SMART STARTER - PRC Exam Review, CIA & CMA Exam · PDF fileFinancial Reporting Planning...

Financial Reporting

Planning

Performance & Control

SMART STARTERSection A of CMA Part 1

PART 1

Financial Reporting, Planning,

Performance, and Control

Introduction

Intro-2 © 2017 Powers Resources Corporation®. All rights reserved.

Acknowledgements: PRC extends its appreciation to the Institute of Management Accountants and its team for their support in developing this material.

The CMA is a registered trademark owned by the IMA.

Introduction

© 2017 Powers Resources Corporation®. All rights reserved. Intro-3

IMPORTANT NOTE

Dear Valued Candidate,

Please check our website regularly for downloads of any new supplemental updates of this material, or for other information provided to assist you in the preparation for your CMA examination. While every effort was made to ensure accuracy and minimize any errors in this 2nd edition of the PRC CMA Review, errors are an integral part of the publishing process. We continuously seek and value your feedback on how we can improve this material.

It is also critical to emphasize that this review material was prepared in accordance with the IMA’s disclosed Content Specification Outline, but due to the nature of the exam and the topics covered, a candidate is expected to apply reasoning and logic to a wide array of potential scenarios that may not be fully covered in review materials. Moreover, when considering the body of knowledge for the CMA exam, it is sometimes impractical to divide with clear lines between the various topics.

All information pertaining to the CMA examination was valid as of the time of printing this material. For more up to date information, log on to our Website at:

www.powersresources.com

Sincerely,

PRC Development Team

Introduction


NOTES

Introduction


INTRODUCTION TO THE CMA EXAM

1. Introduction ...................................................................................................................................... 7

2. Admission to the CMA Program .................................................................................................... 7

3. Content of the CMA Exam ............................................................................................................. 8

4. CMA Application and Exam Registration (IMA CMA Handbook) ................................................... 8 5. Identification Requirements ............................................................................................................. 9 6. Calculator Policy .............................................................................................................................. 9 7. Examinee Conduct .......................................................................................................................... 9 8. Exam Rules and regulations .......................................................................................................... 10

9. PRC’s Passing Tips for Taking The CMA Exam .......................................................................... 11

All Section Read this introduction about the CMA exam.

Make sure to read the exam section a couple of days before your exam.

Introduction


NOTES

Introduction


1. Introduction

To become Certified Management Accountant (CMA), you are required to sit and pass the two parts of the exam.

The exam is administered by The Institute of Management Accountants – IMA. CMA exams are offered through computer-based testing (CBT). This means that you will be able to take your exam in any one of Prometric’s available testing centers around the world (www.prometric.com/icma).

The exam consists of two parts multiple choice and writing questions as follows:

1- Part 1: Financial Reporting, Planning, Performance, and Control

(4 hours – 100 multiple-choice questions and two essay questions)

2- Part 2: Financial Decision Making

(4 hours – 100 multiple-choice questions and two essay questions)

2. Admission to the CMA Program

To become certified, you need to fulfill ALL the following requirements.

1. Active membership in the Institute of Management Accountants

2. Pay the CMA Entrance Fee

3. Satisfy the Education Qualification (A Bachelor’s or advanced degree, from an accredited college or university, or a professional certificate, such as CIA or CFA. A list of approved certifications is available in the CMA handbook)

4. Satisfy the Experience Qualification (two continuous years of professional experience in management accounting and/or financial management)

5. Complete all required examination parts

6. Comply with the IMA Statement of Ethical Professional Practice

You may sit for the CMA exam before fulfilling the education and experience requirements, but you must complete the CMA program within three years from the date of entry into the program (date of payment of CMA entrance fee).

Introduction


3. Content of the CMA Exam

1. Part 1 – Financial Reporting, Planning, Performance, and Control A. External Financial Reporting Decisions (15%) B. Planning, Budgeting and Forecasting (30%) C. Performance Management (20%) D. Cost Management (20%) E. Internal Controls (15%)

2. Part 2 – Financial Decision Making

A. Financial Statement Analysis (25%) B. Corporate Finance (20%) C. Decision Analysis (20%) D. Risk Management (10%) E. Investment Decisions (15%) F. Professional Ethics (10%)

The Board of Regents of the Institute of Certified Management Accountants (ICMA®) has overall responsibility for developing the CMA examinations.

The ICMA was created for the purpose of developing and administering the CMA program.

PRC is committed to continuously adjust the content of its materials and the level of concentration of each topic to keep abreast with the changes in the exam coverage.

4. CMA Application and Exam Registration (IMA CMA Handbook)

The CMA examination is given in a computer-based format, and is offered at Prometric Testing Centers located throughout the world. An up-to-date listing of all Prometric Testing Centers can be found at Prometric’s website (www.prometric.com/ICMA) Parts 1 and 2 are offered during the following three testing windows.

January/February

May/June

September/October

Exam registration steps:

1- IMA Membership application

2- CMA Entrance Fee

3- Exam scheduling

Introduction


DETAILED APPLICATION, REGISTRATION, AND SCHEDULING INSTRUCTIONS are available in the CMA handbook. You are kindly requested to go over them as they are an important guide for the online registration.

The handbook is available on the IMA’s website through the following link: https://www.imanet.org/cma-certification/

5. Identification Requirements

For admission to a Prometric Test Site, you must present proof of your identify. The name on your ID must match exactly with the name on your authorization letter. Following are the only acceptable forms of valid identification.

1. Valid, signed, non-expired Government-issued passport.

Or

2. Two original forms of non-expired identification, one with a photograph, both with your signature. Acceptable forms of ID include a drivers’ license, military ID, credit card or bank debit card with photo and signature, bank debit card with signature, or company ID.

Or

3. A Government-issued National country ID Card with a photograph (with or without a signature), and another acceptable valid form of ID with a signature as defined in #2 above.

6. Calculator Policy

Small battery or solar powered electronic calculators restricted to a maximum of six functions –addition, subtraction, multiplication, division, square root, and percentage are allowed. The calculator must not be programmable and must not use any type of tape. Candidates can also use the Texas Instrument’s BA II Plus, Hewlett- Packard 10BII, HP 12c, or HP 12c Platinum calculators when taking the exams. Candidates will not be allowed to use calculators that do not comply with these restrictions.

7. Examinee Conduct

All candidates are required to sign a statement agreeing not to disclose the contents of the examinations nor remove examination materials from the testing room. All candidates are also required to attest to the authenticity of their credentials and the accuracy of all statements made in their application. Cheating will not be tolerated, and all instances of suspected cheating will be fully investigated. Examinees who are caught cheating will have their grades invalidated and will be disqualified from future examinations. Cheating includes, but is not limited to, the following; copying answers from another candidate during the exam, using unauthorized materials during the exam, helping another candidate during the exam, removing exam materials from the testing room, divulging exam questions, and/or falsifying credentials.

For those already certified by the ICMA, failure to comply with the nondisclosure policy or the subsequent discovery of cheating will be considered a violation of the IMA Statement of Ethical Professional Practice and will result in revocation of the certificate.

Introduction


8. Exam Rules and regulations (www.prometric.com)

1. You will be continuously monitored by video, physical walk-throughs and the observation window during your test. All testing sessions are video and audio recorded.

2. You must present valid (unexpired) and acceptable ID(s) in order to take your test. Validity and number of IDs required is predetermined by your test sponsor.

3. You are required to sign out on the test center roster each time you leave the test room. You must also sign back in and show your ID to the Test Center Administrator (TCA) in order to be re-admitted to the test room.

4. You are prohibited from communicating, publishing, reproducing, or transmitting any part of your test, in any form or by any means, verbal or written, for any purpose.

5. You must not talk to other candidates or refer to their screens, testing materials, or written notes in the test room.

6. You must not use written notes, published materials, or other testing aids, except those allowed by your test sponsor. (The TCA will refer to the applicable client practice for allowances.)

7. You are allowed to bring soft ear plugs (with no wires/cords attached) or center-supplied tissues in the test room.

8. Any clothing or jewelry items allowed to be worn in the test room must remain on your person at all times. Removed clothing or jewelry items must be stored in your locker.

9. You will be scanned with a metal detector wand prior to every entry into the test room. If you refuse, you cannot test.

10. You will be asked to raise your slacks/pants legs above your ankles and pull your sleeves up (if long sleeves are worn) prior to every entry into the test room.

11. You will be asked to empty and turn your pockets inside out prior to every entry into the test room to confirm that you have no prohibited items.

12. You must not bring any personal/unauthorized items into the testing room. Such items include but are not limited to: outerwear, hats, food, drinks, purses, briefcases, notebooks, pagers, watches, cellular telephones, recording devices, and photographic equipment. Weapons are not allowed at any Prometric Testing Center.

13. You must return all materials issued to you by the TCA at the end of your test.

14. You must comply with the policy of your test sponsor regarding the use of phones during scheduled breaks in your test.

15. Your test may have either scheduled or unscheduled breaks which are determined by your test sponsor. The TCA can inform you what is specifically permitted during these breaks.

16. If a break is taken during the exam you must return to your original, assigned seat.

17. Repeated or lengthy departures from the test room for unscheduled breaks will be reported by the TCA.

18. If you need access to an item stored in the test center during a break such as food or medicine, you must inform the TCA before you retrieve the item. You are not allowed to access any prohibited item (as defined by the client practice applicable for the test you are taking).

Introduction


19. You must conduct yourself in a civil manner at all times when on the premises of the testing center. Exhibiting abusive behavior towards the TCA, or any other staff member of the test center, may result in criminal prosecution.

20. To protect the privacy of all testers, the TCA can neither confirm nor deny if any particular individual is present or scheduled at the test center.

21. Persons not scheduled to take a test are not permitted to wait in the test center. Note: Client practice policies applicable to individual exams may supersede any of these regulations.

9. PRC’s Passing Tips for Taking The CMA Exam

A. Preparing for the Exam

- Plan your study program.

- Periodically review, reassess, and revise your study program as to keep yourself within the time budget.

- Make sure to read through all the lectures and solve ALL multiple-choice questions (MCQs).

- Second attempts on solving the MCQs should be concentrated on questions answered incorrectly in previous attempts.

- Spend more time on topics that you are answering incorrectly.

- It is highly recommended to enroll in one of PRC’s live courses, or intensive seminars in your area.

- Utilize PRC’s essay writing support techniques. When practicing your essays, you can send us a sample essay that you answered and one of our lead instructors will provide you with customized support on what you need to do to improve you essay writing techniques.

B. Before you Go

- Have a good night’s sleep before the exam.

- Arrange for a light breakfast.

- Plan to arrive at the exam site at least half an hour before the exam.

- Remember to have the following items with you:

Authorization letter.

Valid photo identification.

C. During the Exam

- You have 180 minutes /3 hours to answer 100 questions, and 60 minutes to answer to essay questions.

- Read the exam instructions carefully.

- If you do not use all the 180 minutes allocated for the MCQ questions, the remaining time will be added to the time allocated for essay questions.

Introduction


- Use PRC’s Exam Answering Technique©:

Go through the questions answering only short and/or questions that you are familiar with. Do not attempt to answer long and/or questions pertaining to topics you are not familiar with or do not like. This step should give you more time on the more difficult questions in addition to building your confidence.

Make a second pass attempting to answer medium length and/or medium difficulty questions.

Repeat the process until you have completed the entire exam Session.

When you have exhausted all the questions you are able to answer, and there are still unanswered questions, attempt to guess the answers.

Be sure to choose only the appropriate checkbox. Budget your time and use PRC’s Exam Answering Technique to maximize your chances of passing.

Read the answer choices carefully.

If you do not know the correct answer, select the best possible choice.

Double check that you have answered all questions before submitting your exam.

Make sure to read and sign the nondisclosure agreement.

Maintain your positive attitude before and during the exam; do not panic if you encounter difficulties while studying or while doing the exam.

D. After Each Exam

- Do not discuss the exam with anyone as it may potentially violate the IMA’s exam non-disclosure clause.

- Contact PRC at [email protected] and let us know how we did and what we need to improve to help future candidates.

GOOD LUCK!

Section A

External Financial Reporting Decisions

All Section External financial reporting decisions is a separate section of the Part 1 exam comprising 15% tested at all three Levels (A, B, and C).

Remember to read the answers of all questions whether solved correctly or incorrectly.

When reviewing the lecture before the exam, emphasize and concentrate on questions solved incorrectly in prior solving attempts.

Section A: External Financial Reporting Decisions

A-2 © 2017 Powers Resources Corporation®. All rights reserved

EXTERNAL FINANCIAL REPORTING DECISIONS

(15% LEVELS A, B, AND C)

A.0 Financial Statements ..................................................................................................................... 3

Conceptual Framework ................................................................................................................... 4

International Financial Reporting Standards ................................................................................... 9

A.1 Financial Statements ................................................................................................................... 13

Different Formats of Financial Statements .................................................................................... 13

A.2 Recognition, measurement, valuation, and disclosure ................................................................. 36

Asset Valuation ............................................................................................................................. 36

Accounts Receivable .................................................................................................................... 36

Inventory ....................................................................................................................................... 45

Securities ...................................................................................................................................... 57

Depreciable and Intangible Assets ................................................................................................ 63

Depreciation .................................................................................................................................. 67

Asset Retirement Methods ............................................................................................................ 70

Liabilities ....................................................................................................................................... 71

Types of Debt (Liabilities) ............................................................................................................. 72

Contingent Liabilities ..................................................................................................................... 74

Off-Balance Sheet Financing ........................................................................................................ 78

Income Taxes ............................................................................................................................... 82

Leases .......................................................................................................................................... 89

Equity Transactions ...................................................................................................................... 92

Revenue Recognition .................................................................................................................. 100

Sample Financial Statements ..................................................................................................... 122


© 2017 Powers Resources Corporation®. All rights reserved A-3

STUDY SESSION 1

A.0 Financial Statements

This is an introduction to financial accounting to serve as a refresher and an introduction to Section A. Throughout Section A, the text distinguishes the major differences for the accounting treatment of various items between US GAAP developed by the Financial Accounting Standards Board (FASB) and International Financial Reporting Standards (IFRS) developed by the International Accounting Standards Board (IASB).

The Accounting Cycle

Identifying and Measuring Transactions and Other Events

Journalizing Transactions

Posting Journal Entries to General

Ledger

Preparing the Trial Balance

Preparing and Booking Adjusting

Entries

Preparing and Booking Reversing

Entries

Preparing thePost-Closing Trial

Balance

Closing Nominal Accounts

Preparing Financial Statements

Preparing the Adjusted Trial Balance



Conceptual Framework Conceptual framework is a coherent system of interrelated objectives and fundamentals that can lead to consistent accounting standards. The objectives identify the goals of financial reporting, while the fundamentals represent the underlying concepts that help achieve those objectives. Those concepts provide guidance in:

‐ Selecting transactions, events and circumstances to be accounted for,

‐ How they should be recognized and measured, and

‐ How they should be summarized and reported.

The conceptual framework developed by the FASB consists of the following three levels.

IFR

S Development of the Conceptual Framework Both the FASB and the IASB are working on reaching a common conceptual framework.

A. First Level: Basic Objectives – Objectives of Financial Reporting by Business Enterprises

The objectives of financial reporting are to provide information to current and potential investors, creditors, and other users with reasonable knowledge of business and economic activities to:

1. Make investment and credit decisions;

2. Assess the amounts, timing and uncertainty of future cash flows; and

3. Assess economic resources, the claims to those resources, and the changes in them.

IFR

S

Objectives of Financial Reporting Both US GAAP and IFRS consider that the main objective of financial reporting is to provide information for credit and investment decisions.

B. Second Level: Fundamental Concepts - Qualitative Characteristics of Accounting Information

1. Primary Qualities

a. Relevance – accounting information must be capable of making a difference in a decision. Characteristics of relevant information:

i. Predictive value – assists users to anticipate the results of future operations (budget) based on historical operations.

ii. Feedback value – assists users to evaluate the results of historical operations.

iii. Timeliness – presented to users on a timely manner to facilitate making judgments.

b. Reliability accounting information is reliable to the extent that it is verifiable, is a faithful representation, and is reasonably free of error and bias.

i. Verifiability – i.e. the same results would be achieved by independent measurers, using the same measurement methods.

ii. Representational faithfulness – the numbers and descriptions represent what really existed or happened (i.e. substance of transactions rather than their form)

iii. Neutrality – information is not biased and cannot be selected to favor one set of interested parties over another.



2. Secondary Qualities

a. Comparability – information about an enterprise is more useful if it can be compared with similar information about another enterprise and with similar information about the same enterprise at other points in time. Comparability enables users to identify the real similarities and differences in economic phenomena because these differences and similarities have not been obscured by the use of non-comparable accounting methods.

b. Consistency – is when an entity applies the same accounting treatment to similar events and from period to period. Consistency is required to enable users to compare performance of a company over different periods of time. Companies “may” change their accounting methods and policies when those new methods/policies more fairly present the information.

3. Basic Elements

a. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

b. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

c. Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

d. Investments by owners are increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests in it. Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise.

e. Distributions to owners are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to its owners. Distributions to owners decrease ownership interests in an enterprise.

f. Comprehensive income reflects the changes in equity of an entity during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

g. Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

h. Expenses are outflows or other using up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

i. Gains are increases in equity from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

j. Losses are decreases in equity from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.



C. Third Level: Recognition and Measurement Concepts

Consist of concepts that implement the basic objectives of level one. These concepts pertain to which, when, and how financial elements and events should be recognized, measured, and reported by the accounting system. To recognize an item, it must meet the definition of an element, be measurable, relevant, and reliable.

1. Measurement Concepts – Definitions

a. Historical cost – how much was actually surrendered in the past to acquire the item.

b. Fair market value – how much is the current value in the market.

c. Current cost – how much would it cost the company today to acquire the same item.

d. Present value of future cash flows – the net discounted cash flows that will be collected from an asset or the discounted cash flows that will be incurred to repay a liability.

e. Net realizable value – the total value that could be realized if the underlying asset is liquidated. It may include the sale proceeds less any costs to dispose.

2. Basic Assumptions

a. Economic Entity Assumption – economic activities can be identified with a particular unit of accountability. The economic entity assumption requires the activities of the entity to be kept separate from the activities of its owner and all other entities. This is required even when the entity is not legally separate from its owner. Therefore, the economic entity concept does NOT necessarily refer to a legal entity. An economic entity can be any organization or unit in society such as a company, a governmental unit, or a non for profit organization.

b. Going Concern Assumption – that the entity will have a long life. The going concern assumption states that the entity will continue in operation for the foreseeable future. That means there are no indicators or intention to liquidate the entity in the foreseeable future. Therefore, the going concern assumption applies in most business situations except where liquidation appears imminent. This assumption provides the basis for many accounting concepts such as the historical cost principle (discussed below).

c. Monetary Unit Assumption – money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis. The monetary unit is relevant, simple, universally available, understandable, and useful.

IFR

S

Monetary Unit During rising inflation economy, entities need to accommodate to special requirements by IAS 29 when reporting.

d. Periodicity Assumption – the economic activities of an enterprise can be divided into artificial time periods.



3. Basic Principles of Accounting

a. Historical Cost Principle – most assets and liabilities are to be accounted for and reported on the basis of acquisition price. If liquidation is imminent, assets and liabilities should be reported at their net realizable value.

b. Revenue Recognition Principle – revenue is recorded when (1) realized or realizable and (2) earned. i. Revenues are realized when products are exchanged for cash or claims to cash. ii. Revenues are realizable when assets received or held are readily convertible into cash

or claims to cash. iii. Revenues are considered earned when the entity has substantially accomplished what it

must do to be entitled to the benefits represented by the revenues.

Passing Tip: The practice of recording advanced payments from customers as liabilities (Unearned Revenues) is an application of the revenue recognition principle.

c. Matching Principle – efforts (expenses) must be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. Costs are generally classified into two groups:

i. Product costs attach to the product and are carried into future periods if the revenue from the product is recognized in subsequent periods (e.g. Cost of Goods Sold)

ii. Period costs are charged off immediately, even though benefits associated with these costs occur in the future, because no direct relationship between cost and revenue can be determined (e.g. Advertising Expenses and Officers’ Salaries)

Passing Tip: The practice of recording insurance expense paid in advance as an asset (Prepayments) is an application of the matching principle.

d. Full Disclosure Principle – accountants follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. The accountant can place information about financial position, income, cash flows, and investments in one of three places:

i. Financial Statements are formalized, structured means of communicating financial information. To be recorded in the financial statements, an item should meet the definition of a basic element, be measurable with sufficient certainty, and be relevant and reliable.

ii. Notes of Financial Statements generally amplify or explain the items presented in the main body of the statements. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element.

iii. Supplementary Information may include details or amounts that present a different perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in reliability, or information that is helpful but not essential.



