periodically or on a surprise basis ii) an employee who is independent of the personnel responsible for the information should make the verification iii) discrepancies and exceptions should be reported to a management level that can take appropriate corrective action c) independent internal verification is especially useful in comparing recorded accountability with existing assets 6) Human resource controls a) include i) bond employees who handle cash: obtaining insurance protection against theft by employees; the insurance company carefully screens all individuals before adding them to the policy and may reject risky applicants; bonded employees know that the insurance company will vigorously prosecute all offenders ii) rotate employees’ duties and require employees to take vacations: deter employees from attempting thefts since they will not be able to permanently conceal their improper actions iii) conduct thorough background checks: conduct thorough background checks; two tips (1) check to see whether job applicants actually graduated from the schools they list (2) never use the telephone numbers for previous employers provided by the applicant -LIMITATIONS OF INTERNAL CONTROL = companies generally design their systems of internal control to provide reasonable assurance of proper safeguarding of assets and reliability of the accounting records; the concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit; the human element is an important factor in every system of internal control; a good system can become ineffective as a result of employee fatigue, carelessness, or indifference; occasionally, two or more individuals may work together to get around prescribed controls; such collusion can significantly reduce the effectiveness of a system, eliminating the protection offered by segregation of duties; the size of the business also may impose limitations on internal control CHAPTER 8 - ACCOUNTING FOR RECEIVABLES -RECEIVABLES = amount due from individuals and companies; claims that are expected to be collected in cash; one of a company’s most liquid assets, the largest assets for many companies; its importance as a percentage of its assets depends on 1) its industry 2) the time of year 3) whether it extends long-term financing 4) its credit policies -three types of receivables: 1) accounts receivable: amounts customers owe on account; will result from the sale of goods and services; usually the most significant type of claim held by a company 2) notes receivable (or trade receivables): written promise for amounts to be received; collection of interest; result from sale transactions 3) other receivables: include non-trade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable; do not generally result from the operations of the business; generally classified and reported as a separate items in the statement of financial position -ACCOUNTS RECEIVABLE 1) a service organization records a receivable when it performs a service on account 2) recorded at the point of sale merchandise 3) increases (debits) Accounts Receivable and increases (credits) Sales Revenue 4) the seller may offer terms that encourage early payment by providing a discount 5) sales returns also reduce receivables 6) companies report accounts receivable on the statement of financial position as an asset => but determining the amount to report is sometimes difficult because some receivables will become uncollectible 7) companies record credit losses as debits to Bad Debt Expense 8) two methods are used in accounting for uncollectible accounts: a) direct write-off method i) when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense ii) Bad Debt Expense will show only actual losses from uncollectibles iii) the company will report accounts receivable at its gross amount iv) companies often record bad debt expense in a period different from the period in which they record the revenue b) allowance method for uncollectible accounts i) involves estimating uncollectible accounts at the end of each period ii) provides better matching on the income statement 3) notes receivable give the holder a stronger legal claim to assets than do accounts receivable 4) promissory notes = negotiable instruments (as are checks), which means that they can be transferred to another party by endorsement 5) the basic issues in accounting for notes receivable are the same as those for accounts receivable a) recognizing notes receivable b) valuing notes receivable c) disposing of notes receivable -DETERMINING THE MATURITY DATE 1) you find the date when it matures by counting the months from the date of issue 2) when the due date is stated in terms of days, you need to count the exact number of days to determine the maturity date 3) in counting, omit the date the note is issued but include the due date -COMPUTING INTEREST 1) the interest rate specified in a note is an annual rate of interest 2) -RECOGNIZING NOTES RECEIVABLE 1) the company records the note receivable at its face value, the amount shown on the face of the note 2) no interest revenue is reported when the note is accepted because the revenue recognition principle does not recognize