Download Asset section of the balance sheet

Summary Financial Accounting
Chapter 1 Financial Statements and Business Decisions
Accounting is a system that collects and processes (analyzes, measures and records) financial
information about an organization and reports that information to decision makers
Internal decision makers (like managers) and External decision makers (like stockholders) use the
reports produced by this system
-
Internal decision maker’s wants detailed information for their day-to-day planning. This is
called managerial or management accounting
The information for external decision makers (creditor, investors, suppliers and customers)
wants financial accounting reports. They don’t want details, just financial info
Remember
-
What categories of items (often called elements) are reported on each of the four
statements? (What information does a statement convey, and where can you find it?)
Hoe is the elements within a statement related? (these relationships are usually described by
an equation that tells you how the elements fit together)
Why is each element important to owners’ or creditors’ decisions? (How important is the
information to decision makers?
The Four Basic Financial Statements:
-
Income Statement
Balance Sheet
Statement of Retained Earnings
Statement of Cash Flows
o (Financial statements summarize the financial activities of the business)
The Balance Sheet:
-
-
Statement of financial position. A balance sheet reports the amount of assets, liabilities, and
stockholders’ equity of an accounting entity at a point in time.
Accounting entity. An accounting entity is the organization for which financial data are to be
collected (this must be precisely defined)
 Name of the entity
 Title of the statement
 Specific date of the statement
 Unit of measure
Basic Accounting Equation (Balance sheet equation):
o Assets = Liabilities + Stockholders’ Equity (financial position).
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Assets are the economic resources owned by the company. The items are measured at the
total cost incurred to acquire the asset
Liabilities are the company’s debts or obligations The notes payable result from cash
borrowings based on a formal written debt contract with lending institutions such as a bank
Stockholders’ equity indicates the amount of financing provided by owners of the business
and earnings.
o The investment of cash and other assets in the business by the owners is called
contributed capital.
o The amount of warnings (profits) reinvested in the business (and thus not distributed
to stockholders in the form of dividends) is called retained earnings.
The income sheet
-
The Income Statement (Statement of Income, Statement of Earnings, and Statement of
Operations) reports the revenues less expenses of the accounting period.
The Accounting Period is the time period covered by the financial statements.
Revenues -/- Expenses = Net income.
o Revenues: Are earned by companies from the sales of goods or services to
customers whether or not they have yet been paid for.
o Expenses: represent the dollar amount of resources the entity used to earn revenues
during the period of time. Expenses reports in one accounting period may actually be
paid for in another accounting period.
o Net income (or net earnings): the excess of total revenues over total expenses. If
total expenses exceed total revenues, a net loss is reported. Net income normally
does not equal the net cash generated by operations.
Statement of Retained Earnings
-
The statement reports the way that net income and the distribution of dividends affected the
company’s financial position during the accounting period.
The retained earnings equation:
o Beginning Retained Earnings + Net Income -/- Dividends = Ending Retained
Earnings.
Statement of Cash Flows
-
The Statement of Cash Flows reports inflows and outflows of cash during the accounting
period in the categories of operating, investing, and financing.
The Cash Flow Statement Equation describes the causes of the change in cash reported on
the balance sheet from the end of last period to the end of the current period.
 + / -/- Cash Flows from Operating Activities (CFO)
+ / -/- Cash Flows from Investing Activities (CFI)
+ / -/- Cash Flows from Financing Activities (CFF)
Change in Cash
o Cash Flows Elements
 Cash Flows from Operating Activities are cash flows that are directly related
to earning income.
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o
o
Cash Flows from Investing Activities are cash flows related to the acquisition or sale
of the company’s productive assets.
Cash Flows from Financing Activities are directly related to the financing of the
enterprise itself.
Relationships among the four basic financial Statements
-
Net income from the income statement increases ending retained earnings on the statement
of retained earnings.
Ending retained earnings from the statement of retained earnings is one of the two
components of stockholders’ equity on the balance sheet.
The change in cash on the cash flow statement added to the beginning-of-the-year balance in
cash equals the end-of-the-year balance in cash on the balance sheet.
Notes are an integral part of these financial statements
Three basic types of notes:
-
Description of the accounting rules applied in the company’s statements.
Additional detail about a line on the financial statements.
Additional financial disclosures about items not listed on the statements themselves.
Price/ Earnings Ratio:
Price/ Earnings Ratio = Market Price
Net Income
Generally Accepted Accounting Principles
-
-
-
-
Generally Accepted Accounting Principles (GAAP)
o Measurement rules used to develop the information in financial statements.
 Has effect on the following:
 The selling price of a company’s stock
 The amount of bonuses received by management and employees
 Loss of competitive information to other companies
 This is why the GAAP is so important. And is actively debated to fit the
wishes of the companies without damaging the quality of the standards
Securities and Exchange Commission (SEC)
o U.S. government agency that determines the financial statements that public
companies must provide to stockholders and the measurement rules that they must
use in producing those statements
Financial Accounting Standards Board (FASB)
o Private sector body given the primary responsibility to work out the detailed rules
that become generally accepted accounting principles.
Since 2002, there has been substantial movement to develop international financial
reporting standards by the International Accounting Standards Board (IASB).
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Management Responsibility and the Demand for Auditing
To ensure the accuracy of the company’s financial information, management (it is primarily the task
of the management to fit the rules):
-
Maintains a system of controls over both the records and the assets of the company
Hires outside independent auditors to verify the fairness of the financial statements
Forms a board of directors to review these two safeguards.
Independent Auditors:
-
Auditors express an opinion as to the fairness of the financial statement presentation.
Independent auditors have responsibilities that extend to the general public.
An Audit is an examination of the financial reports to ensure that they represent what the claim and
conform with GAAP.
The Public company accounting oversight board (PCAOB) is the private sector body given the
primary responsibility to issue detailed auditing standards
Ethics, reputation and legal liability:
-
Appreciate the importance of ethics, reputation, and legal liability in accounting.
The American Institute of Certified Public Accountants (AICPA) requires that all members
adhere to a professional code of ethics.
An auditor’s reputation for honesty and competence is his/her most important asset.
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Chapter 2 investing and financing decisions and the balance sheet
Overview of the Conceptual Framework
The Primary Objective of External Financial Reporting is to provide useful economic information
about a business to help external parties make sound financial decisions: decision usefulness. The
information is necessary for decision makers
Most users need the information to project a business’s future cash inflows and outflows:
-
Can they pay enough interest on a loan over time
Can they pay back the principal n the loan when it is due
Can the pay enough dividends in the future
Can they be successful and be able to rise the stock price, enabling investors to sell their
stock for more than they paid
Qualitative Characteristics of financial information:
The objectives to provide useful information, information should be:
-
Relevant: Information can influence a decision; it is timely and had predictive and/or
feedback value
Reliable: Information is accurate, unbiased and verifiable
Information should also be Understandable, Comparable and Consistent.
