Document1 ACCOUNTING OUTLINE From Stickney & Weil Book OVERVIEW Financial Statements 1.

Balance Sheet: presents a snapshot of the investing and financing activities of a firm at a moment in time a. Assets (1) Current Assets: cash and assets that a firm expects to turn into cash, sell, or consume within approximately one year from the date on the b/s (2) Noncurrent Assets: typically held and used for several years, include land, buildings, equipment, patents, and long-term investments in securities b. Liabilities (1) Current Liabilities: obligations a firm expects to pay within one year (2) Noncurrent Liabilities: firms longer-term sources of funds c. Shareholders Equity (1) contributed capital: funds invested by shareholders for an ownership interest (2) retained earnings: earnings realized by a firm in excess of dividends distributed to shareholders since its formation Assets = Liabilities + Shareholders Equity 2. Income Statement: presents the results of the operating activities of a firm for a specific time period (i.e. one year), indicating the net income or earnings for that time period i.e. the difference between revenues and expenses. a. Revenues: measure the inflows of assets (or reductions in liabilities) from selling goods and providing services to customers. b. Expenses: measure the outflow of assets (or increases in liabilities) used in generating revenues. 3. Statement of Cash Flows: reports to net cash flows relating to operating, investing, and financial activities for a period of time. a. Operating Activities b. Investing Activities c. Financing Activities 4. Notes: to help explain the f/s 5. Opinion of CPA: Accounting Concepts, Principles, Assumptions, and Constraints (including the Big Six) 1. Qualitative Characteristics: a. Relevancy: Information is relevant if it influences the actions of a decision maker. To be relevant, information must have predictive or feedback value and it must be presented on a timely basis. b. Reliability: Information must accurately depict (or at least fairly state) the conditions it is purported to represent. Accounting information is reliable to the

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Document1 extent it is verifiable, is a faithful representation and is reasonably free of error and is unbiased (i.e. accountants are concerned with neutrality in presentation). c. Comparability: Usefulness is enhanced if the f/s of an entity can be compared with other companies f/s. d. Consistency: Use of the same accounting principles each year enhances the ability to compare the f/s of the same company from year to year. 2. Basic Assumptions: a. Entity: A company is an economic unit separate and apart from its owners. b. Going Concern: We assume that t company will continue to operate indefinately. c. Monetary Unit: Everything is measured in money. We also assume that inflation is insignificant and thus ignored. d. Periodicity: We cannot wait forever to issue financial information. Thus, economic activities of a company are divided into artificial time periods (e.g. year, quarter, month) and f/s are issued based on the best estimates available at the end of the period). 3. Basic Principles: a. Historical Cost: Assets should be recorded at their cost. (Cost = the value exchanged at the time something is acquired. Typically, the exchange involves cash). b. Revenue Recognition: Revenue is (generally) recorded when it is earned. And revenue is considered earned when the company has substantially accomplished what it must do to be entitles to the benefits represented by the revenue (i.e. (1) earned, (2) measurable, and (3) is reasonably collectible). Often revenue is recognized at the point of sale. E = MC2 (whether or not to recognize revenue is sometimes difficult to determine under the accrual method). c. Matching Principle: Costs incurred to generate revenues are expenses when the revenue is recognized. Efforts (expenses) should be matched with accomplishments (revenues). d. Full Disclosure Principle: Everything that is relevant must be disclosed in the f/s and accompanying footnotes (notes to the f/s). Example: Related Parties Disclosure: 1. must make disclosure of material related party transactions 2. must make full disclosure 3. absent such a disclosure, assume parties to the transaction are conducting the transaction at arms length basis 4. Constraints: a. Materiality/ Cost-Benefit: Relative significance, both quantitatively and qualitatively, must be considered. An item is material if its inclusion or omission would influence or change the judgment of a reasonable person. In short, if it doesnt make a difference, it doesnt need to be disclosed. Cost-benefit relationship: The cost of making a particular measurement or disclosure should not exceed the benefit derived from it. b. Conservatism: Accounting measurements often take place in a context of significant uncertainty. Possible errors should tend toward understatement, rather than overstatement, of assets and income. When in doubt, select the answer which will be least likely to overstate assets and income.

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Document1 c. Industry Practice: The peculiar nature of some industries and businesses sometimes require departure from basic theory. THE BALANCE SHEET Assets 1. Recognition a. the firm has acquired rights to its use in the future as a result of a past transaction (i.e. dont recognize executory Ks as assets) or exchange and b. the firm can measure or quantify the future benefits with a reasonable degree of precision 2. Valuation a. Acquisition or Historical Cost: the amount of cash payment (or cash equivalent value of other forms of payment) made in acquiring an asset. b. Current Replacement Cost: the current cost to replace it: entry value. c. Current Net Realizable Value: the net amount of cash (selling price less selling costs) that a firm would receive currently if it sold each asset separately: exit value. d. Present Value of Future net Cash Flows: the ability of an asset either to generate future net cash receipts or to reduce future cash expenditures. Must discount to present value 3. Classification a. Current Assets: cash and other assets that a firm expects to realize in cash or to sell or consume during the normal operating cycle of the business, usually one year. Includes: cash, marketable securities held for short term, accounts and notes receivable, inventories of merchandise, raw materials, supplies, work in process, and finished goods and prepaid operating costs, such as prepaid insurance and prepaid rent. EX of journalizing a prepayment: DR Prepaid Rent CR Cash to record prepayment of rent. $10,000 $10,000

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DR Rent Expense $5,000 CR Prepaid Rent $5,000 amortize half the cost over half of the year because the rent was prepaid for the whole year. b. Investments: long-term investments in securities in other firms c. Property, Plant, and Equipment: Fixed Assets: tangible, long-lived assets used in a firms operations over a period of years and generally not acquired for resale. Includes: land, buildings, machinery, automobiles, furniture, fixtures, computers, and other equipment. The b/s shows these items (except for land) at acquisition cost less accumulated depreciation since the asset was acquired, unless the assets have substantially declined in value since acquisition. d. Intangible Assets: Includes: patents, trademarks, franchises, and goodwill. Accountants generally do not recognize expenditures that a firm makes in

Document1 developing intangibles as assets because of the difficulty of ascertaining the existence of future benefits. Accounting does, however, recognize specifically identifiable intangibles acquired in market exchanges from other entities as assets Liabilities 1. Recognition: a firm receives benefits or services and in exchange promises to pay the provider of those goods or services a reasonably definite amount at a reasonably definite future time. 2. Valuation: a. most are monetary, requiring payments of specific amounts of cash b. but if the payment dates extend more than one year into the future, the liability appears at the present value of the future cash outflows. c. some are nonmonetary i.e. delivery of goods or rendering services 3. Classification a. Current Liabilities: obligation that a firm expects to pay or discharge during the normal operating cycle of the firm, usually one year b. Long-Term Debt: obligations having due dates, or maturities, more than one year after the b/s date. Includes: bonds, mortgages, and similar debt c. Other Long-Term Liabilities: Includes: deferred income taxes and some retirement obligations. Shareholders Equity 1. The residual interest 2. Classification: a. common stock: the amount that shareholders contribute directly for an interest in the firm (1) par value (2) amounts contributed in excess of par value b. retained earnings: earnings the firm subsequently realizes in excess of dividends declared (earnings retained at beginning of period + net income for period dividends of period). Accounting Procedures Assets DR CR + = Liabilities DR CR + + Equity DR CR + Revenue - Expense DR CR DR CR + + -

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1. dual effects of transactions (i.e. debit one account and credit another) 2. T-accounts to accumulate the changes that take place in each b/s

Document1 Asset Account Beginning Balance Increases DR Ending Balance Decreases CR

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Liability Account Beginning Balance Decreases DR Increases CR Ending Balance

Shareholders Equity Account Beginning Balance Decreases DR Increases CR Ending Balance