4. The Cost Constraint on Financial Reporting – Because reporting useful financial information imposes costs, it is important to justify those costs by the benefits of reporting that information. This is referred to as the cost constraint (or the cost-benefit relationship). The costs of providing the information must be weighed against the benefits that can be derived from using them.

a. Costs of reporting financial information include costs of collecting, processing, auditing, disseminating, analyzing, and interpreting that information. Those costs reduce the return and affect the overall efficiency of the economy.

b. Benefits to report financial information include better decision making by users, which results in more efficient resource allocation and a lower cost of capital for the economy as a whole.

c. Before making reporting requirements, regulators and governmental agencies must use cost-benefit analysis by assessing whether the benefits of reporting particular information justify the costs incurred to provide and use that information. In order to limit the costs of reporting:

i. Business reporting should exclude information outside management’s expertise or for which management is not the best resource.

ii. Management should not be required to report information that would significantly harm the company’s competitive position.

iii. Management should not be required to provide forecasted financial statements.

iv. Other than for financial statements, management need only report the information it knows.

v. Certain elements of business reporting should be presented only if users and management agree they should be reported.

vi. Companies should not have to expand reporting of forward-looking information.



International Financial Reporting Standards A. International Financial Reporting Standards (IFRS) or (International Accounting Standards (IAS) as

they were referred to in the past) are authoritative statements of how to reflect particular types of transactions and events in the financial statements.

B. Compliance with IFRS requires that firms comply with:

1. The IFRS referred to above; and

2. The Interpretations of the Standards issued by the International Financial Reporting Interpretations Committee (IFRIC).

C. International Accounting Standards Board (IASB) is the board responsible for the setting of the standards.

1. IASB has no authority to require compliance with its accounting standards.

2. It is up to the individual countries to require financial statements to be prepared in accordance with the IFRS and, if and when necessary, describe cases of any material departure from those standards and the reasons for it.

D. IFRS and US GAAP (Generally Accepted Accounting Principles) have some differences in some of the accounting treatments of transactions and/or events. As the CMA exam is an international exam, examiners usually avoid questions in areas with different treatments. The text in this material is generally US GAAP as the terminology and methods are the ones common on the exam. However, this text distinguishes the major differences for the accounting treatment of various items between US GAAP developed by the Financial Accounting Standards Board (FASB) and IFRS developed by the International Accounting Standards Board (IASB).

E. Convergence – The IASB and FASB have both affirmed that development of a common set of high quality global standards remains a strategic priority for both Boards. They signed a Memorandum of Understanding in 2006 that sets forth the relative priorities within the FASB-IASB joint work program in the form of specific milestones to be reached. The Memorandum of Understanding was updated in 2008 and then again in 2010. The Boards also agreed that the goal of joint projects is to produce common, principles-based standards, subject to the required due process of each Board. Most of the joint projects have been completed or are nearing completion. In 2013, the IASB and FASB published an update on the status and timeline of the remaining convergence projects. The projects where the Boards are currently working jointly on are:

1. Financial instruments a. Classification and Measurement b. Impairment (Loan Loss Provisioning) c. Hedge Accounting

2. Leases 3. Revenue recognition (completed in 2014 and effective in 2018) 4. Insurance Contracts



Analyzing Interrelationships Amongst Accounts 1. Assets have debit balances that are increased with a debit (Dr) and decreased with a credit (Cr). 2. Liabilities and owners’ equity have credit balances that are increased with a credit (Cr) and

decreased with a debit (Dr) 3. The following relationship should always hold:

Assets = Liabilities + Owner’s Equity Dr Cr Cr

4. Revenues and gains have credit balances that are increased with a credit (Cr) and decreased with a debit (Dr).

5. Expenses and losses have debit balances that are increased with a debit (Dr) and decreased with a credit (Cr).

6. During a period of time, the company generates revenues and gains and incurs expenses and losses that would result in either a net income or net loss: a. A Net Income would result if the revenues and gains are MORE than the expenses and losses

thus:

Revenues + Gains > Expenses + Losses

Net Income = Revenues + Gains - Expenses - Losses Cr Cr Cr Dr Dr

b. A Net Loss would result if the revenues and gains are LESS than the expenses and losses thus:

Revenues + Gains < Expenses + Losses

Net Loss = Revenues + Gains - Expenses - Losses Dr Cr Cr Dr Dr

7. Net income is added to owners’ equity while net loss is deducted from owners’ equity. Thus:

Assets = Liabilities + Owners’ equity

+ Net

income -

Net loss

Dr Cr Cr Cr Dr

8. Contra-asset account is a valuation account that reduces an asset. It has a credit balance but is reported with the assets section.

9. Contra-liability account is a valuation account that reduces a liability. It has a debit balance but is reported with the liabilities.

10. Adjunct account is a valuation account that either adds to an asset (and thus would have a debit balance) or adds to a liability (and thus would have a credit balance).



11. Accounting entries are recorded initially in a journal by debits and credits. Example of a journal entry when a company purchases on January 3, 20x2 an asset for $100,000 on account (i.e. no cash is involved):

Date Account Dr. Cr. January 3, 2002 Assets 100,000 Accounts payable 100,000

12. Debits are on the left-hand side while credits are indented to the right.

13. Once the entries are made in the journal, they are posted to a ledger account. There is a ledger for each account whereby all related entries are grouped together. Ledgers have numerous forms, however, the easiest to comprehend and apply them are the T-accounts. Thus, posting the above entry to the T accounts would be:

Assets Accounts Payable Dr. Cr. Dr. Cr.

1/3/x2 100,000 100,000 1/3/x2



Selected Accounts Interrelationships Accounts Receivable (A/R)

Beginning accounts receivable Add: Credit sales Sub-total Less: Collections Accounts receivable write-offs Ending accounts receivable

Accounts Receivable Beg. Balance Credit sales Collections Write-offs Total Dr. Total Cr. End. Balance

Allowance for Doubtful Accounts Beg. allowance for doubtful accounts Add: Bad debt expense Write-off recoveries Sub-total Less: Accounts receivable write-offs Ending allowance for doubtful accounts

Allowance for Doubtful Accounts Beg. Balance A/R Write-offs Bad debt expense Write-off recoveries Total Dr. Total Cr. End. Balance

Accounts Payable (A/P) Beginning accounts payable Add: Credit purchases Sub-total Less: Payments on account Ending accounts payable

Accounts Payable Beg. Balance Payments Credit purchases Total Dr. Total Cr. End. Balance

Inventory Beginning inventory Add: Purchases Transportation-in Less: Purchase discounts Purchase allowances Purchase returns Inventory available for sale Less: Cost of goods sold Ending Inventory

Inventory Beg. Balance Purchases Purchase disc. Transportation-in Purchase returns Purchase allowances Cost of goods sold Total Dr. Total Cr. End. Balance

Fixed Assets Beginning fixed assets Add: Purchases Sub-total Less: Disposals Ending fixed assets

Fixed Assets Beg. Balance Purchases Disposals Total Dr. Total Cr. End. Balance

Accumulated Depreciation (Acc. Dep.) Beginning accumulated depreciation Add: Depreciation expense Sub-total Less: Acc. Dep. of disposed assets Ending accumulated depreciation

Accumulated Depreciation Beg. Balance Write-offs Depreciation expense Total Dr. Total Cr. End. Balance



STUDY SESSION 2

A.1 Financial Statements

1. Financial statements a. Balance sheet b. Income statement c. Statement of changes in equity d. Statement of cash flows

Different Formats of Financial Statements

The four financial statements that will be covered in this text per the IMA’s content specification outline are:

Balance Sheet

Income Statement

Statement of Changes in Equity

Statement of Cash flows Other statements that are beyond the scope of this text include:

Statement of Other Comprehensive Income

Statement of Comprehensive Income

Statement of Retained Earnings

Balance Sheet Income Statement

Statement of Changes in Equity Statement of Cash

Flows



Balance Sheet A. Usefulness of the Balance Sheet

A balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to creditors, and the owners’ equity in net resources. The balance sheet provides a basis for:


Statement of Changes in Equity Statement of Cash

Flows

1. Computing rates of return,

2. Evaluating the capital structure of the enterprise, and

3. Assessing its liquidity and financial flexibility.

a. Liquidity describes the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid.

b. Financial flexibility is the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.

IFR

S

Balance sheet

Under IFRS, the balance sheet is referred to as the Statement of Financial Position.

B. Limitations of the Balance Sheet

1. The balance sheet does not reflect the current value of many items since accountants have adopted the historical cost basis in valuing and reporting most assets and liabilities; for which reason many accountants argue that a current cost dollar or net realizable value approach will be more favorable.

2. Judgments and estimates must be used. For example, depreciation method used to depreciate fixed assets, the estimates of useful lives and salvage values all require the use of judgment and estimates.

3. Omits many items that are of financial value to the business but cannot be recorded objectively. For example, human resources are considered amongst the most valuable assets of any firm (especially in the service industry). The value of such an important asset is not recorded in the financial statements.

C. Classification in the Balance Sheet

Balance sheet accounts are classified so that similar items are grouped together to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown. Classifications in financial statements help analysts by grouping items with similar characteristics and separating items with different characteristics:

1. Assets that differ in their type or expected function in the central operations or other activities of the enterprise should be reported as separate items; property may be reported as an investment in a company that intends to use it as such, in inventory by a real estate agent, or under fixed assets if the property is being used by the operation.

2. Assets and liabilities with different implications for the financial flexibility of the enterprise should be reported as separate items; e.g. cash held for payment of current liabilities is reported with current assets, while cash restricted for expanding the company’s manufacturing plant would be reported under other assets.



3. Assets and liabilities with different liquidity characteristics should be reported as separate items e.g. current and non-current.

IFR

S

Classification in the Balance Sheet

The IASB and FASB are working on the next phase of the Financial Statements project, which is to establish consistent principles for aggregating information and to identify the totals and subtotals that should be reported.

Assets

Current assets

Investments

Property, plant, and equipment

Intangible Assets

Other Assets

Liabilities

Short term liabilities

Long-term liabilities

Equity

Common stock

Preferred stock

Retained earnings

Additional paid-in Capital

D. Assets - are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

1. Current Assets - are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are generally presented in the balance sheet in order of liquidity. The five major items found are:

a. Cash

b. Marketable securities

c. Receivables

d. Inventories

e. Prepaid items

2. Long-Term Investments are assets that are invested in securities, fixed assets, special funds, and non-consolidated subsidiaries or affiliated companies.

3. Property, Plant, and Equipment are properties of a durable nature used in the regular operations of the business. They consist of physical property e.g. land, buildings, machinery, furniture, tools, and wasting resources. With the exception of land, most assets classified as property, plant, and equipment are either depreciable or consumable.

4. Intangible Assets are assets that lack physical substance and usually have a high degree of uncertainty concerning their future benefits. Intangible assets include patents, copyrights, franchises, goodwill, trademarks, trade names, and secret processes.



5. Other Assets - some of the items commonly included are:

a. Deferred charges

b. Non-current receivables

c. Assets in special funds, and

d. Advances to subsidiaries.

E. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions.

1. Current Liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within the next year (or operating cycle whichever is longer). Current liabilities include:

a. Payables resulting from the acquisition of goods and services e.g. accounts payable, wages payable, taxes payable . . .etc.

b. Collections received in advance for the delivery of goods or performance of services e.g. unearned rent revenue or unearned subscriptions revenue.

c. Other liabilities whose liquidation will take place within the operating cycle e.g. the portion of long-term bonds to be paid in the current period, or short-term obligations arising from purchase of equipment.

2. Long-Term Liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but, instead, are payable at some date beyond that time. Generally long-term liabilities are:

a. Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable.

b. Obligations arising from the ordinary operations of the enterprise, such as pension obligations and deferred income tax liabilities.

c. Obligations that are dependent upon the occurrence or nonoccurrence of one or more future events to confirm the amount payable, or the payee, or the date payable, such as service or product warranties and other contingencies.

d. Long term liabilities include:

i. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations

ii. Long-term liabilities that mature within the current operating cycle are classified as current liabilities if their liquidation requires the use of current assets.

iii. The terms of all long-term liability agreements are frequently described in notes to the financial statements.



F. Equity

1. Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. Its components are usually as follows:

a. Capital (both common and preferred) Stock - the par or stated value of the shares issued.

b. Additional Paid-In Capital - the excess of amounts paid-in over the par or stated value.

c. Retained Earnings - the corporation’s undistributed earnings.

2. The major disclosure requirements for capital stock are the authorized, issued, and outstanding par value amounts.

a. Authorized refers to the total number of shares that the company is authorized to issue to the general public.

b. Issued refers to the total number of shares that the company issued to the general public. As the authorization process is usually long and costly, a company typically authorizes a large number of shares and issues them as funds are needed. This provides the companies with the opportunities to limit any ideal resources while also having a better chance of issuing the shares at a higher price.

c. Outstanding refers to the total number of shares that have been issued and not re-purchased by the company in treasury stocks.

3. Any capital stock reacquired (called treasury stocks) is shown as a reduction of stockholders’ equity.

4. The additional paid-in capital is usually presented in one amount, although subtotals are informative if the sources of additional capital are varied and material.

5. The retained earnings section may be divided between the unappropriated and any amounts that are appropriate (restricted). Appropriation of retained earnings requires an authorization from the board of directors.

G. Additional Information Reported

There are normally four types of information that are supplemental to account titles and amounts presented in the balance sheet:

1. Contingencies - material events that have an uncertain outcome.

2. Valuations and Accounting Policies

a. Explanations of the valuation methods used or the basic assumptions made concerning inventory valuations, depreciation methods, investments in subsidiaries, . . . etc.

b. Disclosure is particularly useful if given in a separate Summary of Significant Accounting Policies preceding the notes to the financial statement or as the initial note.



3. Contractual Situations

a. Explanations of certain restrictions or covenants attached to specific assets or, more likely, to liabilities.

b. Any contracts and negotiations of significance should be disclosed in the notes to the financial statements.

c. Essential provisions of lease contracts, pension obligations, and stock option plans must be clearly stated in the notes.

4. Post-Balance Sheet Disclosures - disclosures of certain events that have occurred after the balance sheet date but before the financial statements have been issued. Two types of events or transactions occurring after the balance sheet date may have a material effect on the financial statements or may need to be considered to interpret these statements accurately:

a. Events that provide additional evidence about conditions that existed at the balance sheet date, affect the estimates used in preparing financial statements, and, therefore, result in needed adjustments.

b. Events that provide evidence about conditions that did not exist at the balance sheet date but arise subsequent to that date and do not require adjustment of the financial statements. E.g.

i. Sale of bonds or capital stock, stock splits or stock dividends.

ii. Business combination pending or effected.

iii. Settlement of litigation when the event giving rise to the claim took place subsequent to the balance sheet date.

iv. Loss of plant or inventories from fire or flood.

v. Losses on receivables resulting from conditions arising subsequent to the balance sheet date.

vi. Gains or losses on certain marketable securities.

H. Techniques of Disclosure

1. Parenthetical Explanations - additional information is often provided by parenthetical explanations following the item.

2. Notes (Or Footnotes) - notes are used if additional explanations cannot be shown conveniently as parenthetical explanations. The notes must present all essential facts as completely and succinctly as possible. Notes related to the balance sheet may include accounting methods used; pension plan; maturity dates for debts and bonds; stock options; details about property, plant, and equipment; and investment securities.

3. Cross Reference and Contra Items - a procedure to establish contra or adjunct accounts; a contra account on the balance sheet is an item that reduces either an asset, liability, or owners’ equity account. An adjunct account increases either an asset, liability, or owners’ equity account.

4. Supporting Schedules - often a separate schedule is needed to present more detailed information about certain assets or liabilities.



Income Statement A. Importance of the Income Statement

The income statement helps users of the financial statements predict future cash flows in a number of different ways:



Statement of Cash Flows

1. Investors and creditors can use the information on the income statement to evaluate the past performance of the enterprise.

2. The income statement helps users determine the risk (level of uncertainty) of not achieving particular cash flows.

B. Limitations of the Income Statement

1. Income numbers are affected by the accounting methods employed. The quality of earnings of a given enterprise is important to correctly interpret the numbers reported by the income statement.

2. The income statement provides information about income and expense items in the past period, which may not be reflective of the income and expense items for future periods.

3. The income statement does not show items that cannot be measured reliably even though those items may affect the entity’s performance. For example, some unrealized gains and losses are reported on the statement of other comprehensive income and not included in the income statement. Other items of value such as brand recognition, customer service, and customer loyalty are not included in the income statement.

C. Elements of the Income Statement

1. The income statement consists of four elements.

a. Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. Examples of revenues include sales, fees, interest, dividends on investment, and rents.

b. Expenses are outflows or other using up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. Examples of expenses include cost of goods sold, depreciation, amortization, interest, rent, and wages.

c. Gains are increases in equity from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.

d. Losses are decreases in equity from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners. Gains and losses may result from the sale of investments or long-lived assets; settlement of loans or other liabilities; and impairments of assets.

2. The key factor in differentiating revenues from gains and expenses from losses is the typical activities of the entity. For example, if a computer manufacturer sells a laptop, the proceeds are recorded as revenue, but if that manufacturer sells one of its fixed assets (a machine or land), the proceeds in excess of the book value of the asset are recorded as gains. That is because the sale of the laptop is part of the computer manufacturer’s normal operations, while the sale of a machine or land is not.



D. Income Statement Formats 1. Single-step income statement is an income statement where just two groupings exist:

revenues and expenses. Total expenses are subtracted from total revenues to arrive at net income or loss.

2. Multiple-step income statement recognizes a separation of operating transactions from non-operating transactions and matches costs and expenses with related revenues. The following is an example of a multiple-step income statement with full intermediate components:

Sylven Company – Income Statement For the Year Ended on December 31, 20XX

Sales Sales revenue $ 2000,000

- Sales discounts $ 20,000 - Sales returns 45,000 65,000 Net Sales 1,935,000

- Cost of sales 1,135,000 Gross Profit 800,000

- Operating Expenses Selling expenses Sales salaries 120,000 Advertising expense 28,000 Shipping expense 55,000 Depreciation of sales equipment 8,000 General and administrative expenses Officers’ salaries 61,000 Legal services 16,000 Utilities expense 12,000 Insurance expense 14,000 Depreciation of office building and equipment 17,000 331,000 Income from operations (operating income) 469,000

+ Other revenues and gains Dividend and interest revenue 74,000 Rent revenue 29,000 103,000 572,000

- Other expenses and losses Interest expenses 110,000 Loss on sale of land 28,000 138,000 Income from continuing operations before income tax 434,000

- Income taxes 120,000 Income from continuing operations 314,000 Discontinued operations

+ Income from operations of discontinued division (net of tax) 23,000 - Loss on disposal of discontinued division (net of tax) 119,000 96,000 Income before extraordinary items 218,000 Extraordinary items

- Loss from earthquake (net of tax) 83,000 Net income 135,000



E. Irregular Items – Certain irregular income items are required to be highlighted in the income statement so that the reader of financial statements can better assess the long-term earning power of the company. These items fall into unusual gains and losses; discontinued operations; and extraordinary items

1. Unusual Gains and Losses a. Unusual gains and losses are income items that are unusual (irregular) OR infrequent but

not both. Examples of unusual gains and losses include: i. Losses on write-downs of inventory or other assets, or restructuring charges. ii. Gains or losses from exchange of foreign currencies, or from translating the financial

statements into foreign currencies. iii. Gains or losses from disposal of PP&E. iv. Losses on write-downs of receivables, inventory, PP&E, or intangible assets. v. Gains or losses that result from a strike against the entity or its competitors and suppliers. vi. Adjustment of accruals on long-term contracts.

b. Those items are reported in a separate section just above income from operations before income taxes and extraordinary items. Companies usually report unusual gains and losses under “Other Revenues and Gains” and “Other Expenses and Losses”.

c. Unusual gains and losses are not required to be reported net of tax. 2. Discontinued Operations

a. Discontinued operations usually relate to the disposal of a segment of the business or a product line.

b. The results of operations of a segment that has been or will be disposed of are reported in conjunction with the gain or loss on disposal - separate from continuing operations.

c. The effects of discontinued operations are shown net of tax as a separate category after continuing operations but before extraordinary items.

d. To qualify, the assets, results of operations, and activities of a segment of a business must be clearly distinguishable, physically and operationally, from the other assets, results of operations, and activities of the entity.

e. Disposal of assets incidental to the evolution of the entity’s business is not considered disposal of a segment of the business.

f. Disposals of assets that do not qualify as disposals of a segment of a business include: i. Disposal of part of a line of business. ii. Shifting production or marketing activities for a particular line of business from one

location to another. iii. Phasing out of a product line or class of service. iv. Other changes due to technological improvements.