Underlying Assumptions of Accounting:
-
Separate entity. Activities of the business are separate from activities of the owners, all other
persons and other entities
Unit-of-measure assumption states that accounting information should be measured and
reported in the national monetary unit.
Continuity (going-concern) assumption states that businesses are assumed to continue to
operate into the foreseeable future.
Time period. The long life of a company can be reported over series of shorter time periods.
Elements Financial Statements
-
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Asset: economic resources with probable future benefits owned but the entity as a result of
past transactions (in order of liquidity)
o Historic cost principle: requires assets to be recorded at historical cost-cash plus the
current dollar value of all noncash considerations given on the date of the exchange
o Current Asset: are assets the will be used or turns into cash within one year
inventory is always considered a current asset regardless of the time needed to
produce and sell it (vlottende activa en liquide middelen)
o Long term assets (or noncurrent): Are assets that to be used or turned into cash
beyond the coming year.
Liability: probable debts or obligations of the entity that result from past transactions which
will be paid with assets or services (creditors) (in order of maturity, how soon an obligation is
to be paid)
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o
-
-
Current liabilities: obligations that will be settled by providing cash, goods or
services within the coming year
Stockholders’ Equity: financing provided by owners and operations.
o Contributed capital: the cash provided by the owners
o Retained earnings: refers to the cumulative earnings of a company that are not
distrusted to the owners and are reinvested in the business
Revenue: increase in assets or settlement of liabilities from ongoing operations.
Expense: decrease in assets or increase in liabilities from ongoing operations.
Gain: increase in assets or settlement of liabilities from peripheral activities.
Loss: decrease in assets or increase in liabilities from peripheral activities.
Exceptions to the measurement and reporting principles
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Materiality: exception suggests that small amounts that are not likely to influence a user’s
decision can be accounted for in the most cost-beneficial manner
Conservatism: exception suggests that care should be taken not to overstate assets and
revenues or understate liabilities and expenses
What Business Activities Cause Changes in Financial Statement Amounts?
Nature of Business Transactions:
A transaction is:
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An exchange of assets or services for assets, services or promises to pay between a business
and one or more external parties to a business
A measurable internal event such as the use of assets in operations.
An account is a standardized format that organizations use to accumulate the dollar effect of
transactions on each financial statement item. Each company establishes its own chart of accounts
How Do Transactions Affect Accounts?
Principles of Transaction Analysis
-
Transaction analysis is the process of studying a transaction to determine its economic effect
on the business in terms of the accounting equation.
There are two principles underlying the transaction analysis:
o Every transaction affects at least two accounts
o The accounting equation must remain in balance after each transaction:
 Asset (A) = Liabilities (L) + Stockholders' Equity (SE)
A
=
L
+
SE
Dual effects are actually the double-entry system. If an element changes, another element will
change in the opposite direction. (dubbelzijdig boekhouden)
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Systematic transaction analysis includes the following steps:
1. Accounts and effects:
a. Identify the accounts (by title) affected and classify them by type of account
b. Determine the direction of the effect
2. Balancing:
c. Verify that the accounting equation, A= L + SE, remains in balance
The Direction of Transaction Effects
-
Debit means the left side of an account
Credit means the right side of an account
Journal Entry is an accounting method for expressing the effects of a transaction on accounts
in a debits-equal-credits format
As a group, the accounts are called a ledger
The T-account is a tool for summarizing transaction effects for each account, determining
balances, and drawing inferences about a company’s activities
How is the Balance Sheet Prepared?
-
-
It is possible to prepare a balance sheet at any point in time using the balances in the
accounts.
Three ratio’s that provide information about management ‘s effectiveness at:
o managing debt and equity financing, financial leverage ratios in Chapter 2,
o utilizing assets, total asset turnover ratio and
o controlling revenues and costs, net profit margin in Chapter 3 all for the purpose of
enhancing returns to shareholders (Chapter 4)
Financial leverage ratio:
Average Total Assets
Average Stockholders’ Equity
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Investing and Financing Activities
Investing activities:
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Purchasing long-term assets an investments for cash
Selling long-term assets an investments for cash
Lending cash to others
Receiving principal payments on loans made to others
Financing Activities:
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Borrowing cash from banks
Repaying the principal on borrowings from banks
Issuing stock for cash
Repurchasing stock with cash
Paying cash dividends
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Chapter 3 operating decisions and the income statement
The long-term objective for any business is to turn cash into more cash. They must generate money
from operations (that is, form the activities for which the business was established.
1. Acquire inventory and the services of employees
2. Sell inventory or services to customers
The operating (cash-to-cash) circle is the time it takes for a company to pay cash to suppliers, sell
goods and services to customers and collect cash from customers
The Operating Cycle
Time Period Assumption: The long life of a company can be reported over a series of shorter time
periods.
1. Recognition Issues: When should the effects of operating activities be recognized (recorded)?
2. Measurement Issues: What amounts should be recognized?
Elements of the income statement:
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Revenues: Increases in assets or settlement of liabilities from ongoing operations.
o Restaurant sales revenue: revenue from selling goods
o Franchise fee revenue: revenue from franchises. They have to pay to use the brand
name
Expenses: Decreases in assets or increases in liabilities from ongoing operations. Not all cash
expenditures are expenses, expenses are necessary to generate revenues
o Cost of sales: The cost of any supplies that are used to produce products are
expenses as they are used
o Salaries expense: Self speaking
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o
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All other operating expense: All kind of different expenses, such as rent expenses,
advertising expenses, etc.
Gains: Increases in assets or settlement of liabilities from peripheral transactions.
Losses: Decreases in assets or increases in liabilities from peripheral transactions.
Investment income: using excess cash to purchase stock or bonds in other companies. When
this is not the mean activity, are not operating revenue
Interest expense: likewise for the interest expenses. It is a financial activity and when it’s not
your main activity than excluded from the operating expense
Business Activities:
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Primary Operating Activity is selling goods or delivering services.
o Proceeds of primary operating activities are reflected in Revenues.
Peripheral Activities e.g. investments, savings, selling assets.
o Proceeds of peripheral activities are reflected in other revenues and gains.
Primary Operating Expenses:
-
Cost of sales (used inventory)
Salaries and benefits to employees
Depreciation, depletion, and amortization
Other costs e.g. advertising, insurance, interest expenses, and income tax expense
As al last expense there is Income Tax. This has to be paid over the income before income taxes (or
pretax income). This is a certain percentage.