Temporary Accounts Revenue Decreases DR Increases CR (all here except for corrections, adjustments, and final transfer)

Expense Increases DR (all here except for corrections, adjustments, and final transfer)

Decreases CR

Summary of what Account to Debit or Credit for Transactions Debit (left-side) Transaction Credit (right-side) Increase Asset: Cash Issue Capital Stock at par Increase Ownership Equity for Cash Account: Capital Stock Increase Asset: Cash Borrow Money on a Bank Increase Liability: Loan Loan Payable Increase Asset: Office Purchase Office Equipment Decrease Asset: Cash Equipment for Cash Decrease Shareholder Issue a Stock Dividend Increase Shareholder Equity Equity Account: Retained Account: Capital Stock Earnings

Document1 Decrease Shareholder Liability: Equity Account, Preferred Capital Stock Decrease Shareholder Equity Account: Retained Earnings Decrease Liability: Bonds Payable Decrease Liability: Accounts Payable Decrease Liability: Accounts Payable 3. Journalizing Date Account Debited Amount Debited Account Credited Explanation of transaction or event being journalized Redeem Preferred Stock by Issuance of Notes Payable Pay for a Cash Dividend Increase Notes Payable

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Decrease Asset: Cash

Convertible Bonds Converted to Capital Stock Issue a Note Payable to Settle an Account Payable Pay Cash on an Account Payable

Increase Shareholder Equity Account: Capital Stock Increase Liability: Notes Payable Decrease Asset: Cash

Amount Credited

4. Posting: At periodic intervals (i.e. weekly or monthly), the accountant enters, or posts, transactions recorded in the general journal to the individual accounts in the general ledger (T-Accounts) 5. Trial Balance Preparation: lists each of the accounts in the general ledger with its balance as of a particular date (i.e. lists debit balances or credit balances of all accounts) 6. Adjust Trial Balance a. to correct if it doesnt balance (i.e. debits credits) b. to account for Depreciation and Bad Debts, etc. c. Close Entries (i.e. Expense and Revenue Accounts) d. now make a Post-Closing Trial Balance to reflect all the adjustments 7. Financial Statement Preparation Permanent Accounts: 1. Asset 2. Liability 3. Shareholders Equity These are balanced at the end of the fiscal period (hence the name: Balance Sheet) Temporary Accounts: 1. Revenue 2. Expense (i.e. Cost of Goods Sold, Rent Expense, Depreciation Expense) These are closed at the end of the fiscal period the balances are then transferred to an Income Summary Account (Debit the Revenue Accounts and Credit the Income Summary; Credit the Expense Accounts and Debit the Income Summary)

Document1 then this balance is transferred to the Shareholders Equity Account on the B/S (i.e. Credit Retained Earnings) THE INCOME STATEMENT Accounting Methods 1. Cash Basis: a. a firm recognizes revenues in the period when it receives cash from customers b. a firm reports expenses in the period when it makes cash expenditures c. Problems: (1) does not adequately match the cost of the efforts required in generating revenues with those revenues (2) unnecessarily postpones the time when the firm recognizes revenue. A firm should recognize revenue when the firm has finished the difficult parts of the transaction d. users: lawyers, accountants, other professionals 2. Accrual Basis: a. recognizes revenue when a firm sells goods or renders services b. costs of assets used lead to expenses in the period when the firm recognizes the revenues that the costs helped produce c. Why good: (1) revenues more accurately reflect the results of sales activity (2) expenses more closely match reported revenues d. users: business firms i.e. merchandising and manufacturing firms Measurement Principles of Accrual Accounting 1. Timing of Revenue Recognition: a. Requirements: (1) a firm has performed all, or a substantial portion of, the services it expects to provide (2) the firm has received cash, a receivable, or some other asset capable of reasonably precise measurement b. most firms involved in selling goods and services recognize revenue at the time of sale (delivery) c. if the firm makes the sale on account, past experience and an assessment of credit standings of customers provide a basis for predicting the amount of cash the firm will collect d. in general, the firm will recognize revenue when it has no further significant uncertainty about the amount and timing of cash collection from the sales transaction. 2. Measurement of Revenue a. a firm measures the amount of revenue by the cash or cash-equivalent value of other assets it receives from customers b. Uncollectible Accounts: if a firm expects not to collect some portion of the sales for a period, it must adjust the amount of revenue recognized during that period for estimated uncollectible accounts arising from those sales. The adjustment

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Document1 occurs in the period when the firm recognizes revenue and not in the later period when it identifies specific customers accounts as uncollectible. c. Sales Discounts and Allowances: the firm must estimate these amounts and make appropriate reduction, at the time of sale, in measuring the amount of revenue it recognizes. d. Sales Returns e. Delayed Payments: for the period of sale, the firm recognizes as revenue only the present value, at the time of sale, of the amount it expects to receive 3. Timing of Expense Recognition: when do the benefits of an asset expire, leaving the b/s, and becoming expenses, entering the income statement as reductions in shareholders equity? a. Criteria for Expense Recognition: (1) if an asset expiration associates directly with a particular revenue, that expiration becomes an expense in the period when the firm recognizes the revenue. Matching cost expirations with revenues. (2) if an asset expiration does not clearly associate with revenues, that expiration becomes an expense of the period when the firm consumes the benefits of that asset in operations. b. Product Costs: (1) merchandising firm: inventory appears as an asset stated at acquisition cost on the b/s. When the firm sells the inventory, the same amount of acquisition cost appears as an expense (Cost of Goods Sold) on the income statement (2) mfg firm: incurs costs as it changes the physical form of the goods it produces: (1) direct material costs, (2) direct labor costs, and (3) mfg overhead costs. These Product Costs (i.e. Work-in-Process Inventory and Finished Goods Inventory) remain on the balance sheet as assets until the firm sells the goods that they embody; then they become expenses. c. Marketing Costs: expensed in the period when the firm uses their services d. Administrative Costs: Treated like marketing costs and expensed in the period 4. Measurement of Expenses Accounting Procedures 1. accumulate expenses of the period 2. report theses expenses and revenue in the income statement 3. after preparing the income statement at the end of the period, the accountant transfers the balance in each revenue and expense account to the Retained Earnings Account: Closing the Revenue and Expense Accounts. Retained Earnings (SE) Amount Account with Debit Balance (SE), usually expense account Amount Account with Credit Balance (SE) Retained Earnings (SE) Amount Amount

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Document1 closing entries reduce the balances in all temporary accounts to zero. the former debit (credit) balances in temporary accounts become debits (credits) in the Retained Earnings Account. 4. Journalizing for Revenues, Expenses, and Dividends: Asset (A) Increase or Liability (L) Decrease Revenue (SE) Typical entry to recognize revenue Amount Amount

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Expense (SE) Amount Asset (A) Decrease or Liability (L) Increase Typical entry to record expense Retained Earnings (SE) Dividends Payable (L) Typical entry to record dividend declaration Dividends Payable (L) Cash (A) Typical entry to record dividend payment Amount

Amount

Amount

Amount Amount

Contra Account (XA) accumulates amounts subtracted from the amount in another account. Adjusting Entries: 1. Salaries and wages earned by employees 2. Interest that has accrued 3. Recognition of Accrued Revenues and Receivables 4. Recognition of Accrued Expenses and Payables 5. Allocation of Prepaid Operating Costs 6. Recognition of Depreciation 7. Valuation of Liabilities 8. Correction of Errors ACCRUAL ACCOUNTING ON THE INCOME STATEMENT Accrual Basis for Mfg 1. a mfg firm incurs 3 types of costs to convert raw materials into finished products: a. direct material (or raw material) b. direct labor c. mfg overhead 2. most mfg firms recognize revenue at the time they sell the goods; until they sell the goods, it treats mfg costs as product cost assets and accumulates them in inventory accounts a. The Raw Materials Inventory Account: includes the cost of raw materials purchased but not yet transferred to production. When the mfg begins to use raw

