appunti di financial e managerial accounting, Appunti di Ragioneria

Scarica appunti di financial e managerial accounting e più Appunti in PDF di Ragioneria solo su Docsity! ACCOUNTING Chapter 1 Accounting and the business environment 1. FINANCIAL INFORMATION AND DECISION MAKING Accounting the information system that measures business activities, processes the information into reports and communicates the results to decision makers. It consists of 4 steps:  Collecting financial information - bookkeeping  Analyzing it to determine what information is relevant  Presenting the relevant information in a meaningful form to the user  Assisting the user in interpreting the information and applying it in the decision making process Accounting is needed both by insiders of a company, such as employees or business managers, and by outsiders, such as creditors and investors. The GOAL of accounting is to provide the user with information which is relevant to ENSURE EFFECTIVE DECISION-MAKING and ASSESS POTENTIAL SUCCESS. This success consists in financial profit. Information presented through the accounting process is the primary line of communication between a firm and its investors and creditors. It is essential that all parties involved in business activities understand the language used to communicate financial information. A financial statement is a document which is essential to assess the company's ANNUAL PERFORMANCE. Example of a financial statement CAMPARI ANNUAL REPORT - 31-12-2019 NET SALES: all sales in that year CONTRIBUTION MARGIN: product price minus all associate variable cost EBITDA: earnings before tax, interest, depreciation and amortization EBIT: earnings before interest and tax 2. FINANCIAL AND MANAGERIAL ACCOUNTING FINANCIAL ACCOUNTING is a type of accounting that provides information to external decision makers. These users can be  Investors who own a part (share) of the business and who therefore profit if the business profits  Creditors who evaluate the company’s ability to make the payments before extending credit to said business  Taxing authorities Especially because of this last aspect, financial accounting is strictly regulated by laws and the reports are public and publishable. Financial reports usually involve data regarding investments, whether it's worth lending gthe company money, whether the business is profitable or not. MANAGERIAL ACCOUNTING provides information to internal decision makers, such as  Employees  Managers  Individuals  Businesses The data is private and therefore non-disclosable, and it usually concerns budgeting, possibilities of expansion, cost management etc. There are different types of accountants: – Certified Public Accountants (CPAs): they are licensed professionals who serve the general public. – Financial accountants: they deal with preparing financial statements in public and private* firms. – Auditors: they are independent experts who verify the conformity of financial statements to accounting standards; they are especially useful so that a company doesn’t hide factors that might hurt its profitability (like a pending lawsuit), which would be dangerous for investors and unethical. – Certified Management Accountants (CMAs): they specialize in cost accounting and managerial control and often work for a single company. *a private firm is a firm which DOES NOT sell shares in the stock market. Accounting positions can be public, private or governmental. 3. HISTORY OF ACCOUNTING The first accounting records were found in Mesopotamia and are from 2500 B.C. They are marked on a piece of clay and represent tributes paid to the king. For centuries, most transactions are nonmonetary (barter), and accounting records are mainly kept in physical forms (e.g., tally sticks). In the 15th century, many changes happened in Europe: a monetization of the economy took place, and this led to the development of modern banking (Florence, Venice and Genoa). The printing press was invented by Gutenberg in 1439 and so more people become literate. Joint/split financing was developed in Venice. Mathematician Luca Pacioli was the first one who developed DOUBLE-ENTRY BOOKKEEPING, a simple bookkeeping method which had the purpose of leaving mathematics outside of accounting. The main concept of double-entry bookkeeping us having no negative numbers, and instead using accounting terms such as DEBIT and CREDIT, which made financial statements much more intuitive. In the following centuries, after events such as the birth of the Dutch East India Company in the 17th century or the English Industrial Revolution in the 18th century, cash lost its importance in favour of financial markets, which became more and more relevant. The income tax was first introduced in England in the 19th century and in the USA many long-term investments were made, especially in the railroads field. As cash lost its importance, a new accounting method, accrual accounting, was made necessary: accrual accounting determines net income, i.e. the financial wealth created by a business, and takes into consideration all flows of profit, not just cash. - The goal is to trade them in financial markets, which makes transferring and adding ownership much easier. - The more shares you buy, the bigger the portion of the company you own, the more power you have; this is because shareholders meet once a year and appoint the directors of the company, and the value of each shareholder’s vote is directly proportional to the amount of shares they own. THE CAPITALIZATION OF THE WORLD’S STOCK MARKETS AND NUMBER OF LISTED COMPANIES GAAPS – Generally accepted accounting principles - Economic entity assumption: an economic entity is a company which stands apart a separate economic unit. - Cost principle: every asset you purchase for the company will be reported as a cost in the financial statement. The transaction is recorded at the amount shown on the receipt, the actual amount paid. - Monetary unit assumption: the value of every resource must be measured in a monetary unit. If you can’t measure it, you can not report the resource, but that will have its consequences. - Going concern assumption: we assume that the company is going to stay solvent and survive in the foreseeable future. If we remove this assumption, measuring cost of assets is useless, and the only reasonable thing to do would be measuring the value at which we should sell the company right now. THE THREE MAIN FINANCIAL STATEMENTS Financial accounting produces 3 major financial statements which provide a picture of the overall financial position and performance of the business - Balance sheet - Income statement or profit and loss account - Cash flow statement 6. THE BALANCE SHEET (or statement of financial position) The balance sheet reports the financial position of a company as of a specific point in time. It’s a list of the resources available for the business and claims of interested parties against those resources. These parties are the owners/investors and the creditors (unlike owners and investors, creditors have a right to get their money back in case of bankruptcy or severe money loss). The balance sheet is a snapshot of the entity and it makes it possible to quickly assess its health. ASSETS An asset (or investment) is a resource that - Must provide future economic benefits through its sale, consumption or utilization in the course of operation --- the money you spend will be recovered in the future thanks to an optimization of your work (!!! Not all outflows of cash are assets) - The business must have control over it --- the benefits of the asset must flow to you, and not to other businesses - It can be measured reliably One of the most important assets is trade receivables, which means the right to collect money. Other examples are cash, merchandise inventory, furniture and land. Example Say we wanted to start a business, what resources would we need? - Equipment – asset - Brand – not an asset because the value measurement is not reliable enough. The measurement is only reliable enough when the brand is bought, but once it’s bought it’s not mentioned as an asset in the balance sheet anymore. - Inventories - asset - Premises - asset - Staff – employees – not an asset because you don’t have control over them and you can’t measure their value, but only the value of the labour provided by them. The labour isn’t an asset either, because it provides immediate benefit, not future benefit. - Advertising – not an asset - Clients – not an asset (no control over them) - Cash – asset---- in accounting, in a normal financial situation, we can ignore inflation so we can measure it 100% reliably (unlike any other asset) - Location – not an asset - Consultant – not an asset; their services aren’t assets either, because a. they provide immediate benefits and b. they are expenses - Know – how – not an asset (see above EQUITY AND LIABILITY Equity and liability are 2 ways of financing a business - Equity: an equity is the owner’s claim to the asset of the business, for this reason they are also called stockholders’ equity. Changes in equity are generally caused by transactions. Increases in equity result from contributed capital (owner contributions) and revenues; decreases in equity result from dividends (owner distributions) and expenses. - Liability: liabilities are debts that are owed to creditors. Not all liabilities are certain, some are just probable, but they are still reported in the balance sheet according to the prudence principle (see below). A way to recognize them in the balance sheet is the word “payable”, for example accounts payables, notes payables and salaries payables. If you use a liability, it means that you get in debt. Realistically, all companies are funded by a mix of equity and liability. So, to sum it up, a balance sheet shows assets, equity and liabilities. In a balance sheet, we usually find the list of assets (like biological assets, tax assets, trademarks) and the value of those assets. Assets can be current or non-current. We must take into consideration that the value of assets which is written on the report is a slight underestimation of the resources, because