revenue until the performance obligation is satisfied 3) interest is earned (accrued) as time passes 4) -VALUE NOTES RECEIVABLE 1) valuing short-term notes receivable is the same as valuing accounts receivable 2) companies report short-term notes receivable at their cash (net) realizable value 3) the notes receivable allowance account is Allowance for Doubtful Accounts -HONOR OF NOTES RECEIVABLE 1) a note is honored when its maker pays in full at its maturity date 2) for each interest-bearing note, the amount due at maturity is the face value of the note plus interest for the length of time specified on the note -DISHONOR OF NOTES RECEIVABLE 1) a dishonored (defaulted) note is a note that is not paid in full at maturity 2) a dishonored note receivable is no longer negotiable 3) the payee still has a claim against the maker of the note for both the note and the interest 4) the note holder usually transfers the Notes Receivable account to an Accounts Receivable account 5) no hope of collection? The note holder would write off the face value of the note by debiting Allowance for Doubtful Accounts. No interest revenue would be recorded because collection will not occur -STATEMENT PRESENTATION AND ANALYSIS 1) presentation a) companies should identify in the statement of financial position or in the notes to the financial statements each of the major types of receivables b) the notes to the financial statements each of the major types of receivables. Short-term receivables appear in the current assets section of the statement of financial position c) short-term investments appear after short-term receivables because these investments are more liquid (nearer to cash) d) companies report bad debt expense and service charge expense as selling expenses in the operating expenses section e) Interest revenue appears under “Other income and expense” in the non- operating activities section of the income statement 2) analysis a) investors and corporate managers compute financial ratios to evaluate the liquidity of a company’s accounts receivable b) they use the accounts receivable turn-over to assess the liquidity of the receivables c) this ratio measures the number of times, on average, the company collects accounts receivable during the period d) e) a variant of the accounts receivable turnover that makes the liquidity even more evident is its conversion into an average collection period in terms of days f) g) companies frequently use the average collection period to assess the effectiveness of a company’s credit and collection policies h) the general rule is that the collection period should not greatly exceed the credit term period (that is, the time allowed for payment) CHAPTER 9 - PLANT ASSETS, NATURAL RESOURCES, AND INTANGIBLE ASSETS -PLANT ASSETS (or “property, plant and equipment”, “plant and equipment”, and “fixed assets”) 1) resources that have a physical substance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers 2) these assets are expected to be of use to the company for a number of years 3) because plant assets play a key role in ongoing operations, companies keep plant assets in good operating condition -LAND 1) companies often use land as a site for a manufacturing plant or office building 2) the cost of land includes a) the cash purchase price b) closing costs such as title and attorney’s fees c) real estate brokers’ commissions d) accrued property taxes and other liens assumed by the purchaser 3) companies record as debits (increases) to the Land account all necessary costs incurred to make land ready for its intended use 4) LAND IMPROVEMENTS a) structural additions made to land b) have limited useful lives c) companies expense (depreciate) the cost of land improvements over their useful lives 5) BUILDINGS a) facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars b) companies debit to the Buildings account all necessary expenditures related to the purchase or construction of a building c) when a building is purchased, such costs include the purchase price, closing costs (attorney’s fees, title insurance, etc.), and the real estate broker’s commission d) when a new building is constructed, costs consist of the contract price plus payments for architects’ fees, building permits, and excavation costs e) companies charge certain interest costs to the Buildings account i) interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building ready for use f) limited to the construction period g) the company records interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense 6) EQUIPMENT a) includes assets used in operations b) the cost of equipment consists of the cash purchase price, sales taxes, freight charges, insurance during transit paid by the purchaser, and expenditures c) do not benefit future periods -> treated as expenses as they are incurred -DEPRECIATION 1) the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner 2) a process of cost allocation; not a process of asset valuation 3) book value (cost less accumulated depreciation) of a plant asset may be quite different from its fair value 4) an asset is fully depreciated, it can have a zero book value but still