Document1 materials in production departments, it transfers the cost of the materials from the Raw Materials Inventory Account to the Work-in-Process Inventory Account b. The Work-in-Process Inventory Account accumulates (with debits) the cost of raw materials transferred from the raw materials storeroom, the cost of direct labor services used, and the mfg overhead costs incurred. When the firm completes mfging, it reduces (with credits) the balance in the Work-in-Process account and increases (with debits) the balance in the Finished Goods Inventory. c. The Finished Goods Inventory Account includes the total mfg cost of units completed but not yet sold. The sale of mfged goods to customers results in a transfer of their cost from the Finished Goods Inventory Account to the expense account Cost of Goods Sold. 3. however, selling and administrative costs are period expenses Accrual Basis for other Types of Businesses 1. Revenue Recognition: a. the firm has provided all or a substantial portion of the services it expects to perform for customers, and b. is able to measure the amounts of revenues and expenses (that is, cash inflows and cash outflows) with reasonable precision. 2. Measurement : a. the revenues must equal the present value of the amount of cash a firm expects to receive from customers for goods or services sold, and b. expenses must equal the amount of cash a firm has expended or expects to expend to generate the revenues. 3. Firms sometimes recognize revenues and expenses before the sale or delivery of a product. This is typically when the firm has Ked with a particular customer, agreed on a selling price, and performed substantial work to create the product. 4. Income Recognition Before the Sale: a. Long-Term Contractors: b. Percentage-of-Completion Method: recognizes a portion of the K price as revenue during each accounting period of construction. It bases the amount of revenue, expense, and income on the proportion of total work performed during the accounting period. It measures the proportion of total work performed during the accounting period either from engineers estimates of the degree of completion or from the ratio of costs incurred to date to the total costs expected for the entire K. As the contractor recognizes portions of the k price as revenue, it recognizes equal portions of the total estimated k costs as expenses. c. Completed K Method: Postpone revenue recognition until they complete the construction project and its sale. d. Forest Products Companies: Because of the aging of products process, cannot satisfy the criteria for revenue recognition until time of sale. A proper matching of expenses with revenues requires that these firms capitalize, as part of the aging assets, all expenditures made (maintenance, storage) during the aging process. Such costs become expenses at the time of sale, when the firm recognizes revenues. 5. Income Recognition After the Sale:

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Document1 a. Insurance Companies: Recognize revenues and expenses at each period of insurance coverage. Insurance companies must, however, match against this revenue each period a portion of the ultimate cash outflow to satisfy claims. b. Franchisors: When substantial uncertainty exists at the time of sale regarding the amount that (or timing or both) of cash or the cash equivalent value of other assets that a firm will ultimately receive from customers, the firm delays the recognition of revenues and expenses until it receives cash. Such sellers recognize revenue at the time of cash collection using either the installment method or the costrecovery-first method. These methods attempt to match expenses with revenues. c. Installment Method: Can use this method when you cannot make reasonably certain estimates of cash collection. recognizes revenue as the seller collects parts of the selling price in cash. This method recognizes as expenses each period the same portion of the cost of the good or service sold as the portion of total revenue recognized. d. Cost-Recovery-First Method: When the seller has substantial uncertainty about the amount of cash it will collect, it can also use this method. This method matches the costs of generating revenues dollar for dollar with cash receipts until the seller recovers all such costs. Expenses match revenues in each period until the seller recovers all costs. Only when cumulative cash receipts exceed total costs will profit (that is, revenue without any matching expenses) appear in the income statement. Revenue and Expense Recognition Cash Basis Period Revenue 1 $ 1,000 2 1,000 3 2,000 4 4,000 5 4,000 Total $12,000 Percentage of Completion Period Revenue 1 $ 2,0001 2 5,0002 3 5,000 4 -----5 -----Total $12,000

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Expense $1,600 4,000 4,000 --------------$9,600

Income ($600) (3,000) (2,000) 4,000 4,000 $2,400

Expense $1,600 4,000 4,000 ----------$9,600

Income $ 400 1,000 1,000 ------------$2,400

1 2

$1,600/$9,600 x $12,000 $4,000/$9,600 x $12,000

Document1 Completed K Method Period 1 2 3 4 5 Total Installment Method Period 1 2 3 4 5 Total

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Revenue $--------12,000 ------------$12,000

Expense $----------9,600 ----------$9,600

Income $---------2,400 ---------$2,400

Revenue $ 1,000 1,000 2,000 4,000 4,000 $12,000

Expense $ 8003 800 1,6004 3,2005 3,200 $9,600

Income $ 200 200 400 800 800 $2,400

Cost Recovery First Method Period Revenue 1 $ 1,000 2 1,000 3 2,000 4 4,000 5 4,000 Total $12,000

Expense $1,000 1,000 2,000 4,000 1,600 $9,600

Income $ 0 0 0 0 2,400 $2,400

Format and Classification net income is gross income minus extraordinary gains and losses 1. Income from Continuing Operations: revenues, gains, expenses, and losses from the continuing areas of business activity 2. Income, Gains, and Losses from Discontinued Operations: alerts f/s reader that the firm does not expect this source of income to continue 3. Extraordinary Gains and Losses: a. it is unusual in nature b. it is infrequent in occurrence 4. Adjustments for Changes in Accounting Principles: disclose effects of the changes on current and previous years net income 5. Earnings per Share: must be disclosed in order to receive an Unqualified Opinion from an accountant

3 4

$1,000/$12,000 x $9,600 $2,000/$12,000 x $9,600 5 $4,000/$12,000 x $9,600

Document1 Compound Interest 1. Future Value (Table 1): what is $1 today going to be worth in the future, assuming a given interest rate of r with interest compounding over a given number of periods? F = P(1+r)n EX: Deposit $1 in an IRA or 401(k) A 60 40 20 7% $3.87 B 60 22 38 7% $13.08

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Retirement Age Age at Date of Deposit Years Interest is Earned Interest Rate Assumed Value of $1 at Retirement Date for A: F = 1(3.86968) for B: F = 1(13.07927)

2. Present Value (Table 2): if you have to wait to get your money, what is $1 in the future worth today, assuming a given interest rate with interest compounding over a given number of periods? P = F(1+r)-n 3. Annuities a. Future Value (Table 3): if you take a stream of annuity payments and invest them at a given interest rate, what will they aggregate to at some point in the future? i.e. if we put in $1 a year for X number of periods, what will that annuity grow to by the end of the period? (FV of the annuity) b. Present Value (Table 4): whats an annuity of $1 over a certain number of years at a given interest rate worth today (PV of the annuity) what lenders look at when deciding how much interest to charge: 1. pure return: that the lender wants 2. inflation concerns: if high-inflation times, higher interest rate to account for it (because the value of the dollar is eroded). Lender must take length of loan into consideration when determining inflation component of interest rate (because it is easier to make assumptions about interest rates for one year than for ten) 3. credit risk: lender will have a higher interest rate for a company that is a start up, etc. LIQUID ASSETS: CASH, MARKETABLE SECURITIES, AND RECEIVABLES Cash 1. Cash Inclusions and Valuation: Easily convertible into cash i.e. demand deposits, savings accounts, cods (compensating balances must be kept in a separate balance from Cash) Compensating Balances: when the lender asks for the borrower to keep some cash in the bank without earning interest as part of the loan. For example, Bank will loan Co. $50 million and Bank requires Co. to keep in their Cash Account, at all times, a $3 million balance. So available Cash to Co. is only $47 million. (SEC

Document1 requires disclosing the existence of compensating balances or other restrictions on Cash). 2. Cash Control and Management: Internal controls to prevent theft or embezzlement Marketable Securities 1. Classification of Securities: Current asset as long as the firm (1) can readily convert them into cash and (2) intends to do so when it needs cash, usually within one year of the date of the b/s 2. Valuation of Securities at Acquisition: recorded at acquisition cost: DR Marketable Securities CR Cash $10,300 $10,300

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3. Valuation of Securities after Acquisition: a. Debt Held to Maturity: firm has the intent and ability to hold to maturity; shown on b/s as amount based on amortized acquisition cost DR Investment Securities $1,150 CR Cash $1,150 To record purchase of securities (at cost, which included a $1,000 par value, $50 broker fee and $100 premium) DR Interest Expense $50 CR Investment Securities $50 this is amoritizing the security. it will mature in 3 yrs so amortize $50/yr to bring it to the ultimate yield of $1,000. in the meantime, it is earning interest b. Trading Securities: shown on the b/s at market value; changes in the market value are reported each period in income 12/28/19x3 DR Marketable Securities $400,000 CR Cash To record acquisition of trading securities.