some resources can’t be considered an actual asset in accounting even though they are a resource. Liability can be non-current and current, long-term and short-term (must be repaid within 1 year). An important type of liability is the trade payable, which is a payable to suppliers that sell goods or services. Equities, by definition, are long-term, because there is no obligation to pay it back. INCOME Income is the net increase (profit) or net decrease (loss) in owner’s equity over a period of time, with the exclusion of changes related to transactions between firm and equity participants. The changes must be caused solely by the company’s performance and production. Everything that happens in a firm apart from contributions (contributed capital) and distributions (dividends) involving shareholders consists in production. Et1: equity at the end of the year Et0: equity at the beginning of the year EXAMPLE: If Et1=120 and Et0=100 and we paid our shareholders a dividend of 5, our net income=25 !!!!! Income-distributions=retained earnings In an organization we have inputs, which are consumed in production to get outputs, which are either sold or made available for internal use. (consumption) Inputs--production---outputs (sold/available for sale/internal use) In order to create VALUE, the outputs must be worth more than the inputs. EQUITY IN THE BALANCE SHEET *income can be positive or negative As we know, the performance and productivity of a company is measured by changes in equity. The increase in equity can increase if either assets or liabilities increase; a positive increase in equity is due to value converting processes; if the increase is due to contributions or new liabilities, it doesn’t mean progress for the company. The way to assess the performance of the company on the balance sheet is to look at the change in equity, and to check whether there have been contributions or distributions. In particular, the presence of contributions decreases the quality of the performance, while the presence of distributions increases it, because we know that without them the value of E1 would have been even higher. DEFICIT In case of losses, the income is negative so Equity1 will be inferior to Equity0. Income keeps accumulating in the equity so if you keep making profits, your equity will keep increasing, while if you keep losing your equity will get lower and lower. Example: E0= 100 E1=70 E2=30 E3=0 E4=-20 Loss1=30 loss2=40 loss3=30 loss4=20 If your equity is under 0, it’s called a deficit. Because income accumulates, the easiest and most dangerous way of going in a deficit is to keep consistently losing for years in a row. If the equity is negative, in order for the company to survive the assets must be greater than the liabilities, because they are the only resource you have to pay your debts back. BALANCE SHEET A L 80 100 E (20) ----deficit * If you ask a bank for money, your liabilities will increase as well as your assets so the situations won’t change. The solution is to ask your investors (and NOT creditors) for money, but the main goal must be to increase your production, so investors will profit from their investment and your equity will increase “healthily”. However, there are very big and successful companies which survive even with a deficit of billions of euros, like McDonald’s. This is possible if the company law allows the company to pay more money in dividends to shareholders than what they actually have, and so if this “generosity” is the only cause of deficit, not actual loss. This financial behaviour can be dangerous. *in a balance sheet, deficit is written between brackets. REVENUE AND EXPENSES At the top we have equity at time 0: we know equity= assets – liabilities. Then, we have the possible changes we have in certain period of time: the changes (delta) can be positive or negative. If the equity increases, it means that the assets increase and the liabilities decrease: the way to achieve that is by receiving contributions from shareholders, or through revenue. Revenues are increases in economic benefits during the accounting period in the form of inflows or enhancements of assets, or decreases of liabilities, that result in increases in equity, other than those relating to contributions from equity participants. If the equity changes negatively, it means that the assets decrease and the liabilities increase: this can be caused either by distributions or by expenses. Expenses are all decreases in economic benefits during the accounting period in the form of outflows or depletions of assets, or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Revenues and expenses may be cash revenues and expenses, or not. In the INCOME STATEMENT, we isolate those changes in equity that are related to business performance, and we calculate REVENUE – EXPENSES= NET INCOME OR NET INCOME= (Et1-Et0)+distributions-contributions However, by using the first equation we are able to get more information about the revenues and expenses generated in the production process. Mark contributes $30,000 cash to a company in exchange for stock. According to double-entry bookkeeping, we report this both as a new asset, and as an increase in equity in terms of contributed capital. 2.PURCHASE OF LAND FOR CASH The company purchases land for an office location, paying cash of $20,000 . There is no change in equity or assets because we exchanged an asset (cash) for another one (land). The only difference is that there is less liquidity. 3.PURCHASE OF OFFICE SUPPLIES ON ACCOUNT Since we buy on account, there is an increase in liabilities; however, the expense will appear only when we use the new asset, so the value of equity stays the same, as well as the value of other assets. 4.EARNING OF SERVICE REVENUE FOR CASH The company earns service revenue (that is, the revenue that the company earns by providing services for clients) and collects $5,500 in cash. The equity has increased thanks to the successful operation; the asset “cash” increases too. 5.EARNING OF SERVICE REVENUE ON ACCOUNT For a certain service, the clients promise to pay $3000 within one month. Even without an actual inflow of cash, the equity has increased. The company has got a new asset, an account receivable, which is the right to collect that cash from the clients, as the service has been performed. 6.PAYMENT OF EXPENSES WITH CASH The company pays $3,200 in cash expenses: $2,000 for rent and $1,200 for salaries. There is a decrease in assets (cash) as well as in equity, and in particular in retained earnings. 7.PAYMENT ON ACCOUNT (ACCOUNT PAYABLE) The company pays part of the money for the transaction of office supplies (see above) There is a decrease in cash as well as in liabilities, because now the company owes $200 to the office supplies store, and no longer $500. Paying a liability is not an expense because it has nothing to do with performance. 8.COLLECTION ON ACCOUNT (ACCOUNTS RECEIVABLE) The company collects $2,000 from the clients from transaction 5. The value of the assets stays the same; however, the value of the accounts receivable decreases, while the value of cash increases, because the cash is finally collected. 9.PAYMENT OF CASH DIVIDEND Since we pay a cash dividend, the cash decreases. It’s not an expense, since it’s part of the transactions between company and owners, and so it doesn’t appear in the income statement, but there is a direct decrease of the equity. Chapter 2 Recording business transactions 1.HOW TO PREPARE A FINANCIAL STATEMENT According to their nature (that is, whether they are assets, liabilities or equity), accounts are organized in a chart of accounts. A ledger is a record holding all the accounts of a business, the changes in those accounts and their balances; it’s more precise than a chart of accounts because if provides detail about the increases and decreases of each account for a specific period and the balance of each account at a specific point in time. There are 2 classes of accounts: - FIRST CLASS: all assets and liabilities - SECOND CLASS: all equity accounts. We separate them because they have a different behaviour in double-entry bookkeeping: the first class shows us the changes in accounts, while the second class explains the reason behind those changes. 3.WHAT IS DOUBLE ENTRY BOOKKEEPING? We know that transactions always involve at least 2 accounts: double-entry accounting records the dual effects of each transaction. Transactions are recorded as changes in an account of the 1st class (nature of the transaction), and, at the same time, as changes in an account of the 2nd class (explanation). For example, if we pay our employees’ salaries, there is a decrease in cash (asset, 1st class) and an increase in salary expense (equity, 2nd class). The name of the account of the 2nd class, salary expense, explains us why we have this decrease in cash. In order to record this dual effect, we use a shortened form of the ledger, the T-account. On the left side we have the debit, on the right side the credit. At the top, we indicate the name of the account. The left and right side do not have any meaning other than a conventional one; credit and debit are simply labels. For first class accounts, we report the good news in the debit side (left), and the bad news in the credit side(right): therefore, if we are talking about cash, we’ll report an increase in cash at the left (a debit is recorded), and a decrease at the right (a credit is recorded), while if we are talking about liabilities we will do the opposite. e.g. cash e.g. a payable For second class accounts (equity, and therefore common stock, dividends, revenues and expenses), we report good news on the right side and bad news on the left, since revenues are by definition positive and expenses are by definition negative. THE THREE PROPERTIES OF DOUBLE-ENTRY BOOKKEEPING - ∑ 1ST class=∑ 2nd class This is simply another way to put the basic accounting equation - ∑ all debited amounts= ∑ all credited amounts That’s because of the nature of double-entry bookkeeping, which reports causes and consequences of changes in assets/liabilities/equity. - ∑ all debit balances= ∑ all credit