Corporations are taxable entities. Income tax expense = Income before Income Taxes × Tax Rate
(Federal, State, Local and Foreign) Bottom-line is Net income
Also Earnings per Share (EPS) is presented:
Net Income
Weighted Average Number of Common Shares Outstanding
Cash basis accounting records revenues when cash is received and expenses when cash is paid
Accrual accounting (not Cash Accounting)
Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes
them occurs, not necessarily when cash is paid or received. That is, revenues are recognized when
they are earned and expenses when they are incurred
Two principles:
1. Revenue Principle
2. Matching Principle
Revenue Principle Recognize revenues when (all four):
1. Delivery has occurred or services have been rendered.
2. There is persuasive evidence of an arrangement for customer payment.
3. The price is fixed or determinable.
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4. Collection is reasonably assured.
Cash revenues, different kinds:
-
If cash is received before the company delivers goods or services, the liability account
UNEARNED REVENUE is recorded.
When the company delivers the goods or services UNEARNED REVENUE is reduced and
REVENUE is recorded.
If cash is received after the company delivers goods or services, an asset ACCOUNTS
RECEIVABLE is recorded. When the cash is received the ACCOUNTS RECEIVABLE is reduced.
Matching Principle
The Matching principle requires that expenses be recorded when incurred in earning revenue
Matching Costs with Revenues: Resources consumed to earn revenues in an accounting period
should be recorded in that period, regardless of when cash is paid.
-
If cash is paid before the company receives goods or services, an asset account, PREPAID
EXPENSE is recorded.
When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded.
If cash is paid after the company receives goods or services, a liability PAYABLE is recorded.
When cash is paid the PAYABLE is reduced.
The expand transaction analysis model
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For Example:
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Statements overview
-
-
-
Income Statement
o Revenues – Expenses = Net Income
Statement of Retained Earnings
o Beginning Retained Earnings + Net Income – Dividends Declared = Ending Retained
Earnings
Balance Sheet
o Assets = Liabilities + Stockholders’ Equity (Stockholders’ Equity = Contributed Capital
+ Retained Earnings)
Statement of Cash Flows
o Change in Cash = Cash from Operating Activities + Cash from Investing Activities +
Cash from Financing Activities
Relationship between Financial Statements (articulation):
-
Net income of the Income Statement is added to the Statement of Retained Earnings
Ending of Retained Earnings of the Statement of Retained Earnings is added to Shareholders‘
Equity of the Balance Sheet
Change of Cash of the Balance Sheet is disclosed in the Statement of Cash Flows
Total asset turnover ratio
Asset Turnover Ratio =
Sales (or Operating) Revenues
Average total Assets
-
Measures the sales generated per dollar of assets
Creditors and analysts use this ratio to assess a company’s effectiveness at controlling
(current and non-current) assets.
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Chapter 4 Adjustments, financial statements and the quality of earnings
The accounting Cycle
Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to
get the revenues and expenses into the “right” period.
During the period:
-
Analyze transactions.
Record journal entries.
Post amounts to general ledger.
At the end of the period:
-
Prepare a trial balance to determine if debits equal credits
Adjust revenues and expenses and related balance sheet accounts
Prepare financial statements and Disseminate statements to users.
Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post
to ledger
The (unadjusted) Trial Balance is a list of all accounts with their balances to provide a check on the
quality of the debits and credits
-
A listing of individual accounts, usually in financial statement order.
Ending debit or credit balances are listed in two separate columns.
Total debit account balances should equal total credit account balances.
Accumulated depreciation is a contra-asset account. It is directly related to an asset account
but has the opposite balance.
Cost - Accumulated depreciation = BOOK VALUE
Purpose of adjustments
Cash is not always received in the period in which the company earns revenue; likewise, cash is not
always paid in the period in which the company incurs an expense.
Adjusting entries are entries necessary at the end of the accounting period to measure all revenues
and expenses of that period.
-
Revenues are recorded when they are earned (the revenue principle)
Expenses are recorded when they are incurred to generate revenue (the matching principle)
Assets are reported at amounts that represent the probable future benefits remaining at the
end of the period
Liabilities are reported at amounts that represent the probable future sacrifices of assets or
services owed at the end of the period
Two types of Adjusting Entries
-
ACCRUALS: revenues earned or expenses incurred that have not been previously recorded.
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-
DEFERRALS: Receipts of assets or payments of cash in advance of revenue or expense
recognition.
Examples:
-
Accrued Revenue
o interest earned during the period
Accrued Expense
o wages earned by employees but not yet paid
Deferred Revenue
o rent received in advance
Deferred Expense
o prepaid rent, advertising, and insurance
Recall that accrued expenses are expenses incurred in the current period but not billed or paid until
the next accounting period.
Examples are:
-
interest expense incurred on debt,
wages expense owed to employees, and
utilities expense
Certain circumstances require adjusting entries to record accounting estimates.
Examples include:
-
Depreciation
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-
Bad debts
Income taxes
Depreciation
The accounting concept of depreciation involves the systematic and rational allocation of the cost of
a long-lived asset over multiple accounting periods it is used to generate revenue
Depreciation is a cost allocation concept, not a valuation concept
The journal entry required is:
-
to debit Depreciation Expense and
to credit an account called Accumulated Depreciation
o Accumulated Depreciation is a contra-asset account
The next step in the accounting cycle is to prepare the financial statements:
1.
2.
3.
4.
Income Statement,
Statement of Stockholders’ Equity,
Balance Sheet, and
Statement of Cash Flows.
Notice that:
-
-
Revenues minus expenses yields net income on the income statement
Net income (or net loss) and dividends to stockholders affect the Retained Earnings and any
additional issuances of stock during the period affect the balance in Contributed capital, both
on the Statement of Stockholders’ Equity
Stockholders’ Equity is a component of the Balance sheet
Thus, if a number on the income statement changes or is in error, it will impact the other statements.
Financial Statement relationships (articulation):
-
Net income increases retained earnings (a net loss decreases retained earnings).
Dividends decrease retained earnings.
Net Income = Revenue – Expenses
Contributed Capital and Retained Earnings make up Stockholders’ Equity.
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-
Assets = Liabilities + Stockholders’ Equity
Income Statement (prepared first)
-
Contains revenues and expenses.
Earnings per Share (EPS) must be reported on the Income Statement. Measured by time
period
o 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 =
𝑁𝑒𝑡𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 (𝑐𝑢𝑟𝑟𝑒𝑛𝑡𝑙𝑦 ℎ𝑒𝑙𝑑 𝑏𝑦 𝑠ℎ𝑎𝑟𝑒𝑐𝑜𝑙𝑑𝑒𝑟𝑠) 𝑑𝑢𝑟𝑖𝑛𝑔 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑
Statement of Stockholders’ Equity
-
Net income appears on the statement of stockholders’ equity as an increase in Retained
Earnings.
Balance Sheet
-
Assets = Liabilities + Stockholders’ Equity
Net book value reflects the actual value of assets after Accumulated depreciation
(afschrijvingen)
Statement of Cash Flows is a list of all transactions of the period that affected the Cash account
(asset). Three categories are:
-
Operating activities,
Investing activities, and
Financing activities.