$400,000

12/31/19x3 DR Marketable Securities $35,000 CR Unrealized Holding Gain on Trading Securities (Inc.St.) $35,000 To revalue trading securities to market value and recognize an unrealized holding gain in income. (realize as income because as a brokerage firm, securities are like your inventory) 1/3/19x4 DR Cash $48,000 CR Marketable Securities CR Realized Gain on Sale of Trading Securities (Inc.St.)

$435,000 $ 45,000

Document1 To record the sale of trading securities at a gain. c. Securities Available for Sale: shown on the b/s at market value; changes in the market value do not affect reported income until the firm sells the securities 11/1/19x3 DR Marketable Securities $400,000 CR Cash To record acquisition of securities available for sale.

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$400,000

12/31/19x3 DR Marketable Securities $35,000 CR Unrealized Holding Gain on Securities Available for Sale (SE) $35,000 To revalue securities available for sale to market value and record unrealized gain (unrealized holding gain is a component of retained earnings and recorded on the b/s: do not want to muck up income statement if trading securities is not your business as in trading securities is for brokerage firms). 8/15/19x4 DR Cash $480,000 CR Marketable Securities $400,000 CR Realized Gain on Sale of Securities Available for Sale (Inc.St.) $80,000 To record the sale of securities available for sale at a gain based on acquisition cost. Recording a Loss on Marketable Securities DR Unrealized Loss on Decrease in Market Value Securities Available for Sale (SE) below Book Value CR Marketable Securities Decrease in Market Value below Book Value Proceeds of Sale Plug Amount

DR Cash DR Realized Loss on Sale of Securities Available for Sale (Inc.St.) CR Marketable Securities

Acquisition Cost

Accounts Receivable The sum of all individual customers net balances, reduced by the amounts of estimated uncollectible accounts, sale discounts, and sales returns and allowances. The charge against income for expected uncollectible amounts, sale discounts, and sales returns and allowances preferably occurs in the period when the sales occur

Document1 Sale of Goods on Account DR Accounts Receivable CR Sales Revenue Collection of Cash from Customers DR Cash CR Accounts Receivable

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selling price selling price

amount collected amount collected

1. Uncollectible Accounts: a. Direct Write-Off Method: (1) recognizes losses form uncollectible accounts in the period when a firm decides that specific customers accounts are uncollectible DR Bad Debt Expense (Inc. St.) CR Accounts Receivable (L) actual amount uncollectible actual amount uncollectible

(2) shortcomings: (a) does not usually recognize the loss from uncollectible accounts in the period in which the sale occurs and the firm recognizes revenue (b) provides firms with an opportunity to manipulate earnings each period by deciding when particular customers accounts become uncollectible (c) the mount of accounts receivable on the balance sheet under the direct write-off method does not reflect the amount a firm expects to collect in cash (3) GAAP does not allow firms to use the direct write-off method for financial reporting when they have significant amounts of expected uncollectible accounts and when the selling firm, such as a retail store, can reasonably predict them. (4) Firms must, however, use the direct write-off method for income tax reporting purposes. Tax allows firms to claim a deduction for bad debts only when they can demonstrate that particular customers will not pay. b. Allowance Method: (1) when a firm can estimate with reasonable precision the amounts of uncollectibles, GAAP requires the allowance method for uncollectibles DR Bad Debt Expense (Inc. St.) estimated uncollectible amount CR Allowance for Uncollectible Accounts (XE) estimated uncollectible amount (2) when a firm judges particular customers accounts to be uncollectible, it writes off the account (credit) and debits the contra asset account: Allowance for Uncollectible Accounts DR Allowance for Uncollectible Accounts (XE) actual uncollectible amount CR Accounts Receivable (L) actual uncollectible amount

Document1

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(3) the write-off of specific customers accounts using the allowance method does not affect income. The income effect occurs in the year of the sale, when the firm provides for estimated uncollectible accounts (4) two methods: (a) percentage-of-sales method for estimating uncollectibles: if cash sales occur in a relatively constant proportion to credit sales, the accountant can apply the estimated uncollectible percentage, proportionately reduced, to the total sales for the period (b) aging-of-accounts-receivable method for estimating uncollectibles: estimates the amount or receivables the firm expects not to collect; classifies each customers account as to the length of time the account has been uncollected. assign an estimate as to what portion is going to be uncollected. the more current the receivable is, the lower the probability that it is uncollectible. total A/R $45,000 Current $29,000 2% $ 580 30-60 days $15,000 5% $ 750 60-90 days $1,000 10% $ 100

total A/R uncollectible estimate allowance for uncollectible accounts

$1,430

DR Bad Debt Expense (Inc. St.) $1,430 CR Allowance for Uncollectible Accounts (XE) to record estimate for uncollectible accounts.

$1,430

when determining estimated uncollectible percentages, take into account: 1. the type of industry: for example, some companies, like hospitals, are notorious for having a/r in the 60-90 days range 2. the companys historical experience in valuation allowances (c) specific identification method: if you know something about a specific companys account that they owe you i.e. on the brink of chapter 11 and you are concerned that they may never be able to pay you, supplement the number you come up with in the aging-of-accounts method with an additional allowance identified with a specific troubled customer. 2. Sales Discounts: the amount of ales discounts made available to customers appears as an adjustment in measuring net sales revenue 3. Sales Return and Allowances: The selling firm debits a revenue contra (Sales Allowances) during the period of sale for expected returns so as to report correctly the amount of cash it expects to collect form each periods sales

Document1 Notes Receivable 1. Calculation of Interest Revenue Interest = Base (Principal or Face) x Interest Rate x Elapsed Time 2. Accounting for Interest-Bearing Notes Receivable 6/30 DR Notes Receivable CR Accounts ReceivableS Co. 8/31 DR Cash CR Notes Receivable CR Interest Revenue entry upon collection at maturity

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3,000 3,000

3,060 3,000 60

but if accounting period was 1 month and the note has not been paid yet 7/31 DR Interest Receivable 30 CR Interest Revenue ($3,000 x 12 x 30/360 = $30) and upon collection at maturity 8/31 DR Cash CR Notes Receivable CR Interest Receivable CR Interest Revenue

30

3,060 3,000 30 30

INVENTORIES: THE SOURCE OF OPERATING PROFITS Beginning Inventory + Additions Withdrawals = Ending Inventory Costs Included in Inventory at Acquisition 1. Components of Inventory Cost: mfg firm inventory costs are (1) direct materials, (2) direct labor, and (3) mfg overhead. An mfg firm debits all production costs to Workin-Process Inventory: full absorption costing. 2. The Purchase Transaction: a firm should record purchases in the formal accounting records when legal title to the goods passes from seller to buyer (watch out for buyback options in purchase Ks and potential abuses). 3. Merchandise Purchases Adjustments: The accounting should debit or credit all adjustment costs (i.e. transporting and handling the goods, cash discounts, goods returned, and other adjustments of the invoice price) to the Merchandise Inventory account. Frequently, the accountant uses adjunct (accumulates additions to another