balances The way we check this is trial balance: at all times if we list all debit balances and all credit balances, their values must be the same CASH 1,000 300 700 ----- this is a DEBIT BALANCE (assets) ACCOUNTS PAYABLE 200 600 400 ------ this is a CREDIT BALANCE (liabilities) You can have a credit balance in your bank account: it stops being an asset and it becomes a liability called overdraft. An account is closed when the balance is 0, and we write an “x” on the T symbol. THE NORMAL BALANCE All accounts are summarized on one side of the T-account, called the normal balance. The normal balance appears on the increasing side of the account. Since assets increase with a debit, the normal balance is a debit, while liabilities and equity increase with a credit so the normal balance is a credit. Example The ending balance is shown on the side with the larger number. In order to understand the reason behind these values, we need the journal, which reports all transactions. - Assets: debit - Liabilities: credit - Common stock: credit - Revenues: credit - Dividends: debit - Expenses: debit 4. HOW DO YOU RECORD TRANSACTIONS? First of all, in order to record transactions, accountants need source documents (like an invoice) to provide evidence and data for recording transactions; it’s important for the information to be reliable in order to make correct decisions and to avoid fraud. Transactions are recorded in a journal, which records the transactions in date order. It’s important to keep the double-entry method. Ledger: 4. EARNING OF SERVICE REVENUE FOR CASH This transaction causes a change in equity: both Cash, an asset account, and Revenue, an equity account, increase, so we debit Cash and credit Revenue. 5. EARNING OF SERVICE REVENUE ON ACCOUNT The company performs services for clients, for which the clients are yet to pay $3000; this service revenue is earned on account. In accounting cash doesn’t make a difference: the account Accounts receivables (which are the right to collect cash for a service that has already been performed) is just as much of an asset as cash, and therefore it increases on the debit side just like cash, while revenue increases on the credit side, being a 2nd class account. 6.PAYMENT OF EXPENSES WITH CASH The company has paid office rent (2000$) and salaries (1200$): the asset account, Cash decreases so we credit it; on the other hand, we debit each expense account to record its increase. This is a COMPOUND JOURNAL ENTRY because it has got multiple debits and/or credits; as we can see, the increase in expense (2nd class account) explains the decrease in cash (1ST class account). We are recording an increase in expenses because the business has more expenses now than it had before; however, the overall effect on the accounting equation is that increases in expenses decrease equity, since we are increasing a negative account. 7.PAYMENT ON ACCOUNT The company pays $300 on the accounts payable created in transaction 3; now the balance of that account is $500-$300=$200. The payment decreases the asset Cash, which we credit, as well as the liability Accounts payable, which we debit. 8.COLLECTION ON ACCOUNT The company collect $2000 out of the $3000 its clients owed for the service provided in transaction 5: the asset Cash increases, so we debit it, and the asset Accounts receivable decreases, so we credit it by the same exact amount. This transaction has no effect on the revenue. 9.PAYMENT OF CASH DIVIDENDS The payment decreases the asset Cash, which we credit, as well as the equity; therefore, we debit the Dividends account. Keep in mind that dividends are not expenses, they are simply another equity account, and therefore we must not debit expenses. 10. PREPAID EXPENSE Since in accrual accounting, you can’t recognize an expense if the service hasn’t been performed, we use a type of asset called a Prepaid expense, which gives us right to a future service (and therefore, to a future benefit). In this case, the company is prepaying 3 months of rent ($3000): we credit the asset Cash, which is decreasing, and credit the asset Prepaid rent, which is increasing. 5. THE TRIAL BALANCE A trial balance is a list of all ledger accounts with their balances at a point in time. The asset accounts are listed first, followed by liabilities and then equity. Total habits must equal total credits. It is important to understand the difference between the trial balance and the balance sheet: the trial balance verifies the equality of debits and credits, and it is an internal document used only by the employees of the company. The balance sheet, on the other hand, presents the business’s accounting equation and is a financial statement that can be used by both internal and external users. HOW TO CORRECT BALANCE ERRORS: - Search a missing account - Divide the difference between debits and credits by 2 - Divide the out-of-balance amount by 9 6. THE DEBT RATIO The debt ratio evaluates the financial position of a business, in that it shows its ability to pay its debts and it determines if the company has too much debt to be considered financially healthy. It portrays the proportion of assets financed with debt: Debt ratio=total liabilities/total assets The result can only be understood by comparing it to other ratios as benchmarks: these ratios can be the ones of other companies or the ones of the same company but during a different accounting period. Companies that have a high debt ratio are at risk of default and if they are unable to pay their creditors as the amounts become due, the creditors have a right to claim their assets. 7.THE CURRENT RATIO Current ratio=current assets/current liabilities The value of the current ratio should be bigger or equal to one; if it’s lower than one, it means that the company is not going to be able to repay its current debts (let’s keep in mind that current means “within 1 year”). Chapter 3 The adjusting process THE TIME PERIOD CONCEPT The time period concept assumes business activities can be sliced into small times segments and that financial statements can be prepared for specific periods such as a month, quarter or year. The length of the period depends on the size of the company, even though the balance sheet is only published once a year. A fiscal year is an accounting year of 12 consecutive months that may or may not coincide with the calendar year, and it is the accounting period usually used for annual financial statements THE REVENUE RECOGNITION PRINCIPLE The revenue recognition principle tells accountants when to record revenues based on a 5-step process: - Identify the contract with the customer - Identify the performance obligations in the contract - Determine the transaction price - Allocate the transaction price to the performance obligations in the contract - Recognize revenue when the entity satisfies each performance obligation. WHAT ARE ADJUSTING ENTRIES? An unadjusted trial balance lists the revenues and expenses, but these amounts are incomplete because they omit various revenue and expense transactions. Adjusting entries are made at the end of the accounting period to record revenues to the period in which they are earned and expenses to the period in which they occur. They are needed to measure items such as net income or loss on the income statement, or assets and liabilities on the balance sheet. They involve assets and liabilities other than cash. There are 2 main categories of adjusting entries - DEFERRALS (risconto) In a deferral adjustment the cash payment or receipt has already occurred but we defer the recognition of expense or revenue to a later date. - ACCRUALS (rateo) In an accrual adjustment we recognize an expense before the cash is paid, or record revenue before the cash is received. An example of a deferral is prepaid rent; an example of an accrual are salary or utility expenses. 1.DEFERRED EXPENSES Deferred expenses are advance payments of future expenses. They are also called prepaid expenses and they are treated as assets until used; when the prepayment is used, they are recognized as an expense, and at this point we must adjust the journal entry. Prepaid expenses usually refer to services. When we are referring to goods, we use the term “advance payment”. When we adjust these values, we must record the decrease in value of these assets and the increase in expenses as time passes and therefore as we use the service. For services like rent, this is gradual and the value of the asset decreases gradually until the expiration date, when the value of the asset reaches 0 and the whole transaction is recorded as an expense. In these cases we record these changes in value gradually thanks to the perpetual method. Example In November, a company prepays 3 moths of rent and recognizes this outflow of cash as an expense. As of December 31, the value of prepaid rent should have decreased by the amount that has been used up, which is 1000$; therefore we credit the asset account Prepaid rent and debit the expense account Rent expense by 1000$. There is another method that can be used, which is the periodic method: this method defers the recognition of the asset “prepaid rent”, and instead it records the reason of the outflow of cash as an expense. The prepayment is only recognized at the end of the year by lowering the expenses when they are excessive. The Watch out: a dramatic loss of value can be caused by: - Accidents - External laws and rules which call for a replacement of the assets However, this IS NOT depreciation!!! Example A company receives a contribution of furniture with a market value of $18,000, in exchange for common stock (which, let’s remember, means authority inside of the corporation). We have an increase in assets (furniture) as well as in equity (common stock). The company believes the furniture will remain useful for 5 years and will have no value at the end. Using the straight- line method we get: Therefore, after the 1st month, at the end of the accounting period, we must adjust the entry this way: We credit the contra asset instead of the asset because the original value of the furniture must always be clear, according to the cost principle. The accumulated depreciation account is the sum of all depreciation expense recorded to date; the 2 main characteristics of a contra account are: - It is paired with and is listed immediately after its related account in the chart of accounts and associated financial statement - Its normal balance is the opposite of the normal balance of the related account HOW TO REPORT PROPERTY, PLANT AND EQUIPMENT Depreciation is an expense, and all taxes are tax-deductable so many companies use it to deduct taxes. 