Supplemental Disclosure:
-
Interest paid,
Income Taxes paid, and
A listing of the nature and amounts of significant non-cash transactions.
Net profit margin indicates how effective management is at generating profit on every dollar of sales
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𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
Closing the books (end of the accounting cycle)
Permanent (real) accounts are the balance sheet accounts that carry their ending balances into the
next accounting period. Are not reduced to zero at the end of the accounting period.
-
Balance Sheet account balances carry forward from period to period.
o Assets, Liabilities and Stockholders’ Equity at 31 December 2008.
o A new year (1 January) starts with Assets, Liabilities and Stockholders’ Equity of the
prior year (31 December)
Temporary (nominal) accounts are income statements accounts that are closed to Retained earnings
at the end of the accounting period, for example Income Statement accounts
A closing entry transfers balances in temporary accounts to Retained earnings and establishes zero
balances in temporary accounts.
The following accounts are called temporary or nominal accounts and are closed at the end of the
period:
-
Revenues,
Expenses,
Gains,
Losses, and
Dividends declared.
Assets, liabilities, and stockholders’ equity (Balance Sheet) are permanent or real accounts, and are
never closed.
Two steps are used in the closing process:
-
-
Close revenues and gains to Retained Earnings.
o Debit: Sales Revenue
o Credit: Retained Earnings
Close expenses and losses to Retained Earnings.
o Debit: Retained Earnings
o Credit: Cost of Sales
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Companies that make relatively pessimistic estimates that reduce current income are judged to
follow conservative financial reporting strategies, and experienced analysts give these reports more
credence. These companies are viewed as having “higher quality” earnings.
After the closing process is complete, all income statement accounts have a zero balance.
Post-closing trial balance should be prepared at the last step of the accounting cycle to check that
debits equals credits and all temporary accounts have been closed.
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Chapter 5 Communicating and interpreting accounting information.
Corporate Governance refers to the procedures designed to ensure that the company is managed in
the interests of the shareholders.
Players in the Accounting Communication Process:
-
-
-
Management: Preparation
o CEO, CFO, Accounting Staff
o Guided by GAAP
Independent Auditors: Verification
o Partners, Managers, Staff
o Guided by GAAS
Information Intermediaries: Analysis and Advice
o Financial analysis, Information services
Board of directors elected by the stockholders to represent their interest, is responsible for
maintaining the integrity of the company’s financial reports.
An unqualified (clean) audit opinion is an auditor’s statement that the financial statements are fair
presentations in all material respect in conformity with GAAP
-
-
Users: Analysis and Decision
o Investors, Lenders, …
Government Regulators: Verification
o SEC Members
o Guided by SEC regulations
Netherlands Syllabus: Institutioneel kader
Earnings forecasts are predictions of earnings for future accounting periods
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Institutional investors are manager of pension, mutual, endowment and other funds that invest on
the behalf of others.
Private investors include individuals who purchase shares in companies
Lenders include supplies and financial institutions that lend money to companies.
The cost-benefit constraint suggests that the benefits of accounting for and reporting information
should outweigh the costs.
Guiding Principles for Communicating Useful Information
-
-
-
Primary Objective of External Financial Reporting
o To provide economic information to external users for decision making.
Primary Qualitative Characteristics
o Relevance: Timely and Predictive Feedback Value
o Reliability: Accurate, Unbiased, and Verifiable
Secondary Qualitative Characteristics
o Comparability: Across businesses
o Consistency: Over time
Relevant information can influence a decision, it is timely and had predictive a/or feedback
value.
Reliable information is accurate, unbiased and verifiable.
Consistent information can be compared over time because similar accounting method has
been applied.
Comparable information allows comparisons across businesses because similar accounting
methods have been applies
Material amounts are amount that are large enough to influence a user’s decision
Conservatism suggests that care should be taken not to overstate assets and revenues or
understate liabilities and expenses.
International Accounting Standards Board and Global Differences in Accounting
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-
GAAP: Generally Accepted Accounting Principles
IFRS: International Financial Reporting Standards
Difference in Accounting Standards
Extraordinary items
LIFO for inventory
Reversal of inventory write-downs
Basis of property, plant, and equipment
US GAAP
Permitted
Permitted
Prohibited
Historical cost
IFRS
Prohibited
Prohibited
Required
Fair Value or
Historical cost
The Disclosure Process
Press Releases are used to announce quarterly and annual earnings as soon as the verified figures
are available. It is a written public news announcement normally distributed to major news services.
Annual reports contain:
1. Four basic financial statements: income statement, balance sheet, stockholders’ equity or
retained earnings statement and cash flow statement.
2. Related notes (footnotes)
3. Report of Independent Accountants (auditor’s opinion) if the statements are audited
For public companies, annual reports are elaborate due to SEC reporting requirements:
-
-
A Non-financial Section
o A letter to the stockholders, a description of management’s philosophy, products,
successes, etc.
A Financial Section
o Summarized financial data for 5- or 10-years.
o Management Discussion and Analysis (MD&A).
o The four basic financial statements.
o Notes (footnotes).
o Independent Accountant’s Report and the Management Certification.
o Recent stock price information.
o Summaries of the unaudited quarterly financial data.
o Lists of directors and officers of the company and relevant addresses.
Quarterly Reports (nor audited)
-
Usually begin with short letter to stockholders
Condensed unaudited income statement and balance sheet for the quarter.
Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes
to the financial statements also may be omitted.
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SEC Reports
-
-
-
Form 10-K Annual Report: Due within 90 days of the fiscal year-end. Is the annual report that
publicly traded companies must file with the SEC,
o Contains audited financial statements.
Form 10-Q Quarterly Report: Due within 45 days of the end of the quarter. Is the quarterly
report that publicly traded companies must file with the SEC.
o Financial statements can be unaudited
Form 8-K Current Report: Due within 15 days of the major event date. Is used by publicly
traded companies to disclose any material event not previously reported that is important to
investors
o Financial statements can be unaudited.
Financial Statement Formats
Asset section of the balance sheet:
-
-
Current assets are assets that will be turned into cash or expire (be used up) within the
longer of one year or the operating cycle.
Property, plant and equipment include assets with useful lives of more than one year
acquired for use in the business rather than for resale. The amount is reported net of
accumulated depreciation.
Intangible assets have no physical existence and a long life. They include patents, copyrights,
trademarks, etc.
Liability section of a classified balance sheet:
-
Current liabilities are obligations that will be paid with current assets, normally within one
year.
Long-term liabilities are debts that have maturity dates extending beyond one year from the
balance sheet date.
Stockholders’ equity section of a classified balance sheet.
Contributed capital is often shown in two separate accounts:
-
-
Common stock is the money earned when the shares are new on the market. Par value is a
legal amount per share established by the board of director; it established the minimum
amount stockholder must contribute and had no relationship to the market price of the
stock. Common stock is the Par value * amount of shares sold.