3. Extraordinary Items a. Extraordinary items are nonrecurring material items that differ significantly from the entity’s

typical business activities. b. The item must be BOTH unusual (irregular) in nature and infrequent in occurrence. c. The following are considered extraordinary items:

i. Gains or losses resulted directly from unusual disasters such as earthquakes, tornados, hurricanes, and volcanic activity.

ii. Losses from expropriation by governments. d. Material gains and losses from extinguishment of long-term debt used to always be

reported as an extraordinary item. With recent changes, gains and losses from extinguishment of long-term debt are only reported as an extraordinary item if they are considered extraordinary i.e. unusual and infrequent.

e. Extraordinary items are shown net of taxes. f. Extraordinary items are different from unusual gains and losses covered above. The following

table illustrates the difference between the two sections:

Frequency of Occurrence

Frequent Infrequent

Nature Usual Revenue/Expense Gain/Loss

Unusual Gain/Loss Extraordinary

IFR

S

Extraordinary Items

Separate presentation of gains or losses as extraordinary items is prohibited by international standards.

F. Changes in Accounting Estimate 1. Accounting estimates include estimating the useful lives and salvage values of fixed assets,

uncollectible receivables, or the number of years the company is expected to benefit from an expenditure.

2. Changes in estimates are accounted for in the period of change if they affect only that period, and future periods if the change affects both.

3. Changes in estimates are not handled retroactively, that is, carried back to adjust the statements of prior years.

4. Changes in estimates are not considered errors (prior period adjustments) or extraordinary items.

G. Footnotes disclosures related to income statement include detailed depreciation amounts, revenue recognition method, detailed tax amounts, and earnings per share.



Statement of Changes in Equity Balance Sheet Income Statement



A. Statement of Changes in Equity is a reconciliation of each of the equity components from the beginning to the end of the period/year. A simplified statement of changes in stockholders equity (excluding preferred shares and additional paid-in capital) is illustrated below:

Sylven Company Statement of Changes in Equity

For the Year Ended December 31, 201X

Total Retained Earnings

Accumulated Other

Comprehensive Income

Common Stock

Beginning balance 2,250,000 750,000 500,000 1,000,000

Comprehensive Income

Net income 210,000 210,000

Other comprehensive income 50,000 50,000

Issuance of common stock 100,000 100,000

Less: dividends declared (60,000) (60,000)

Ending balance 2,550,000 900,000 550,000 1,100,000



Statement of Cash Flows A. Purpose of the Statement of Cash Flows

5. The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement of cash flows reports:


Statement of Retained Earnings


a. The cash effects of operations during a period,

b. Investing transactions,

c. Financing transactions, and

d. The net increase or decrease in cash during the period.

6. The statement’s value is that it helps users evaluate liquidity, solvency, and financial flexibility.

a. Liquidity refers to the “nearness to cash” of assets and liabilities or the ability to settle current liabilities as they become due, by converting current assets to cash.

b. Solvency refers to the firm’s ability to meet its liabilities as they mature. The cash flow from operating activities is the most important factor in determining the entity’s solvency based on the statement of cash flows.

c. Financial flexibility refers to the firm’s ability to respond and adapt to financial adversity and unexpected needs and opportunities i.e. the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.

d. In order to evaluate liquidity or financial flexibility, the user should study the balance sheet in conjunction with the statement of cash flows.

7. The statement’s value is that it helps users evaluate:

a. Amount, timing, and uncertainty of prospective net cash inflows of a firm.

b. Firm’s ability to pay its obligations as they become due.

c. Firm’s ability to generate future cash flows.

B. Components and Classifications – Statement of cash flows classifies cash receipts and cash payments during the period into three different activities:

1. Operating Activities – Cash flows from operating activities are generally those related to transactions that enter into the determination of net income. They are all transactions that are not classified as investing or financing activity. Cash flows from operating activities result primarily from the central operations of the entity. Examples of cash flows from operating activities include:

a. Cash receipts from sales and collection from customers.

b. Interest received on loans to other entities.

c. Dividends received on equity investments.

d. Cash paid to suppliers for inventory.

e. Cash paid to employees.

f. Cash paid to government as taxes.

g. Interest paid on debts.



2. Investing Activities – Investing activities generally involve transactions to acquire or dispose resources intended to generate future income. Examples of cash flows from investing activities include:

a. Cash flows from purchasing or selling PP&E and other long-lived assets.

b. Cash flows from making or collecting loans to other entities (Associated interests are included in operating cash flows).

c. Cash flows from purchasing or selling equity instruments of other entities.

3. Financing Activities – Financing activities involve liability and the entity’s equity accounts. Cash flows from financing activities include:

a. Cash flows from issuing equity stocks, or repurchasing treasury stocks.

b. Cash flows from borrowing from other parties, or repaying the amounts borrowed. (Associated interests are included in operating cash flows).

c. Cash payments of dividends.

C. The Preparation of the Statement of Cash Flows

1. Information to prepare the statement of cash flows is obtained from the following sources:

a. Comparative balance sheets – Comparative balance sheets are used to calculate the amounts of changes in assets, liabilities, and equities’ accounts from the beginning of the period to the end of it.

b. The current income statement – Cash flows generated from, or used in, the entity’s operations during the period are derived from the current income statement.

c. Selected transaction data – Additional information about using or generating cash during the period is obtained from selected transaction data from the general ledger.

2. Determining the cash flows from investing and financing activities is a straightforward process. All transactions relating to the items included in investing or financing activities are first determined and then the cash amounts involved in those transactions are recorded in the cash flow statement.

a. For example, to determine the cash flows from investing activities, we first determine all transactions related to the items included in investing activities (purchasing or selling PP&E for example). Then we record the cash inflows/outflows involved in those transactions in the investing activities section of the statement of cash flow. The same manner is used for financing activities.

3. Determining the cash flows from operating activities is relatively a complex task. There are two methods to calculate cash flows from operating activities, the direct method and the indirect method.

a. Direct Method – accounts for the cash collections made and the cash payments made during the period. Because companies do not normally keep primary records of such transactions, the indirect method is often used.

b. Indirect Method – under this method, the statement would begin with net income, and then adjusts the net income for non-cash items and for changes in balance sheet accounts. For the purpose of the CMA exam, only the indirect method is relevant.

c. Both methods are discussed overleaf.



D. Preparing Operating Cash Flows under the Direct Method – The direct method presents cash flow from operating activities as operating cash receipts (such as cash collected from customers and cash received from interest) reduced by operating cash disbursements (such as cash paid to suppliers and payments to employees). GAAP and IFRS require the use of the accrual basis of accounting which is recording revenues and expenses when recognized or when incurred. Revenues and expenses may include items that are recognized in the income statement but not settled in cash. Therefore, under the accrual basis, net income does not equal the net cash flows from operating activities. Calculating net cash flows from operating activities requires adjusting income statement elements to eliminate the effects of transactions that do not change cash. The following formulas provide the means of obtaining the amounts to prepare a statement of cash flows using the direct method from the accounting entries prepared under the accrual method and vice versa.

1. Collections vs. Sales – to obtain accrual sales from cash receipts, the formula is: cash receipts + increase in accounts receivable – decrease in accounts receivable + decrease in unearned revenues – increase in unearned revenues. On the other hand, to obtain cash receipts from accrual sales, the formula is: sales – increase in accounts receivable + decrease in accounts receivable – decrease in unearned revenues + increase in unearned revenues.

Cash Receipts + ↑ Accounts Receivable

= Sales

– ↓ Accounts Receivable

+ ↓ Unearned Revenues

– ↑ Unearned Revenues

Sales – ↑ Accounts Receivable

= Cash Receipts

+ ↓ Accounts Receivable

– ↓ Unearned Revenues

+ ↑ Unearned Revenues

2. Cash Purchases vs. Cost of Goods Sold – to obtain cost of goods sold from cash payments to suppliers, the formula is: cash payments to suppliers – increase in inventory + decrease in inventory + increase in accounts payable – decrease in accounts payable – increase in advances to suppliers + decrease in advances to suppliers. On the other hand, to obtain cash paid to suppliers from the accrual cost of goods sold, the formula would be: cost of goods sold + increase in inventory – decrease in inventory – increase in accounts payable + decrease in accounts payable + increase in advances to suppliers – decrease in advances to suppliers.

Cash Payments to Suppliers

– ↑ Inventory

= Cost of Goods Sold

+ ↓ Inventory

+ ↑ Accounts Payable

– ↓ Accounts Payable

– ↑ Advances to Suppliers

+ ↓ Advances to Suppliers



Cost of Goods Sold

+ ↑ Inventory

= Cash Payments to Suppliers

– ↓ Inventory

– ↑ Accounts Payable

+ ↓ Accounts Payable

+ ↑ Advances to Suppliers

– ↓ Advances to Suppliers

3. Cash Expenditures vs. Expenses – to obtain accrual expenses from cash expenditures, the

formula is: cash expenditures – increase in prepayments + decrease in prepayments + increase in accruals – decrease in accruals. On the other hand, to obtain the cash expenditures from operating expenses, the formula is: operating expenses + increase in prepayments – decrease in prepayments – increase in accruals + decrease in accruals.

Cash

Expenditures – ↑ Prepayments

= Operating Expenses

+ ↓ Prepayments

+ ↑ Accruals

– ↓ Accruals

Operating Expenses

+ ↑ Prepayments

= Cash Expenditures

– ↓ Prepayments

– ↑ Accruals

+ ↓ Accruals



Sylven Company Statement of Cash Flows – Direct Method

For the Year Ended December 31, 20XX Cash flows from operating activities

Cash collections from customers xxx

Cash payment for expenses xxx xxx

Net cash provided by (used in) operating activities xxx Cash flows from investing activities

Sale (purchase) of property, plant, and equipment xxx

Sale (purchase) of debt/equity securities of other entities xxx

Collection of loans from (loans to) other entities xxx xxx

Net cash provided by (used in) investing activities xxx Cash flows from financing activities

Issuance (purchase) of entity’s securities xxx

Issuance (redemption) of debt xxx

(Payments of dividends) xxx xxx

Net cash provided by (used in) financing activities xxx Net increase (decrease) in cash during the period xxx

Add: Cash, beginning of the period xx

Cash, end of the period xxx

E. Preparing Operating Cash Flows under Indirect Method – The indirect method starts with net income and adjusts it for items that affect reported net income but do not affect cash. The adjustment is performed as follows: 1. Noncash expenses are added back to net income. Examples include depreciation, amortization,

and impairment losses. 2. Noncash revenues are subtracted from net income. Examples include undistributed earnings of

equity-method investments. 3. Gains (and losses) included in net income and related to investing or financing activities are

subtracted from (or added back to) net income. Examples include gains or losses on sales of PP&E, and gains or losses on early extinguishment of debt.

4. The net income is also adjusted for changes in accounts that are related to operating activities. These accounts include inventory, accounts receivable, accounts payable, and other operating assets and liabilities.



Sylven Company Statement of Cash Flows – Indirect Method

For the Year Ended December 31, 20XX

Cash flows from operating activities

Net income xxx

Adjustments to reconcile net income to net cash provided by operating activities: Add (deduct)

Depreciation, amortization, and depletion xxx

Loss (gain) on sale of fixed assets xxx

Exchange (gain) loss xxx

Increase (decrease) in payables xxx

Increase (decrease) in current/operating liabilities xxx

Decrease (increase) in receivables xxx

Decrease (increase) in current/operating assets xxx xxx

Net cash provided by (used in) operating activities xxx

Cash flows from investing activities

Sale (purchase) of property, plant, and equipment xxx

Sale (purchase) of debt/equity securities of other entities xxx

Collection of loans from (loans to) other entities xxx xxx

Net cash provided by (used in) investing activities xxx

Cash flows from financing activities

Issuance (purchase) of entity’s securities xxx

Issuance (redemption) of debt xxx

(Payments of dividends) xxx xxx

Net cash provided by (used in) financing activities xxx

Net increase (decrease) in cash during the period xxx

Add: Cash, beginning of the period xx

Cash, end of the period xxx



Illustration of the Indirect Method

The following are comparative balance sheets of a company:

Comparative Balance Sheets as of December 31

Assets Year 2 Year 1 Change Cash $ 27,000 $ 20,000 $ 9,000 Accounts receivable 25,000 30,000 (5,000) Inventory 34,000 24,000 10,000 Prepaid expenses 5,000 2,000 3,000 Machine 120,000 80,000 40,000 Accumulated depreciation - Machine (30,000) (18,000) 12,000 Totals 181,000 138,000 Liabilities and Equity Accounts payable 12,000 20,000 (8,000) Loan 20,000 40,000 (20,000) Common stock 79,000 38,000 41,000 Retained earnings 70,000 40,000 30,000 Totals 181,000 138,000

The following is the company’s income statement for the year ended on December 31, Year 2:

Income Statement for the Year Ended on December 31, Year 2

Sales 150,000 Cost of goods sold 70,000 Depreciation expense 18,000 Interest expense 2,000 Gain on machine disposal 4,000 (94,000) Income from operations 56,000 Income tax 16,000 Net income 40,000

Additional information:

1. In Year 2, $20,000 of the outstanding loan was paid in cash.

2. Interest expense was paid in cash.

3. Common stocks were issued for cash.

4. Dividends of $10.000 were declared and paid in cash.

5. A machine with a cost of $60,000 was purchased for cash.

6. A machine was sold for $18,000 in cash. The cost of the machine is $20,000 and its book value is $14,000.

Prepare the statement of cash flows of the company for Year 2 under the indirect method.



Solution

Operating Activities – Under the indirect method, we start with net income and adjust it to determine the net cash flow from operating activities. The needed adjustments are:

1. Accounts receivable have decreased by $5,000. That means the cash collections in Year 2 were higher than the recorded accrual-basis revenues. Therefore, we need to add back this decrease to net income in order to reflect the cash flows from operating activities.

2. Inventory has increased by $10,000. This increase is not reflected in the income statement as an expense even though it represents an operating use of cash. Thus, we need to deduct this increase from net income to arrive at net cash flow from operating activities.

3. Prepaid expenses have increased by $3,000. That means this amount was paid in Year 2 but the company did not recognize it in the income statement as an expense until the next year. Therefore, we need to deduct this increase from net income of tear 2 to arrive at net cash flow from operating activities.

4. Accounts payable have decreased by $8,000. This amount represents an operating use of cash, which is not reflected on income statement. Therefore, we need to deduct this amount from net income to arrive at net cash flow from operating activities.

5. Accumulated depreciation has increased by $12,000. However, the company sold a machine with a book value of $14,000 and a cost of $20,000, which decreases the accumulated depreciation by $6,000. Therefore, the depreciation expense for Year 2 was $18,000 (12,000 + 6,000). This amount represents a noncash expense that should be added back to net income in order to arrive at net cash flow from operating activities.

6. The company sold a machine for $18,000. The book value of the machine is $14,000. As a result, the gain reported on this sale is $4,000. This amount increases net income but it does not increase cash because it is a noncash gain. Thus, this amount should be deducted from net income in order to arrive at net cash flow from operating activities.

Investing Activities – Analyzing the investing items indicates the following:

1. The machine account has increased by $40,000. This increase is a result of purchasing a new machine for $60,000 and selling another one that costs $20,000. (60,000 – 20,000 = 40,000).

2. The company paid $60,000 in cash to purchase the machine. This represents a cash outflow for the period.

3. The company received $18,000 in cash from selling a machine. This represents a cash inflow for the period.

Financing Activities – Analyzing the financing items indicates the following:

1. The company paid $20,000 in cash to extinguish a portion of its loan. This represents a cash outflow from financing activities.

2. The company issued common stocks for cash. The common stock account increased by $41,000 during Year 2. This financing transaction represents a cash inflow of $41,000.

3. Retained earnings have increased by $30,000. This increase is a result of $40,000 net income minus $10,000 cash dividends. The dividends represent a cash outflow from financing activities.



From the above items, we can prepare the statement of cash flows as follows:

Statement of Cash Flows for the Year Ended on December 31, Year 2

Cash flows from operating activities Net income $ 40,000 Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation expense $ 18,000 Gain on sale of a machine (4,000) Decrease in accounts receivable 5,000 Increased in inventory (10,000) Increase in prepaid expenses (3,000) Decrease in accounts payable (8,000) (2,000) Net cash provided by operating activities 38,000 Cash flows from investing activities Sale of a machine 18,000 Purchase of a machine (60,000) Net cash used in investing activities (42,000) Cash flows from financing activities Issuance of common stocks 41,000 Redemption of debt (20,000) Payments of dividends (10,000) Net cash provided by financing activities 11,000 Net increase in cash during the period 7,000 Add: Cash, beginning of the period 20,000 Cash, end of the period 27,000



Relationship among Financial Statements

Each financial statement describes a different aspect of the company's financial condition. Financial statements are all interrelated and complement each other in providing the complete picture of the company’s financial condition. The elements of one financial statement are related to the elements of the other statements. Some of these relations include:

1. The net income or loss from the income statement reconciles the beginning balance of the retained earnings account to reach at the ending balance. Retained earnings is a component of the equity section of the balance sheet.

2. The statement of cash flows illustrates the changes in the cash account from the beginning balance sheet cash account to the ending balance sheet cash account.

3. Equity items from the balance sheet are reconciled with the beginning balances of the statement of changes in equity.

4. Depreciation and amortization expenses are reported in the income statement and also accumulated in the balance sheet.

Sample Financial Statements are presented at the end of this section.



Practice Questions – Session 2

1. A statement of financial position is intended to help investors and creditors

a. Assess the amount, timing, and uncertainty of prospective net cash inflows of a firm.

b. Evaluate economic resources and obligations of a firm.

c. Evaluate economic performance of a firm.

d. Assess the management's efficient and profitable use of the firm's resources.

2. The information reported in the statement of cash flows should help investors, creditors, and others to assess all of the following except the

a. Amount, timing, and uncertainty of prospective net cash inflows of a firm.

b. Company's ability to pay dividends and meet obligations.

c. Company's ability to generate future cash flow.

d. Management with respect to the efficient and profitable use of the firm's resources.

3. RLF Corporation had income before taxes of $60,000 for the year 2009. Included in this amount was depreciation of $5,000, a charge of $6,000 for the amortization of bond discounts, and $4,000 for interest expense. The estimated cash flow for the period is

a. $60,000

b. $66,000

c. $49,000

d. $71,000

4. Which of the following irregular income statement items is considered to be a change in an accounting estimate?

a. Gains or losses resulting from an expropriation.

b. A change from accelerated to straight line depreciation.

c. Gains or losses resulting from a change in foreign exchange rates.

d. A change in the collectibility of receivables.

5. A change in the estimate for bad debts should be

a. treated as an error.

b. handled retroactively.

c. considered as an extraordinary item.

d. treated as affecting only the period of the change.



Feedback:

1. Answer (b) is correct. The statement of financial position is intended to help investors and creditors evaluate economic resources and obligations of a firm.

Not (a) because the statement of cash flows is intended to help investors and creditors to assess the amount, timing, and uncertainty of prospective net cash inflows of a firm.

Not (c) because the income statement not the statement of financial position is intended to assist investors and creditors in evaluating economic performance of a firm.

Not (d) because the income statement not the statement of financial position is intended to help investors and creditors assess the management's efficient and profitable use of the firm's resources.

2. Answer (d) is correct. The income statement not the statement of cash flows helps investors, creditors, and others to assess management with respect to the efficient and profitable use of the firm's resources.

Not (a) because the statement of cash flows should help investors, creditors, and others to assess the amount, timing, and uncertainty of prospective net cash inflows of a firm.

Not (b) because the statement of cash flows should help investors, creditors, and others to assess the company's ability to pay dividends and meet obligations.

Not (c) because the statement of cash flows should help investors, creditors, and others to assess the company's ability to generate future cash flows.

3. Answer (d) is correct. To convert from net income to cash flows, all non-cash expenses are added back and all non-cash revenues are deducted. Out of the three listed charges, only the depreciation and the amortization of bond discounts are non-cash expenses, and thus should be added back. $60,000 + $5,000 + $6,000 = $71,000.

4. Answer (d) is correct. A change in the collectability of receivables is an example of a normal, recurring correction or adjustment. This is considered to be a change in an accounting estimate.