3.DEFERRED REVENUES A deferred revenue (also called unearned revenue) occurs when a company receives cash before it does the work or delivers a product; it is a liability because the business owes the customer the product, the service, or a refund. In other words, the revenue has been realized, because we received the payment, but it hasn’t been earned. Only after completing the job or delivering the product does the business earn the revenue. In order to journalize this transaction, we debit cash and credit a liability (!!bad news); upon performance (services) or delivery (goods), deferred revenue is converted to service revenue (equity). Depending on the service, this conversion takes place slowly, at least month by month. Example Say we have an unearned revenue of $600 for 1 month worth of rent, Perpetual method After 10 days we will have earned approximately 1/3 of the revenue; therefore we will decrease (debit) deferred revenue, a liability account, for $200 and increase (credit) service revenue, an equity account, for $200. Periodic method At the beginning we credit service revenue for $600 and debit cash, as if the revenue had been earned; at the end of the period, we realize that part of the revenue ($400 out of $600) hasn’t been earned yet so we debit $400 in service revenue and credit a new liability account, “unearned revenue”, by the same amount. 4.ACCRUED EXPENSES Accrued expenses are expenses the business has incurred but not yet paid, like salaries expense, interest expense (you know the interest will get higher and higher, you calculate it but you will pay it as time passes), utilities expense (electricity, water etc), taxes. These expenses are said to accrue, which means they grow as the accounting period passes. Corporations don’t make daily or weekly journal entries to accrue expenses, they usually wait until the end of the accounting period. Example - accrued salaries expense The company pays a monthly salary of $2400, half on the 15th and half on the 1st day of the following month; on the 15th, the company makes the following entry: In a compound closing entry, each individual account is credited and the income summary account is debited for the total amount of expenses. HOW TO CLOSE A BOOK - Make the revenue accounts equal zero by transferring total revenues to the credit side of the Income Summary account. - Make expense accounts equal zero by transferring total expenses to the debit side of the Income Summary account. - Make the Income summary account equal zero by transferring its balance (to net income or loss) to the Retained earnings account. - Make the Dividends account equal zero by transferring its balance to the debit side of the Retained earnings account. Example We must zero out a service revenue account. In order to zero the account out, since it is a credit account, we debit its balance to the account itself (which means the new balance is 0), and we credit it to another account, Income Summary. Let’s zero out the dividends account via the Retained earnings account. Since dividends are a debit account, we must credit its balance in the account in order to bring it to 0; therefore, we must then debit it to another account, Retained Earnings, in order to transfer it there. We must be careful: dividends are NOT an expense because they are a transaction between the firm and the owners, so they do not have an impact on the income. Because of this, we must skip the passage of the Income summary. The POST-CLOSING TRIAL BALANCE is a list of the accounts and their balances after journalizing and posting the closing entries; therefore, it only includes the permanent accounts. 2.THE ACCOUNTING CYCLE The accounting cycle us the process by which companies produce their financial statements for a specific period. It starts with the beginning asset, liability and stockholders’ equity account balances left over from the preceding period. During the period we journalize transactions and post them to the ledger; at the end of the period we adjust the accounts, prepare the financial statements and close the accounts. The length may vary according to the size and needs of the corporation; not all financial statements have to be published (classified balance sheet) THE FINANCIAL STATEMENTS - Income statement: it reports revenues and expenses and calculates net income or loss for the period. It is the starting point for every financial statement - Statement of retained earnings: it shows how retained earnings changes during the period due to net income/loss and dividends. - Balance sheet: it reports assets, liabilities and equity as of the last day of the period. THE CLASSIFIED BALANCE SHEET A classified balance sheet places each asset and liability into a specific category: assets are shown in order of liquidity (how quickly and easily they can be converted to cash within their normal course of operation, that is by respecting the original purpose of the asset) while liabilities are classified as current (due within one year) or long term (due after one year). Long term assets must be financed by long term sources of finance, such as equity or long term liabilities. ASSETS Current assets will be converted to cash, sold or used up during the next 12 months or more. The operating cycle is the time span when: - Cash is used to acquire goods and services - These goods and services are sold to customers - The business collects cash from customers It usually lasts 12 months but it can be longer based on the company. Long term assets are all the assets that will not be converted to cash or used up within the business’s operating cycle and within the normal course of operation (is it normal to sell this asset at this price?): - Long-term investments: investments in bonds (debt) or stocks (equity) that the company intends to hold for longer than 1 year. Stocks are riskier than bonds because in stocks, if you have an insolvency you will lose 100% of your investment, without the chance of any insurance covering you: of course, with risk comes rewards, so stocks give you a higher chance of profit. - Property, plant and equipment: long-lived tangible assets used in the operation of a business. The cash is generated by using these assets. - Intangible assets: assets with no physical form that are valuable because of the special rights carried, like patents, copyrights and trademarks. An example of current asset, on the other hand, is prepaid insurance or prepaid rent: the prepayment is what appears as an asset. LIABILITIES - Current liabilities must be paid either with cash or with goods and services within the entity’s operating cycle (accounts payables, salaries payables, unearned revenue, interest payables). - Long term liabilities do not have to be paid within the operating cycle, and they are usually financial liabilities (notes payables) EQUITY Equity represents the stockholders’ claim to the assets of the business. It reflects the stockholders’ contributions through common stock, and it also represents the amount of assets left over after the corporation has paid its liabilities. PURCHASE DISCOUNT A purchase discount is a discount businesses offer to purchasers as an incentive for early payment. Credit terms are the payment terms of purchase or sale as stated on the invoice: most express the discount, the discount time period and the final due date. Example: 3/15, n/30 means a 3% discount is given if paid within 15 days, otherwise the full amount is due in 30 days. See the transaction above: if the liability is paid within 15 days, the transaction will go as follows The purchase discount is recorded as a credit to the Merchandise Inventory account because the discount or early payment decreases the actual cost paid for Merchandise Inventory. It’s important to debit Accounts Payable for the full amount of the invoice, even if there is a discount, because otherwise there will be a balance remaining in the account, even if the invoice has been paid in full. If the company were to pay the payable after the discount period, the transaction would go down as follows: PURCHASE RETURNS AND ALLOWANCES (from the buyer’s perspective) - Purchase returns exist when sellers allow purchasers to return merchandise that is defective, damaged or otherwise unsuitable - Purchases allowances are amounts granted to purchasers as an incentive to keep goods that are not “as ordered”; these allowances are deducted from the amount the buyer owes These things may cause the need to adjust the invoice price; they decrease the buyer’s cost of the merchandise inventory. How do we journalize a return? We debit the accounts payable(liability), because we are not going to pay for these goods, and we credit the inventory (asset), because the number of items in our inventory decreases. For the allowance, the entry is the same, except that in this case the company keeps the inventory. Example On June 10, a company purchases 15 tablets on account with credit terms of 3/15, n/30 at a cost of $5,250. Five tablets are returned on June 15 for $1,750 and payment is made on June 20. In this case, the return takes place before the payment has been made, and well within the discount period; therefore, the discount ($105) is calculated on the amount due (5,250$) less the return (1,750$), and therefore on a total of $3,500. TRANSPORTATION COSTS Purchase agreements specify shipping terms to determine when the title of the goods transfers to the purchaser and who pays the freight. - FOB shipping point: the buyer takes ownership to the goods as soon as they leave the seller’s place of business, and he usually pays for the freight. - FOB destination: the buyer