Lecture 4 ifa1_2011[1](2)
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Transcript of Lecture 4 ifa1_2011[1](2)
Chapter 9 1Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 1
IFA1 Lecture 4
Chapter 9
Inventories
Chapter 10
Financial instruments in the balance sheet and fair
value accounting
Chapter 9 2Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 2
Chapter 9 Inventories
Financial Accounting and Reporting -
A Global Perspective (third edition)
Chapter 9 3Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 3
Major topics
1 Classification
2 Recording systems
3 Costing systems
4 Illustration Glinka
5 Decline in value
6 Income statement format
7 Financial statement analysis
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Introduction
• Inventories play a critical role in the operating cycle of many organizations
• As long as a product has not been sold, all costs attached to it are withheld from the income statement
• Inventories are still a reporting issue (despite the ‘just in time’)
• Definition of costs attached to inventories
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Figure 9.1 Inventories majors issues
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1 Classification of inventories
• Definition from IAS 2 (revised 2003, § 6): ‘inventories are assets:
• held for sale in the ordinary course of business;
• in the process of production for such sale; or
• in the form of materials or supplies to be consumed in the production process or in the rendering of services’
• Different types of inventories (see figure 9.2)
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Figure 9.2 Classification of inventories
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Classification of inventories
• The six inventory types shown are shown in three grades of tinting: – From dark blue for inventories of goods closest to the
customer– to light blue for inventories in the process of
transformation that will eventually, but certainly, turn into sellable products
– to grey to reflect the fact these last two categories of inventories are not potentially sellable in the condition in which they are held
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Table 9.1 Main categories of inventoriesActivity Name of the goods Definition Examples
Commercial activity
Merchandise Goods purchased for resale without transformation
Wholesale and retail activities
Manufacturing activity
Raw materials, parts, components and consumables
Goods that, once incorporated in the production process, become integrally and physically part of the product
Electronic parts in a computer manufacturing business
Manufacturing supplies Items used in supporting production and not part of the product
Machine fluids, cleaning materials, spare parts
Work in process called by IASB work in progress (WIP)
Products still in the manufacturing process at the close of the day and services rendered but not invoiced
Chassis and parts of a computer still on the assembly line at the end of the day
Semi-finished goods Items that are finished with regard to one stage of production but are nonetheless not sellable in that condition. They will generally be integrated in a finished product at a later date
Subassembly of the chassis of a computer waiting to receive the microprocessor and the skirt, once the customer order is known
Finished goods Completed products ready for sale Computers ready to be shipped
Service activity
Work in progress Accumulated costs incurred in fulfilling a contract and not yet billed
Consultancy projects, law suit, engineering projects
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2 Inventory recording systems
• Chapter 2 introduced two methods to report inventory movements:– purchases recorded in the balance sheet and
transferred to the income statement or,– purchases recorded in the income statement and
transferred to the balance sheet
• Two systems:– Perpetual (or permanent) inventory system– Periodic inventory system
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Perpetual (or permanent) inventory system
A continuous record of changes in inventory (entries as well as withdrawals) is maintained in the Inventory account
Perpetual inventory account Asset increase
Beginning inventory Purchases (cost of goods purchased) or
additions to the inventory (cost of goods manufactured)
Asset decrease Withdrawals from inventory (cost of
goods sold or cost of goods consumed in the next segment of the ‘manufacturing’ process)
Balance: Ending inventory (by deduction)
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Illustration Borodine Company
Inventory of goods for resale (merchandise) at beginning of year 200Purchases of goods for resale (merchandise) during year 900Sales of goods for resale (merchandise) 1,200Cost of goods sold (valued at their purchase price) 800Inventory of goods for resale (merchandise) at end of year 300