Document1 account) and contra (accumulates subtractions from another account) accounts for these adjustments to provide a more complete analysis of the cost of purchases (i.e. Purchase Discounts, Freight-in, Purchase Returns, and Purchase Allowances accounts). 4. General Rule: any cost incurred directly in preparing an asset for its intended use (for sale) generally becomes a part of the cost of that asset. There are two main categories: a. product costs: all the costs associated with your inventory (getting it ready for intended use) b. period costs: costs incurred as part of ongoing operations: (1) these are expensed in the current period (i.e. rent) or (2) if the costs will extend beyond many periods, capitalize these costs and, in subsequent periods, amortize or depreciate them over their useful life (i.e. a building) Basis for Inventory Valuation 1. Acquisition Cost Basis: values units in inventory at their historical cost until sold. Gains or losses are realized (show up in income) upon final disposition. 2. Current Cost Basis: a. Replacement Cost (Entry Value): the amount a firm would have to pay to acquire the item at that time (assumes a fair market). b. Net Realizable Value (Exit Value): the amount that a firm could realize as a willing seller in the ordinary course of business. 3. Lower-of-Cost-or-Market Basis (LCM): the smaller of acquisition cost or market value, with market value generally measured as replacement cost. This is a conservative accounting policy because (1) it recognizes losses from decreases in market value before the firm sells goods, but it does not record gains from increases in market value before a sale takes place; and (2) inventory figures on the balance sheet are never greater, but may be less, than acquisition cost. This results in reporting unrealized holding losses but delays reporting unrealized holding gains until the firm sells the goods. a. step 1: determine what the designated market value is: (1) look at what the replacement cost is (generally, we will take this number) (2) but if the replacement cost is higher than the net realizable value (estimated selling price less costs of completion and disposal), we wont take the replacement cost (3) or if the net realizable value minus the normal profit margin (generally measured as a percentage of selling price) is higher than the replacement cost, we wont take the replacement cost (4) select the amount that is the middle of the 3 (NRV, Replacement Cost, NRV Normal Profit Margin) this becomes the designated market value b. step 2: compare designated market value with the cost and select the lower of the two this number gets carried as inventory value on the b/s c. step 3: journal entry to write down to the designated market vale (cost = $25; designated market value = $20):

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Document1 Direct Method DR Cost of Goods Sold CR Inventory

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$5 $5

Indirect Method DR Loss on Market Decline of Inventory $5 CR Allowance (XE)

$5

4. Standard Cost: a predetermined estimate of what items of manufactured inventory should cost 5. GAAP Basis for Inventory Valuation: GAAP requires loser of cost or market for inventory, which implies that accounting uses market values when inventory has fallen below cost. Computing market value requires both replacement cost and net realizable value amounts. Timing of Computations 1. Periodic Inventory System: a. the ending inventory figure results from the firms making a physical count of units on hand at the end of an accounting period and multiplying the quantity on hand by the cost per unit. b. the firm then uses the inventory equation to calculate the withdrawals that represent the cost of goods sold, an expense. c. makes no entry for withdrawals (COGS) until it counts and costs the inventory on hand at the end of the accounting period. d. any losses from shrinkage (i.e. losses due to breakage, theft, evaporation, and waste) appear in the COGS amount. Beginning Inventory + Purchases Ending Inventory = Cost of Goods Sold EX: sales during a year amounted to $165,000: DR Cash and A/R $165,000 CR Sales Sales recorded throughout the year

$165,000

At the end of the year, the firm takes a physical count and assigns costs (using a lower-of-cost-or-market) to ending inventory. This results in an ending inventory of $20,000. Subtracting this amount from the $119,000 cost of goods available for sale yields COGS of $99,000: DR Cost of Goods Sold $99,000 CR Merchandise Inventory COGS recognized under a periodic system

$99,000

2. Perpetual Inventory System: a. calculates and records cost of goods sold whenever a firm takes an item from inventory

Document1 b. this requires a constant tracing of costs as items move into and out of inventory c. computes goods expected to be remaining in the ending inventory after each acquisition or withdrawal Beginning Inventory + Purchases Withdrawals = Ending Inventory DR A/R CR Sales DR COGS CR Merchandise Inventory $800 $800 $475 $475

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3. Periodic v. Perpetual Systems: a. periodic system: (1) costs less to use because less accounting computations (2) likely to be cost effective when being out of stock is not extremely costly, when there is a large volume of items with a small value per unit, or when items are hard to steal or pilfer. b. perpetual system: (1) provides useful information not provided by the periodic system (2) cost-effective when there is a small volume of high-value items or when running out of stock is costly. Cost Flow Assumptions Beginning Inventory + Net Purchases = COGS + Ending Inventory 1. FIFO: a. first in first out: assigns the costs of the earliest units acquired to the withdrawals and assigns the costs of the most recent acquisitions to the ending inventory b. conforms to good business practice in managing physical flows, especially in the case of items that deteriorate or become obsolete c. COGS expense tends to be out-of-date because FIFO assumes that the earlier purchase prices of the beginning inventory and the earliest purchases become expenses. d. When purchase prices rise, FIFO usually leads to the highest reported net income of the three methods, and when purchase prices fall, it leads to the smallest. 2. LIFO: a. last in first out: assigns the cost of the latest units acquired to the withdrawals and assigns the costs of the oldest units to the ending inventory b. firms are increasingly using LIFO because of tax purposes: results in a higher cost of goods sold, a lower reported periodic income, and lower current income taxes than FIFO or Weighted Average (LIFO Conformity Rule: if you use LIFO for taxes, must use if for its financial reports to shareholders) c. When purchase prices have been rising and inventory amounts increasing, LIFO produces b/s figures usually much lower than current costs.

Document1 d. LIFOs COGS figure closely approximates current costs; b/s amount for ending inventory contains some very old costs (SEC requires firms using LIFO to disclose the amounts at which LIFO inventories would appear if the firm had used FIFO or current cost). e. results in the least fluctuation in reported income in businesses in which selling prices tend to change as purchase prices of inventory items change f. LIFO Layers: in any year when purchases exceed sales, the quantity of units in inventory increases. The amount added to inventory for that year is called a LIFO inventory layer (1) EX: firm purchases 100 Xs a year and sells 98 Xs a year. After 4 years, the costs of the 8 unsold units are the costs of Xs 1 and 2, 101 and 102, 201 and 202, and 301 and 302. (2) dipping into LIFO layers: if inventory quantities decline, the older, lower costs per units of prior years LIFO layers leave the b/s and become expenses: results in a lower COGS as well as larger reported income and larger income taxes in that period. (3) LIFO permits firms to defer taxes as long as they do not dip into LIFO layers g. LIFO b/s: LIFO usually leads to a b/s amount for inventory so much less than current costs that it may mislead readers of f/s 3. Weighted Average: a. the firm calculates the average of the cost of all goods available for sale (or use) during the accounting period, including the cost applicable to the beginning inventory. b. resembles FIFO more than LIFO in its effects on the f/s. When inventory turns over rapidly, the weighted average inventory cost flow provides amounts virtually identical to FIFOs amounts. Example: 1/1/96 Beginning Inventory of 1/10/96 Purchase Inventory 1/15/96 Sale 1/20/96 Purchase 1/31/96 Ending Inventory:

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1,000 units @ $ 5 per unit 200 units @ $ 8 per unit 500 units @ $12 per unit 300 units @ $ 6 per unit 1,000 units @ $? per unit

need to solve for: (1) Cost of Ending Inventory, (2) COGS, and (3) Gross Profit on Sale the inventory equation Beginning Inventory + Purchases = Goods Available for Sale - Ending Inventory = Cost of Goods Sole FIFO $5,000 $3,400 $8,400 $5,900 $2,500 LIFO $5,000 $3,400 $8,400 $5,600 $2,800 Weighted Average $5,000 $3,400 $8,400 $5,000 $3,400