Not (a) because this is an example of an extraordinary item.

Not (b) because this is an example of a change in accounting principle.

Not (c) because these are unusual, material gains or losses that are not considered to be extraordinary if they are typical of the customary business activities of the company.

5. Answer (d) is correct. A change in estimate for bad debts should affect the period in which the change took place. Changes in estimates are viewed as normal recurring corrections and retrospective treatment is prohibited.



STUDY SESSION 3

A.1 Recognition, Measurement, Valuation, and Disclosure

2. Recognition, measurement, valuation, and disclosure a. Asset valuation b. Valuation of liabilities c. Equity transactions d. Revenue recognition e. Income measurement f. Major differences between US GAAP and IFRS

Asset Valuation

Accounts receivable

Inventory

Securities

Depreciable and intangible assets

Accounts Receivable Inventory Securities

Depreciable and Intangible Assets

Accounts Receivable

A. Receivables are amounts owed to the company by its customers and others for services rendered, products sold, and or advances made. For financial statement presentation purposes, receivables are classified as either current or noncurrent and are also classified as either trade or nontrade receivables.

Accounts Receivable Inventory Securities


B. Trade receivables are amounts owed by customers for services rendered and/or goods sold, and they are further classified as either Accounts Receivable or Notes Receivable. 1. Accounts Receivable are oral promises of customers to pay the company for goods and/or

services received. By nature, accounts receivable are usually short-term and are therefore considered current for presentation in the financial statements. Accounts receivable are recorded net of any trade discounts. For cash (sales) discounts, there are two methods to record them: the Gross Method and the Net Method. a. Cash (sales) discounts are discounts offered by the company to induce payments by

customers. An example of a trade discount would be a 2/10, n/30. This means that the customer would receive a 2% discount if paid within 10 days, otherwise, the gross amount is due in 30 days.

b. Gross Method whereby the sale and the related accounts receivable are recorded at the gross amount, and if the customer pays within the discount period, the discount is recognized. The discount would be presented on the income statement as a deduction from sales to arrive at “Net Sales”.



Sales Discount - Gross Method Sale of $5,000, terms 2/10, n/30:

Accounts Receivable 5,000

Sales 5,000

Payment of $2,000 received within discount period:

Cash 1,960

Sales Discount 40


Payment of $3,000 received after discount period:

Cash 3,000


c. Net Method whereby the discount is recognized when the sale occurs. If the customer pays

within the discount period, then no additional entries are required. If the customer forfeits the discount and pays after the discount period, then the previously discounted amounts are recorded as a credit to “Sales Discount Forfeited” which is classified as other revenues on the income statement.

Sales Discount - Net Method Sale of $5,000, terms 2/10, n/30:


Sales 4,900

Payment of $2,000 received within discount period:

Cash 1,960


Payment of $3,000 received after discount period:

Accounts Receivable 60

Sales Discount Forfeited 60

Cash 3,000


2. Notes Receivable are written promises made by customers to pay a sum of money on a set date for goods and/or services received. Notes receivable would be classified as current on noncurrent on the balance sheet depending on their maturity date.



C. Nontrade receivables are amounts owed to the company that arise from peripheral activities that are not part of the core business of the company such as employee advances, performance bonds, dividends and interest receivable . . .etc. Nontrade receivables must be identified and reported separate from any trade receivables.

D. Measurement, Valuation, and Disclosure 1. Short-term trade receivables are recorded at the net realizable value, that is, the net amount

expected to be collected. In order to classify receivables as current assets, they should be short-term i.e. expected to be collected within one year or operating cycle whichever is longer. Determining the net realizable value of receivables requires an estimation of both uncollectible amounts and/or any returns or allowances to be granted.

2. Noncurrent receivables are recorded at their discounted value, that is, the present value of the amounts to be received in the future.

3. Any anticipated loss due to uncollectible accounts, the amount and nature of any non-trade receivables, and any amounts pledged or discounted should be clearly stated and disclosed.

E. Uncollectible Accounts Receivable - uncollectible accounts receivable should be deducted from reported accounts receivable with an offsetting reduction to income. There are two methods to record uncollectible accounts receivable: Direct Write-Off Method and Allowance Method. 1. Direct Write-Off Method under this method, an entry to write-off the accounts receivable and

record a Bad Debt Expense only when an account is deemed uncollectible. a. The direct write-off method is NOT GAAP since it potentially violates the matching principle.

According to the matching principle, expenses must be matched with their related revenues whenever it is reasonable and practicable to do so. Writing off an account receivable and charging it to an expense when deemed uncollectible may occur over two different periods, and thus the violation to the matching principle.

b. The direct write-off method is required for tax reporting, since the tax code allows for claiming a bad debt expense only when an account is deemed uncollectible.

c. The entry to record the bad debt expense is as follows:

Recording bad debts when an account is deemed uncollectible

Bad Debt Expense 5,000


d. The entry to record the collection of an account previously written-off:

Recording bad debts when a written off account is collected

Cash 2,500

Uncollectible Amounts Recovered (a revenue account) 2,500



2. Allowance Method under this method, an estimate is made each period for uncollectible accounts receivable, and a charge to income is made during the period that the associated revenues were recorded. The entry would be a debit to Bad Debt Expense and the credit would be to a contra-asset account “Allowance for Doubtful Debt”. The allowance method may be applied in one of two approaches: Percentage of Sales Approach and Percentage of Receivables Approach.

a. Percentage of Sales Approach (also referred to as the income statement approach) estimates the debit side of the entry by calculating a percentage of credit sales as bad debts. The percentage applied is estimated from the company’s prior years’ trends.

Bad Debts – % of Sales From prior experience, Nice Corp estimates its bade debts as 1% of credit sales. During 2013, Nice Corp’s credit sales were $10,000,000. To record the allowance for bad debts, the expense is 1% of $10 million or $100,000.


Allowance for Doubtful Debts 100,000

b. Percentage of Receivables Approach (also referred to as the balance sheet approach) estimates the balance of the contra account (Allowance for Doubtful Debts) and records any additionally required credit to the Allowance for Doubtful Debts as the Bad Debt Expense for the period. This approach can either apply a percentage to all outstanding receivables or use an aging schedule to the outstanding receivables with varying percentages to each age category.



Illustration of the Percentage of Receivables Approach

Nice Corp Aging Schedule

Name of Customer Balance Under 61-90 91-120 Over

Dec. 31 60 days days days 120 days Customer 1 $88,000 $70,000 $18,000 Customer 2 310,000 310,000 Customer 3 50,000 $50,000 Customer 4 54,000 40,000 ______ $14,000 _______ $502,000 $420,000 $18,000 $14,000 $50,000

From prior experience, Nice Corp estimated the % of uncollectible receivable in each age category.

Age Category

Balance

Estimated % Uncollectible

Required Balance In Allowance

Under 60 days old $420,000 3% $12,600 61-90 days old 18,000 10% 1,800 91-120 days old 14,000 30% 4,200 Over 120 days 50,000 75% 37,500 Year-end balance of allowance for doubtful accounts $56,100

If Nice Corp had a balance of $12,500 in the Allowance for Doubtful Debts, the 2013 required charge to income (or the Bad Debt Expense) is:

Required Allowance $56,100 Less: Existing balance 12,500 Required provision $43,600

The required journal entry at year end would be:





c. Write-off under the Allowance Method – when an account is deemed uncollectible under the allowance method, the entry to record the write-off would be a debit to the Allowance for Doubtful Debts and a credit to the Accounts Receivable.

Recording write-offs when an account is deemed uncollectible



d. Write-off Recoveries – If a previously written-off account is deemed collectible, then there are two entries necessary: 1) to restore/reverse the write-off, and 2) to record the collection.

Recording a previously written-off account



Cash 2,500


Summary of Accounts Receivable Transactions

Accounts Receivable (A/R) Beginning accounts receivable Add: Credit sales Sub-total Less: Collections Accounts receivable write-offs Ending accounts receivable

Accounts Receivable Beg. Balance Credit sales Collections Write-offs Total Dr. Total Cr. End. Balance

Allowance for Doubtful Debts Beg. allowance for doubtful debts Add: Bad debt expense Write-off recoveries Sub-total Less: Accounts receivable write-offs Ending allowance for doubtful debts

Allowance for Doubtful Debts Beg. Balance A/R Write-offs Bad debt expense Write-off recoveries Total Dr. Total Cr. End. Balance



F. Disposing Accounts Receivables – companies are sometimes required to extend credit in order to secure sales, and thus this may put pressure on a company’s working capital. Faced with such a situation, a company may wish to transfer its receivables for credit. Transfer of receivables may be done in one of two ways: Secured Borrowing or Sale of Receivables: 1. Secured Borrowing whereby the owner of the receivables borrows money from a lender by

pledging the receivables as collateral.

Recording a borrowing secured by accounts receivable

Cash 950,000

Discount on Transferred Accounts Receivable 50,000

Liability on Transferred Accounts Receivable 1,000,000

2. Sale of Receivables whereby receivables are typically sold to a factor or are securitized. Both

factoring and securitization may be with recourse or without recourse. a. Factoring refers to selling the receivables to a finance company for a fee. When compared to

securitization, factoring is often associated with lower quality of receivables, and the seller would not normally service the receivables after the sale.

b. Securitization refers to pooling receivables of some common nature together and issuing shares in these pools. The holders of the shares will be entitled to their respective shares from repayments of both principal and interest. When compared to factoring, securitization is often associated with relatively higher quality receivables and the seller usually continues to service the receivables.



G. Transfer With Recourse 1. In a transfer with recourse, the seller guarantees the payments to the buyer in case the debtors

default. 2. Three conditions must be met for a transfer to be treated as such (rather than a loan):

a. The transferor (seller) surrenders control of the future economic benefits associated with the receivables

b. The transferor’s obligation under the recourse obligation can be reasonably estimated c. The transferor cannot be required by the transferee (the factor) to repurchase the receivables.

3. If the transfer with recourse does not meet the conditions to be considered a transfer (per G.2 above), then the transfer is accounted for as a borrowing.

Illustration of Transfer with Recourse

Nice Corp factors $1,000,000 of accounts receivable with Factor Financing with recourse and the records will be transferred to the factor who will also be receiving all future collections. The factor charges a 3% finance charge and retains 5% to cover probable sales discounts, sales returns or sales allowances. In addition, it has been estimated that Nice Corp’s estimated obligation for uncollectible debts is $25,000 The journal entries for the transaction are as follows:

Nice Corp’s books Cash 920,000 Due from Factor (5% x $1,000,000) 50,000 Loss on Sale of Receivables (Plug)*1 55,000

Accounts Receivable 1,000,000 Recourse Liability 25,000

Factor Financing’s Books Accounts Receivable 1,000,000

Due to Nice Corp 50,000 Financing Revenue 30,000 Cash 920,000

*1) Calculation of the Loss is a two-step process: Cash Received $920,000 Due from Factor 50,000 Subtotal 970,000 Less: Recourse obligation 25,000 Net Proceeds 945,000 Book value of Accounts Receivable 1,000,000 Net Proceeds 945,000 Loss on Sale of Receivable $55,000



H. Transfer Without Recourse 1. In a transfer without recourse, the purchaser assumes the risk of default by the debtors. A sale

without recourse is treated as a sale since the seller is no longer liable should the debtors default. 2. The entry is a debit of Cash, and a credit to Accounts Receivable for the face value of the

receivables. Any difference reduced by any provisions is recognized as a Loss on the Sale of Receivables.

3. If the factor retains any proceeds to cover probable sales discounts, sales returns, or sales allowances, the seller would use a Due from Factor account to account for it.

Transfer Without Recourse

Nice Corp factors $1,000,000 of accounts receivable with Factor Financing without recourse and the records will be transferred to the factor who will also be receiving all future collections. The factor charges a 3% finance charge and retains 5% to cover probable sales discounts, sales returns or sales allowances. The journal entries for the transaction are as follows:

Nice Corp’s books Cash 920,000 Due from Factor (5% x $1,000,000) 50,000 Loss on Sale of Receivables (3% x $1,000,000) 30,000

Accounts Receivable 1,000,000 Factor Financing’s Books Accounts Receivable 1,000,000

Due to Nice Corp 50,000 Financing Revenue 30,000 Cash 920,000



Inventory

A. Inventories are asset items:

1. Held for sale in the ordinary course of business, and/or

2. Materials that will be used in the production or sale of other goods.

Accounts Receivable

Inventory Securities


B. Types of Inventory

1. Raw materials are inventory items that are processed further in a manufacturing process and are traceable into the final product.

2. Work-in-process is the manufacturing cost of material that was incomplete as of year-end.

3. Finished goods are the completed manufactured units that are ready for sale in the ordinary course of business. Finished goods may be held by the company at its warehouses, or held on consignment with distributors.

4. Materials and supplies are items used in the manufacturing process that cannot be traced to the final product.

C. Inventory Costs (also referred to as product costs)

1. Generally, inventory costs attach to the inventory, capitalized on the balance sheet, and expensed to cost of goods sold when inventory is sold. All costs incurred to make inventory available for resale are considered inventory costs. Examples of inventory costs include:

a. Cost

b. Freight-in (costs of shipping the inventory from suppliers to the company’s warehouse).

c. Insurance in-transit

d. Production costs (for manufacturing entities) which include direct material, direct labor, and factory overhead.

e. Sometimes, procurement costs and costs of the purchasing department are allocated to inventory.

f. Interest costs related to assets constructed for internal use or assets produced as discrete projects for sale may be capitalized.

2. The following costs are treated as period costs and should not be included as inventory costs:

a. Selling expenses

b. General and administrative expenses

c. Freight-out (costs of shipping the inventory to customers).

d. General interest costs, even for funds used to acquire or produce inventory are period costs and should not be capitalized.

3. Purchase discounts – it is preferable to report inventories net of any purchase discounts forfeited since such discounts may be considered financing costs rather than inventory costs.



D. Inventory Management and Control 1. Periodic Inventory System is an inventory management system that accumulates all purchases

and related returns in a special “Purchases” account throughout the year. At year end, a physical inventory is performed, ending inventory is valuated, and the cost of goods sold is computed based on the following formula:

Cost of Goods Sold Beginning Inventory + Purchases – Purchase Returns and Allowances Available for Sale – Ending Inventory (per Physical Count) Cost of Goods Sold

2. Perpetual Inventory System is an inventory management system whereby updated inventory records are maintained for inventory on-hand. Purchases and sales directly update the inventory records, thus management always has an updated record of inventory. Annually, a physical inventory is made, and results are compared to the records. Significant differences are then investigated.

E. Inventory Cost Flow Assumptions – when companies account for inventories, they have to adopt one of the four commonly used assumptions:

1. Specific Identification

2. Average Cost

3. First-In, First-Out (FIFO)

4. Last-In, First-Out (LIFO)

Under US GAAP, there is no requirement for the cost flow assumption to be consistent with the physical flow, however, under IFRS, the assumption adopted should be consistent with the order in which inventory is stored and sold, and specific identification should be used whenever possible.

Data for Comprehensive Example

Parts Co. is a retailer of numerous raw material inventory items used in the manufacturing of refrigerators. Amongst these parts is part No. WS-34. The following are details of purchases and shipments for WS-34 during the year 200x.

Date Transaction Purchases Sales (Units)

Balance (Units)

Jan. 1 Opening Balance 2,000 @ $5.00 - 2,000 Feb. 15 Ship. No. 1 1,500 @ $5.40 - 3,500 Mar. 28 Sales A 700 2,800 Apr. 12 Ship. No. 2 400 @ $5.65 3,200 Aug. 25 Sales B 1,300 1,900



1. Specific Identification is used to charge to cost of goods sold the historical cost of the particular item sold. The method is used when it is practical to physically separate inventory items.

Illustration of the Specific Identification Method

Assume that all of sales B and half of sales A are from the opening balance, and the remaining half of sales A are from shipment No. 1, compute the cost of sales and the ending inventory.

Cost of Sales Ending Inventory Units Cost Total

Sales A 350 $5.00 $1,750.00 350 $5.40 1,890.00 Sales B 1,300 $5.00 6,500.00 Total 2,000 $10,140.00

Units Cost Total Opening Bal. 350 $5.00 $1,750.00 Ship. No. 1 1,150 $5.40 6,210.00 Ship. No. 2 400 $5.65 2,260.00 Total 1,900 $10,220.00

2. Average Cost computes average cost for inventory items.

a. Weighted Average is used with a periodic inventory system whereby only one average for each inventory item is calculated every year.

Illustration of the Weighted Average Method

Assume that the company uses the average cost and a periodic inventory system, compute the cost of sales and ending inventory. Average Cost During the Year

Units Cost Total Opening Bal. 2,000 $5.00 $10,000.00 Ship No. 1 1,500 $5.40 8,100.00 Ship No. 2 400 $5.65 2,260.00 Total 3,900 $20,360.00 Average Cost $5.22

Cost of Sales Ending Inventory

Units Cost Total Sales A 700 Sales B 1,300 Total 2,000 $5.22 $10,440.00

Units Cost Total Available 3,900 Sales (2,000) Ending Inv. 1,900 $5.22 $9,920.00



b. Moving Average is used with a perpetual inventory system whereby a new average is calculated with each inventory purchase.

Illustration of the Moving Average Method

Assume that company uses the average cost and a perpetual inventory system, compute the cost of sales and ending inventory.

Average Cost Through Sales A Units Cost Total Opening Bal. 2,000 $5.00 $10,000.00 Ship No. 1 1,500 $5.40 8,100.00 Total 3,500 $18,100.00 Average Cost $5.17

Average Cost Through Sales B Units Cost Total Carry Forward 2,800 $5.17 $14,480.00 Ship No. 2 400 $5.65 2,260.00 Total 3,200 $16,740.00 Average Cost $5.23

Cost of Sales Ending Inventory Units Cost Total

Sales A 700 5.17 3,620.00 Sales B 1,300 5.23 6,800.00 Total 2,000 $10,420.00

Units Cost Total Available 3,900 Sales (2,000) Ending Inv. 1,900 $5.23 $9,940.00

3. First-In First-Out (FIFO) assumes that inventory sold is from the earliest inventory purchases thus ending inventory is from the most recent inventory purchases.

a. Whether using a perpetual inventory system or a periodic inventory system, cost of goods sold and ending inventory will always be the same.

b. During a period of rising inventory costs, using FIFO will result in the lowest cost of goods sold and the highest net income.

Illustration of the FIFO Method

Assume that the company uses the FIFO assumption. What is the cost of sales and ending inventory? Cost of Sales Ending Inventory

Units Cost Total Sales A 700 $5.00 3,500.00 Sales B 1,300 $5.00 6,500.00 Total 2,000 $10,000.00

Units Cost Total Opening Bal. 0 $5.00 $0.00 Ship. No. 1 1,500 $5.40 8,100.00 Ship. No. 2 400 $5.65 2,260.00 Total 1,900 $10,360.00



4. Last-In First-Out (LIFO) assumes that inventory sold is from the most recent inventory purchases thus ending inventory is from the earliest inventory purchases.

a. Ending inventory and cost of goods sold may differ between using a periodic inventory system and a perpetual inventory system.

b. During a period of rising inventory costs, using the LIFO method will result in the highest cost of goods sold and thus the lowest net income.

IFR

S

LIFO LIFO used to be an acceptable method by IAS 2. However, LIFO became unacceptable by international standards, which contradicts with US GAAP standards.

Illustration of the LIFO Method

Assume that the company uses the LIFO assumption. What is the cost of sales and ending inventory under both the periodic and perpetual inventory systems?

Cost of Sales (Periodic) Ending Inventory (Periodic) Units Cost Total

Ship. No. 2 400 $5.65 $2,260.00 Ship. No. 1 1,500 $5.40 8,100.00 Opening Bal. 100 $5.00 500.00 Total 2,000 $10,860.00

Units Cost Total Opening Bal. 1,900 $5.00 $9,500.00 Total 1,900 $9,500.00

Cost of Sales (Perpetual) Ending Inventory (Perpetual)

Units Cost Total Sales A Ship. No. 1 700 $5.40 $3,780.00 Sales B Ship. No. 2 400 $5.65 2,260.00 Ship. No. 1 800 $5.40 4,320.00 Opening Bal. 100 $5.00 500.00 Total 2,000 $10,860.00

Units Cost Total Opening Bal. 1,900 $5.00 $9,500.00 Total 1,900 $9,500.00



5. Other Inventory Valuation Methods

a. Dollar-Value LIFO treats inventory in terms of dollar pools rather than quantities. Decreases and increases in a pool are measured in terms of total dollar value rather than the physical quantity of the inventory.

b. Retail Method is used by retail businesses that generally sell a large number of inventory items with relatively low unit costs. Inventory is recorded at its retail selling value and records are kept for sales, markups, markup cancellations, markdowns, and markdown cancellations. Steps in applying the retail method are as follows:

i. Organize a worksheet using two columns one for the cost and the other for the retail price.

ii. Start with beginning inventory at both cost and retail.

iii. Add purchases at both cost and retail.

iv. A subtotal of the beginning inventory and purchases will result with the available for sale.

v. The following are applied to the available for sale subtotal at retail to result in a new subtotal:

Add markups and any markdown cancellations to the available for sale subtotal (retail only since markups and markdowns were originally applied on the retail price not the cost).