Basic data
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Perpetual (or permanent) inventory system
Beginninginventory
+ Purchasesor additions
- Withdrawals = Ending inventory(The unknown)
200 + 900 - 800 = X
X = 200 + 900 – 800 = 300
The fundamental inventory equation is used to calculate the ending inventory as follows:
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Periodic inventory systemBasis of the system: required periodic (annual) physical counting to establish the quantities in the ending inventory so that they can be valued
Periodic inventory account Asset increase
Beginning inventory (opening balance)
Ending inventory (measured at year end)
Asset decrease Beginning inventory (assumed
consumed)
Balance: Ending inventory (measured at year end)
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Periodic inventory system
The fundamental inventory equation is expressed as follows
Beginning inventory + Purchases or additions
- Ending inventory (independently
measured)
= Cost of goods sold or cost of goods
transferred (deducted)
200 + 900 - 300 = X
X = 200 + 900 – 300 = 800
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Figure 9.3 Recording of inventory - impact on
the financial statements
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Comparison of recording
- The ending inventory value, 300 CU, is the same under either method
- Both methods provide the same cost of goods sold (or cost of goods consumed)
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Comparison
• The periodic system provides weaker controls on such things as misuse, pilferage or shrinkage (See developments on differences between physical and accounting inventory count in Appendix 9.1)
• See a comparison in Appendix 9.2
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Figure 9.4 Inventories
in the income
statement by nature
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3 Costing inventories (figure 9.5)
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4 Illustration Glinka Company
• 1st purchase: 10 units are purchased and are recorded for an acquisition cost of 10 CU per unit
• 2nd purchase: 10 units are purchased and are recorded for an acquisition cost of 12 CU per unit
• 15 units are sold at the end of the period for a unit selling-price of 18 CU per unit
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Table 9.3 Cost of consumption and value of remaining inventory
Transactions (in and out) Ending inventory FIFO Quantity Cost per unit Total cost Quantity Cost per unit Total cost Purchase 1 10 10 100 10 10 100 Purchase 2 10 12 120 20 10 units at 10 100 10 units at 12 120 COGS -10 10 -100 -5 12 -60 5 12 60 LIFO Quantity Cost per unit Total cost Quantity Cost per unit Total cost Purchase 1 10 10 100 10 10 100 Purchase 2 10 12 120 20 10 units at 12 120 10 units at 10 100 COGS -10 12 -120 -5 10 -50 5 10 50 WAC Quantity Cost per unit Total cost Quantity Cost per unit Total cost Purchase 1 10 10 100 10 10 100 Purchase 2 10 12 120 20 20 units at 11 220 COGS -15 11 -165 5 11 55
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Table 9.4 Impact on income statement FIFO LIFO WAC
Sales 270 270 270 Cost of goods sold (direct computation) 160 170 165 Alternatively the COGS can be obtained by applying the full equation
Purchases 220 220 220 Plus beginning inventory 0 0 0 Equals cost of goods available for sale 220 220 220 Minus ending inventory -60 -50 -55 Equals cost of goods sold 160 170 165 Gross margin (before tax) 110 100 105 - Income tax (assuming a 40% rate) -44 -40 -42 Gross margin (after tax) 66 60 63 Control: Cost of goods sold + Ending inventory 220 220 220 Purchases + Beginning inventory 220 220 220
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Table 9.5 Impact on net income and ending inventory
Impact on income and ending inventory of the three methods in the context of rising or falling costs of acquisition
See some other LIFO considerations in Appendix 9.3
Context Impact on net income Impact on ending inventory FIFO higher income reported FIFO higher ending inventory reported Rising costs WAC medium income reported WAC medium ending inventory reported LIFO lower income reported LIFO lower ending inventory reported FIFO lower income reported FIFO lower ending inventory reported Falling costs WAC medium income reported WAC medium ending inventory reported LIFO higher income reported LIFO higher ending inventory reported
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Table 9.6 Impact on cash flow
• No impact of the valuation methods on cash flow before tax
• Impact on the tax expense• Impact on the cash flow after tax FIFO LIFO WAC Cash inflow from sales 270 270 270 Minus Cash outflows for purchases -220 -220 -220 Equals Cash flow before tax 50 50 50 Minus Income tax (40% rate) (see Table 9.4) -44 -40 -42 Equals Cash flow after tax 6 10 8