Additional paid-in capital is the amount of contributed capital less the par value of the stock
Retained earnings are the total earnings of the company less the total dividends declared
since inception of operations.
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Balance Sheet Ratios and Debt Contracts
When a company borrows money, it often agrees to certain restrictions on activity. Ratios typically
part of the borrowing agreement includes:
÷÷
==
Total
Total Liabilities
Liabilities
Stockholders'
Stockholders' Equity
Equity
Debt-to-Equity
Debt-to-Equity Ratio
Ratio
Current
Current Assets
Assets
÷÷ Current
Current Liabilities
Liabilities
== Current
Current Ratio
Ratio
Classified income statement
Classified Income Statement may contain five sections:
1.
2.
3.
4.
5.
Continuing operations
Discontinued operations
Extraordinary items
Cumulative effect of changes in accounting methods
Earnings per share (EPS)
Other Items Reported on the Income Statement
In addition, companies may have non-recurring items. These non-recurring items may include:
-
Discontinued operations,
Extraordinary items,
Cumulative effect of changes in accounting methods.
These items are reported separately because they are not useful in predicting future income of the
company.
-
-
Extraordinary Items
o Unusual
o Infrequent
Show net of applicable taxes.
Cumulative Effect of Changes in Accounting Methods from one GAAP method to an
alternative GAAP method
o The change must be to a preferable method and must be disclosed in notes to
financial statements
General Format for the Classified Income Statement:
-
Gross sales minus any discounts, returns, and allowances during the period.
Cost of inventory sold.
Not related to the company’s primary operations. Usually includes interest income or
expense and any gains or losses from the retirement of equipment.
Common-Size Income Statement: Total revenue is equal to 100%.
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Diluted EPS: Stock options, debt securities, equity securities are assumed to be converted into
common stock at the beginning of the period.
𝐸𝑆𝑃 =
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑏𝑙𝑒 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑛𝑑 𝑎𝑣𝑎𝑟𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑟𝑒𝑝𝑜𝑟𝑡 𝑝𝑒𝑟𝑖𝑜𝑑
Gross profit (gross margin) is net sales less cost of goods sold
Income from operations (operating income) equals net sales less cost of goods sold and other
operating expenses
Income before income taxes (pre-tax earnings) is revenues minus all expenses except income tax
expense.
Recall that the Statement of Cash Flows is divided into three major sections.
1. Cash Flows from operating activities.
2. Cash Flows from investing activities.
3. Cash Flows from financing activities.
Using direct or indirect way of making the Statement of Cash Flows.
We will examine the indirect method of preparing the statement. This format begins with a
reconciliation of accrual income to cash flows from operations.
Notes to Financial Statements:
-
-
-
Descriptions of the key accounting rules that apply to the company’s statements.
o Summary of significant accounting policies
o Different methods are correct to use, by GAAP
Additional detail supporting reported numbers.
o Provides supplemental information concerning the data shown on the financial
statements
Relevant financial information not disclosed on the statements.
o Includes information that impacts the company finically but is not shown on the
statements
Return on Assets
During the period, how well had management used the company’s total invested capital provided by
both debt holders and shareholders. How much the firm earned for each dollar of investment.
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 =
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
RAO decomposition breaks ROA into two factors called profit drivers or profit levers because they
describe the two ways that management can improve ROA.
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-
-
Net profit margin is Net income / net sales. It measures how much of every sales dollar is
profit. It can be increased by:
o Increasing sales volume
o Increasing sales price
o Decreasing cost of goods sold and operating expenses
Total assets turnover (efficiency) is net sales / average total assets. It measures how many
sales dollar’s the company generates with each dollar of assets. It can be increased by:
o Collecting accounts receivable more quickly
o Centralizing distribution to reduce inventory kept on hand
o Consolidating production facilities in fewer factories to reduce the amount of assets
necessary to generate each dollar of sales.
Profit Drivers and Business Strategy
-
-
High-value or product-differentiation
o Rely on R&D and product promotion to convince customers of the superiority of your
product (and raise the prices to earn more money)
Low-Cost
o Rely on efficient management of accounts receivable, inventory and productive
assets to produce high asset turnover. Lower the costs.
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Chapter 6 Reporting and interpreting sales revenue, receivables, and cash
The revenue principle is as followed:
-
Delivery has occurred or services have been rendered
There is persuasive evidence of an arrangement for customer payment
The price is fixe or determinable
Collection is reasonably assured
The point at which title (ownership) changes hands is determined by the shipping terms in the sales
contract:
-
FOB (free on board) shipping point: title changes hands at shipment and the buyer normally
pays for shipping. Revenues are recognized at shipment.
FOB destination: tittle changes hand on delivery, and the buyer normally pays for shipping.
Revenues are recognized at delivery.
The appropriate amount of revenue to record is the cash equivalent sales price.
Long-Term Construction Contracts:
-
-
Completed Contract Method:
o Revenue and expenses are recognized in the year the contract is completed.
o Construction-in progress years show no revenue or expenses.
Percentage-of-Completion Method:
o Revenue and expenses recognized each year as work is accomplished.
o Revenues each year are based on the ratio of costs incurred to total costs.
Companies allow customers to pay with credit cards (on the internet) to:
-
Increase customer traffic
Avoiding the costs of providing credit directly to consumers, including recordkeeping and bed
debts
Lowering losses due to bad checks
Avoiding losses from fraudulent credit card sales (as long as adidas follows the credit card
company’s verification procedure)
Receiving money faster (since credit card receipts can be directly deposited in its bank
account, adidas receives tis money faster than it would if it provided credit directly to
consumers)
Credit card discount is the fee charged by the credit card company for its services
When companies allow customers to purchase merchandise on an open account, the customer
promises to pay the company in the future for the purchase.
When customers purchase on open account, they may be offered a sales discount to encourage early
payment.
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Sales (cash) discount is a cash discount offered to encourage prompt payment of an account
receivable. This provides two benefits:
-
Prompt receipt of cash from customers reduces the necessity to borrow money to meet
operating needs
Since customers tend to pay bills providing discounts first, a sales discount also decreases the
change that the customer will run out of funds before the bill is paid.
Sales returns and allowances is a reduction of sales revenues for return of or allowances for
unsatisfactory goods.
Receivables are classified in three common ways:
-
-
Classified as either an account receivable or notes receivable: Accounts receivables (trade
receivables, receivables) are open accounts owed to the business by trade customers. Note
receivables are written promises that require another party to pay the business under
specified conditions (amount, time, interest). The following conditions occur for notes:
o A specific amount, the principal. At a definite future date known as the maturity date
o A specific amount of interest at one or more future dates. The interest is the amount
charged for use of the principal
Receivable may be classified as trade or nontrade receivables: Trade receivables are created
in the normal course of business when a sale of merchandise or services on credit occurs.