Document1 the gross profit FIFO LIFO Weighted Average equation Sales $6,000 (500 x $12) $6,000 $6,000 - Cost of Goods $2,500 $2,800 $3,400 Sold = Gross Profits $3,500 $3,200 $2,600 Determining Ending Inventory in the above chart: 1. FIFO: a. 500 units sold came from the first 500 units in inventory b. so 1,000 x $5 = $5,000 becomes 500 x $5 = $3,500 c. total of 1,000 units remaining: what remains are the ones that most recently came in: 1,000 = $5,900 (300 x $6, 200 x $8, and the 500 x $5). 2. LIFO: a. last units in (from the 20th and 10th) are the first out b. take off the 300 x $6 and the 200 x $8 c. what is left is the 1,000 at $5 = $5,000 3. Weighted Average: a. add all units and divide by total cost of inventory to get average cost: b. $5.60/unit c. 1,000 x $5.60 = $5,600 DR Cost of Goods Sold (Inc. St.) CR Inventory (A) DR Cost of Goods Sold CR Inventory DR Cost of Good Sold CR Inventory $2,500 (FIFO) $2,500 $2,800 (WA) $2,800 $3,400 (LIFO) $3,400

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Identifying Operating Margin and Holding Gains 1. conventionally reported gross margins (sales minus cost of goods sold) comprises: a. an operating margin, and b. a realized holding gain (or loss) 2. operating margin: the difference between the selling price of an item and its replacement cost at the time of sale. 3. realized holding gain: the difference between the current replacement cost of an item and its acquisition cost FIFO recognizes most of the realized holding gain in computing income each period LIFO does not recognize most of the unrealized holding gain in the income statement. 4. unrealized holding gain: the difference between the current replacement cost of the ending inventory and its acquisition cost. This does not appear in the income statement.

Document1 unrealized holding gains are higher under LIFO than under FIFO because earlier purchases with lower costs remain in ending inventory under LIFO. 5. the sum of the operating margin plus all holding gains (realized and unrealized), economic profit, is the same under FIFO and LIFO. 6. total increase in wealth for a period includes both realized and unrealized holding gains. PLANT, EQUIPMENT, AND INTANGIBLE ASSETS: THE SOURCE OF OPERATING CAPACITY Acquisition of Plant Assets Self-Constructed Asset: The capitalization of interest into plant assets during construction reduces otherwise reportable interest expense and thereby increases income during periods of construction. In later periods, the plant will have higher depreciation charges, reducing income i.e. a portion of the interest expense for borrowing associated with building that is being built for longer than 1 year can be included in the cost of the building: Co. borrows $3 million: the interest is added to the cost of the building. It takes 2 years to build the building: borrowing went from $0 to $3 million. Average borrowing was $1.5 million per year: record interest. At the end of the firs year, interest cost is $150,000, so instead of debiting the Interest Expense Account: DR Bldg CR Interest Payable $150,000 $150,000

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stop capitalizing costs once the asset is ready for intended use. The subsequent Interest Costs are Expensed as a period cost. Costs Subsequent to Acquisition Depreciation Purpose of Depreciation: to systematically allocate the cost of an asset to the periods of its useful life. 1. depreciation is a process of cost allocation: as the firm uses the asset in each accounting period, it treats a portion of the cost of the asset as the cost of the service received and recognizes the cost as an expense of the period (costs leave the b/s and go onto the income statement as debits) 2. return of capital: a firm attempts to earn both a return of capital and a return on capital. Before a firm can earn a return on capital (as measured by accounting profits), it must recover all costs. Depreciation allows for a return of the cost of the asset, no more, no less. 3. depreciation is not a decline in value Issues in Depreciation Accounting measuring the depreciable basis of the asset estimating its useful life deciding on the pattern of expiration of asset cost over the useful service life 1. Depreciable Basis of Plant Assets: Cost Less Salvage Value:

Document1 a. historical cost accounting bases depreciation charges on the acquisition cost of the asset less the estimated residual valuethe amount the firm will receive when it retires the asset from service b. estimating salvage value: estimated proceeds on the disposition of an asset less all removal and selling costs; for buildings, assume a zero salvage value 2. Pattern of Expiration of Costs: a firm must do one of the following a. accelerated depreciation b. straight line depreciation c. decelerated depreciation (GAAP wont allow this one) d. expense immediately e. no depreciation Depreciation Methods 1. Straight-Line (Time) Method: a. financial reporting most commonly uses this method b. divides the cost of the asset, less any estimated salvage value, by the number of years of its expected life, to arrive at the annual depreciation. Annual Depreciation = Cost Less Estimated Salvage Value/Estimated Life in Years 2. Production or Use (Straight-Line Use) Method: when the rate of usage varies over periods and when the firm can estimate the total usage of an asset over its life, the firm can use this method, based on actual production or usage during the period. Depreciation Cost per Unit = Cost Less Estimated Salvage Value/Est # of Units 3. Accelerated Depreciation: a. the earning power of some plant assets decline as they grow older b. these cases justify this method, which recognizes larger depreciation charges in early years and smaller depreciation charges later (1) Declining-Balance Method: depreciation charge results from multiplying a fixed rate time the net book value of the asset (cost less accumulated depreciation but without subtracting salvage value) at the start of each period. The depreciation stops when net book value reaches salvage value. The result is a declining periodic charge for depreciation throughout the life of the asset. (2) Sum-of-the-Years-Digits Method: the depreciation charge results from applying a fraction, which decreases from year to year, to the cost less estimated salvage value of the asset (3) Modified Accelerated Cost Recovery System for Income Tax Reporting: (MACRS) 4. Factors in Choosing the Depreciation Method: can pick a different method for tax reporting and for financial reporting. a. Tax Reporting: the firm should try to maximize the present value of the reductions in tax payments from claiming depreciation. When tax rates stay constant over time, earlier deductions have greater value than later ones: least and latest rule.

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Document1 b. Financial Reporting: firms seek an income statement that realistically measures the expiration of the assets benefits and provides a reasonable pattern of cost allocation. Financial statements should report depreciation charges based on reasonable estimates of asset expirations. Most firms use the straight-line for financial reporting. 5. Accounting for Periodic Depreciation: a. In recording depreciation, most firms credit a contra-asset account, Accumulated Depreciation. This leaves the acquisition cost of the asset. b. Book Value: the difference between the balance of an asset account and the balance of its accumulated depreciation account. DR Depreciation Expense (Inc. St.) CR Accumulated Depreciation (XE) $1,500 $1,500

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6. Changes in Periodic Depreciation: a. periodically, a firm will reestimate the useful life and salvage value of an asset. b. no adjustment for the past misestimate is made, but the firm spreads the remaining undepreciated balance less the new estimate of salvage value over the new estimate of the remaining service life of the asset. Example: Cost Salvage Value Depreciable Base $120 ($ 20) $100

Estimated Useful Life of 5 yrs: 5/$100 = $20 of Depreciation per year: Year Beg. Dep. Base 1 $100 2 $80 Dep. for Year $20 $20 End of Year Dep. Base $80 $60

Then, in the 3rd year, the Estimated Useful Life has been re-evaluated to be only 4 years. So now we have a Depreciable Base of $60 and only 2 years left. 2/$60 = $30 of Depreciation for each remaining year: Year Beg. Dep. Base 3 $60 4 $30 5 Dep. for Year $30 $30 End of Year Dep. Base $30 $0

Repairs and Improvements 1. Repairs and Maintenance: a. Repairs: the costs of restoring as assets service potential after breakdowns or other damage b. Maintenance: routine costs such as for cleaning and adjusting. c. Expenditures for these items do not extend the estimated service life or otherwise increase productive capacity beyond the firms original expectations for the asset.