have a positive fair value 5) applies to three classes of plant assets (“depreciable asset”) a) land improvements b) buildings c) equipment 6) depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact over time 7) during a depreciable asset’s useful life, its revenue-producing ability declines because of wear and tear -EXPENDITURES DURING USEFUL LIFE 1) during the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, or improvements 2) ordinary repairs = expenditures to maintain the operating efficiency and productive life of the unit; they are fairly small amounts that occur frequently; companies record such repairs as debits to Maintenance and Repairs Expense as they are incurred; they are immediately charged as an expense against revenues, thus these costs are often referred to as “revenue expenditures” 3) additions and improvements = costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset; usually material in amount and occur infrequently; increase the company’s investment in productive facilities; companies generally debit these amounts to the plant asset affected. They are often referred to as “capital expenditures” 4) materiality concept = states that if an item would not make a difference in decision- making, the company does not have to follow IFRS in reporting that item -PLANT ASSET DISPOSAL 1) companies dispose of plant assets that are no longer useful to them 2) -SALE OF PLANT ASSETS 1) in a disposal by sale, the company compares the book value of the asset with the proceeds received from the sale 2) if the proceeds of the sale exceed the book value of the plant asset, a gain on disposal occurs 3) if the proceeds of the sale are less than the book value of the plant asset sold, a loss on disposal occurs -EXTRACTABLE NATURAL RESOURCES 1) common natural resources consist of standing timber and resources extracted from the ground, such as oil, gas, and minerals 2) IFRS defines extractive industries as those businesses involved in finding and removing natural resources located in or near the earth’s crust 3) the acquisition cost of an extractable natural resource is the price needed to acquire the resource and prepare it for its intended use 4) for an already-discovered resource, such as an existing coal mine, cost is the price paid for the property 5) depletion = the allocation of the cost of natural resources in a rational and systematic manner over the resource’s useful life; companies generally use the units-of-activity method to compute depletion; the reason is that depletion generally is a function of the units extracted during the year 6) -INTANGIBLE ASSETS 1) rights, privileges, and competitive advantages that result from the ownership of long- lived assets that do not possess physical substance 2) arise from these sources a) government grants, such as patents, copyrights, licenses, trademarks, and trade names b) acquisition of another business, in which the purchase price includes a payment for goodwill c) private monopolistic arrangements arising from contractual agreements, such as franchises and leases -ACCOUNTING FOR INTANGIBLE ASSETS 1) companies record intangible assets at cost. This cost consists of all expenditures necessary for the company to acquire the right, privilege, or competitive advantage 2) Intangibles are divided in two categories a) limited life = the company allocates its cost over the asset’s useful life using a process similar to depreciation (= amortization) b) indefinite life = should not be amortized 3) patent a) an exclusive right issued by a patent office that enables the recipient to manufacture, sell, or otherwise control an invention for a specified number of years from the date of the grant b) the initial cost of a patent is the cash or cash equivalent price paid to acquire the patent c) the patent holder amortizes the cost of a patent over its legal life or its useful life, whichever is shorter 4) copyrights a) give the owner the exclusive right to reproduce and sell an artistic or published work b) the cost of a copyright is the cost of acquiring and defending it c) the useful life of a copyright generally is significantly shorter than its legal life. Therefore, copyrights usually are amortized over a relatively short period of time 5) trademarks and trade names a) a word, phrase, jingle, or symbol that identifies a particular enterprise or product b) they also generally enhance the sale of the product c) the creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with a patent office or similar governmental agency d) if a company purchases the trademark or trade name, its cost is the purchase price 6) franchises and licenses a) a franchise is a contractual arrangement between a franchisor and a franchisee b) the franchisor grants the franchisee the right to sell certain products, perform specific services, or use certain trademarks or trade names, usually within a designated geographic area c) another type of franchise is that entered into between a governmental body and a company d) this franchise permits the company to use public property in performing its services e) such operating rights are referred to as licenses