takes ownership to the goods when they are delivered, therefore the seller pays the freight. This influences the value of the merchandise, especially in case of custom taxes being added to the product price. There are 2 types of shipping costs, when merchandisers are required to pay for them: - Freight in: transportation cost to ship goods into the purchaser’s warehouse (freight on purchased goods) - Freight out: transportation cost to ship goods out of the seller’s warehouse (freight on sold goods). The freight is a cost thar must be paid in order to acquire the inventory, so freight in costs are debited to the Merchandise Inventory account. Example FREIGHT CHARGE FOR A SHIPPING WITH FOB SELLING POINT FREIGHT IN WITHIN DISCOUNT PERIOD Under FOB shipping point, the seller might prepay the transportation (in the case below, $400) as a convenience and list this cost on the invoice. The 3% discount is only applied to the merchandise price, not on the shipping cost. Therefore, we calculate it only on the $5,000, not on the full $5,400 reported on the invoice (merchandise cost + prepaid freight). COST OF INVENTORY PURCHASED Net cost of Inventory Purchased= Purchase cost of inventory – purchase returns and allowances – purchase discounts + freight in Knowing it allows a business to determine the actual cost of the merchandise purchased. SALES RETURNS AND ALLOWANCES It is important to estimate sales returns - Under the “new revenue recognition standard”, companies should only record sales revenue in the amount they expect to eventually realize. - Companies must decrease sales revenue by an estimated amount of sales return - Historical data can be used for this estimate, which must take place before the return itself Example: say a company has sales of $1,000,000 and cost of goods sold of $600,000 for the period; they estimate that approximately 4% of the merchandise sold will be returned. We lower the revenues by crediting the liability Refunds payable (the money we will probably owe our clients as refunds); moreover, we decrease the equity account Cost of goods sold since part of these goods will come back to the warehouse as returns: therefore, we increase the asset account Estimated returns inventory. If our estimation is wrong, we will need to make adjustments; of course, for purchases we do not need to estimate because we are the ones to decide whether to return/ask for a refund or an allowance or not. What if we have an actual return of inventory? A customer returns merchandise purchased with cash with a sale price of $2,000; the cost of the goods was $800. We decrease the asset Cash since we must pay part of the Refunds payable; we decrease the receivable Estimated Returns Inventory but increase the other asset Merchandise inventory, since we do get part of the inventory back in our warehouse. SALES ALLOWANCE The company grants a $100 sales allowance for goods damaged; they were sold on account and remain unpaid. The company reduces the customer’s Accounts Receivable or issue a cash refund, moreover, it reduces the estimated Refunds payable. Since there is no return of goods, the company doesn’t need to record a second entry to adjust the Merchandise Inventory account. 6.ADJUSTMENTS Actual inventory on hand may differ from what the books show: for example, there might me an inventory shrinkage, which is loss of inventory due to theft, damages and errors. Because of this, businesses take a physical count of inventory at least once a year. Merchandise Inventory is adjusted based on the physical count. Imagine the Merchandise inventory account shows a balance of $31,530 but a physical count comes to only $30,000. It would be best to debit a shrinkage expense, instead of the cost of goods sold. 7.CLOSING THE ACCOUNTS There are 4 steps: 1. Make the revenue accounts equal zero via the Income Summary 2. Make expense accounts equal zero via the Income Summary account 3. Make the Income Summary account equal zero via the Retained Earnings account (we transfer net income/loss to retained earning) 4. Make the Dividends account equal zero via the Retained Earnings account 8.THE FINANCIAL STATEMENT A merchandiser’s financial statement is called a multi-step income statement and it contains several subtotals to highlight significant relationships between accounts: in addition to net income, it reports gross profit, operating income and income before income tax expense. The Gross Profit is the markup on the merchandise inventory, which we calculate as net sales revenue minus COGS. Operating expenses (also called period cost) consists of selling expenses and administrative expenses; it appears on the financial statement even if the company doesn’t sell anything. It is subtracted from Gross profit from reoccurring operations and we get recurring operating income. Selling expenses are related to marketing and selling the company’s goods and services; all the other expenses, like for example depreciation or amortization, are administrative expenses. The operating income reports the performance of the business as if it didn’t have to pay interests or taxes: this way we isolate the financial structure of the company (how it finances its operations). If the operating income is negative, the operating expenses are higher than the operating revenues: even the operations cause loss, so even if the company has absolutely no liabilities we would have a loss. Sometimes, the income can be too low if there are too many liabilities, which generate interest expenses; in that case, stockholders are encouraged to increase their contributions. THE GROSS PROFIT PERCENTAGE It measures the profitability of each sales dollar above the cost of goods sold; it should be as high as possible. In order to increase this ratio, the company either convinces the customers to pay more (typically by creating a brand image which differentiates their products from the ones of their competitors) or decreases the cost of the products for the company itself by lowering the cost of production. This ratio allows us to compare the performances and profitability of companies of very different sizes, which would be impossible to do only based on absolute values. ACCOUNT FOR MULTIPLE PERFORMANCE OBLIGATIONS When we sell multiple products/services, we have to identify the performance obligations associated with each contract. Then we close this account to the Income summary. In the periodic method, no adjustment is required for inventory shrinkage or for returns. However, there is still an adjustment we need to make: the Estimated Returns Inventory: there are 2 ways to do this on the periodic system. - Including it in the Ending Inventory value, however this changes the actual value of the inventory on hand . - Using the same adjustment as in the perpetual system. Chapter 6 Merchandise inventory 1.MERCHANDISE INVENTORY PRINCIPLES CONSISTENCY PRINCIPLE The consistency principle states that businesses should use the same accounting methods and procedures from period to period. DISCLOSURE PRINCIPLE The disclosure principle holds that a company should report enough information for outsiders to make knowledgeable decisions for the company, including, for example, the methods used to account for merchandise inventories. MATERIALITY CONCEPT The materiality concept stated that a company must perform strictly proper accounting for items which are significant to the business’s financial situation. For example, $10,000 is material to a small business with sales of $100,00 but not to a company with sales of $1 billion. This is important to consider when it comes to figuring out which accounting mistakes we can ignore. CONSERVATISM Conservatism means a business should report the least favourable option in the financial statements when two or more possible options are presented. For example - we anticipate no gains and provide for all probable losses - we record an asset at the lowest reasonable amount and a liability at the highest reasonable amount - when there is a question, we record an expense rather than an asset - we undervalue our business, rather than overvaluing it 2.HOW ARE MERCHANDISE INVENTORY COSTS DETERMINED (perpetual method) At the end of the period: - Count the units in the ending inventory and assign dollar amounts to the account - Determine the units sold during the period and assign dollar amounts to Cost of Goods Sold. - Each unit originally cost $350 - Ending inventory = 4 units x $350 per unit= $1,400 - COGS= 14 units x $350 per unit=$4900 3.INVENTORY COSTING METHODS When the costs are different for different groups we have different methods to approximate the flow of inventory costs in order to determine the amount of cost of goods sold and ending merchandise inventory. - Newest items sold first (Last-in, first-out)------ not allowed internationally because it is not consistent with the physical flow of the inventory, since it is unlikely that a company sells the newest items first; however, it is very common where it is allowed (Italy, USA) because it brings many benefits such as tax benefits and increases the purchasing power of the company in case of inflation. - Oldest items sold first (First-in, first-out) - Weighed-average - Specific identification: I know exactly the cost of each item. THE SPECIFIC IDENTIFICATION METHOD It is a method based on the specific cost of particular units , such as automobiles, jewels and real estate. Example: on august 15 1 tablet sold cost $350 and 3 cost $360 each. On august 31, 1 cost $350 and 9 cost $380. FIRST IN FIRST OUT METHOD The FIFO method assumes the first units purchased are the first to be sold: it is very used because it is realistic and consistent with the flow of merchandise. Cost of Goods Sold is based on the oldest purchases, while Ending Inventory closely reflects current replacement cost. Cost of goods available for sale is the total cost spent on inventory that was available to be sold during a period. LAST IN FIRST OUT METHOD It is the opposite of FIFO. As inventory is sold, the cost of the newest item in inventory is assigned to each unit as COGS. COGS closely reflects current replacement cost, while Ending Inventory contains the oldest costing units. It is preferred for tax purposes because the Cost of Goods Sold is higher, making the income (and therefore the income tax) lower. Therefore, not all jurisdictions allow it, since it is also not realistic and consistent with the actual flow of inventory. WEIGHED AVERAGE METHOD It computed a new weighted-average cost per unit after each purchase. Weighted-average cost per unit is determined by dividing the cost of goods available for sale by the number of units available. Both Ending Inventory and Cost of Goods sold are based on the same weighted-average cost per unit. Weighted average of a unit = cost of goods available/number of units. 