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5 Decline in value (end of year adjustments)
• Rule of ‘lower of cost or market’
• Illustration: Glazunov Company• Purchase: 1,000 products (unit cost of acquisition: 20 CU)
• Market unit price of these products drops to 15 CU
• The company still holds 100 units in inventory at the end of the accounting period
• A provision for loss of value of inventory must be recorded. It amounts to (20 – 15) x 100 = 500 CU
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Figure 9.6 End-of-year adjustments
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6 Income statement by nature and income statement by function
• Expenses in the income statement can be classified either by nature or by function
• In Chapter 5, illustration of how to go from one presentation to the other for Brahms company, a retailer
• Moussorgski Company: illustration of the passage from one presentation to the other for a manufacturing company
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Table 9.7 Moussorgski: Data
Beginning inventory of raw materials 20 Depreciation expenses Purchases of raw materials 40 . Production equipment 19 Sales revenue (finished products sold) 100 . Sales equipment 5 Raw materials consumed in manufacturing 50 . Administrative equipment 3 Ending inventory of raw materials 10 Rent expenses Personnel expenses . Production 3
. Direct labor 20 . Administration 1
. Supervisory labor 6 Beginning inventory of work in process 2
. Sales personnel 4 Cost of units transferred into finished goods inventory during the period
88
. Accounting and administration personnel 3 Ending inventory of work in process 12 Total cost of units sold during the period 80 Beginning inventory of finished products 3 Ending inventory of finished products 11
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Table 9.8 Income statement by nature and by function
The operating income is mechanically exactly the same under both approaches
Income statement by nature Income statement by function Sales revenue from finished products 100 Sales revenue from finished products 100
+ Change in inventory of finished products (a) 8 - Cost of goods sold (f) -80 + Change in inventory of work in process (a) 10 = Gross margin 20 - Purchases of raw materials -40 - Selling expenses (g) -9 - Change in inventory of raw materials (b) -10 - Administrative expenses (h) -7 - Rent expenses (c) -4 = Operating income 4 - Personnel expenses (d) -33 (f) Cost of goods sold - Depreciation expense (e) -27 + Raw materials consumed 50 = Operating income 4 + Direct labor 20 + Supervisory labor 6
(a) Ending minus beginning + Depreciation (production equipment) 19 (b) Beginning minus ending (subtraction of the
change) + Rent expense (production overhead 3
(c) 3 + 1 = Production costs incurred this period 98 (d) 20 + 6 + 4 + 3 - Change in inventory of finished products (a) -8 (e) 19 + 5 + 3 - Change in inventory of work in process (a) -10
= Cost of goods sold (f) 80 (g) Selling expenses + Personnel expenses (sales person) 4 + Depreciation (sales equipment) 5 = Selling expenses (g) 9 (h) Administrative expenses + Personnel expenses (administration) 3 + Depreciation (administration) 3 + Rent expense (administration) 1 = Administrative expenses (h) 7
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7 Financial statements analysis
Two metrics:
• Inventory turnover: number of times the inventory ‘turns’ during the accounting period
• Average days of inventory available: inverse of the turnover ratio
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Table 9.9 Formulae for the calculation of the Inventory turnover in the income statement by
nature
Cost of merchandise sold, or Cost of raw materials consumed, or
Cost of finished products sold (COGS)
Divided by
[(Beginning inventory + ending inventory)/2]
(Beginning inventory
+ Purchases of merchandise or raw materials or cost of goods
manufactured (COGM)
- Ending inventory)
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Real-life example Inventory ratios: Toray Industries (Japan - 2008/09)
Millions of yen Note 3 to financial statements 2009 2008 Balance sheet Merchandise and finished goods 175,572 174,801 Work in process 86,524 86,455 Raw materials and supplies 57,866 67,191
(A) 319,962 (B) 328,447 Income statement Cost of goods sold (1) 1,208,056 Computation Average inventory (2)=[(A)+(B)]/2 324,205 Inventory turnover (3)=(1)/(2) 3.73 times Average days of inventory available (4)=1/(3)*365 98 days
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Chapter 10 Financial instruments in the balance
sheet and fair value accounting
Financial Accounting and Reporting -
A Global Perspective (third edition)
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Major topics1 Definitions financial assets and liabilities
2 Cash and cash equivalents
3 Financial assets and liabilities at fair value through profit and loss