Nontrade receivable arises from transaction other than the normal sale of merchandise or
services.
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-
Receivables are classified as current o noncurrent (short term or long term). Depending on
when the cash is expected to be collected.
Sale returns and allowances:
-
Debited or damaged merchandise
Debited for returned merchandise
Contra revenue account.
Bad debts result from credit customers who will not pay the business the amount they owe,
regardless of collection efforts.
Matching Principle: record in same accounting period as sales revenue.
Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the
accounting period.
Allowance method bases bad debts expense on an estimate of uncollectible accounts. The allowance
is based on estimates of the expected amount of bad debts:
-
Making the end-of-period adjusting entry to record estimated bad debt expense
Writing off specific accounts determined to be uncollectible during the period.
Bad debt expense (doubtful accounts expense, uncollectable accounts expense, provision for
uncollectible accounts) is the expense associated with estimated uncollectible accounts receivable.
Included in the category selling, it decreases net income and stockholders’ equity.
It is not allowed in the balance because there is no way to know which customers’ accounts
receivable is involved. To solve this problem an allowance for doubtful accounts (allowance for bad
debts, allowance for uncollectible accounts) is a contra-asset account contains the estimated
uncollectible accounts receivable. As a contra asset, the balance in Allowance for Doubtful accounts
it always subtracted from the balance of the asset accounts receivable. Thus, the entry decreases the
net book value of accounts receivable and total assets.
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It is recorded in the books as follows:
Notice: this journal entry did not affect any income statement accounts. Also, the entry did not
change the net book value of accounts receivable.
Methods for Estimating Bad Debts
-
Percentage of credit sales
Aging of accounts receivable
o Each customer’s account is aged by breaking down the balance by showing the age
(in number of days) of each part of the balance.
o Based on past experience, the business estimates the percentage of uncollectable
accounts in each time category.
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The bed debt expense amount is estimated on either:
-
-
A percentage of total credit sales for the period (simple to apply)
o Bases bad debt expense on the historical percentage of credit sales that result in bad
debts. This is directly recorded as bad debts.
o Directly compute the amount to be recorded as bad debt expense on the income
statement for the period in the adjusting journal entry
An aging of accounts receivable (more accurate)
o Estimates uncollectible accounts based on the age of each account receivable. If an
account become older it is less likely that it will be collected.
o Compute the estimated ending balance we would like to have in the allowance for
doubtful accounts on the balance sheet after we make the necessary adjusting entry.
The difference between the current balance in the account and the estimated
balance is recorded as the adjusting entry for bad debt expense for the period.
The following practise can help minimalizing bad debts:
-
Require approval of customers’ credit history by a person independent of the sales and
collection function
Age accounts receivable periodically and contact customers with overdue payments
Reward both sales and collection personnel for speedy collections so that they work as a
team.
This ratio measures how many times average receivables are recorded and collected for the year.
The higher the ratio, the more it benefits the company because they can reinvest their money.
Cash is money or any instrument that banks will accept for deposit and immediate credit to a
company’s account, such as a check, money order or bank draft. Cash equivalents are short-term
investments with original maturities of three months or less that are readily convertible to cash and
whose value is unlikely to change (certificates of deposit, treasury bills).
Cash management is necessary because cash is easy spendable. So it’s really fraud sensitive.
Therefore controls are needed:
-
-
Accurate accounting so that reports of cash flows and balances may be prepared
Controls to ensure that enough cash is available to meet
o Current operating needs
o Maturing liabilities
o Unexpected emergencies
Prevention of the accumulation f excess amounts of idle cash. Idle cash earns no revenue.
Therefore, it is often invested in securities to earn a return until it is needed for operations.
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Internal controls are the process by which a company safeguards its assets and provides reasonable
assurance regarding the reliability of the company’s financial reporting, the effectiveness and
efficiency of its operations and its compliance with applicable laws and regulations.
Internal control refers to policies and procedures that are designed to:
-
Properly account for assets.
Safeguard assets.
Ensure the accuracy of financial records.
Cash is the asset most susceptible to theft and fraud. Effective internal controls of cash should
include the following:
-
-
Separation of Duties:
o Custody: complete separation of the jobs of receiving cash and disbursing cash
o Recording: complete separation of the procedures of accounting for cash receipts
and cash disbursements
o Authorization: complete separation of the physical handling of cash and all phases of
the accounting function
Prescribed policies and procedures
o Require that all cash receipts be deposited in a bank daily. Keep any cash on hand
under strict control.
o Require separate approval of the purchases and actual cash payments. Pre
numbered checks should be used. Special care must be taken with payments by
electronic funds transfers since they involve no controlled documents (checks)
o Assign the responsibilities for cash payment approval and check-signing or electronic
funds transfer transmittal to different individuals
o Require monthly reconciliation of bank accounts with the cash accounts on the
company’s books
Bank statement is a monthly report from a bank that shows deposits recorded, checks cleared, other
debits and credits and running bank balance.
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Bank reconciliation is the process of verifying the accuracy of both the bank statement and the cash
accounts of a business. Explains the difference between cash reported on bank statement and cash
balance on company’s books. Provides information for reconciling journal entries.
Most common causes of differences between the ending bank balance and the ending book balance
of cash are as follows:
-
Outstanding checks
Deposits in transit
Bank service charges
NSF (not sufficient funds)
Interest
Errors
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Chapter 7 Reporting an interpreting cost of goods sold an inventory
Inventory is tangible property held for sale in the normal course of business or used in producing
goods or services for sale. It is reported on the balance sheet as a current asset, because it normally
is used or converted into cash within one year.
Businesses hold different types of inventory:
-
Raw materials inventory includes items acquired for the purpose of processing into finished
goods. When they are used they become part of work in process inventory.
Work in process inventory includes goods in the process of being manufactured. They are
not yet completed; when they are they become finished goods inventory.
Finished goods inventory includes manufactured goods that are complete and ready for sale.
Merchandise inventory includes goods held for resale in the ordinary course of business.
These goods usually are acquired in a finished condition and are ready for sale without
further processing. (this is not for manufacturing businesses)
The cost principle requires that inventory be recorded at the price paid or the consideration given.
-
Invoice Price
Freight
Inspection Costs
Preparation Costs
The flow of inventory costs
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When merchandise is purchased, the merchandise inventory account is increased. When the goods
are sold, cost of goods is sold is increased and merchandise inventory is decreased (zie merchandiser)
For the manufacturer it is more complex. First raw materials (direct materials) must be purchased
(ea. steel or aluminium or sand). When they are used, the cost of these materials is removed from
the raw materials inventory and added to the work in process inventory. Direct labour: refers to the
earnings of employees who work directly on the products being manufactured and factory overhead:
are manufacturing costs that are not raw materials or direct labour costs are added to the production
process. When the finished goods are sol, costs of goods sold increases and finished goods inventory
decreases.