5.THE LOWER-OF-COST-OR-MARKET RULE This rule is an important rule based on conservatism; it requires that inventory be reported in the financial statements at the lower of the inventory’s historical cost or its market value (=current replacement cost). Example A company pays $3000 for inventory; at the end of the period, it can be replaced for only $2200 and the decline in value appears permanent. Instead of debiting COGS it would be best to debit the new account Impairment expense. If market value was higher than cost, we wouldn’t need any entry: only if market value decreases below cost do we need an adjustment. 6.INVENTORY TURNOVER The inventory turnover ratio measures how quickly the inventory is sold, and it should be evaluated against industry averages: a high rate indicates ease of selling, a low one indicates difficulty of selling. We must keep in mind that holding inventory is expensive, because you need to finance it and therefore you will have to increase equity or liabilities. The goal is to sell the inventory as quickly as possible. If we calculate 365/Inventory turnover, we get the days’ sales in inventory ratio, which measures the number of days it would take for the merchandiser to sell ALL of its inventory, even with 0 production. Chapter 8 Receivables A receivable is the right to receive cash in the future from a current transaction. It occurs when a business sells goods or services to another party on account, or when a business lends money to another party. It is a monetary claim against a business or an individual. It is an asset. Each receivable transaction involves 2 parties: - The creditor = they receive a receivable and will collect cash from the customer/borrower - The debtor = they take on an obligation/payable (a liability) which they will have to pay with cash later 1.TYPES OF RECEIVABLES Accounts receivables represent the right to receive cash in the future from customers for goods or services performed. It is generally collected within 30 to 60 days (depending on the conditions of the market in each country) Notes receivables usually have longer terms than accounts receivable (they can be current but also long term) and they are more formal (the promissory note is signed by the debtor as proof of the liability: they represent the promise to pay a fixed amount of principle plus interest by a certain due date, called the maturity date. There are other types of receivables, such as dividends receivable, interest receivable and taxes receivable. Receivables are classified as either current or long-term, depending on whether they will be collected within 1 year or not. It is important to have internal control over cash payments received by mail (checks) or online (EFT) and a critical element of it is separating cash-handling and accounting duties. For example, credit departments (which evaluate customers’ credit applications, in order not to lose sales to good customers and at the same time to avoid issuing receivables that will never be collected) should have no access to cash, and those who handle cash should not grant credit to customers. Example The control account, Accounts receivable, shows a balance of 15,000$; the sum of the individual customer accounts in the subsidiary ledger equals that number. When the company collects cash from both customers, the following journal entry is made: Companies must wait to receive cash from sales on account, and sometimes accounts are never collected which might lead to legal action, which is very expensive and time-consuming. Options to decrease collection time while transferring the risk of noncollection to a third party include credit and debit card sales or factoring and pledging receivables. - Credit card and debit cards offer multiple advantages: firstly, they attract customers in that they offer the convenience of not having to pay cash immediately or to pay cash but electronically and not with currency or by check. Moreover, they enable businesses to not worry about checking every customer’s credit rating, keeping records or even collecting the money because these responsibilities are of the card issuer. Instead of collecting cash from the customer, the seller receives cash from the card issuer. - When a company factors its receivables, it means that they are sold to a finance company or bank (called the factor) in exchange for a fee: the factor now collects the cash on the receivables and gives it to the business. - When a company pledges its receivables, it means they are used as security for a loan: the company is still responsible for their collection but it uses this money to pay off the loan with interest; if the loan is not paid, the bank can collect on the receivables. 2.UNCOLLECTIBLES Bad Debts Expense is not debited when a company writes off an account receivable when using the allowance method because the company has already recorded the Bad Debts Expense as an adjusting entry. If the customer makes payment on a receivable that has already been written off, then the business will need to reverse the write-off and record the receipt of cash: 3.ESTIMATING AND RECORDING BAD DEBTS EXPENSE The estimation is based upon past experience, the average of the industry, the economy or other variables which are specific to the customer or to the type of transaction (maybe the customer has stopped paying other companies). There are 3 methods to estimate uncollectibles using the allowance method: - Percent-of-sales - Percent-of-receivables - Aging-of-receivables PERCENT-OF-SALES METHOD This method (also known as the income-statement approach) computes bad debt expense as a percentage of net credit sales (although some companies use all sales. Example: *it’s past experience which suggests that 0,5% of credit sales (total=$60,000) will be uncollectible the following entry is recorded at the end of the accounting period to recognize bad debts expense for the year. PERCENT-OF-RECEIVABLES METHOD This method computes bad debts expense as a percentage of accounts receivables. Example: A company’s unadjusted accounts receivables balance is $6375 and 4% of accounts receivables is estimated to be unreceivable. The Allowance of Bad Debts account has a credit balance of $55 so the adjustment is $200. We report the result of our calculation in the following entry. If the company has a debit balance before the adjustment, instead of subtracting the unadjusted balance of the Allowance for Bad Debts from the target balance, the unadjusted balance will be added to the target balance. AGING-OF-RECEIVABLES In this method, businesses group individual accounts based on how long the receivable has been outstanding, and different percentages are applied to each category. The target balance is calculated using the aging schedule and it is always reported as a credit balance. With the value we found, we make the following entry at the end of the period: COMPARING ALLOWANCE METHODS We do not wait until the maturity date to recognize the revenue, we do that at the end of the accounting period. For example, if a note was signed on sept. 30th 2019, we first recognize the revenue at the end of the period (dec. 31); 3 months’ worth of interest have been accrued. For 2020, the company earns 9 months’ worth of interest: On the maturity date, the company will receive cash for the principal amount + interest. The company considers the note honored and makes the following entry. DISHONORED NOTES RECEIVABLE When a maker dishonors a note, the dishonored note and the unpaid interest are transferred to Accounts receivable, since the debtor still owes the payee; then this account can be written off under the direct write-off method or the allowance method, if at a later date the payee still can’t collect the payable If a maker dishonours a note, it is made public and so the maker is classified as a high risk investment: this will make getting new loans much harder. Example 6.THE ACID-TEST RATIO The acid-test ratio, also known as quick ratio, is an improvement of the current ratio (current assets/current liabilities). It is used to measure a company’s ability to pay its current liabilities through quick assets (cash, cash equivalents, short-term investments and net current receivables), and it is more stringent than the current ratio. The higher it is, the more able the business is to pay its current liabilities if they were to become due immediately. In general, an acid-test ratio of 1,00 or higher is safe, but it depends on the industry. 7.ACCOUNTS RECEIVABLE TURNOVER RATIO The accounts receivable turnover ratio measures the number of times the company collects the average accounts receivable balance in a year: the higher the ratio, the faster the cash collections. 