Deduct markdowns and any markup cancellations from the available for sale subtotal (retail only since markups and markdowns were originally applied on the retail price not the cost).

vi. Calculate the cost to retail ratio from the new subtotal.

vii. To estimate ending inventory at retail, deduct the sales from the calculated subtotal in (v).

viii. To estimate ending inventory at cost, multiply the ending inventory at retail by the cost-retail ratio.

ix. To estimate ending inventory applying the lower-of average-cost-or net realizable value, include markups but exclude markdowns when calculating the cost to retail ratio.

x. Shrinkage should not be included in the calculations to obtain the cost to retail ratio, however, it should be deducted in arriving at the estimated ending inventory at retail.



Illustration of the Retail Method

Assume that a company has the following information during the year: Cost Retail Beginning Inventory 1,000 2,000 Purchases 40,000 70,000 Markups 6,000 Markup cancellations 2,000 Markdowns 5,000 Markdown cancellations 4,000 Sales 40,000

Compute the value of ending inventory at cost using the retail method.

Cost Retail Beginning Inventory 1,000 2,000 Purchases 40,000 70,000 Available for Sale 41,000 72,000 Add: Markups - 6,000 Less: Markup cancellations - (2,000) Less: Markdowns - (5,000) Add: Markdown cancellations - 4,000 41,000 75,000 Cost-to-Retail Ratio 54.67% Sales (40,000) Ending Inventory 35,000

Ending Inventory = Cost-to-Retail Ratio x Ending Retail Inventory Ending Inventory = 54.67% x 35,000 = $19,134.50

c. Gross Profit Method is a method of estimating inventory when applying a fixed gross profit percentage to the cost of inventory when pricing for sales.

i. Gross Profit on Sales Price

GP on Sales Price = % Markup of Cost

% Markup of Cost + 100%

ii. % Markup of Cost

% Markup of Cost = GP on Sales Price

100% - GP on Sales Price



Illustration of the Gross Profit Method

In year 200x, Parts Co. has an opening inventory with a cost of $90,000 and purchases during the year of $300,000. The company has a 25% gross profit percentage of the selling price. Sales during the year 200x were $420,000. Compute the cost of ending inventory.

Beginning Inventory $ 90,000 Purchases 300,000 Available for Sale $390,000 Sales $420,000 Less: Gross Profit (25%) (105,000) Cost of Goods Sold (315,000) Ending Inventory $75,000

d. Lower of Cost or Market (LCM) recognizes that inventory value may be impaired if the future selling price of the inventory is lower than its original cost. The inventory is stated in the financial statements at the lower of historical cost or the market value. The market value of an inventory item is the median of the following values:

i. Replacement Cost is the current cost to repurchase the inventory item. ii. Market Ceiling is the net realizable value which is the selling price less the costs to

complete and sell or dispose. iii. Market Floor is the net realizable value less a normal profit margin.

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LCM IAS 2 standard supports net realizable value. As for the FASB, it requires a “rule” to be applied that incorporates all the definitions of “market”.

Illustration of the Lower-of-Cost or Market Method

On December 31, 200x, Lorie Co. has an ending inventory with a historical cost of $123,000. Lorie uses the lower of cost or market to value its ending inventory. At year end, the accountant collected the following information.

Replacement Cost $115,000 Expected Selling Price $120,000 Cost to complete and sell 13,000 Profit Margin 14,000

Based on the above, compute the market value of Lorie’s ending inventory. What should be the reported value of Lorie’s inventory at December 31, 200x?

Historical Cost $123,000 Replacement Cost $115,000 Market Ceiling 107,000 Market Floor 93,000 Market Value (median of the above) 107,000 LCM 107,000



F. Inventory Errors

1. Beginning Inventory Misstated

a. Understated – retained earnings and net income are overstated. Cost of goods sold understated.

b. Overstated – retained earnings and net income are understated. Cost of goods sold overstated.

2. Ending Inventory Misstated

a. Understated – retained earnings, working capital, current ratio, and net income are all understated. Cost of goods sold overstated.

b. Overstated – retained earnings, working capital, current ratio, and net income are all overstated. Cost of goods sold understated.

3. Ending Inventory and Purchases on account are both Misstated

a. Understated – ending inventory, accounts payable, and purchases are understated. Current ratio is overstated. Retained earnings, working capital, cost of goods sold, and net income are not affected.

b. Overstated – ending inventory, accounts payable, and purchases are overstated. Current ratio is understated. Retained earnings, working capital, cost of goods sold, and net income are not affected.

Illustration of Inventory Errors For example, the actual information for a firm are listed below, the effects of the following are also reflected:

1. Ending inventory is understated – Net income understated 2. Beginning inventory is understated – Net income overstated 3. Purchases are understated – Net income overstated

Actual 1 2 3

1 Sales 2,300 2,300 2,300 2,300 2 Less: Cost of Goods Sold 3 Beginning Inventory 2,000 2,000 1,500 2,000 4 + Purchases 500 500 500 200 5 Available for Sale 2,500 2,500 2,000 2,200 6 – Ending Inventory (1,500) (1,000) (1,500) 1,500 7 Cost of Goods Sold (3+4-6) 1,000 1,500 500 700 8 Net Income (1-7) 1,300 800 1,800 1,600 9 Add: Beginning Retained Earnings 500 500 500 500

10 Ending Retained Earnings (8+9) 1,800 1,300 2,300 2,100



4. Year-on-Year Effect of Inventory Errors

Generally, the year-on-year effect of errors in the ending inventory is zero since an overstatement in one year will be offset by an understatement in a second year and vice versa.

Illustration of Year-on-Year Effect of Inventory Errors

For example, given the following information for Tel Retailers for years 20x1 and 20x2, and the combined total of the two years:

No Misstatements 20x1 Ending Inventory Understated

20x1 Ending Inventory Overstated

20x1 20x2 Total 20x1 20x2 Total 20x1 20x2 Total 1 Sales 200 300 500 200 300 500 200 300 500 2 Less: Cost of Goods Sold 3 Beginning Inventory 50 40 50 50 20 50 50 50 50

4 + Purchases 100 175 275 100 175 275 100 175 275

5 Available for Sale 150 215 325 150 195 325 150 225 325

6 – Ending Inventory (40) (45) (45) (20) (45) (45) (50) (45) (45)

7 Cost of Goods Sold (3+4-6) 110 170 280 130 150 280 100 180 280 8 Net Income (1-7) 90 130 220 70 150 220 100 120 220




1. In accounting for inventories, generally accepted accounting principles require the departure from the historical cost principle when the utility of inventory has fallen below cost. This rule is known as the "lower of cost or market" rule. Market as defined here means: a. Original cost less allowance for obsolescence.

b. Original cost plus normal profit margin.

c. Median of replacement cost, market ceiling, and market floor.

d. Cost to dispose.

2. The cost of materials has fallen steadily over the year. Which of the following methods of estimating the ending balance of the materials inventory account will result in the highest net income, assuming all other variables remain constant? a. Weighted average.

b. Last-in, first-out (LIFO).

c. First-in, first-out (FIFO).

d. Specific identification.

3. Which inventory pricing method generally approximates current cost for each of the following?

Ending Inventory Cost of Goods Sold

I. LIFO LIFO II. FIFO LIFO III. LIFO FIFO IV. FIFO FIFO

a. LIFO - LIFO b. FIFO - LIFO c. LIFO - FIFO d. FIFO – FIFO

4. A merchandising company has $500,000 in accounts receivable and a bad debt provision of 4%. A local bank offered the company to factor the receivables with the right of recourse. what is the net provision amount that the company should take: a. $0.

b. $20,000.

c. $25,000.

d. $40,000.



Feedback:

1. Answer (c) is correct. In the "lower of cost or market" rule, market is defined as the median of replacement cost, market ceiling, and market floor. The replacement cost is the current cost to repurchase the inventory item, the market ceiling is the selling price less the costs to complete and sell or dispose, and the market floor is the market ceiling less a normal profit margin.

Not (a) because this is not the market.

Not (b) because this is the market ceiling not the market.

Not (d) because this is not the market.

2. Answer (b) is correct. During a period of decreasing prices, the sale of the last items first implies the recording of the least cost of goods sold, and thus will result in the highest net income.

Not (d) because under specific identification the net income will depend upon which items are sold first to customers, and thus which items will remain in inventory. Since we are not given any information about the actual flow of the inventory, this cannot be the correct answer.

3. Answer (b) is correct. The method that would approximate the current cost of ending inventory is FIFO since the items remaining in the ending inventory are assumed to be the most recent purchases (which should approximate current costs). Whereas, LIFO would approximate current costs for cost of goods sold since it assumes that the items sold are from the most recent purchases (which should approximate current costs).

Not (a) because the method that would approximate the current cost of ending inventory is FIFO since the items remaining in the ending inventory are assumed to be the most recent purchases (which should approximate current costs).

Not (c) because the method that would approximate the current cost of ending inventory is FIFO (not LIFO) since the items remaining in the ending inventory are assumed to be the most recent purchases (which should approximate current costs). Whereas, LIFO (not FIFO) would approximate current costs for cost of goods sold since it assumes that the items sold are from the most recent purchases (which should approximate current costs).

Not (d) because LIFO (not FIFO) would approximate current costs for cost of goods sold since it assumes that the items sold are from the most recent purchases (which should approximate current costs).

4. Answer (b) is correct. Factoring the receivables with the right of recourse keeps the obligation of bad debt on the company so the company should keep the same bad debt provision at 4% Bad debt provision = 500,000 X 4% = 20,000 .



STUDY SESSION 4

Securities

A. Marketable Securities – Marketable securities are investments in equity and debt securities of other companies. Marketable securities are grouped into three separate portfolios for valuation and reporting purposes:

Accounts Receivable



1. Held-to-maturity - debt securities only that the enterprise has the positive intent and ability to hold to maturity. Because these securities are interest bearing, they are reported at amortized cost which is the acquisition cost adjusted for the amortization of any discount or premium using the effective interest rate method. At the date of original purchase, amortized cost is usually equal to the Fair Market Value (FMV). However, as time passes, any discount or premium on the security is amortized by a debit (credit) to held-to-maturity securities account and a credit (debit) to interest income account. Held-to-maturity securities do not require re-measurement to fair market value at the end of the reporting period, thus there are no unrealized holding gains or losses.

2. Trading - debt and equity securities bought and held primarily for sale in the near term to generate income on short-term price differences. These should be reported as current assets and are valued at FMV. Trading securities are initially recorded at cost, and at the end of each reporting period they are re-measured at FMV. Any unrealized holding gains or losses resulting from the re-measurement are reported as part of net income.

3. Available-for-sale - debt and equity securities neither classified as held-to-maturity nor trading securities. Available-for-sale securities are initially recorded at cost, and at the end of each reporting period, they are re-measured at FMV. Any unrealized holding gains and losses resulting from the re-measurement are reported as part of other comprehensive income, NOT net income. Upon the sale of these securities, the related unrealized gains and losses become realized and must be moved from other comprehensive income to the income statement.

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Impairment of Held-To-Maturity Investments

Under IAS 39, if the value of a held-to-maturity investment is impaired, it is written down to the present value of future cash flows using the original discount rate at acquisition of the instrument. If an event that reduces the impairment occurs after the write-down, the write down can be reversed.

Summary of Accounting for Marketable Securities

Trading Available-for-sale Held-to-maturity

Current/Noncurrent C C or N C or N

Balance sheet FMV FMV Amortized cost

Realized gain/loss Income statement Income statement Income statement

Unrealized gain/loss Income statement Other comprehensive income

N/A

Statement of cash flows Operating Investing Investing



Illustration of Accounting for Available-for-Sale Securities

Republic Co. purchased 2,000 shares of another company on May 1, 20X1 for $10 per share. Those shares were classified as available-for-sale securities. Republic Co. sold those shares on June 1, 20X2 for $14 per share. The fair market value of the shares on December 31, 20X1 was $8 per share.

Recording the purchase on May 1, 20X1:

Available-for-sale Securities 20,000 Cash 20,000

Adjusting the value on December 31, 20X1: Unrealized Holding Loss [2,000 × (10 - 8)] 4,000

Available-for-sale Securities 4,000

On December 31, 20X1, the unrealized holding loss account is presented in the equity section of the balance sheet under Other Comprehensive Income. While the Available-for-sale Securities account is presented in the balance sheet at its new market value $16,000 ($8 × 2,000 ).

Recording the sale of the securities on June 1, 20X2:

Cash (2,000 × $14) 28,000 Available-for-sale Securities 16,000 Unrealized Holding Loss 4,000 Realized gain on disposal of securities 8,000

The realized gain on disposal of securities is reported as part of the income statement of 20X2.

Let us assume that the share price on December 31, 20X1 was $11, and on the sale date was $14. The entry to adjust the value of the securities on December 31, 20X1 would be:

Available-for-sale Securities [2,000 × (10 - 11)] 2,000 Unrealized Holding Gain 2,000

And the entry to record the sale of the shares on June 1, 20X2 would be:

Cash (2,000 × $14) 28,000 Unrealized Holding Gain 2,000

Available-for-sale Securities 22,000 Realized gain on disposal of securities 8,000

Note: In reality, most companies carry a portfolio that contains many available-for-sale securities from different entities. Companies may use a valuation allowance account (Fair Value Adjustment account) to record the difference between the total cost and the total fair value of the securities in the portfolio. In this way, the company adjusts the value of the securities without changing the original value recorded in the Available-for-sale Securities account. The use of the allowance account enables the company to maintain a record of the investments’ costs. However, the balance of the allowance account is added (or subtracted) to the cost of the securities to arrive at the fair value on the balance sheet.



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IAS 39 permits categorizing broad group of financial assets as: - Financial assets at fair value through profit or loss, - Available for sale, or - Held to maturity.

While under GAAP, these categories apply only to securities.

B. Long-Term Investments - often referred to as investments, normally consist of one of four types:

1. Investments in securities e.g. bonds, common stock, or long-term notes.

2. Investments in tangible fixed assets not currently used in operations e.g. land held for speculation.

3. Investments set aside in special funds e.g. a sinking fund, pension fund, or plant expansion fund, and the cash surrender value of life insurance.

4. Investments in non-consolidated subsidiaries or affiliated companies.

C. Investments in non-consolidated subsidiaries are accounted for in one of two methods:

1. Fair Value Method (No control/No Influence)

a. The fair value method is typically used when the parent company owns less than 20% of the voting common stock of an investee company. In this case, it is said that the parent does not exercise significant influence.

b. The acquisition is recorded in the books of account at cost, cost being the fair market value of consideration given including legal fees.

c. This investment is accounted for as trading or available-for-sale securities as described above.

2. Equity Method (No control/Influence)

a. The equity method is typically used when the investor company owns between 20%-50% of the voting common stock of the investee company. In this case, it is said that the investor company does exercise significant influence.

b. The acquisition is recorded in the books of account at cost, cost being the fair market value of consideration given including legal fees.

c. Under the equity method, the investor company would:

i. Increase the investment account each year by its % of the earnings of the investee company even if these earnings are not distributed. This is because the earnings increase the net assets of the investee company. Similarly, the investment account must be decreased by its % of the losses of the investee company.

ii. Decrease the investment by its share of the dividends declared.

d. The changes in the fair market value of the investment account are not accounted for under the equity method.



Illustration of Equity Method

An investor company purchased a 30% interest in X Company for $600,000 on the beginning of Year 1. This interest enables the investor company to exercise significant influence over the investee company, which requires the use of the equity method to account for this investment. The entry to record the purchase in the investor company books is:

Investment in X Company 600,000 Cash 600,000

At the end of Year 1, X Company reported net income of $300,000, the investor company share of these income is $90,000 ($300,000 × 30%). The entry to record the investor company’s share of these income is:

Investment in X Company 90,000 Investment Income 90,000

The Investment Income account appears in the investor company’s income statement for Year 1.

On February 20, Year 2, X Company announced cash dividend of $100,000. The investor company’s share of this dividend is $30,000 ($100,000 × 30%). The entry in the investor company books is:

Dividend Receivable 30,000 Investment in X Company 30,000

On March 10, Year 2, X Company paid the cash dividend announced on February 20, Year 2. The entry in the investor company books is:

Cash 30,000 Dividend Receivable 30,000

At the end of Year 2, X Company reported net loss of $220,000, the investor company share of this loss is $66,000 ($220,000 × 30%). The entry to record the investor company’s share of this loss is:

Investment Loss 66,000 Investment in X Company 66,000

The Investment Loss account appears in the investor company’s income statement for Year 2.

The balance of “Investment in X Company” account at the end of Year 2 is as follows:

Investment in X Company Cash 600,000 Dividend Receivable 30,000 Investment Income 90,000 Investment Loss 66,000 Total Dr. 690,000 Total Cr. 96,000 End. Balance 594,000



D. Investments in Consolidated Subsidiaries (Control) – when a company owns more than 50% of the common stock of another company, it is said to have a controlling interest. In this case, the investor company is referred to as the parent and the investee company is referred to as the subsidiary. This investment is presented on the financial statements of the parent company as a long-term investment. Inter-period financial statements are prepared using the equity accounting method. However, at the end of each accounting period, the subsidiary’s financial information is consolidated with the parent company.

1. Exception – if for any reason an investor owns more than 50% of another company but does not control the other company and/or if ownership is temporary, then the financial statements are not consolidated.

2. Consolidation – generally, the acquisition method is used for consolidation purposes under both US GAAP and IFRS. Under this method, the parent company recognizes the assets and liabilities of the subsidiary at the fair value on acquisition date. Generally, the following steps are done to consolidate:

a. Eliminate the common stock, additional paid-in capital, and retained earnings of the Subsidiary.

b. Eliminate the “investment in subsidiary” recorded in the Parent company’s books.

c. Create the non-controlling interest (which is the equity value of any shares or ownership interest that the Parent company did not acquire). For example, if P Company acquires 80% of the common stock of S Company, then there will be a non-controlling interest for the remaining outstanding 20% stock.

d. Adjust the balance sheet accounts of the subsidiary to fair value as of the acquisition date.

e. Record the value of identifiable intangible assets at fair value as of the acquisition date.

f. If the company paid a value for the stock of a subsidiary in excess of the net assets (at fair value on acquisition date) and any identifiable intangible assets, the excess is accounted for as goodwill. Therefore, goodwill is measured as the excess of the cost of purchasing the subsidiary (and any non-controlling interest) over the fair value of the net identifiable assets of the subsidiary.



Illustration of Recognizing Goodwill

An investor company purchased a 75% interest in X Company for $1,500,000 on January 20. On that date, the fair value of the non-controlling remaining interest was $500,000, and the fair values of the identifiable assets and liabilities of X Company were $2,200,000 and $400,000 respectively. The resulted goodwill is determined as follows:

Paid amount 75% $1,500,000 Fair value of non-controlling interest 25% 500,000 2,000,000 Assets 2,200,000 Liabilities (400,000) Fair Value of net identifiable assets (1,800,000) Recognized goodwill 200,000

Therefore, when the parent company (the investor company) prepares its consolidated financial statements, this $200,000 will appear on its balance sheet as goodwill.

Summary of Accounting for Equity Investments

% of Ownership Level of Influence Valuation Method

Between 0% and 20% Little Fair Value

Between 20% and 50% Significant Equity

Between 50% and 100% Control Consolidation




A. Property, Plant, and Equipment

1. Properties of a durable nature used in the regular operations of the business.

2. Consist of physical property e.g. land, buildings, machinery, furniture, tools, and wasting resources.

Accounts Receivable



3. With the exception of land, most assets classified as property, plant, and equipment are either depreciable or consumable.

4. The basis of valuing the property, plant, and equipment, any liens against the properties, and accumulated depreciation should be disclosed - usually in notes to the statements.