f) when a company incurs costs in connection with the purchase of a franchise or license, it should recognize an intangible asset g) annual payments made under a franchise agreement are recorded as operating expenses in the period in which they are incurred 7) goodwill a) represents the value of all favorable attributes that relate to a company that is not tied to any other specific asset b) unlike assets such as investments and plant assets, which can be sold individually in the marketplace, goodwill can be identified only with the business as a whole c) therefore, companies record goodwill only when an entire business is purchased. In that case, goodwill is the excess of cost over the fair value of the net assets (assets less liabilities) acquired d) Goodwill is not amortized because it is considered to have an indefinite life, but its value should be written down if impaired e) companies report goodwill in the statement of financial position under intangible assets -RESEARCH AND DEVELOPMENT COSTS 1) expenditures that may lead to patents, copyrights, new processes, and new products 2) present accounting problems as it is sometimes difficult to assign these costs to specific projects -STATEMENT PRESENTATION AND ANALYSIS 1) companies combine plant assets and natural resources under “Property, plant, and equipment” in the statement of financial position 2) they show intangibles separately 3) companies disclose either in the statement of financial position or the notes to the financial statements the balances of the major classes of assets, such as land, buildings, and equipment, and accumulated depreciation by major classes or in total 4) they should describe the depreciation and amortization methods that were used, as well as disclose the amount of depreciation and amortization expense for the period 5) using ratios, we can analyze how efficiently a company uses its assets to generate sales 6) asset turnover = analyzes the productivity of a company’s assets 7) -EXCHANGE OF PLANT ASSETS 1) companies record a gain or loss on the exchange of plant assets 2) the rationale for recognizing a gain or loss is that most exchanges have commercial substance 3) an exchange has commercial substance if the future cash flows change as a result of the exchange 4) the exchange has commercial substance, and the companies recognize a gain or loss in the exchange 3) 4) because bondholders do not have voting rights, owners can raise capital with bonds and still maintain corporate control 5) are attractive to corporations because the cost of bond interest is tax-deductible in some countries 6) bonds may result in a lower cost of financing than equity financing -TYPES OF BONDS 1) secured and unsecured bonds a) have specific assets of the issuer pledged as collateral for the bonds b) mortgage bonds = bond secured by real estate c) sinking fund bond = bond secured by specific assets set aside to redeem (retire) the bonds d) unsecured bonds (or “debenture bonds”) = issued against the general credit of the borrower 2) convertible and callable bonds a) convertible bonds = bonds that can be converted into ordinary shares at the bondholder’s option b) the conversion feature generally is attractive to bond buyers c) callable bonds = bonds that the issuing company can redeem (buy back) at a stated currency amount (call price) prior to maturity -ISSUING PROCEDURES 1) in authorizing the bond issue, the board of directors must stipulate the number of bonds to be authorized, total face value, and contractual interest rate 2) face value = amount of principal the issuing company must pay at the maturity date 3) maturity date = date that the final payment is due to the investor from the issuing company 4) contractual interest rate ( or “stated rate”) = rate used to determine the amount of cash interest the issuing company pays and the investor receives 5) bond indenture = terms of the bond issue are set forth in a legal document; shows the terms and summarizes the rights of the bondholders and their trustees, and the obligations of the issuing company 6) trustee = keeps records of each bondholder, maintains custody of unissued bonds, and holds conditional title to pledged property 7) bond certificate = printed by the issuing company 8) bond prices are quoted as a percentage of the face value of the bond, which is usually $1,000 -DETERMINING THE MARKET PRICE OF A BOND 1) time value of money = used to indicate the relationship between time and money 2) the current market price (present value) of a bond is the value at which it should sell in the marketplace 3) market price therefore is a function of the three factors that determine present value a) amounts to be received b) length of time until the amounts are received c) market interest rate 4) market interest rate = rate investors demand for loaning funds -ACCOUNTING FOR BOND ISSUES 1) a corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into ordinary shares 2) if bondholders sell their bond investments to other investors, the issuing company receives no further money on the transaction, nor does the issuing company journalize the transaction 3) bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond. Face value is usually €1,000 4) 5) the company classifies interest payable as a current liability because it is scheduled for payment within the next year 6) -DISCOUNT OR PREMIUM ON BONDS 1) contractual interest rate = rate applied to the face (par) value to arrive at the interest paid in a year 2) market interest rate = rate investors demand for loaning funds to the corporation 3) when the contractual interest rate and the market interest rate are the same, bonds sell at face value (par value) 4) discount = when a bond is sold for less than its face value, the difference between the face value of a bond and its selling price 5) premium = when a bond is sold for more than its face value, the difference between the face value and its selling price 6) -ISSUING BONDS AT A DISCOUNT 1) carrying (or book) value of the bonds = on the date of issue, this amount equals the market price of the bonds 2) additional cost of borrowing = the difference between the issuance price and face value of the bonds (the discount) 3) interest expense over the life of the bonds = additional cost recorded by the company 4) amortization of bond discount 5) amortization of bond premium -CARRYING VALUE OF THE BONDS = the face value of the bonds adjusted for bond discount or bond premium amortized up to the redemption date -ACCOUNTING FOR LONG-TERM NOTES PAYABLE 1) long-term notes payable are similar to short-term interest-bearing notes payable except that the term of the notes exceeds one year 2) a long-term note may be secured by a mortgage that pledges title to specific assets as security for a loan 3) like other long-term notes payable, the mortgage loan terms may stipulate either a fixed or an adjustable interest rate. The interest rate on a fixed-rate mortgage remains the same over the life of the mortgage. The interest rate on an adjustable-rate mortgage is adjusted periodically to reflect changes in the market rate of interest 2) after the government approves the application, it grants a charter (may be an approved copy of the application form, or it may be a separate document containing the same basic data) 3) the corporation establishes by-laws (establish the internal rules and procedures for conducting the affairs of the corporation) 4) corporations engaged in commerce outside their state or country must also obtain a license from each of those governments in which they do business 5) organization costs = costs incurred in the formation of a corporation -OWNERSHIP RIGHTS OF SHAREHOLDERS 1) the corporation may begin selling ownership rights in the form of shares 2) when a corporation has only one class of shares, it is ordinary shares 3) proof of share ownership is evidenced by a form known as a share certificate -SHARE ISSUE CONSIDERATION -AUTHORIZED SHARES 1) the charter indicates the amount of shares that a corporation is authorized to sell 2) the total amount of authorized shares at the time of incorporation normally anticipates both initial and subsequent capital needs 3) the authorization of ordinary shares does not result in a formal accounting entry. The reason is that the event has no immediate effect on either corporate assets or equity -ISSUANCE OF SHARES 1) a corporation can issue ordinary shares directly to investors 2) alternatively, it can issue the shares indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors 3) the investment banking firm may agree to underwrite the entire share issue -MARKET PRICE OF SHARES 1) the shares of publicly held companies are traded on organized exchanges 2) the interaction between buyers and sellers determines the prices per share 3) the prices set by the marketplace tend to follow the trend of a company’s earnings and dividends 4) the trading of ordinary shares on securities exchanges involves the transfer of already issued shares from an existing shareholder to another investor. These transactions have no impact on a corporation’s equity -PAR AND NO-PAR VALUE SHARES 1) par value shares (sometimes “nominal”) = ordinary shares to which the charter has assigned a value per share 2) no-par value shares = ordinary shares to which the charter has not assigned a value 3) in many countries, the board of directors assigns a stated value to no-par shares -CORPORATE CAPITAL 1) equity is identified by various names: stockholders’ equity, shareholders’ equity, or corporate capital 2) the equity section of a corporation’s statement of financial position consists of two parts: a) share capital i) total amount of cash and other assets paid in to the corporation by shareholders in exchange for shares ii) when a corporation has only one class of shares, they are ordinary shares b) retained earnings (earned capital) i) net income that a corporation retains for future use ii) Net income is recorded in Retained Earnings by a closing entry that debits Income Summary and credits Retained Earnings 3) the distinction between share capital and retained earnings is important from both a legal and a financial point of view -ACCOUNTING FOR ORDINARY SHARE ISSUES 1) issuing par value ordinary shares for cash 2) issuing no-par ordinary shares for