4 Held-to-maturity financial assets
5 Accounts receivable
6 Recording a sales return
7 Available-for-sale financial assets
8 Financial statement analysis
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1 Definition of financial assets and liabilities (IAS 32, IASB 2008a: § 11)
• Financial instruments: ‘any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity’
• Financial assets:– Cash; – An equity instrument of another entity; – A contractual right: (i) to receive cash or another financial asset from
another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity; or
– A contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments
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Definition of financial assets and liabilities (IAS 32, IASB 2008a: § 11)
• Financial liability: any liability that is:– A contractual obligation: (i) to deliver cash or another financial asset to
another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or
– A contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments
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Financial instruments in assets (IAS 39, IASB 2008b: § 9)
• Financial asset held ‘at fair value through profit or loss’ [i.e., held for trading or sale, and for which latent (potential or unrealized) gains or losses are transferred to the income statement on the basis of the fair value on the closing date]
• Held-to-maturity investments
• Loans and receivables
• Available-for-sale financial assets
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Table 10.1 Subsequent measurement of financial assets
Category IASB (IAS 39) Valuation or measurement of the
current investment in the balance sheet
Treatment of potential (unrealized) gains and losses
measured by comparing cost to fair market value
Financial assets at fair value through profit or loss
At ‘fair value’ (unless the asset has no quoted market price in an active market or the fair value cannot be reliably measured)
Included in net profit or loss of the period in which it arises
Held-to-maturity investments
At cost -
Loans and receivables At cost - Available-for-sale financial assets
At ‘fair value’ (unless the asset has no quoted market price in an active market or the fair value cannot be reliably measured)
Recognized (recorded) directly in equity
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2 Cash and cash equivalents• Definitions (IAS 7, IASB 1992)
• Cash comprises – cash on hand (coins and currency available)– demand deposits (deposits in bank accounts that
are available on demand)
• Cash equivalents: short-term, highly liquid investments readily convertible to known amounts of cash and subject to an insignificant risk of changes in value
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3 Financial asset and liability at fair value through profit or loss (IAS 39, IASB 2008b: § 9)
• A financial asset or financial liability at fair value through profit or loss is a financial asset or financial liability that meets either of the following conditions: – (a) It is classified as held for trading. A financial asset or financial
liability is classified as held for trading if (i) it is acquired or incurred principally for the purpose of selling or repurchasing it in the near term, (ii) on initial recognition it is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or (iii) it is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument)
– (b) Upon initial recognition it is designated by the entity as at fair value through profit or loss (…)
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Table 10.3 Data of Mozart Company’s current investment example
Date of purchase
Security Quantity Unit Cost
Total cost
Market value at
year-end
Total market value
Period-end adjustment (individual
basis)
Period-end adjustment (aggregate
portfolio basis) 25/10/X1 Bonds Alpha Company 10 150 1,500 160 1,600 100 23/11/X1 Shares Beta Company 20 100 2,000 90 1,800 -200 Total Portfolio 30 (10B
+ 20S) 3,500 3,400 -100 -100
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Figure 10.1 Accounting for current investments – Year X1
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Figure 10.2 Accounting for current investments – Quarter 1 of X2
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Reporting financial asset at fair value through profit or loss
Format 1 (detailed vertically and using a contra-asset account) Current investments (gross – at cost) 3,500 Minus provision for potential loss - 100 Current investments (net) 3,400
Format 2 (synthetic with detail in the balance sheet itself)
Current investments (net of provision for potential loss: 100) 3,400
Format 3 (synthetic with detail in a note to the balance sheet) Current investments (net) (see note X) 3,400
Notes to the financial statements: Note X – Current investments: The accumulated amount of provision for potential losses is equal to 100.