5. Property, plant, and equipment is usually recorded at cost, cost being all the necessary amounts incurred until the asset is ready for its intended use. This includes: a. Original cost. b. Property taxes and import duties. c. Transportation-in. d. Installation costs and costs of trial runs. e. For assets constructed by the company, any interest incurred for loans (amounts borrowed for

constructing or assembling the asset) during the construction period may be capitalized as part of the cost of the asset. Once the asset is ready for its intended use, interest on such loans should be expensed.

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PP&E Valuation

Based on the IAS 16, historical cost is considered the favored treatment for property, plant and equipment. However, IAS 16 also allows revaluation of PP&E to its fair value. The revaluation must be based on market evidence. Entities must revalue assets’ class on regular basis when revaluation is applied.

IAS 23 on borrowing costs has been adjusted, requesting the capitalization of interest costs on funds that are borrowed for acquisition, construction or production of an asset. For interest revenue earned on temporary investment of funds borrowed solely for acquiring an asset, IAS 32 requires that interest revenue is subtracted from interest cost before being capitalized.

IAS 16 demands a reconciliation of the opening and closing balances in the capital asset accounts, along with the disclosure of the asset’s historical cost and the change in any revaluation surplus.



B. Intangible Assets 1. Intangible assets are nonmonetary assets that lack physical substance and usually have a high

degree of uncertainty concerning their future benefits. Examples of intangible assets Include patents, copyrights, franchises, goodwill, trademarks, trade names, licenses, company names, internet domain names, and secret processes.

2. Intangible assets are usually classified as long-term assets because they provide benefits over many years.

3. Valuation of Intangible Assets – depends on whether the intangible assets were purchased or created internally

a. Purchased intangibles are initially recorded at cost including acquisition cost and all expenditures to prepare the intangible asset for its intended use. Intangible assets acquired in exchange for other assets are valued at the fair value of the consideration given or the fair value of the intangible received, whichever is more reliable.

b. Internally Created intangibles (other than goodwill) are also recorded initially at cost. However, cost, in this case, includes only direct costs such as legal fees related to internally created intangible asset. Research and development costs to create an intangible asset cannot be included in the cost of that asset. Research and Development (R&D) costs must be expensed as incurred and may NOT be capitalized.

c. Goodwill - internally generated goodwill cannot be capitalized. Goodwill can be recognized only as a result of the acquisition of another entity as illustrated earlier.

4. Amortization is the process of allocating the cost of the intangible asset over its useful life. The amortization of intangible assets is the equivalent to the depreciation of tangible assets.

a. Intangibles with finite useful lives are amortized over their useful lives. The amount to be amortized is the initial cost minus any residual (salvage) value. An intangible asset with a finite useful life is listed on the balance sheet at the carrying value, which equals the initial cost minus accumulated amortization and any impairment losses.

b. Intangibles with indefinite lives are not amortized but are tested for impairment at least annually. An intangible asset with an indefinite useful life is listed on the balance sheet at the carrying value, which equals the initial cost minus any impairment losses.

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Research & Development Costs

Research costs are expensed as incurred.

Development costs may be recognized as an intangible asset if the following conditions are met: 1. The entity has the technical feasibility and intent to complete the asset and the ability to use or

sell it. 2. The asset can generate probable future economic benefits. 3. The entity has the resources required to complete and use or sell the asset. 4. Expenditures related to the asset can be measured reliably.

Under GAAP, Research and development costs are expensed as incurred.



C. Impairments (US GAAP) – The carrying amounts of both fixed assets and intangible assets need to be reviewed for impairment at least annually or whenever events or other circumstances indicate that the carrying amounts may not be recoverable.

1. Fixed Assets

a. Applicability – tangible assets including property, plant, and equipment.

b. Test – the future cash flows expected to result from the use and ultimate disposal of the asset is estimated and compared to the carrying amount. If the carrying amount is higher than the expected future cash flows (undiscounted), an impairment loss must be recognized.

c. Impairment Loss – the impairment loss is calculated as the difference between the carrying value of the asset and its fair value. The fair value of the asset is:

i. The market price of the asset if an active market for the asset exists, or

ii. The discounted expected future cash flows of the asset if no active market exists.

d. The impairment loss is credit to accumulated depreciation, which reduces the book value of the asset. The entry to record the impairment loss is:

Impairment Loss XXX Accumulated Depreciation XXX

2. Intangible Assets with Finite Lives

a. Applicability – intangible assets with finite lives include patents, copyrights, and franchises.

b. Test – the future cash flows expected to result from the use and ultimate disposal of the asset is estimated and compared to the carrying amount. If the carrying amount is higher than the expected future cash flows, an impairment loss must be recognized.

c. Impairment Loss – the impairment loss is calculated as the difference between the carrying value of the asset and its fair value. The fair value is the market price of the asset if an active market for the asset exists, or the discounted expected future cash flows of the asset if no active market exists.

3. Intangible Assets with Infinite Lives Other than Goodwill

a. Applicability – intangible assets with indefinite lives including trade names, trademarks, and secret processes.

b. Test – the fair value of the intangible asset is compared to its carrying value. If the carrying value of the asset is greater than the fair value, the asset is deemed impaired.

c. Impairment Loss – the impairment loss is calculated as the difference between the carrying value of the asset and its fair value.

4. Goodwill

a. Applicability – goodwill acquired only (and not internally generated goodwill). Goodwill is tested at least annually for impairment.

b. Test – the fair value of the entity is compared to its carrying value (including goodwill). If the carrying value of the entity is greater than the fair value, goodwill is deemed impaired.

c. Impairment Loss – the impairment loss is calculated as the difference between the carrying value of the goodwill and its fair value.



5. Impairment losses are reported as a component of income from continuing operations before income taxes.

6. Under US GAAP, reversal of impairment losses recognized is generally NOT permitted.

Illustration of Goodwill Impairment

A parent company has three subsidiaries. One of these subsidiaries was purchased three years ago for $3 million, which results in recognizing a goodwill of $600,000. The parent company is now revaluing the subsidiary to determine if there is an impairment. The subsidiary’s assets and liabilities, including the goodwill, are listed below:

Cash $ 200,000 Receivables 400,000 Inventories 800,000 Property, Plant, and Equipment 1,500,000 Patents 700,000 Goodwill 600,000 Liabilities (900,000) Net Assets $3,300,000

The net assets of $3,300,000 represent the carrying value of the subsidiary. The parent company determines that the fair value of this subsidiary including the goodwill is $3,100,000. Because the fair value of the subsidiary is less than the carrying amount of its net assets, the goodwill is deemed impaired.

The impairment loss is the difference between the carrying value of the goodwill and its fair value (also called the implied value). The carrying value of the goodwill is $600,000. The fair value of the goodwill is calculated as follows:

Fair value of the subsidiary $3,100,000 Carrying value of net identifiable assets (excluding goodwill) ($3,300,000 - $600,000) (2,700,000) Fair value of goodwill (implied value) 400,000

Therefore, The impairment loss in goodwill is $200,000 ($600,000 - $400,000)

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Impairment Test

The carrying value of an asset (except goodwill) is compared to its recoverable value. If the carrying value of the asset is greater than its recoverable value, the asset is deemed impaired and impairment loss is recognized. The impairment loss equals the excess of the carrying value over the recoverable value. The recoverable value is the greater of: 1. The fair value of the asset minus cost to sell. 2. The value in use, which is the present value of the asset’s cash flows.

Under IFRS, reversal of impairment losses recognized (except for goodwill) is permitted.



Depreciation A. Depreciation is the accounting process of allocating the cost of tangible assets to expense in a rational

and systematic manner to those periods expected to benefit from the use of the asset.

Data for Comprehensive Example

Poor Co. purchased a machine for use in its manufacturing process. Date pertaining to the machine are as follows: Cost $1,000,000 Estimated useful life 5 years Estimated salvage value $100,000 Productive capacity (hours) 20,000 hours

B. Depreciation Methods

1. Activity Method – estimates depreciation based on use or productivity rather than passage of time. Life of the asset is considered in terms of either the output (ratio of units produced / total estimated units) or input (ratio of number of hours / total estimated operational hours).

Illustration of the Activity Method

Assume that the machine was used for 3,000 hours during year 200x, compute the depreciation using the activity method:

Cost $1,000,000 Less: salvage (100,000) Depreciable cost 900,000 Productive capacity (hours) 20,000 hours Depreciation / Hour usage $45/hour Usage 3,000 Depreciation 200x $135,000

2. Straight-Line Method – estimates deprecation as a function of time, calculated as the cost less

the salvage value divided by the estimated service life. Illustration of the Straight-Line Method

Assume that the company uses the straight-line method of depreciation, compute the depreciation for the year 200x. Cost $1,000,000 Less: salvage (100,000) Depreciable cost 900,000 Estimated useful life 5 Years Depreciation rate 20% Depreciation 200x $180,000



3. Decreasing Charge Methods a. Sum-of-the-Years’-Digits (SYD) – results in a decreasing depreciation charged based on a

decreasing fraction of depreciable cost. Illustration of the Sum-of-the-Years’-Digits Method

Assume that the company uses the SYD method of depreciation. Compute the depreciation for each year over its useful life.

Cost $1,000,000 Less: salvage (100,000) Depreciable cost 900,000 Estimated useful life 5 Years

Year 20x1 20x2 20x3 20x4 20x5

Factor (Numerator) 5 4 3 2 1 Denominator (5+4+3+2+1) 15 15 15 15 15 Depreciable cost 900,000 900,000 900,000 900,000 900,000 Annual depreciation 300,000 240,000 180,000 120,000 60,000

b. Declining-Balance Method – uses a depreciation rate expressed as a multiple of the straight-line rate.

i. The declining balance does not reduce the salvage value from the cost of the asset when calculating depreciation.

ii. Further, the depreciation for any year is calculated by the carrying value (not the original cost) multiplied by the declining rate.

iii. Salvage value is only used in the calculation to ensure that the book value will not be depreciated below the salvage value. Once the depreciation results in a book value less than the salvage value, the depreciation should be the difference between the book value and the salvage value.

Illustration of the Declining Balance Method

Assume that the company uses the double declining balance method of depreciation. Compute the depreciation for each year over its useful life.

Cost $1,000,000 Estimated useful life 5 Years Declining balance (SL rate) 20% Double declining balance 40%

Year 20x1 20x2 20x3 20x4 20x5 Carrying value cost 1,000,000 600,000 360,000 216,000 129,600 Rate 40% 40% 40% 40% 40% Salvage N/A N/A N/A N/A 100,000 Annual depreciation 400,000 240,000 144,000 86,400 29,600 Book value 600,000 360,000 216,000 129,600 100,000



4. Other Depreciation Methods

a. Inventory Method – used for tools and utensils allocating the difference between opening inventory and ending inventory to depreciation.

Illustration of the Inventory Method

Opening inventory of tools 1,500 Add: purchases of tools during the period 4,000 5,500 Less: ending inventory (2,600) Depreciation expense for the period 2,900

b. Compound Interest Method – results in lower depreciation charges in the early years and higher depreciation charges in the later years. Used to amortize interest or premiums in bonds.

c. Group and Composite Method – considers a pool of similar (group) assets or dissimilar (composite) assets as one depreciable asset and depreciates this asset based on an average depreciation rate.

d. Replacement Method – charges the cost of the asset purchased less salvage of the asset retired to depreciation expense.

e. Retirement Method – charges the cost less the salvage value of the retired asset to depreciation expense.

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Depreciation IAS 16 allows revaluing capital assets to their fair value and requires that their amortization be

based on the revalued amount.

IAS 16 determines only three methods for allocating depreciable amounts to expense: equal charges, reducing amounts, and amounts that vary with expected use or output.

Passing Tip: Straight-Line vs. Declining Balance SL DB Early Years Depreciation Lower Higher

Net Income Higher Lower

Later Years Depreciation Higher Lower

Net Income Lower Higher

Accumulated Depreciation Lower Higher

Retained Earnings Higher Lower

Gross Fixed Assets Same Same



Asset Retirement Methods A. Assets may be retired voluntarily or involuntarily by a(n):

1. Sale 2. Exchange 3. Abandonment 4. Involuntary conversion (caused by a flood, fire, accident . . .etc.)

B. Regardless of the retirement method used: 1. Depreciation should be calculated for the period until the date of retirement. 2. The net proceeds of the retirement transaction are offset against the book value of the related

assets, and the result would either be a gain or a loss on disposal. The asset and its related accumulated depreciation accounts are closed in the process of recording the gain or the loss. a. The entry to record a gain would be:

Cash (Boot) (if any) xxx New asset (if any) xxx Accumulated depreciation xxx Assets xxx Gain on disposal of asset xxx

b. The entry to record a loss would be:

Cash (Boot) (if any) xxx New asset (if any) xxx Accumulated depreciation xxx Loss on disposal of asset xxx Assets xxx

3. Gains and losses on disposal of assets are presented on the income statement below operating income as part of income from continuing operations.

4. Losses from asset retirements are considered extraordinary only when they result from an involuntary conversion that is typically classified as an extraordinary item (both abnormal in nature and infrequent in occurrence).



Liabilities A. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a

particular entity to transfer assets or provide services to other entities in the future as a result of past transactions. 1. Current Liabilities are obligations that are reasonably expected to be liquidated either through the

use of current assets or the creation of other current liabilities within the next year (or operating cycle whichever is longer). Current liabilities include: a. Payables resulting from the acquisition of goods and services e.g. accounts payable, wages

payable, taxes payable . . .etc. b. Collections received in advance for the delivery of goods or performance of services e.g.

unearned rent revenue or unearned subscriptions revenue. c. Other liabilities whose liquidation will take place within the operating cycle e.g. the portion of

long-term bonds to be paid in the current period, or short-term obligations arising from purchase of equipment.

2. Long-Term Liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but, instead, are payable at some date beyond that time. Generally long-term liabilities are: a. Obligations arising from specific financing situations, such as the issuance of bonds, long-term

lease obligations, and long-term notes payable. b. Obligations arising from the ordinary operations of the enterprise, such as pension obligations

and deferred income tax liabilities. c. Obligations that are dependent upon the occurrence or nonoccurrence of one or more future

events to confirm the amount payable, or the payee, or the date payable, such as service or product warranties and other contingencies.

d. Long term liabilities include: i. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension

obligations ii. Long-term liabilities that mature within the current operating cycle are classified as current

liabilities if their liquidation requires the use of current assets. iii. The terms of all long-term liability agreements are frequently described in notes to the

financial statements. B. Classification – generally, the distinction between current liabilities and non-current liabilities is

primarily determined by whether current assets will be used to pay-off the liabilities, and thus, even if liabilities are due within the next operating cycle or year, they would not be included in current liabilities if either of the following applies: 1. The liabilities will be settled from non-current assets. This would be the case when a company has

a dedicated fund for paying-off the liabilities and this fund is not reported as a current asset and/or the company intends to sell non-current assets to settle the liabilities.

2. The liabilities will be refinanced provided that the company has BOTH the intention and ability to refinance the liabilities.



Types of Debt (Liabilities)

A. Short-term Debt typically finances current needs for cash or inventory at times when cash requirements exceed available funds. These sources must be repaid within one year. The sources of short-term funds are:

1. Trade Credit provides a short-term source of funds resulting from purchases made on credit or open account.

2. Unsecured Bank Loans are borrowed short-term funds for which the borrower does not pledge any asset as a collateral. Banks furnish these loans on the basis of previous experience with the firm. Banks usually require the firm to maintain compensating balances under loan agreements. Compensating balances are intended to compensate banks for their services. Such an arrangement would typically increase the effective rate of interest charged by banks. There are three types of unsecured loans:

a. Promissory Note is a traditional bank loan for which the borrower signs a note that states the terms of the loan, including its date of repayment and interest rate.

b. Line of Credit is an agreement between a firm and a commercial bank that states the amount of unsecured short-term credit that the bank will make available to the borrower on demand, if available in the bank.

c. Revolving Credit Agreement is a guaranteed line of credit whereby the amount agreed upon in the line of credit is guaranteed to be available to the borrower.

3. Commercial Paper is the purchase of commercial paper by firms with excess funds in order to earn interest. Selling commercial paper can also be an important source of funds for major corporations attempting to raise money.

4. Secured Short-term Loans require the owner to pledge collateral such as accounts receivable or inventory.

a. Inventory may be pledged in numerous ways including:

i. Field warehousing arrangement whereby the inventory is stored in the company’s warehouses however, the creditor has on-site control and supervision over it.

ii. Warehouse receipts are evidence of inventory storage in public warehouses. The inventory is delivered to the party holding the receipt. A creditor could pledge the inventory by taking custody over the warehouse receipt.

b. Chattel Mortgages are short-term loans secured by moveable personal property such as equipment or livestock.

c. Repurchase Agreement is the sale of certain securities with a repurchase agreement at a given date and a set price.

5. Factoring is selling of accounts receivable below their face value to a factor.

6. Bankers’ Acceptances are drafts drawn on deposits at a bank guaranteed by the bank for payment at maturity.



B. Long-term Debt usually needed to finance major purchases and/or investments. Types of long-term debt include:

1. Long-term Loans are loans that can be repaid over periods of one year or longer. Interest rates are higher than those of short-term loans to compensate for the uncertainty associated with a longer maturity. Long-term loans may be:

a. Term loans

b. Leases

2. Bonds are certificates of indebtedness sold to raise long-term funds for governments or corporations. Bonds are usually used only by reputable large corporations.



Contingent Liabilities A. A Contingency is an existing condition, situation, or set of circumstances involving uncertainty as to

possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.

B. Contingent Liabilities are obligations that are dependent upon the occurrence or nonoccurrence of one or more future events to confirm either the amount payable, the payee, the date payable, or its mere existence.

C. Accounting for Contingencies

When a contingency exists, the likelihood that the future event or events will confirm the incurrence of a liability can range from:

100% 50% 0%

Probable

Reasonably Possible

Remote

Gain Disclose - -

Loss Accrue Disclose -

D. Disclosure of Loss Contingencies 1. If the loss is either probable OR estimable but not both and if there is at least a reasonable

possibility that a liability may have been incurred, the following disclosure in the notes is required:

a. The nature of the contingency, and

b. An estimate of the possible loss or range of loss or a statement that an estimate cannot be made.

2. Contingencies involving an unasserted claim or assessment need not be disclosed when no claimant has come forward unless:

a. It is considered probable that a claim will be asserted and

b. There is a reasonable possibility that the outcome will be unfavorable.

E. An estimated loss from a loss contingency should be accrued by a charge to expense and liability recorded only if BOTH of the following conditions are met: 1. Information available prior to the issuance of the financial statements indicates that it is probable

that a liability has been incurred at the date of the financial statements.

2. The amount of the loss can be reasonably estimated.

F. A liability is NOT accrued for the following contingencies: 1. General or unspecified business risks.

2. Risk of loss from catastrophes that might occur to a company.

3. Risk of loss or damage to property from fire, explosion, or other hazards.



G. Litigation, Claims, and Assessments To make a reasonable estimate of the litigation, it must have occurred on or before the date of the financial statements. To evaluate the probability of an unfavorable outcome, consider:

1. The opinion of legal counsel;

2. The nature of the litigation;

3. The experience of the company and others in similar cases;

4. The progress of the case; and

5. Any management response to the lawsuit.

With respect to unfiled suits and unasserted claims and assessments, a company must determine the degree of probability that a suit may be filed or a claim or assessment may be asserted and the probability of an unfavorable outcome.

H. Guarantee and Warranty Costs 1. A warranty is a promise made by a seller to a buyer to make good on a deficiency of quantity,

quality, or performance in a product.

2. A guarantee is a promise made by a party to reimburse the counter party should certain conditions occur. For example, a franchisee may be requested to pay 2% of sales to the franchisor. The 2% payable are not considered a contingent liability because there is no uncertainty involved. Once sales occur, the franchisee will accrue the related franchise fee. However, if the franchise agreement contains a minimum guarantee clause if certain minimum sales requirements are not achieved, it becomes a contingency since the amount might be paid when no sufficient sales are made.

3. Warranties and guarantees entail future costs.

4. The amount of liability is an estimate of all the costs that will be incurred after sale and delivery and that are incidental to the correction of defects or deficiencies required under the warranty provisions.

5. There are three methods of accounting for warranty costs:

a. Cash Basis - warranty costs are charged to expense as they are incurred. The cash basis method is required when a warranty liability is not accrued in the year of sale either because:

i. It is not probable that a liability has been incurred, or

ii. The amount of the liability cannot be reasonably estimated.