8.DAYS’ SALES IN RECEIVABLES Days’ sales in receivables, also called the collection period, indicates how many days it takes to collect the average level of accounts receivable. This number should be close to the number of days customers are allowed to make payment when credit is extended, and it should be relatively short, because the shorter the period, the more quickly the organization can use its cash. Chapter 9 Plant assets, natural resources and intangibles 2.ACCOUNTING FOR DEPRECIATION of PP&E Depreciation is the allocation of a plant asset’s cost over its useful life; it is an application of the matching principle: it matches the expense against the revenue generated from using an asset. All assets except land wear out as they are used, and some may become obsolete before they wear out: this means that a newer asset can perform the same job more efficiently, and in this case the asset’s useful life is significantly shorter than its physical life. This phenomenon is kept into consideration when we calculate the useful life of an asset. Impairment losses are further losses on top of normal depreciation. Depreciation of a plant asset is based on 3 main factors: - Capitalized cost: all items paid for the asset to perform its intended function - Estimated useful life: how long the company expects it will use the item, based on experience and judgment. It is measured in time or usage, and it could be shorter that the actual physical life of the asset - Estimated residual value at the end of the useful life: the asset’s expected value at the end of its useful life, and consequently the amount the company expects to receive when it scraps/sells/trades the asset. Depreciable cost= cost – estimated residual value There are 3 methods do depreciate plant assets: - Straight-line method - Units-of-production method:it is based on the actual use of the asset, and not on time (for example, for cars we use miles, and for machines we use machine hours) - Double-declining-balance method: the asset is depreciated quickly when it is new and slowly when it gets old. STRAIGHT-LINE METHOD It allocates an equal amount of depreciation to each year: SLD= (Cost-Residual value)/Useful life Journal entry: Depreciation expense is reported on the income statement, while Accumulated depreciation, a contra asset, is reported on the balance sheet following the Trunk account. The book value of the asset, cost minus accumulated depreciation, is reflected on the balance sheet as well: UNITS-OF-PRODUCTION METHOD This method allocates a varying amount of depreciation based on the asset’s usage. It depreciated by units, rather than by years. There are 2 steps in this calculation - Depreciation per unit= (Cost- residual value)/Useful life in units - Units-of-production depreciation= depreciation per unit x current year usage DOUBLE-DECLINING BALANCE METHOD It is an accelerated depreciation method, which expenses more of the asset’s cost near the start of its life and less towards the end. It can be used for technological assets which are the most efficient and effective when they are new. Double-declining-balance depreciation= (Cost- accumulated depreciation) x 2 x (1/Useful life) PARTIAL YEAR DEPRECIATION When a business purchases an asset during the year, it should record depreciation only for the portion of the year that the asset was used in the operations of the business. The half month convention is used for assets purchased during the month, and it states that if we purchase the asset before or on the 15th, we record depreciation for the entire month, while if we purchase it after the 15th we do not record it at all until the following month Straight-line depreciation: [(Cost- residual value)/useful life] x (Number of months/12 months) CHANGING ESTIMATES OF A DEPRECIABLE ASSET As the asset is used, the business may change its estimated useful life or estimated residual value, so the business must recalculate depreciation expense both for the current year and for the future, while prior years are not restated. The asset’s remaining depreciable book value is spread over the asset’s remaining life. Revised depreciation: (Book value – revised residual value)/Revised useful life remaining. Property, plant and equipment are reported at book value on the balance sheet; sometimes they are reports as a single amount, with the cost and the accumulated depreciation disclosed in the notes. Some companies report their buildings at market value 3.DISPOSALS OF PLANT ASSETS When as asset wears out or becomes obsolete, the business can either: - Discard it - Sell it - Exchange it for another asset In any case, we must bring the depreciation up to date, remove the old, disposed-of asset and associated accumulated depreciation from the books, record the value of any cash received (or paid) and determine the amount of any gain or loss (keep in mind that selling a plant asset is not its purpose). We must close the contra asset before disposing of the asset. As a first step, we bring the depreciation up to date. We have a 1500 $ loss so we record the following entry to dispose of the equipment: At that point, we have 3 possibilities as to how to dispose of the plant asset: we can scrap it (and we will have an automatic loss), we can sell it (with either a gain or a loss) or we can exchange it for another asset (with either a gain or a loss). ---- accumulated depletion is a contra asset, just like accumulated depreciation; indeed, we can notice the entry looks like the one we must make for depreciation. 5.INTANGIBLE ASSETS Intangible assets are assets that have no physical form, like patents, copyrights, trademarks and other creative works; their purpose is to convey special rights. Because they are very hard to measure, sometimes they are not reported in financial statements, and therefore these resources, which investors value greatly, are underestimated. Intangible assets that are purchased are recorded at cost, and they are expensed through amortization, which is the allocation of the cost of an intangible asset to expense over its useful life; however, we must keep in mind that only intangibles with a definite useful life can be amortized. Intangible assets with an indefinite life are tested annually for impairment, which occurs when the fair value of the asset is less than its book value. When this happens, the company records a loss, because there has been a permanent decline in the value of the asset. PATENTS A patent is a grant which conveys an exclusive 20- year right to produce and sell an invention (which can be a process, product or formula). The acquisition of a patent is debited to the Patent account. Let’s say the useful life of the patents is determined to be five years, at which point the invention I have a right to will become obsolete; the amortization will be as follows. Unlike in depreciation, we do not usually use the contra asset Accumulated amortization, but we credit the asset Patent directly; this is because the residual value is generally zero an there is no physical asset to dispose of at the end of its useful life, so the asset removes itself from the books through amortization. COPYRIGHTS AND TRADEMARKS - Copyright: exclusive right to reproduce and sell a book, musical, composition, film or any other work of art or intellectual property. It is granted for the life of the creator + 70 years - Trademark: it represents distinctive identifications of products or services, such as the Nike “swoosh” or McDonald’s “golden arches”. FRANCHISES AND LICENCES - Franchises: they are privileges granted by a business to sell goods or services under specified conditions - Licenses: they are privileges granted by the government to use public property in performing services GOODWILL When buying another company, goodwill is the value paid above the net worth of the assets (assets – liabilities) of the company we acquire. It has no definite useful life so it is not amortized, but it is subject to impairment testing. Example We pay 10 million $ but the company is worth 8 million $ in net assets (9 million $ assets – 1 million $ liabilities), so we have 2 million $ of goodwill. To sum it up: - Plant assets are subject to depreciation - Natural resources are subject to depletion - Intangible assets are subject to amortization Chapter 10 Investments FINANCIAL INSTRUMENTS - Debt instrument: it represents the right to collect cash in the future + interest (or obligation to pay cash + interest in the future, from the point of view of the issuer), usually after lending (borrowing) money (bonds/loans) - Equity instrument: it represents position of shareholder in a corporation (shares) SECURITIES Securities are a subset of financial instruments: they are tradeable financial instruments that can be sold to someone else, and represent financial value through a certificate. They can either be debt or equity. - The most common equity securities are called shares, and they are investments in stock ownership in another company; for this reason they pay cash dividends or issue stock dividends. - Debt securities are commonly bonds or notes: they are investments issued by another company and represent a credit relationship with said company (or sometimes a governmental entity). They can easily be transferred/traded through sale in financial markets, and they pay interest for a fixed period and a final payment of face value at the end of the term. The security is an asset because it can produce future benefits, which means I can sell them or I can get dividends. The investor is the owner of a bond or share of stock; the investee is the corporation which issues the bond or stock to the investor. WHY DO WE INVEST: - To invest excess cash in order to generate investment income Sales tax is not an expense, it is a current liability: the company collects sales tax and forward it to the state at regular intervals, therefore, until this happens, the company owes this amount to the state. INCOME TAX PAYABLE The government requires corporations to pay income tax on their net income; the amount of taxes the corporation owes and still hasn’t paid is classified as Income Tax Payable. Example When the company makes payment, we’ll have the following entry: UNEARNED REVENUE Unearned revenue arises when a business has provided cash before providing goods or performing work, and therefore the revenue can’t be recognized; the company has an obligation to provide goods or services to the customer in the future. It clearly is an operative liability. Example A company has received $900 on May 21st for a month’s work starting from that date, and at the time of the journal entry, the work hasn’t been provided yet. After 10 days, the company has performed 1/3 of the work and therefore earned 1/3 of the revenue, therefore the following entry is made: SHORT-TERM NOTES PAYABLE A short-term note payable represents a written promise by a business