Goods available for sale refer to the sum of beginning inventory and purchases (or transfer to
finished goods) for the period. The porting of goods available for sale that is sold becomes cost of
goods sold. The ending inventory is the beginning inventory of the next accounting period.
Cost of goods sold equation: BI+P-EI=CGS (Beginning inventory + purchases - ending inventory = cost
of goods sold)
-
-
Specific Identification when units are sold, the specific cost of the unit sold is added to cost
of goods sold. Keep track of all the goods. Not practically when selling products in large
quantities but for houses or so it is okay.
FIFO (first-in, first-out) oldest costs in cost of goods sold; recent cost in ending inventory.
Assumes that the first goods purchased are the first to be sold.
LIFO (last-in, last-out) oldest costs in ending inventory; recent costs in cost of goods sold.
Assumes that last products purchased are sold the first.
Weighted Average when a unit is sold, the average cost of each unit in inventory is assigned
to cost of goods sold.
The choice of an inventory costing methods is NOT bases on the physical flow of goods that is whey
that are called cost flow assumptions.
Advantages of methods:
-
FIFO: ending inventory approximates current replacement cost.
LIFO: better matches current costs in cost of goods sold with revenues.
Weighted Average: smoothed out price changes.
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Most managers choose accounting methods based on two factors:
-
Net Income Effects: Managers prefer to report higher earnings for their companies.
Income Tax Effects: Managers prefer to pay the least amount of taxes allowed by law as late
as possible
For inventory with increasing costs, LIFO is used on the tax return because it normally results in
lower income taxes. (zie table)
For inventory with decreasing costs, FIFO is most often used for both the tax return and
financial statements. (zie table)
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A company is allowed to use different methods for different products. But it is not allowed to
change from method for one period and then changes back. They are only allowed to change
methods when it is improve the measurement of financial results.
Replacement cost is the current purchase price for identical goods.
Net realizable value is the expected sales price less the selling costs (e.g. repair and disposal
costs)
Lower of cost or market (LCM) is a valuation method departing from the cost principle; it serves
to recognize a loss when replacement cost or net realizable value drops bellows cost.
Ending inventory is reported at the lower of cost or market (LCM). The company will recognize a
“holding” loss in the current period rather than the period in which the item is sold. This practice is
conservative.
Average Inventory is: (Beginning Inventory + Ending Inventory) / 2
This ratio reflects how many times average inventory was produced and sold during the period. A
higher ratio indicates that inventory moves more quickly thus reducing storage and obsolescence
costs.
U.S. public companies using LIFO also report beginning and ending inventory on a FIFO basis if the
FIFO values are materially different.
-
FIFO not permitted: Canada, Great Britain, Singapore, Australia, IFRS
LIFO permitted: China
LIFO reserve: is a contra-asset for the excess of FIFO of LIFO inventory. It is for adjusting the
inventory value.
Internal control of inventory, after cash the most vulnerable to theft.
-
Separation of inventory accounting and physical handling of inventory.
Storage in a manner that protects from theft and damage.
Limiting access to authorized employees
Maintaining perpetual inventory records.
Comparing perpetual records to periodic physical counts.
Perpetual System: a detailed inventory record is maintained, recoding each purchase and sale during
the accounting period.
-
Provides up-to-date inventory records.
Provides up-to-date cost of sales records.
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Periodic System: ending inventory and cost of goods sold are determined at the end of the
accounting period based on a physical count
-
No up-to-date record of inventory is maintained during the year.
Perpetual System: Beginning Inventory + Purchases – Cost of goods sold =Ending Inventory
Periodic System: Beginning Inventory + Purchases – Ending Inventory = Cost of goods sold
Perpetual inventory system:
Periodic inventory system:
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Chapter 8 Reporting and interpreting property, plant and equipment:
Natural resources and intangibles
Long-lived assets are tangible and intangible resources owned by a business and used in its
operations over several years.
-
-
Tangible assets (or fixed assets) have physical substance (they can be touched)
o Land used in operations
o Buildings, fixtures and equipment used in operations
o Natural resources used in operations
Intangible assets have special rights but not physical substance, they cannot be touched.
Think of patents, licences, trademarks, etc.
Definition of long-lived productive (non-current) assets: Definition of an asset: An asset is a
resource controlled by the entity as a result of past events and from which economic benefits are
expected to flow to the entity.
An asset shall be classified as current when:
-
It is expected to be realized in, or is intended for sale or consumption in the entity’s normal
operating cycle.
It is held primarily for the purpose of being traded.
It is expected to be realized within twelve months after the balance sheet date.
It is cash or cash equivalent.
All other assets shall be classified as non-current.
Long-lived (fixed)
productive assets
Tangible assets
(physical substance)
Types of fixed tangible assets:
Land
Buildings, fixtures and equipment
Natural resources
Land
Buildings, fixtures and equipment
Natural resources
Intangible assets
(special rights but no
physical substance)
Examples: patents, copyrights
franchises, licenses and trademarks.
•
•
•
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Cost principle: all reasonable and necessary expenditures made in acquiring and preparing an asset
for use should be recorded as the cost of the asset. Acquisition cost is the net cash equivalent
amount paid or to be paid for the asset. This includes posts like preparation costs, and for example
repairs costs.
-
Examples of expenditures that should be capitalized:
Sales taxes (only if non-refundable!)
Legal fees
Transportation costs
Installation costs
Renovation and repair costs (in case of used/old assets)
Interest costs (in case of a self-constructed asset)
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Repairs, maintenance and additions. Ordinary repairs and maintenance: Expenditures that maintain
the productive capacity of the asset.=> Expenditures are expensed.
Debit: Repair expenses
Credit: Cash
XXX
XXX
Additions and improvements: Expenditures that increase the productive life, operating efficiency, or
capacity of the asset. => Expenditures are capitalized.
Debit: Asset
Credit: Cash
XXX
XXX
Capitalized interest: refer to interest expenditures included in the cost of a self-constructed asset.
Ordinary repair and maintenance are expenditures for normal operating upkeep of long-lived assets.
Revenue expenditures maintain the productive capacity of the asset during the current accounting
period only and are recorded as expenses.
These are actually the same. They do not directly lengthen the useful life of the asset and are always
recorded as expenses.
Additions and improvements are infrequent expenditures that increase an asset’s economic
usefulness in the future. Capital expenditures increase the productive life, operating efficiency or
capacity of the assets and are recorded as increases in asset accounts, not as expenses.
These are also the same. In this case the repairs incurred large amounts of money and increase the
economic usefulness in the future through either increase efficiency or longer life.
In most cases there is no clear line, the managers must decide to report the repair as an expense or
as an investment in a longer life an increase the value of the asset. This has influents on the tax
payment. Most companies have policies for these kinds of situations.