Document1 Therefore, accounting treats these expenditures as expenses for the period in which they are made. d. when an accountant is in doubt about whether something is a repair or improvement, she will be conservative and call it a repair. 2. Improvements: make an asset perform better than before. Because the expenditure improves the assets service potential, accounting treats such an expenditure as an asset acquisition. Therefore, the firm can capitalize on the asset by debiting a new asset account or the existing asset account. Impairment of Assets 1. Accounting does not permit assets whose values have declined substantially to remain on the b/s at amortized acquisition cost 2. if the decline in value is so drastic that the expected future cash flows from the asset have declined below book value, the asset is impaired 3. the firm writes down the book value of the asset to its then-current fair value, which is the market value of the asset or, if the firm cannot assess the market value, the expected net present value of the future cash flows. DR Accumulated Depreciation DR Apartment Bldg (new valuation) DR Loss on Impairment CR Apartment Bldg (original cost) $10 $ 4 $11 $25

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Retirement of Assets 1. when a firm retires a long-lived asset, it may be by sale to another entity 2. the firm must then record an entry to bring the depreciation up to date 3. when a firm retires an asset from service, it removes the cost of the asset and the related amount of accumulated depreciation from the books. a. the firm records the amount received from the sale, a debit, and b. the amount of net book value removed from the books, a net credit. c. these two differ from each other. The excess of the proceeds received on retirement over the book value is a gain or loss selling an asset at book value: DR Cash DR Accumulated Depreciation CR Equipment

$2,000 $3,000 $5,000

selling for more than book value: DR Cash $2,300 DR Accumulated Depreciation $3,000 CR Equipment CR Gain on Retirement of Equipment recognizes that past depreciation charges have been too large gain appears on the income statement after closing entries, it increases Retained Earnings

$5,000 $ 300

Document1 the gain restores to Retained Earnings the excess depreciation charged in the past selling for less than book value: DR Cash $1,500 DR Accumulated Depreciation $3,000 DR Loss on Retirement of Equipment $ 500 CR Equipment $5,000 recognizes that past depreciation charges have been too small loss appears on the income statement after closing entries, it decreases Retained Earnings the loss reduces Retained Earnings for the shortfall in depreciation charged in the past, in effect increasing depreciation charges all at once Wasting Assets and Depletion 1. Full Costing: capitalizes the costs of all explorations (both successful and unsuccessful) so long as the expected benefits from the successful explorations will more than cover the cost of all explorations 2. Successful Efforts Costing: capitalizes the costs of only the successful efforts; the costs of the unsuccessful exploration effects become expenses of the period 3. Amortize what is capitalized: usually using the units-of-production depletion method Intangible Assets and Amortization lacks physical existence has a high degree of uncertainty concerning future benefits 1. Research & Development: GAAP requires immediately expensing such costs a. the future benefits are too uncertain to warrant capitalization b. writing them off as soon as possible is more conservative 2. Software Development Costs: begin development technological feasibility commercial production

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a. all costs incurred from beginning of development until technological feasibility are expensed. b. all costs from time of technological feasibility until commercial production are capitalized (as Software Costs) because, at this point, the company has a product of future economic benefit. Must also Amortize these costs: amortize according to units of software the company is planning to sell instead of its useful life: EX: $1 million in Software Costs; predict you will sell 100,000 units; so amortize as $10/unit. c. all costs after commercial production are inventory costs room for manipulation: 1. when do you reach technological feasibility? 2. how do you estimate the number of units the company will probably sell?

Document1 3. Patents: a. acquire by acquisition: capitalize the cost (Asset on the B/S) and amortize over the shorter of: (1) the remaining legal life or (2) its estimated economic life can in no event exceed 40 years (but new rules may change this) b. acquire by internal research & development: expense 4. Advertising: common practice to expense even though GAAP now allows capitalization and amortization. Expense because: a. expensing advertising costs is more conservative than capitalizing them b. it is too difficult to quantify the future effects and timing of benefits derived from these costs 5. Goodwill (if internally developed, expense all costs associated with it, but if purchasing a company:) a. goodwill arises when one company purchases another company or an operating unit from another company b. accounting measures goodwill as the difference between the amount paid for the acquired company as a whole and the sum of the current values of its identifiable net assets, less its liabilities. c. goodwill appears on the f/s of the company making the acquisition d. capitalize e. amortize for the lesser of its useful life or 40 years. (proposed new max. of 20 yrs) f. to determine: (1) Co. A purchases Co. B for $350,000 (2) determine the fmv of all the identifiable assets that have been acquired: $262,000 (3) determine the difference between fmv and purchase price ($350,000 $262,000) $88,000: this is the goodwill (4) Debit Goodwill Account (A)

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Document1 LIABILITIES Basic Issues 1. Liability Recognition: a. the obligation involves a probable future sacrifice of resources at a specified or determinable date and the firm can measure, with reasonable precision, the cash equivalent value of resources needed to satisfy the obligation b. the firm has little or no discretion to avoid the transfer c. the transaction or event giving rise to the entitys obligation has already occurred 2. Contingencies: Potential Obligations: a. a firm should recognize an estimated loss from a contingency in the accounts only if the contingency meets both of the following: (1) information available before issuance of the f/s indicates that it is probable that an asset has been impaired or that a liability has been incurred, and (2) the amount of the loss can be reasonably estimated if the amount of the liability is a range, use the lower end of the range b. notes to the f/s must disclose significant contingencies even if not included in the f/s themselves (disclose but dont accrue) if contingency is probable and the amount of loss can be reasonably estimated, record the liability in the period in which the event occurred: DR Loss from Environmental Spill $5 million CR Est. Liability for Environmental Cleanup $5 million and when you start paying the cleanup costs: DR Est. Liability CR Cash

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$X $X

if you recorded the $5 million in PV but payments will be made over 20 years, what happens as the years go by (because youll be making more than $5 million in payments)? each year, look at the PV of the remaining liability and record an entry in that current estimate in the new PV: DR Interest Expense $X CR Est. Liability for Environmental Cleanup

$X

3. Liability Valuation: liabilities appear on the b/s at the present value of payments a firm expects to make in the future, using the historical interest rate 4. Liability Classification: a. current liabilities: fall due within the operating cycle, usually one year (dont discount to PV) b. noncurrent liabilities: fall due later (record at PV) Current Liabilities 1. Accounts Payable to Creditors 2. Short-Term Notes and Interest Payable 3. Wages, Salaries, and other Payroll Items

Document1 4. Income Taxes Payable 5. Deferred Performance Liabilities before performance: DR Cash CR Advances from Customers after performance: DR Advances from Customers CR Performance Revenue

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$200,000 $200,000

$200,000 $200,000

warranty: DR A/R $280,000 DR Warranty Expense $ 11,200 CR Sales $280,000 CR Estimated Warranty Liability $ 11,200 To record sales and estimated liability for warranties on items sold. recognize the warranty expense in the period when the firm recognizes revenue, even though it will make the repairs in a later period: match warranty expense with associated revenue. Long-Term Liabilities 1. Procedures for Recording Long-Term Liabilities: a. borrower initially records a long-term liability at the cash value the borrower receives in return for promising to make future payments b. the book value of the borrowing at any time equals the present value of all the then-remaining promised payments using the historical market interest rate applicable at the time the firm originally incurred the liability c. finding the market interest rate implied by the receipt of a given amount of cash now in return for a series of promised future repayments requires a process called finding the internal rate of return which is the interest rate that discounts a series of future cash flows to its present value. d. retiring long-term liabilities: (1) debits the liability account for its current book value (2) credits cash (3) recognizes any difference as gain (when book value exceeds cash disbursement) or loss (when cash disbursement exceeds book value) on retirement of debt. 2. Mortgages and Notes 3. Ks and Long-Term Notes: Interest Imputation: a. GAAP requires that all long-term monetary liabilities, including those carrying no explicit interest, appear on the b/s at the present value of the future cash payments b. there is an imputed interest rate c. there are two ways to compute the present value of the liability and the amount of imputed interest:

Document1 (1) base interest rate on market value of asset: uses the market value of the asset acquired as a basis for computing the present value of the liability. (2) use of market interest rate to establish market value of asset and present value of note: to find the present value of the note, the firm would discount the payments using the interest rate it would have to pay for a similar loan in the open market at the time that it acquired the equipment 4. Bonds STATEMENT OF CASH FLOWS Introduction 1. b/s: portrays financial condition or financial position 2. income statement: portrays the results of operation i.e. the relationship of revenues and expenses 3. but neither the b/s nor the income statement describes the movement/changes in that most critical of assetsCash Purposes 1. to provide information about cash receipts and cash payments during a period 2. to summarize the operating, investing, and financing activities of a company 3. answers the following questions: a. where did cash come from? b. what was cash used for? c. what was the change in the cash balance?