cash 3) issuing ordinary shares for services or non-cash assets -ACCOUNTING FOR TREASURY SHARES 1) treasury shares = a corporation’s own shares that it has issued and subsequently reacquired from shareholders but not retired; various aims a) to reissue the shares to officers and employees under bonus and share compensation plans b) to signal to the securities market that management believes the shares are underpriced, in the hope of enhancing its market price c) to have additional shares available for use in the acquisition of other companies d) to reduce the number of shares outstanding and thereby increase earnings per share 2) purchase of treasury shares 3) outstanding shares = number of issued shares that are being held by shareholders 4) disposal of treasury shares -ACCOUNTING FOR PREFERENCE SHARES 1) have contractual provisions that give them some preference or priority over ordinary shares 2) preference shareholders have a priority as to a) distributions of earnings (dividends) b) assets in the event of liquidation 3) -DIVIDEND PREFERENCES 1) preference shareholders have the right to receive dividends before ordinary shareholders 1) share dividends change the composition of equity because they transfer a portion of retained earnings to share capital and share premium => however, total equity remains the same 2) share dividends also have no effect on the par or stated value per share, but the number of shares outstanding increases -SHARE SPLITS 1) involves issuance of additional shares to shareholders according to their percentage ownership 2) however, a share split results in a reduction in the par or stated value per share 3) the purpose of a share split is to increase the marketability of the shares by lowering the market price per share 4) the effect of a split on market price is generally inversely proportional to the size of the split 5) a share split does not have any effect on share capital, share premium, retained earnings, or total equity 6) a company does not need to journalize a share split -RETAINED EARNINGS 1) net income that a company retains in the business 2) the balance in retained earnings is part of the shareholders’ claim on the total assets of the corporation 3) when a company has a net loss (expenses exceed revenues), it also closes this amount to retained earnings 4) companies do not debit net losses to share capital or share premium -RETAINED EARNINGS RESTRICTIONS 1) the balance in retained earnings is generally available for dividend declarations 2) restrictions a) legal restriction = keeps intact the corporation’s legal capital that is being temporarily held as treasury shares b) contractual restriction = limits the use of corporate assets for payment of dividends c) voluntary restriction = The board of directors may voluntarily create retained earnings restrictions for specific purposes -PRIOR PERIOD ADJUSTMENT 1) correction of an error in previously issued financial statements 2) -RETAINED EARNINGS STATEMENT 1) shows the changes in retained earnings during the year 2) 3) as indicated, net income increases retained earnings, and a net loss decreases retained earnings. Prior period adjustments may either increase or decrease retained earnings. Both cash dividends and share dividends decrease retained earnings -STATEMENT PRESENTATION AND ANALYSIS 1) the equity section of the statement of financial position reports share capital, share premium, and retained earnings a) share capital = preference (before) and ordinary shares b) share premium = includes the excess of amounts paid over par or stated value and share premium from treasury shares 2) 3) investors and analysts can measure profitability from the viewpoint of the investor in ordinary shares by the return on ordinary shareholders’ equity 4) indicates how many euros of net income the company earned for each euro invested by the ordinary shareholders 5) it is computed by dividing net income available to ordinary shareholders (which is net income minus preference dividends) by average ordinary shareholders’ equity 6) 7) if a company has preference shares, we deduct the amount of preference dividends from the company’s net income to compute income available to ordinary shareholders 8) CHAPTER 12 - INVESTMENTS -corporations purchase investments in debt or share securities generally for one of three reasons 1) a corporation may have excess cash that it does not need for the immediate purchase of operating assets 2) to generate earnings from investment income 3) companies also invest for strategic reasons -DEBT INVESTMENTS = investments in government and corporation bonds -RECORDING ACQUISITION OF BONDS = at acquisition, investments are recorded at cost -RECORDING BOND INTEREST -RECORDING SALE OF BONDS => difference between the net proceeds from the sale (sales price less brokerage fees) and the cost of the bonds -SHARE INVESTMENTS 1) investments in the shares of other corporations 2) when a company holds shares (and/or debt) of several different corporations, the group of securities is identified as an investment portfolio 3) the accounting for investments in shares depends on the extent of the investor’s