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Except for land al other temporary assets need to be depreciated. Following the matching principle
the costs made when the revenue is booked.
Depreciation is the process of allocating the cost of buildings and equipment over their productive
lives using a systematic and rational method.
What is depreciation and what is it not?
-
Depreciation represents allocation of acquisition cost over the useful life of the asset.
Matching: Depreciation expense against revenues.
Depreciation is taken into account even when asset is increasing in value.
Depreciation is NOT used to value an asset, but to allocate the cash outflow to the useful life.
Depreciation is NOT setting aside money to buy a new asset.
Net book (or carrying) value is the acquisition cost of an asset less accumulated depreciation.
To calculate depreciation expense, three amounts are required for each asset:
-
Acquisition cost (see LO2).
Estimated useful life to the company: Expected service life of an asset to the present owner
(does not need to be the total economic life of the asset).
Estimated residual value at the end of the asset’s useful life to company: The estimated
amount to be recovered at the end of the company’s estimated useful life of an asset, after
deducting the estimated costs of disposal (so, residual may be negative).
The depreciation method used shall reflect the pattern in which the asset’s future economic benefits
are expected to be consumed (land is not depreciated) by the entity. Alternative depreciation
methods:
-
Straight-line method: Depreciation of asset depends only on the passage of time. Allocates
the cost of an asset in equal periodic amounts over its useful life. The same every year.
-
Units of production method: Depreciation is solely the result of use and that the passage of
time plays no roll. Allocates the cost of an asset over its useful life based on the relation of its
periodic output to its total estimated output.
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-
Declining-balance method (also known as diminishing balance method): Many kinds of plant
assets are most efficient when new, and so provide more and better service in the early
years. Allocates the cost of an asset over its useful life based on a multiple of the straight-line
rate
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Attention: there are two important differences between this method and the other described
previously:
-
-
Notice that accumulated depreciation, not residual value, is includes in the formula above.
Since accumulated depreciation increases each year, net book value (cost minus
accumulated depreciation) decreases. The double-declining rate is applied to a lower net
book value each year, resulting in a decline in depreciation expense over time.
An asset’s book value cannot be depreciated below residual value. Therefore, if the annual
computation reduces net book value below residual value, a lower amount of depreciation
expense must be recorded so that net book value equals residual value. No additional
depreciation expense is computes in subsequent years.
It is the manager’s job to determine the kind of depreciation used per asset. The straight-line
depreciation is the most common.
Corporations must review long-lived tangible and intangible assets for possible impairment. Two
steps are necessary:
-
-
Impairment occurs when events or changed circumstances cause the estimated future cash
flows/benefits (=Fair Value) of these assets to fall below their book value.
o If Book value > Estimated future cash flows, then the assets is impaired.
For any asset considered to be impaired, companies recognize a loss for the difference
between the asset’s book value and its fair value
Impairment Loss = Net Book Value – Fair Value
At the disposal of assets, two journal entries should be made:
-
Recording depreciation to update the depreciation expense and accumulated depreciation
accounts.
• Depreciation expense
XXX
• Accumulated depreciation
XXX
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-
Removing the cost of the asset and the accumulated depreciation from the accounts and (if
any) gain/loss on disposal.
o (Loss on disposal
XXX)
o Accumulated depreciation
XXX
o Asset
XXX
o (Gain on disposal
XXX)
This is necessary when a company want to dispose a long life asset. This can in two ways, voluntary
and non-voluntary.
Natural resources: are assets that occur in nature such as mineral deposits, timber tracts, oil and gas.
Natural resources are recorded in conformity with the cost principle. The consumption of natural
resources is recognized by depletion: The term depletion describes the process of allocating a
natural resource's cost over the period of its exploitation.
Matching principle: Units-of-production method is applied.
Acquisition and amortization of intangible assets:
Intangible assets are recorded at cost, only if they have been purchased: Internally developed
intangible assets are expensed when incurred.
Intangible assets can have a definite or indefinite life:
-
Definite life: The useful life of the asset can be determined.
Indefinite life: There is no foreseeable limit to the period over which the asset is expected to
generate net cash inflows for the entity. So, indefinite ≠ infinite (endless).
Allocating cost of intangible assets:
-
-
Definite life: The cost of an intangible asset with a definite life is allocated on a straight-line
basis each period over its useful life in a process called amortization that is similar to
depreciation and depletion. Normally intangible assets do not have a residual value.
Indefinite life: Intangible assets with indefinite lives are not amortized. Instead, these assets
are to be tested at least annually for possible impairment. (Intangible assets with definite life
may also be impaired if there is an indication that the fair value of the assets is lower than its
book value.)
Amortization is the systematic and rational allocation of the acquisition cost of an intangible asset
over its useful life.
Definitions of different types of intangible assets:
-
Goodwill: Excess of the cost of an acquired company over the sum of the market value of its
net assets. (assets minus liabilities)
Trademark: Asset that represents distinctive identifications of a product or service; also
called trade name.
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-
-
Copyright: Exclusive right to reproduce and sell a book, musical composition, film, other
work of art, intellectual property, or computer program. Issued by the federal government, a
copyright extends 70 years beyond the author’s life.
Patent: A federal government grants giving the holder the exclusive right to produce and sell
an invention for 20 years.
Technology: Includes costs for computer and web development.
Franchises: Privileges granted by a private business or a government to sell a product of
service under specific conditions; also called licenses.
If expenditure are equal to expenses => Expenses = Cash outflow
But in case of fixed assets:
-
-
-
-
Purchasing asset: Cash flow ≠ Expenses
o Asset
XXX
o Cash
Using asset (depreciation): Cash flow ≠ Expenses
o Depreciation expense
XXX
o Asset (Accumulated depreciation)
Disposal of assets: Cash flow ≠ Expenses
o Cash
XXX
o Asset
And in cash ≠ book value:
o Loss/Gain on disposal*
XXX
XXX
XXX
XXX
XXX
*) Loss when cash < book value; Gain when cash > book value.
Depreciation expenses are calculated based on two assumptions:
-
Useful life.
Residual value.
What to do if during the use of the asset, these assumptions must be adjusted? (Called change is
estimate) => New depreciation expense is calculated:
Example of Changes in Depreciation Estimates:
Delta purchased an aircraft for $60,000,000. The aircraft is depreciated using the straight-line
method with a useful life of 20 years and an estimated residual value of $3,000,000. So, yearly
depreciation expense is 2,850,000 => (60,000,000 – 3,000,000)/20.
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Yearly journal entry for depreciation:
-
Depreciation expense
Accumulated depreciation
2,850,000.
2,850,000
In year 5, Delta changed the estimated useful life to 25 years and lowered the residual value to
$2,400,000. Required: Calculate depreciation expense for the fifth year using the straight-line
method.
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