The cash basis is usually used when warranty costs are immaterial or when the warranty period is relatively short.

b. Expense Warranty Approach - warranty costs are charged to operating expense in the year of sale by an estimate. It should be used whenever the warranty is an integral and inseparable part of the sale and is viewed as a loss contingency.

c. Sales Warranty Approach – typically used when a warranty is sold separately from the product. The revenue attributed to the warranty would be credited to an Unearned Warranty Revenue account with any future repairs offset against this account. Any amounts remaining in the Unearned Warranty Revenue account after the expiration of the warranty period are recognized as revenues from warranties.



Illustration of Accounting for Warranties

Assume that Clean Co. sells washing machines on a 2-year warranty and that from experience, it is known that the company incurs an average of $200 of warranty costs per item. The company sold 3,000 machines during the year 20x2 for an average of $1,500 per machine. The company also incurred $560,000 in warranty costs on machines sold in 20x1. Prepare the entries for Clean Co.’s warranty costs for the year 20x2 under both cash and Expense Warranty Approach. Cash Method

Warranty costs 560,000 Cash, inventory, or payables 560,000

Expense Warranty Approach

Warranty costs 600,000 Estimated liability for warranties 600,000

Estimated liability for warranties 560,000

Cash, inventory or payables 560,000

In the year 20x3, the clean company incurred and paid 430,000 under warranty costs for machines sold in 20x2. What is the journal entry to record the warranty costs incurred during 20x3?

Estimated liability for warranties 430,000 Cash, inventory, or payables 430,000

Assume that Clean Co. sells the washing machines with an extended warranty for two additional years for an additional cost of $300 per machine. The entry to record the initial sale would be as follows:

Cash or receivables 5,400,000 Sales 4,500,000 Unearned warranty revenue 900,000

The entry in years 3 or 4 to record $350,000 incurred warranty costs pertaining to the extended warranty would be as follows:

Unearned warranty revenue 350,000 Cash, inventory, payables 350,000

At the end of the 4th year, when the extended warranty period has expired, the entry to recognize the warranty revenue would be as follows:

Unearned warranty revenue 550,000 Warranty revenue 550,000



I. Other Contingencies 1. Premiums and Coupons

a. Premiums are extra products or services attached to the product.

b. Printed coupons can be redeemed for a cash discount on items purchased.

The costs of premiums and coupon should be charged to expense in the period of the sale that benefits from the premium plan. The number of outstanding premium/coupon offers that will be presented for redemption must be estimated in order to reflect the existing current liability and to match costs with revenues.

2. Environmental Liabilities – in some industries, a company may be subject to liabilities resulting from environmental pollution caused by the company.

3. Risk of Loss Due to Lack of Insurance Coverage

Exposure to risk of loss resulting from uninsured past injury to others is an existing condition involving uncertainty about the amount and timing of losses that may develop.

IFR

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Purchase Commitments IAS 37 addresses additional types of contingencies such as purchase commitments that may result in losses.

4. Purchase Commitment

a. A purchase commitment is a commitment to acquire goods or materials from a supplier in the future. This type of commitment is not recorded in the inventory account until the goods are actually received.

b. However, if the commitment is non-cancelable, and is for a fixed price, the buying party should recognize and report a loss when the market price of the goods is less than the commitment price. The entry for recoding the loss is:

Unrealized holding loss - purchase commitment xxxx Estimated liability on purchase commitment xxxx

c. If the market price of the goods is higher than the commitment price, the buying party cannot recognize gains until the goods are received and actually sold.

d. The buying party is required to disclose, in the notes to the financial statements, the nature of the commitment and the terms of its contract along with any obligations imposed by this commitment.

Illustration of Purchase Commitment

During the year 2017, a company signed a long-term contract to purchase 10,000 units of product A in 2018 at a price of $30 per unit. Unfortunately, the market price for product A has dropped to $20 in the latter part of the year 2017. On December 31, 2017, the company would record the following entry to recognize the loss on this commitment:

Unrealized holding loss - purchase commitment $100,000 Estimated liability on purchase commitment $100,000

The unrealized loss = ($30 - $20) × 10,000 = $100,000



Off-Balance Sheet Financing

A. Off-balance sheet financing pertains to assets or liabilities that are being utilized by a company but due to accounting treatments are not reflected on the company’s balance sheet. Entities such as Enron managed to hide huge amounts of debt through the use of off-balance sheet financing techniques. Off-balance sheet accounting techniques aim to make a company appear to have less liabilities than it actually has. Examples of off-balance sheet financing include:

1. Operating leases – the most typically used techniques for off-balance sheet financing involve operating leases. Rather than a company purchasing an asset using a loan, the company would enter into a leasing arrangement whereby it will utilize the asset without having to record the associated liability if the asset was acquired against a loan.

2. Sales of receivables – the company would sell its receivables to a factor instead of borrowing money and reporting a liability.

3. Guarantees or letters of credit – may indicate that the company has guaranteed the debt of its subsidiary that was taken for its benefit (indirectly) without having to report the associated liability as the liability would be reported on the financial statements of the subsidiary.

4. Joint ventures or research and development activities – whereby the company would be interested in venturing into new products and/or new areas but does not wish to show the associated costs/liabilities on its balance sheet so it would setup separate joint-ventures and/or contract out the research and development activities to an external party that may or may not be within the control of the company.

B. Special purpose entities (vehicles) are separate entities setup by a company for the purpose of arranging any of the above off-balance sheet items by reporting the debt on the balance sheet of the SPE rather than on the balance sheet of the company.

C. US GAAP mandates various financial statements disclosures which highlight the existence of any off-balance sheet financing arrangements to a prudent financial statement reader, however, investors reading the face of the financial statements may not be able to immediately identify the existence of such arrangements. Moreover, the SEC and other regulators globally have strict penalties for companies and/or corporate officers who attempt to hide such financing arrangements.




1. An investment in available-for-sale securities is measured on the statement of financial position at the :

a. Cost to acquire the asset.

b. Accumulated income minus accumulated dividends since acquisition.

c. Fair value.

d. Par or stated value of the securities.

2. Which of the below is correct regarding goodwill?

a. Goodwill is amortized over its estimated useful life.

b. Goodwill is depreciated over its estimated useful life.

c. Goodwill is tested at least annually for impairment.

d. Goodwill has a definite life time, and it needs to be allocated over it.

3. Under the sum of the years'-digits depreciation method, for an asset with a four-year useful life, the depreciation expense in the first year would be:

a. 10 percent.

b. 25 percent.

c. 40 percent.

d. 50 percent.

4. Which of the following is required in order for a company to record an estimated loss contingency as a liability?

a. The exact payee must be known.

b. The exact date payable must be known.

c. It must be considered reasonably possible that a liability has been incurred.

d. It must be possible to reasonably estimate the amount of the loss.

5. Blake Ltd. has determined that an impairment exists on one of its machines, but the company expects to continue using the asset for another three full years as no active market exists for the machine. Selected information on the impaired asset (on the date that impairment was determined to exist) is provided below.

Original cost of the machine £22,000 Book (carrying) value of the machine 20,000 Value in use 15,000 Net selling price 12,000

According to IFRS, what is the amount of the impairment loss to be recorded by Blake?

a. £3,000.

b. £5,000.

c. £7,000.

d. £8,000.



6. Which of the following is not a form of off-balance sheet financing?

a. Operating leases

b. Joint ventures

c. Factoring receivables

d. Capital leases



Feedback:

1. Answer (c) is correct. Under U.S. GAAP, available-for-sale securities are investments in debt securities that are not classified as held-to-maturity or trading securities and in equity securities with readily determinable fair values that are not classified as trading securities. They are measured at fair value in the balance sheet.

2. Answer (c) is correct. Goodwill has an infinite lifetime, accordingly it is tested at least annually for impairment.

3. Answer (c) is correct. The fraction of the depreciation base charged to depreciation expense in the first year is: Fraction depreciated = Number of years remaining at start of year / Sum of the years in first year of a 4-year asset = 4/(1 + 2 + 3 + 4) = 4/10 = 40 percent.

Not (a) because it is in the final year that 10 percent of the depreciation base of the asset will be charged to depreciation expense: Fraction depreciated = 1/(1 + 2 + 3 + 4) = 1/10 = 10 percent.

Not (b) because this is the fraction of the asset cost that will be charged to depreciation expense under the straight-line method: Straight-line depreciation rate = 1/ number of years = 1/4 = 25%.

Not (d) because this is only the fraction of the asset cost that will be charged to depreciation expense under the double declining balance method: DDB method = two times the straight-line method = 2(1/4) = 1/2 = 50 percent.

4. Answer (d) is correct. In order for a company to record an estimated loss contingency as a liability, two conditions must be met:

Information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements.

The amount of the loss can be reasonably estimated.

Not (a) because the exact payee does not have to be known. It does not matter with John or William will receive the amount.

Not (b) because the exact date payable does not have to be known.

Not (c) because a company records an estimated loss as a contingent liability when it is considered probable that a liability has been incurred. If it is considered reasonably possible that a liability has been incurred, the amount would only be disclosed.

5. Answer (b) is correct. Under IFRS, impairment loss computed as the difference between net book value of the asset and fair value of the asset without passing the recoverability test. Impairment loss = 20,000 – 15000 = 5,000

6. Answer (d) is correct. Operating leases, joint ventures and factoring of receivables are all considered off-balance sheet financing. Capital leases are not off-balance sheet financing.



STUDY SESSION 5

Income Taxes

Taxes are payments made to the government by individuals and corporations representing one of the major sources of government financing. A. Payments and tax assessments are usually on income, consumption, ownership of property (wealth), or

other factors as dictated by each country’s tax code.

1. Value-Added Tax is a tax levied on the value a firm adds to a good or service. The amount is usually measured as the difference between the value of a firm’s sales and its cost of sales.

2. Income Tax is a tax levied on income and may be:

a. Corporate Income Tax that refers to taxing the taxable income generated by corporations.

b. Personal Income Tax that refers to taxing the taxable income earned by individuals.

3. Capital Gains Tax is a tax levied on a firm’s capital gains that are the result of a profit on capital assets. Capital assets include real and personal property held by the tax payer such as land, buildings, machinery, partnership interests, securities, other assets held for investments . . .etc.

4. Property Tax is a tax levied on property ownership.

B. Tax Credits are used in each country’s tax code in various types and amounts. A tax credit is a reduction of the calculated amounts of tax due. It is used by governments to grant special treatment for certain categories of people (old aged, low-income groups . . . etc.) or companies to encourage certain behavior, or even sometimes to encourage certain investments. Other reasons for tax credits include granting the taxpayer some reductions for taxes paid abroad on the same income.

C. Types of Taxes 1. Proportional Tax is a tax that is paid in the same proportion by all taxpayers. It is usually a flat

rate and therefore taxpayers pay the same proportion regardless of amounts involved (wealth, consumption, income . . . etc.).

2. Progressive Tax is a tax that is paid in a higher proportion as the related amount increases.

a. Progressive taxes are usually assessed on income. b. They allow for a redistribution of wealth or income. c. When taxes are progressive, the marginal tax rate is always higher than the average tax rate.

3. Regressive Tax is a tax that is paid in a lower proportion as the related amount increases.

a. Regressive taxes do not necessarily take a larger absolute amount of income as income rises. b. Regressive taxes are usually assessed when high-income taxpayers do not benefit from the

use of such taxes. c. When taxes are regressive, the marginal tax rate is always lower than the average tax rate. d. For example, regressive taxes would be usually associated with social security that is used to

finance unemployment benefits and Medicare. High-income or high-wealth taxpayers are less likely to apply for and benefit from government unemployment benefits and Medicare.

e. Property taxes tend to be regressive as families with lower incomes must pay a higher portion of their income for housing and hence property taxes tend to be a larger percentage of their income.



D. Tax Rates

1. Nominal Tax Rate is the stated tax rate under certain circumstances.

2. Average Tax Rate is the total amount of calculated taxes divided by the value of the taxed item.

3. Marginal Tax Rate is the incremental rate paid on additional value of the taxed item.

Illustration of the Three Kinds of Tax Rates

The tax code for XYZ country applies a progressive tax on income as follows:

From To Rate 0 20,000 5%

20,000 45,000 10% 45,000 70,000 15% 70,000 25%

Paul and John are both nationals of XYZ and are subject to the above income tax rates. During 20x1, the annual income was 38,000 for Paul and 76,000 for John.

1. How much should Paul and John pay in taxes? 2. What is the average tax rate for both Paul and John? 3. If the income of both Paul and John increases by 10,000, what is the marginal tax rate?

Solution: 1. Taxes

Paul John Bracket Income ($) Tax ($) Income ($) Tax ($)

5% 20,000 1,000 20,000 1,000 10% 18,000 1,800 25,000 2,500 15% 25,000 3,750 25% 6,000 1,500

Total 38,000 2,800 76,000 8,750

2. Average Tax Rate Paul John

Average Tax Rate = Tax 2,800 8,750

Income 38,000 76,000 = 7.37% 11.51%

3. Marginal Tax Rate Paul John

Bracket Income ($) Tax ($) Income ($) Tax ($) 5%

10% 7,000 700 15% 3,000 450 25% 10,000 2,500

Total 10,000 1,150 10,000 2,500

Paul John Marginal Tax Rate

= Incremental Tax 1,150 2,500

Incremental Income 10,000 10,000 = 11.5% 25%



E. Difference Between Tax Reporting and Financial Reporting

1. Differences between tax reporting and financial reporting arise from different treatment of some revenue and expense items that would lead to a difference between taxable income and net income as calculated for financial reporting. These differences may be temporary or permanent.

a. Temporary differences relate primarily to timing differences between the date of tax payment and the date of recognizing the tax liability. Temporary differences eventually reverse. For example,

i. Using depreciation rates for financial reporting that are different from the required rates under tax reporting. Over the life of the asset, the whole depreciable amount will be recognized as expense, however, the annual depreciation may be different thereby creating a difference between the taxable income and the net income.

ii. In most countries, prepayments are considered taxable income even if they extend beyond the taxable period. For example, if a company receives in year one, rent in advance for the next five years, for tax reporting, the whole amount received is recorded as revenues in year one and is thus taxable in year 1. For financial reporting, the amount should be recorded as a liability (Unearned revenues) and recognized as revenue in five installments over the five years. In year one, when the tax is paid, it will be considered a prepaid tax and charged to tax expense over the next five years.

iii. Other temporary differences include recording bad debts and warranty costs.

b. Permanent differences relate primarily to income statement items (either revenues or expenses) that are recorded for financial reporting but never reported for tax reporting. Permanent differences do not reverse over time. For example,

i. Revenues that are not taxable are recorded for financial reporting but are excluded in tax reporting.

ii. Expenses that are not tax-deductible are recorded for financial reporting but are excluded in tax reporting (e.g. tax penalties).

Passing Tip: Permanent differences have no deferred tax consequences because they affect only the period in which they occur, while temporary differences result in taxable or deductible amounts in some future year(s), when the reported amounts of assets are recovered and the reported amounts of liabilities are settled.

F. Inter-period Tax Allocation – As discussed above, income taxes payable for a certain year may differ from income tax expense for that year. These differences result from temporary differences, not permanent differences, between the amount of income reported for tax purposes and those reported for financial reporting purposes. Deferred taxes may be deferred tax liabilities or deferred tax assets.

1. Deferred Tax Liability – A deferred tax liability is the increase in taxes payable in future periods as a result of temporary differences in taxable income at the end of the current period. A deferred tax liability arises when the taxable income in the current year is lower than book income. Therefore, the amount of taxes that the company is required to pay in the current year will be less than the amount of taxes that the company should pay based on its books. The portion of taxes that was not paid in this year will be paid in the next years. That is why this portion is recorded as a deferred tax liability in the financial records.



a. For example, if the amount of taxes based on the company’s books is $3,000 and the amount that the company is required to pay based on taxable income is $2,500, the taxes will be recorded as follows:

Dr Income Tax Expense 3,000 Cr Cash 2,500 Cr Deferred Tax Liability 500

b. Note that the amount of income tax expense on the income statement will always be the amount calculated based on the company’s financial records in accordance with GAAP, NOT the amount that is actually paid based on taxable income in accordance with tax code.

c. Deferred tax liabilities are caused by

i. Revenues or gains that are recognized in financial reporting before they are recognized for tax purposes. For example, some holding gains recorded for financial reporting purposes may be deferred for tax purposes.

ii. Expenses or losses that are deductible for tax purposes before they are recognized in financial reporting. Examples include using accelerated depreciation of property for tax reporting and straight-line depreciation for financial reporting, or prepaid expenses that are deducted for tax reporting in the period they are being paid.

Illustration of Deferred Tax Liability

A company bought a machine for $200,000 on January 1, 2017. The company will depreciate this machine using straight-line method over its useful life. The useful life of the machine is 2 years. For tax purposes, the machine will be depreciated over its useful life using the following percentages, 70%, and 30% respectively. The annual tax rate is 40%.

For financial reporting, the depreciation expense in 2017 is $100,000 ($200,000 × 50%).

For tax purposes, the depreciation expense in 2017 is $140,000 ($200,000 × 70%).

As a result, the net income in 2017 for financial reporting will be more than the net income for tax purposes. The excess of net income for financial reporting over taxable income in 2017 is $40,000 ($140,000 - $100,000). The tax amount for this excess amount is $16,000 ($40,000 × 40%). This $16,000 represents the deferred tax liability for year 2017 and will be paid in the next year 2018.

2. Deferred Tax Assets (Prepaid Taxes) - A deferred tax asset is the decrease in taxes payable in future periods as a result of temporary differences in taxable income at the end of the current period. A deferred tax asset arises when the taxable income in the current year is higher than book income. Therefore, the amount of taxes that the company is required to pay in the current year will be more than the amount of taxes that the company should pay based on its books. The excess portion of taxes that is paid in this year will reduce the amount of taxes that the company is going to pay in future years. That is why this portion is recorded as a deferred tax asset (or prepaid tax) in the financial records.

a. For example, if the amount of taxes based on the company’s books is $2,500 and the amount that the company is required to pay based on taxable income is $3,000, the taxes will be recorded as follows:

Dr Income tax expense 2,500 Dr Deferred tax asset (Prepaid taxes) 500

Cr Cash 3,000



b. Deferred tax assets are caused by:

i. Revenues or gains that are recognized for tax purposes before they are recognized in financial reporting. Examples include unearned rent or subscriptions received in advance.

ii. Expenses or losses that are recognized in financial reporting before they are deductible for tax purposes. For example, bad debt expenses are recognized in financial records under the allowance method, but tax codes in most countries dictate that bad debt expenses are recognized only when the debts are determined to be uncollectible using the write-off method. Similarly, warranty costs are recognized in financial records based on an estimated allowance in the year of sale, but for tax purposes, warranty costs are recognized only when they are actually incurred or paid.

Illustration of Deferred Tax Assets

In 2017, a company received in advance $150,000 as rent revenues in respect of building rent for the year 2017 and the next two years. The annual rent amount for the years 2017 through 2019 are $40,000, $50,000, and $60,000 respectively. The company is subject to a fixed income tax rate of 40%. If you know that the tax code treats revenues received in advance as taxable income, calculate the deferred tax asset or liability for this company in 2017 and 2018.

At the end of 2017:

The rent for 2017 is $40,000. This amount is earned in 2017. The remaining rent received is unearned revenues. Therefore, the amount of temporary timing difference in net income is $110,000 ($150,000 – $40,000). This difference will be included in taxable income but not included in the financial income because it is unearned yet. Since the company will pay tax on this unearned revenue, this paid tax will be treated as prepaid taxes (or deferred tax asset). Therefore, the deferred tax asset at the end of 2017 is $44,000 ($110,000 × 40%).

At the end of 2018:

An additional $50,000 is earned in the year 2018. The total earned amount at the end of 2018 will be $90,000 ($40,000 for 2017 + $50,000 for 2018). The remaining unearned amount of the rent will be $60,000 ($150,000 - $90,000). In light of this, the deferred tax asset at the end of 2018 is $24,000 ($60,000 ×40%).

Note: deferred tax assets (and liabilities) are calculated using the tax rate of the year when the difference reverses. In the example above, we assumed that the tax rate is fixed over the next years. Assume that the tax rates are going to be 40% for 2017, 35% for 2018 and 30% for 2019. In this case the deferred tax asset at the end of 2017 will be:

The Year of Reverse Temporary Timing Difference (A) Tax Rate (B) (A) × (B)

2018 $50,000 35% $17,500

2019 $60,000 30% $18,000

Deferred tax asset at the end of 2017 $35,500

Similarly, the deferred tax asset at the end of 2018 will be:

$18,000 ($60,000 unearned revenue × 30% tax rate in 2019)



G. Tax Treatment of Net Operating Loss – When a company incurs a net operating loss for a year, the tax laws permit the company to use the loss of one year to offset the profits of other years. The company can carryback this operating loss up to two years and receive a tax refund and/or carry this loss forward up to 20 years to reduce future taxes payable.