influence over the operating and financial affairs of the issuing corporation (the investee) ii) intended to be converted into cash within the next year or operating cycle, whichever is longer (1) intent to convert means that management intends to sell the investment within the next year or operating cycle, whichever is longer c) investments that do not meet both criteria are classified as long-term investments 5) long-term investments a) companies generally report long-term investments in a separate section of the statement of financial position immediately above “Current assets” b) long-term investments in held-for- collection debt securities are reported at amortized cost c) long-term investments in non-trading share investments are reported at fair value d) investments in ordinary shares accounted for under the equity method are reported at equity -PRESENTATION OF REALIZED AND UNREALIZED GAIN AND LOSS 1) companies must present in the financial statements gains and losses on investments, whether realized or unrealized 2) in the income statement, companies report gains and losses in the non-operating activities section 3) in a comprehensive income statement, companies report unrealized gains or losses on non- trading securities as other comprehensive income or loss 4) in the statement of financial position, companies report in the equity section accumulated other comprehensive income or loss -CLASSIFIED STATEMENT OF FINANCIAL POSITION 1) the investments in short-term securities are considered trading securities 2) the long-term investments in shares of less than 20% owned companies are considered non-trading securities 3) CHAPTER 13 - STATEMENT OF CASH FLOWS -the statement of financial position, income statement, and retained earnings statement provide only limited information about a company’s cash flows (cash receipts and cash payments) => BUT they do not show how the additions were financed or paid for -the income statement shows net income => BUT it does not indicate the amount of cash generated by operating activities -STATEMENT OF CASH FLOWS 1) reports the cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities during a period 2) the information in a statement of cash flows should help investors, creditors, and others assess the following a) the entity’s ability to generate future cash flows => examining relationships between items in the statement of cash flows b) the entity’s ability to pay dividends and meet obligations => if a company does not have adequate cash, it cannot pay employees, settle debts, or pay dividends c) the reasons for the difference between net income and net cash provided (used) by operating activities => net income provides information on the success or failure of a business d) the cash investing and financing transactions during the period => by examining a company’s investing and financing transactions, a financial statement reader can better understand why assets and liabilities changed during the period -CLASSIFICATION OF CASH FLOWS 1) the statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities 2) transactions and other events characteristic of each kind of activity are as follows a) operating activities i) include the cash effects of transactions that create revenues and expenses ii) thus they enter into the determination of net income iii) most important category, because it shows the cash provided by company operations iv) this source of cash is generally considered to be the best measure of a company’s ability to generate sufficient cash to continue as a going concern b) investing activities i) include (1) acquiring and disposing of investments and property, plant, and equipment (2) lending money and collecting the loans c) financing activities i) include (1) obtaining cash from issuing debt and repaying the amounts borrowed (2) obtaining cash from shareholders, repurchasing shares, and paying dividends -SIGNIFICANT NON-CASH ACTIVITIES 1) not all of a company’s significant activities involve cash, for example a) direct issuance of ordinary shares to purchase assets b) conversion of bonds into ordinary shares c) direct issuance of debt to purchase assets d) exchanges of plant assets 2) companies do not report in the body of the statement of cash flows significant financing and investing activities that do not affect cash 3) instead, they report these activities in either a separate note or supplementary schedule to the financial statements -FORMAT OF THE STATEMENT OF CASH FLOWS 1) the general format of the statement of cash flows presents the results of the three activities discussed previously - operating, investing, and financing - plus the significant non-cash investing and financing activities 2) 3) the cash flows from operating activities section always appears first, followed by the investing activities section, and then the financing activities section 4) the sum of the operating, investing, and financing sections equals the net increase or decrease in cash for the period 5) this amount is added to the beginning cash balance to arrive at the ending cash balance—the same amount reported on the statement of financial position