Format 4 (detailed horizontally)
Gross value Accumulated provisions
Net value
Current investments 3,500 100 3,400
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4 Held-to-maturity financial assets
• Non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity (…) (IAS 39: § 9)
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5 Accounts receivable
• Application of the non offsetting principle to accounts receivable
• Subsidiary ledgers
• Collectibility of receivables (see Figure 10.3)
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Figure 10.3 Different categories of claims
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Figure 10.4 Doubtful accounts receivable
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Collectibility of receivables
Identification of doubtful or disputed accounts (see Figure 10.4)
Evaluation of the probability of uncollectibility– Global estimation (percentage of sales or percentage
of receivables– Specific write down or write-off (aging analysis)
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Collectibility of receivables
Recording of a provision expense corresponding to the probability of uncollectibility (see Figures 10.5, 10.6 and 10.7)
Recording a bad debt expense corresponding to a specifically identified uncollectible receivable
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Figure 10.5 Doubtful accounts – Year X1
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Figure 10.6 Doubtful accounts - Year X2
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Figure 10.7 Doubtful accounts - Year X3
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Impact on income of each of the year’s entries
Year X1 Provision expense
- 40
Year X2 Provision expense
- 30
Year X3 Reversal of provision expense + 70 Bad debt expense - 90
- 20
- 90
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Reporting accounts receivable (1/2) Brückner example – Year X2
Method 1 (detailed vertically and using a contra asset account) Accounts receivable (gross) 100 Less Provision for doubtful accounts - 70 Accounts receivable (net) 30 Method 2 (synthetic with detail in the balance sheet) Accounts receivable (net of provision for doubtful accounts: 70) 30
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Reporting accounts receivable (2/2) Brückner example – Year X2
Method 3 (synthetic with detail in a note to the balance sheet) Accounts receivable (net) (see note X) 30 Notes to the financial statements: Note X - Accounts receivable The accumulated amount of provision for doubtful accounts is equal to 70. Method 4 (detailed horizontally) Gross value Amortization and provisions Net value Accounts receivable 100 70 30
Chapter 9 58Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 58
6 Recording of a sales return with direct cancellation (method 1,
figure 10.9)
Chapter 9 59Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 59
Recording of a sales return with use of a contra-account(method 2, figure 10.10)
Chapter 9 60Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 60
7 Available-for-sale financial assets
• Non-derivative financial assets that [either] are [formally] designated as available for sale, or are not classified as (a) loans and receivables, (b) held-to-maturity investments or (c) financial assets at fair value through profit or loss (IAS 39: § 9)
Chapter 9 61Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 61
8 Financial statement analysis
• Average days of sales (in receivables) (or Average collection period) or Days Sales Outstanding [DSO]) = (Average accounts receivable/Net sales) 365 days
• Receivables turnover = Net sales/Average accounts receivable
Chapter 9 62Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2
© 2010 H. Stolowy, M. J. Lebas and Y. Ding 62
Real-life example: Ericsson (Sweden – IFRS – 2008)
Millions of SEK
Net sales 2008 208,930 Net sales in Sweden 2008 8,876 Trade receivables 2008 75,891 Trade receivables 2007 60,492 Trade receivables Average 68,192 Average days’ sales (68,192/208,930) * 365 119.1 Receivables turnover (208,930/68,192) 3.06