to pay a debt plus interest within one year or less. Example: we buy inventory with a 10%, 90-day note payable for $8,000. When the note is due, we pay the note plus interest and record the following entry: When we borrow cash from banks, the bank requires a business to sign a promissory note stating that the business will pay the principal plus interest at a specific maturity date. Example: we borrow $10,000 from a bank at 6% for 5 months, starting from Nov. 1st At the end of the year we accrue interest expense for the 2 months as follows: During the following year, the interest on this note for the 3 remaining months is $150; the final payment is recorded as follows (we remove interest payable and note payable from the books, since we paid them off): CURRENT PORTION OF LONG-TERM NOTES PAYABLE Long-term notes payable are reported in the long-term liability section of the balance sheet; if they are paid in installments, the business reports the current portion of notes payable (current maturity) as a current liability while the remainder is classified as long-term. Dr Long term debt Cr Short term debt 20 20 2.PAYROLL TRANSACTIONS Payroll, also called employee compensation, creates liabilities for a business, and it is the major expense for service organizations. Another big expense is pensions: they become a problem when pensions are more than the people working, since they pay for today’s pensions. Two pay amounts are important for accounting purposes - Gross pay is the total amount of salary, wages, commissions and bonuses earned by the employee during a pay period, before taxes or any other deductions; it’s an expense to the employer. - Net pay (or take-home pay) is the amount an employee gets to keep after deductions Long-term liabilities Long-term liabilities are liabilities that do not need to be paid within one year or within the entity’s operating cycle; they are reported in the long-term liability section of the balance sheet. Examples are long-term notes payable and mortgages payable. They can be paid in installments in order to be more sustainable: the current portion is the principal amount that will be paid within one year (current liability), while the remaining portion is long-term. LONG-TERM NOTES PAYABLE A company signs a $20,000 note payable, due in four annual payments of $5,000 plus 6% interest each December 31st. In order to deal with this, we must write an amortization schedule which details each loan payment’s allocation between principal (in this case, $ 20, 000) and interest at the beginning and ending balances of the loan. Interest = beginning balance x interest rate x time Since the interest expense is calculated on the principal, which is decreasing with every installment payment, the interest expense decreases each year. In the simplest way to do this (see above), the principal payment is constant; in reality, the issue is that interest accrues on the debt every year, so for example in June 2020 the residual debt will be 15,000 + the interest accrued between January and June. PRESENT VALUE VS FUTURE VALUE ACCOUNTING notes payable= principal MORTGAGES Mortgages payable are long-term debts which are backed with a security interest in specific property (collateral). Unlike long-term notes, they are secured with specific assets , but otherwise they are similar. They commonly specify a monthly payment of principal and interest to the lender, usually a bank. Example A company purchases a building for £150,000, paying $49,925 in cash and signing a 30-year mortgage for $100,075, taken out at 6% interest payable in $600 monthly payments (principal + interest) beginning January 31, 2019. First mortgage payment: BONDS PAYABLE They are long term debts issued to multiple lenders called bondholders, usually in increments of $1000 per bond; the amount a borrower must pay back to the bondholders on the maturity date is called face value (value of bond + interest). The stated interest rate is the interest rate that determines the amount of cash interest the borrower pays and the investor receives each year. These values DO NOT change if the purchase price of the bond changes either because of a discount or a premium. The goal of bond investors is to earn interest. The bond certificate states the interest rate that the company will pay and the dates the interest is due, generally semiannually. For example, a five-year, 9% bond issued at the face value of $100,000 on 1/01/2018 will pay 10 semiannual interest payments of $4500 (100,000 x 9% x 6 /12) in addition to the face value payment of $100,000 at the maturity rate: Bonds are promises of payment, similar to a note: you are going to get back the entirety of the amount you lent at maturity date, and in the meantime each semester you are going to receive the interest on your loan. In order for the investment to be convenient, the borrower must be reliable, so it is important to assess the risk of the loan. Assuming the company is reasonably safe, let’s also assume they have a rating from an external agency which states the solvency risk (this is expressed in letters, from AAA – very safe - to D – junk bond). The higher the risk, the higher the interest (---the reward), and of course the opposite for low risk investments. Therefore, the value of the bond is dictated by the market. When it comes to making an investment, we must keep in mind a factor called the time value of money: this means that money earns interest over time, so in order for an investment in a $1000 (future value) bond which reaches maturity 3 years from now and carries no interest to be profitable, we would pay some amount (present value) less than $1000. In general, present value is always less than future value. The stated rate is the rate printed on a bond and it never changes; the market interest rate (also known as the effective interest rate) is the rate that investors demand to earn for loaning their money and it changes according to the conditions of the market: A bond can be issued at any prince agreed upon by the issuer and the bondholders, so either at face value, a discount or at a premium: - Discount: when the issue price is less than face value - Premium: when the issue price is above face value The issue price of a bond (expressed in percentage of face value) determines the amount of cash the company receives when it issues the bond. In all cases, however, the company must pay the bond’s entire face value at maturity. This means: - 12 of the company’s 9% bonds maturing in 2021 (indicated by “21” were traded - The bonds’ highest price on this day was $795 Bonds payable minus the discount gives the carrying amount of bonds, also known as carrying value or present value. The value of bonds fluctuates so holding on to them can be risky. STRAIGHT-LINE AMORTIZATION OF BOND DISCOUNT We can amortize a bond discount by using the straight-line method. See example above: the discount is divided over the 10 semiannual interest periods and $385 is amortized each period. The payment is less than the expense because we issued the bond at discount, so we have “extra” expenses to catch up on as time passes. Interest expense is the sum of stated interest and the amortization of discount. 2^ PAYMENT ON DEC. 31 balance sheet ISSUING BONDS AT A PREMIUM Bonds are sold at a premium when the stated interest rate is greater than the market interest rate, because they are obviously attractive to investors who are willing to pay more in order to gain a higher-than- average interest over time. The account Premium on Bonds payable is an adjunct account to Bonds payable, meaning it is directly related to said account, and has got the same normal balance, so it is added to the related account on the balance sheet. Example The bonds are priced at 104,100$, which is more than the face value the investor will receive at maturity date. This is a benefit for the company obviously, but this benefit must be spread over the life of the bond, and not only at sale or at maturity. Because of this, the expenses will be less than payments. The Premium is a liability, because it is very similar to an unearned revenue which will be recognized by lowering expenses over the course of the bond’s life. STRAIGHT-LINE AMORTIZATION OF BOND PREMIUM The beginning premium is 4,100, spread over 10 semiannual interest periods, therefore $410 (4100/10) are amortized each interest period. In this case interest expense equals stated interest minus the amortization of the premium of $410. HOW TO CALCULATE THE VALUE OF BONDS A dollar received today is worth more than one received in the future: the fact that invested cash earns interest over time is called the time value of money, and this concept is used to determine the values of bonds over time - Principal (p) : the amount of the investment or borrowing, either as a lump sum (single payment) or as an annuity (stream of equal cash payments made at equal time intervals) - Number of periods (n) : the length of time from the beginning of the investment or borrowing until termination. The shorter it is, the lower the total amount of interest paid or earned - Interest rate (i) : the percentage earned on the investment or paid on the borrowing The calculations work under the concept of compound interest: in this case, unlike in simple interest (which is calculated only on the principal amount), the interest is calculated on the principal and on all previously earned interest, with the assumption that the interest we earned will be reinvested and earn additional interest at the same interest rate. 1. Present value of a lump sum (where PV is the present value and FV the future value) 2. Present value of an annuity *R is the stated interest rate, i is the market interest rate. We can use these 2 concepts to determine the selling price of a bond: this is the sum of: - The present value of the principal amount to be paid at maturity - The present value of the future stated interest payments, an annuity Example 1- discount - Present value of principal - Present value of interest - Present value of bond payable Example 2 – premium - Present value of principal - Present value of stated interest