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Classifications 1. Operating Activities: transactions that enter into determination of net income (e.g. sales to customers, collection of receivables from customers, payment to suppliers and employees, payment of interest and income taxes). a. make adjustments to reconcile net earnings to net cash from operating activities i.e. depreciation and amortization are non-cash expenses, so no money is going out: add back non-cash transactions. b. but, A/R and Inventory may have gone up: the company may have used resources to increase these non-cash assets: subtract the additional investment in non-cash current assets. cash flows associated with current assets and current liabilities 2. Investing Activities: transactions that involve acquiring and disposing of noncurrent assets, investing in and selling securities, and making loans to and collecting on loans from other companies (it is not unusual for growing companies to have a negative cash flow from investing activities). cash flows associated with noncurrent assets 3. Financing Activities: transactions that involve (1) obtaining capital from owners by issuing equity securities, paying dividends to owners, repurchasing equity securities from owners, or (2) borrowing money from creditors and repaying the amounts borrowed. cash flows associated with noncurrent liabilities and shareholders equity

Document1

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Balance Sheet Current Assets (O) Noncurrent Assets (I)

Current Liabilities (O) Noncurrent Liabilities (F) Shareholders Equity (F)

VALUATION ISSUES 1. Salvage Value (what can the asset be sold for at salvage)? $30 2. Net Book Value (acquisition cost less accumulated depreciation) $40 3. Future Revenue (what will the total future revenue be i.e. $100/yr for 15 years) (the Marketing Fool Method because it disregards expenses associated with the asset and PV considerations) $1,500 4. Capitalization of Earnings: a. Historical earnings for one year capitalized at a specified rate of return e.g. assume net earnings of $60/yr and buyer requires a 20% rate of return (Net earnings divided by required rate of return) $60/20% $300 b. Historical earnings for multiple years capitalized at a specific rate of return e.g. assume average net earnings over past 4 years and assume that the buyer requires a 20% rate of return (Average net earnings divided by required rate of return) $50/20% $250 c. Projected earnings at a specified rate of return e.g. assume projected net earnings of $75 per year and buyer requires a 20% rate of return (Projected net earnings divided by required rate of return) $75/20% $375 5. Projected Discounted Cash Floss: assume projected cash flows over some number of years in the future and discount that amount at an appropriate discount rate (e.g. PV of annuity of $75 for 30 years discounted at 20%; see Table 4: 4.97894 x $75) $374 KEY RATIOS 1. Earnings per Share: (EPS) Net Income/Weighted Average Number of Shares Outstanding: given the net earnings per share basic (earnings of the company divided by weighted average of shares without taking account of dilution resulting from common stocks equivalent i.e. disregard stock options) and diluted (assume stock options have been converted, thus increasing the denominator of this ratio) 2. Price Earnings Ratio: (PE Ratio) Market Price of Stock/EPS: the higher the ratio is, the more excited investors are (associated with Income Statements) 3. Dividend Yield: Dividends per Share/Market Value per Share: if the Co. doesnt pay dividends, the ratio is 0. 4. Book Value per Share: (from B/S) Shareholders Equity/Common Shares Outstanding at Yearend: if you own 1 share of the Co, this ratio tells you what that share is worth (Shareholders Equity is Net Book Value) 5. Price to Book Value per Share: Market Value per Share/Book Value per Share

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if a Co. pays no dividends but has a high PE Ratio: people are willing to spend a high multiple of earnings for stock because think the Co. will have significant growth if a Co. pays good dividends but have low PE Ratios it is because the market thinks prospects of future growth are not that favorable cannot infer anything about earnings form the Price per Share alone MARKET DATA Indexes 1. Dow Jones Industrial: 30 largest stocks traded on the NYSE 2. Nasdaq: historically smaller stocks, but no longer the case 3. Standard & Poors 500: 500 large companies generally traded on the NYSE: more broad reading of the overall market than the Dow 4. NYSE Composite: all the shares traded on the NYSE 5. Russell 2,000: Small Cap Index: smaller companies with lower market value. THE ACCOUNTING BUSINESS 1. The Accounting Profession: a. Independence: must be neutral i.e. dont own stock in the company you are auditing. b. R.U.L.E.S.: a. Rates (hourly rate) b. Utilization (number of billables you can get out of an associate) c. Leverage (how many people can you get working for you so when you bill then out and you only pay them a fraction of that, the better for the person getting the profits?) d. Expenses (historically, at accounting firms, 1/3 revenue supports infrastructure i.e. rent expense, and now technology costs as well; 1/3 goes to pay staff; 1/3 to the partners) e. Speed: (of billing and collecting) 2. Responsibilities of the Auditor: a. with respect to the GAAP f/s, express and opinion as to the fairness of the f/s (not that theyre accurate) based on the auditing procedures b. with respect to the other information, read to make sure not inconsistent with f/s 3. Types of Audit Opinions: a. Unqualified: . . . in accordance with GAAP (1) intro paragraph: tells the reader that the auditor has audited the f/s and reinforces that the f/s are the responsibility of the companys management and states that the auditors responsibility is to express an opinion based on their audits (2) scope paragraph: auditor tells the world what they have done i.e. did their work in accordance with generally accepted auditing standards: (a) purposes of obtaining reasonable assurance about whether f/s are free of material misstatement (not saying if accurate) (b) test basis: look at evidence supporting the amounts and the disclosure of the f/s

Document1 (c) look at the accounting principles that the company has chosen and the significant estimates (3) opinion paragraph: gets to the point: in our opinion, the f/s fairly presents the financial position in all material respects and are in conformity with GAAP b. Qualified: . . . except for . . .: rare c. Adverse: . . . not in accordance with GAAP: very unusual d. Disclaimer: . . . we express no opinion. Audit Procedures: a. evaluate internal control system b. inspect things c. external communications i.e. confirm that a client has received goods, that balances are accurate at the bank, etc d. meaningful analytic review: do all the increases and decreases make sense? Managements Financial Responsibility: a. they are responsible for everything in the financial report because they prepare the f/s b. information outside the f/s must be consistent with the f/s c. warn readers that preparing financial report entails making judgment calls d. acknowledge role to set up internal accounting controls: reasonable insurance that f/s are free of material misstatements and that assets are safe-guarded e. makes reference to the fact that the independent auditors are appointed by the bd. and then annually, the bd votes on the auditors and the shareholders also vote (ratification) Auditing Committee: a. end to be outside directors b. lots of judgments to be made (so lots of lawyers) c. meet periodically, typically 2-4 times a year, to meet with the auditors d. audit committee and top management get involved when key accounting policies must be made i.e. when there are new procedures e. if there is an internal audit department, the internal audit director reports to the audit committee (independence from management) Fraud a. dont do it b. collusion delays detection

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