1. Operating Loss Carryback – The company can carry the net operating loss back two years and receive refunds for taxes previously paid in those years. The operating loss must be applied to the earlier year first (second prior year). If any of the operating loss remains after exhausting the income of the earlier year, the company can then apply the remaining loss to the most recent year.

a. The entry to recognize the refund tax amount received as a result of loss carryback is as follows (in the year in which the loss occurred):

Dr Income Tax Refund Receivable XXX Cr Tax Benefit due to Loss Carryback XXX

b. The tax receivable is recorded as a current asset at year end. The benefit due to loss carryback is recorded as a gain (or reduction of losses) and appears on the income statement below the “operating loss before income taxes” line.

2. Operating Loss Carryforward - The company can elect to carryback the operating loss and carry forward any operating loss remaining after exhausting the taxable income of the prior two years. However, the company may forgo carrying back the loss and use only the loss carryforward by offsetting future taxable income for up to 20 years.

a. Carrying the operating loss forward will offset future taxable income and create future tax savings, which requires a recognition of a deferred tax asset in the period of the loss. The deferred tax asset is calculated by multiplying the amount of the loss that will be carried forward by the tax rate of the year in which the loss is expected to be used. That is why companies elect to carry the loss forward when the expected tax rate for the future will be higher.

b. The entry to recognize the deferred tax asset as a result of loss carryforward is as follows (in the year in which the loss occurred):

Dr Deferred Tax Asset .XXX Cr Tax Benefit Due to Loss Carryforward XXX

c. The deferred tax asset is recorded as a current asset at year end. The benefit due to loss Carryforward is recorded as a gain (or reduction of losses) and appears on the income statement below the “operating loss before income taxes” line.

d. Needless to say that whether a deferred tax asset will be realized depends on whether the company expects to have enough taxable income during the next 20-years to use the carried loss as a deduction from future taxable income. The company must determine that it is more likely than not that the entire benefit of any loss carryforward will be realized.



Illustration of Loss Carryback and Carryforward

Assume that Aurora Inc. experienced the following financial results for the listed years:

Year Taxable Income Tax Rate Tax Paid

2014 $300,000 30% $90,000

2015 $200,000 30% $60,000

2016 $300,000 35% $105,000

2017 ($600,000) 40% -

The management of Aurora Inc. decided to carry the operating loss of 2017 back and forward. Therefore, the loss is carried back to 2015 first, then to 2016, and any unused loss will be carried forward. The amount of taxes refund received for 2015 and 2016 will be [($200,000 × 30%) + ($300,000 × 35%)] = $165,000.

The 2017 entry to record the tax refund is as follows:

Dr Income Tax Refund Receivable ............................................. $165,000 Cr Tax Benefit due to Loss Carryback .................................. $165,000

Since the net operating loss for 2017 exceeds the total taxable income from the two prior years, the company carries forward the remaining loss of $100,000 ($600,000 - $500,000). Assuming that the enacted tax rate in the year 2018 is 45%, the tax effect of the loss carryforward would be a deferred tax asset of $45,000 ($100,000 × 45%). The 2017 entry to record the loss carryforward is as follows:

Dr Deferred Tax Asset ……………………………………………….$45,000 Cr Tax Benefit Due to Loss Carryforward ………………………. $45,000

The tax benefits are presented on the income statement for Aurora Inc. at the end of 2017 as follows:

Aurora Inc, Income Statement for 2017

Operating loss before income taxes $(600,000) Income tax benefit Benefit due to loss carryback $165,000 Benefit due to loss carryforward $45,000 $210,000 Net loss $(390,000)

Assume that Aurora Inc. generated taxable income of $300,000 in 2018. Aurora Inc. then can realize the benefits of the operating loss carryforward. The tax payable for 2018 is computed as follows:

Taxable income before loss carryforward Loss carryforward deduction (200,000) Taxable income for 2018 Income taxes payable for 2018 (200,000 × 45%)

$300,000 (100,000) 200,000 90,000

The entry to record income taxes in 2018 is as follows:

Dr Income Tax Expense ………………………………… $135,000 Cr Deferred Tax Asset …………………..…………… $45,000 Cr Income Taxes Payable ………………..………….. $90,000



Leases

A lease is a contractual agreement between a lessor and a lessee that grants the lessee the right to use the property throughout the term of the lease in return for periodic payments made to the lessor.

A. Types of Leases

Lessee Lessor Rent Operating Lease Operating Lease Sale Capital Lease Sale or Direct Financing

1. Operating Lease is a lease that does not meet the criteria for a capital lease. Operating leases are treated as a regular rental of assets.

2. Lessee Capital Lease is classified as such by a lessee if it meets one of the following criteria: a. The lease terms contain a bargain purchase option. b. Title to the property passes to the lessee at the end of the lease term. c. The term of the lease is 75% or more of the economic useful life of the property. d. The present value of the lease payments over the life of the lease are 90% or more of the

current fair market value. If a lease is classified as a capital lease, the lessee is required to state the leased assets as depreciable assets in the books of account at the fair market value and state the contra amount in liability account for the PV of the lease payments.

3. Lessor Sales-Type / Direct Financing is a lease that meets the criteria for a capital lease by the lessee. If the lessor’s profit is evident, it is considered a sales-type lease, otherwise, it is considered a direct-financing lease.

B. Financial Statement Presentation

1. Operating Lease

a. Lessor – the lease payment is recorded as a revenue on the Lessor’s income statement. The asset is recorded on the Lessor’s balance sheet and the depreciation expense on the Lessor’s income statement.

b. Lessee – the lease payment is recorded as an expense on the Lessee’s income statement. For the lessee, an operating lease may qualify as an off-balance sheet financing arrangement as described in the Off-Balance Sheet Financing section above. The Lessee is required to disclose the following:

i. Lease terms including term, renewals, purchase options, and/or any restrictions imposed by the lease contract.

ii. Schedule of total rental expense commitments and any associated sublease income.

iii. Minimum future rental payments for each of the next years.



2. Capital Lease

a. Lessor (Sales-Type) – the Lessor under a capital sales-type lease would record both a receivable from the lease payments receivable and a cost of goods sold as follows:

Lease payments receivable 550,000 Sales Revenue 450,000 Unearned interest revenue (contra account to the lease receivable)

100,000

Cost of goods sold 350,000

Asset (inventory) 350,000 b. Lessor (Direct Financing) – the Lessor under a capital direct financing lease would record

the following at the inception of the lease:

Lease payments receivable 550,000 Asset 450,000 Unearned interest revenue (contra account to the lease receivable)

100,000

c. Lessee – for a capital lease, the lessee would calculate the present value of the minimum lease payments and both an asset and a liability would be recorded in the amount calculated. The asset would be “Leased Assets under Capital Lease” while the liability would be “Minimum Obligations under Capital Lease”. Every period, both the asset and the liability are amortized over the remaining lease term (or asset’s useful life if shorter) and classified as current and non-current appropriately. The Lessee is required to disclosed the following:

i. Lease terms including term, renewals, purchase options, and/or any restrictions imposed by the lease contract.

ii. The complete details of both the Leased Assets under Capital Lease and the Minimum Obligations under Capital Lease.

Passing Tip: Capital Lease A capital lease transfers substantially all of the benefits and risks of ownership of the

asset from the lessor to the lessee. A capital lease is recorded as an asset in the books of the lessee and removed from

the books of the lessor. The lessee may prefer the accounting for a lease as an operating lease to use it as

an off-balance sheet financing by utilizing the asset without having to record the associated liability.



IFR

S Land and Building Lease

Under GAAP, when a lease includes both land and buildings elements, land and building elements are generally treated as a single unit unless land represents 25 percent or more of the total fair value of the leased property.

Under IFRS, when a lease includes both land and buildings elements, each element must be classified separately as an operating or finance (capital) lease: 1. The building element is classified either as a finance lease or an operating lease based on the

regular criteria. 2. The important consideration in determining whether the land element is an operating or a

finance lease is that land normally has an indefinite economic life. The land element may be classified as capital lease if the land lease term lasts for a long period (several decades), and if the lease conditions pass the title to the lessee at the end of the lease term.



Equity Transactions A. Shareholders’ Equity - The equity section in the balance sheet of a company includes the following

classifications of shareholders’ equity (each one will be discussed separately):

‐ Contributed Capital which consists of two accounts:

Capital Stock Account records the par value of the sold stocks. A different capital stock account is held for each of the different types of issued stocks (common and preferred stocks).

Additional Paid-in-capital Account records the amount received above the par value of issued stocks.

‐ Retained Earnings records all undistributed profits of the company.

‐ Accumulated Other Comprehensive Income.

‐ Treasury Stocks are any capital stocks reacquired by the issuing company.

1. Stocks are units of ownership in a corporation. Two types of stocks exist:

a. Common stock

b. Preferred stock

2. Common Stock is stock providing owners voting rights but only a residual claim to company assets.

a. It is the basic form of corporate ownership as common stockholders are considered the true owners of a corporation.

b. In return for their investment, common stockholders expect to receive dividends and/or capital gains resulting from increases in the value of their stock holdings.

c. Common stockholders vote on major company decisions, such as purchasing other companies or electing a board of directors.

d. Common stockholders have residual claim on assets because creditors and holders of preferred stock have priority.

e. Common stock may be sold at either a par or no-par value basis and may be quoted at book or market value:

i. Par Value is the value printed on the stock certificates of some companies.

ii. Non-Par Value shares may be issued to reduce the state taxes on incorporation and to avoid the use of the arbitrary par value basis.

iii. Book Value is the residual value of a corporation (assets – liabilities – preferred stock) divided by the number of common stocks to find the value of each stock.

iv. Market Value is the market price at which a stock is currently selling.



f. When common stocks are issued for cash, the cash account is debited for the amount received and common stocks account is credited only by the par value of the issued stocks. The cash received in excess of the par value is credited to the additional paid-in capital account. For example, assume a company issued 1,000 common stocks of $50 par value and the market price for these stocks is $75 per stock. The entry to record this transaction would be:

Dr Cash 75,000 Cr Common Stocks 50,000 Cr Additional Paid-in capital – common stocks 25,000

g. Common stockholders usually have pre-emptive rights that prevent their ownership and management interest from being diluted when issuance of new shares occur.

i. Pre-emptive rights provide the common shareholders with the right of buying shares of new issuances in proportion to their existing ownership.

ii. If the preemptive right is not statutory, the company may elect to sell the common stockholders these rights in the form of call options.

iii. The shares are traded rights-on before the rights are issued. The rights are inseparable from the shares and are traded together. The price of a stock right when the shares are rights-on is:

Price of Share (rights-on) – Subscription price/share No. of rights required to buy 1 share + 1

iv. The shares are traded ex-rights when the shareholders receive the rights. The rights may then be sold separately.

h. Disadvantages of Common Stock

i. Cash dividends are not tax deductible.

ii. Earnings per share and voting rights are diluted as a result of common stock issuance.

iii. Excessive equity (above the optimum level) may increase the cost of capital for the firm.

iv. Underwriting costs associated with common stock issuance.

3. Preferred Stock is stock providing owners preferential dividend payment and first claim to assets after debts are paid (but before common shareholders), however, usually lacking the voting rights.

a. Preferred shareholders may be given votes in extremely important issues such as mergers.

b. They are considered owners of the firm, and their dividends are thus not guaranteed.

c. Preferred stock may be issued with a conversion privilege i.e. the preferred stocks can be converted to common stocks at a stated price.

d. Preferred stock may be redeemed by the issuing company, callable by the issuer, and may have a sinking fund allowing for the repurchase of the outstanding preferred stocks.

e. Preferred stock may be exchangeable for the firm’s bonds.

f. Preferred stock usually has a par (stated) value for liquidation. Dividends are usually stated as a percentage of par.



g. Preferred stock may participate with common stock with superior earnings.

h. For payments of dividends, preferred stock may be:

i. Cumulative preferred stock stockholders must be paid a dividend for each year before common stockholders can be paid. As earlier explained, preferred shareholders are only paid a dividend when the board of directors declares a dividend, however, the dividend for a cumulative preferred share would vest (but not recorded as a liability) and would be paid in the first instance the board declares a dividend. All cumulative dividends in arrears need to be paid prior to paying dividends to common shareholders.

ii. Noncumulative preferred stock need only be paid on the current year’s dividends before common stockholders receive their dividends.

i. Advantages of Preferred Stock

i. Control remains with the common shareholders.

ii. Earnings of the firm remain for the common stockholders.

iii. Preferred stock are considered equity financing (with debt-like characteristics) thus improving the firm’s creditworthiness.

j. Disadvantages of Preferred Stock

i. Cash dividends are not tax deductible compared to interest on long-term debt.

ii. Cumulative dividends create a firm commitment that may burden the firm during economic difficulties.

4. Additional Paid-In Capital are funds paid to the company other than stocks that may be from the excess over par from stock issuances and/or other contributions to the organization.

5. Retained Earnings are the cumulative earnings of the company since inception that were not distributed to the shareholders as dividends.

a. Retained earnings may be restricted - appropriated - in accordance with contractual requirements, board of directors’ policy, or the apparent necessity of the moment.

b. The amounts of retained earnings appropriated are transferred to Appropriated Retained Earnings.

c. The retained earnings section may therefore report two separate amounts:

i. Retained earnings - free (unrestricted); and

ii. Retained earnings - appropriated (restricted).

iii. The total of these two amounts equals the total retained earnings.



6. Treasury Stocks are stocks of a company that are repurchased by the company after they have been sold to other parties. The company may elect to retire those shares or hold them for reissue in the future.

a. A company may repurchase its outstanding shares for several reasons including:

i. Improving performance ratios such as earnings per share and return on equity by reducing both the number of shares outstanding and the stockholders’ equity.

ii. Creating a demand on its own shares in order to stabilize share price or increase it.

iii. Providing shares to be used for employee stock compensations or for stock dividend.

b. Treasury shares are considered issued shares, but they are not outstanding. Therefore, treasury shares do not receive dividends, nor do they have the right to vote.

c. Purchasing treasury stock is recorded by debiting the treasury stock account and crediting cash. The treasury stock account is a contra-equity account. It is not an asset, nor a liability or equity. Purchasing treasury stock reduces both assets and stockholders’ equity.

Illustration of Treasury Stock

A company has the following stockholders’ equity on December 31, 2016:

Stockholders’ equity:

Paid-in capital Common stock, $5 par value, 10,000 shares issued and outstanding $ 50,000 Additional paid-in capital 100,000 Total paid-in capital 150,000 Retained earnings 20,000 Total stockholders’ equity 170,000

On March 1, 2017, the company purchased 1,000 shares of its stock at $16 per share. This transaction is recorded as follows.

Dr Treasury Stock 16,000 Cr Cash 16,000

The treasury stock account is presented on the balance sheet as a reduction of total paid-in capital and retained earnings in the stockholders’ equity section as follows:


Paid-in capital Common stock, $5 par value, 10,000 shares issued and 9,000 outstanding $ 50,000 Additional paid-in capital 100,000 Total paid-in capital 150,000 Retained earnings 20,000 Total paid-in capital and retained earnings 170,000 Treasury stock (1,000 shares) (16,000) Total stockholders’ equity 154,000



Sale of Treasury Stock Above Cost: On June 5, the company sold 100 shares of its treasury stock for $18 per share. This transaction is recorded by reducing the Treasury Stock account by the cost of the sold shares, and the difference is credited to the account “Paid-in Capital from Treasury Stock” which represent an increase in the Paid-in Capital.:

Dr Cash 1,800 Cr Treasury Stock 1,600 Cr Paid-in Capital from Treasury Stock 200

Sale of Treasury Stock Below Cost: On July 10, the company sold another 100 shares of its treasury stock for $13 per share. The excess of cost over selling price for this sale is $300 [100 × (16 – 13)]. This excess is recorded first by offsetting the credit balance in Paid-in Capital from Treasury Stock account until it is fully depleted. After eliminating the credit balance in Paid-in Capital from Treasury Stock account, the company debits to Retained Earnings any additional excess of cost over selling price. The balance in Paid-in Capital from Treasury Stock is $200 from the sale made on June 5. Therefore the entry to record the sale of additional 100 shares on July 10 will be:

Dr Cash (100 × 13) 1,300 Dr Paid-in Capital from Treasury Stock 200 Dr Retained Earnings 100 Cr Treasury Stock (100 × 16) 1,600

Note that no income statement account was affected with the purchase or the sale of treasury stock, even when the shares are sold for less than their purchase cost. The difference between the cost of the shares sold and their selling value is debited to stockholders' equity accounts (Paid-in Capital from Treasury Stock or Retained Earnings).

7. Venture Capital are funds invested for equity in a new, small, or struggling business with a potential for rapid growth.

a. Venture capital usually lacks liquidity for the investor, however, investors bet on a significant future capital gain.

b. Venture capital is usually expensive to the firm as investors require a larger ownership % to compensate for the lack of liquidity.

8. Liquidating Assets or the selling of a firm’s assets to be used for future investments.

B. Prior Period Adjustments

1. Prior period adjustments are items of income or loss related to corrections of errors in the financial statements of a prior period. These adjustments are accounted for and reported in the statement of retained earnings as “prior period adjustments” (net of tax). The charge is made directly to the opening balance of retained earnings for the current period. They can also be to the opening balance of the retained earnings column on the statement of changes in equity.

2. They are excluded from the determination of net income for the current period.

3. E.g. Changing from the cash method of accounting (not GAAP) to the accrual method of accounting (GAAP) or discovering the failure to record a significant expense in a prior period.



C. Changes in Accounting Principle

1. Changes in accounting principle occur when a company adopts a different accounting principle. Examples include moving from the average-cost method to the FIFO method for inventory valuation, or from the completed-contract method to the percentage-of-completion method in accounting for construction contracts.

2. Changes in accounting principle are recognized by including the cumulative effect net of tax to adjust the beginning balance of retained earnings. Prior to 2006, the cumulative effect of changes in accounting principle was included in the current year’s income statement net of tax after discontinued operations.

3. This amount is based on a retroactive computation of changing to a new accounting principle.

4. Changes in accounting principles are different from the changes in accounting estimates

a. Accounting estimates include estimating the useful lives and salvage values of fixed assets, uncollectible receivables, or the number of years expected to benefit from an expenditure.

b. Changes in estimates are accounted for in the period of change if they affect only that period of change, and future periods if the change affects both.

c. Changes in estimate are not handled retroactively, that is, carried back to adjust the statements of prior years.

d. Changes in estimate are not considered prior period adjustments or extraordinary items. D. Stock Splits

1. When the price of a company’s stock becomes high in the market, a company may opt to do a stock split whereby each existing share is split into 2 or more new shares. This will automatically pro-rate the value of the share prior to the split over the number of new shares resulting from the split. For example, a company’s stock is currently trading at $100 and the company decides to do a 4:1 stock split. Each share would be split to 4 new shares and the stock price will likely trade around (not exactly) $25. For accounting purposes, a stock split is recorded by a memorandum entry only.

2. Reverse stock split refers to the opposite of a stock split whereby multiple shares are consolidated in a bigger share.

E. Dividends

1. A corporation’s board of directors may elect to distribute dividends to the shareholders. A dividend is not considered a liability until declared by the Board. Once declared, the dividend becomes a liability and is recorded as follows:

Retained Earnings 50,000 Dividends Payable 50,000

2. Once the company pays the dividends, the following entry is made:

Dividends Payable 50,000 Cash 50,000



F. Stock Dividends

1. A Company may sometimes opt to declare a stock dividend rather than a cash dividend. This will allow the company to increase its legal capital without incurring the associated flotation costs. The recipients (shareholders) of the stock dividends may opt to sell them, and thus will do the marketing/flotation functions on the company’s behalf.

2. Accounting for the stock dividend would be different if the stock dividend is considered a small dividend (less than 20-25%) or a large dividend (more than 20-25%).

a. Small Stock Dividend – when the stock dividend is small, the reduction from retained earnings is at the fair market value, and any excess of fair market value over par is credit to additional paid-in capital. The entry would be as follows:

Retained Earnings (market value of issued stocks) 75,000 Common Stocks (par value of issued stocks) 50,000 Additional Paid-in Capital – common stocks 25,000

b. Large Stock Dividend – when the stock dividend is large, the reduction from retained earnings is equal to the par value of the shares issued. The entry would be as follows:

Retained Earnings 200,000 Common Stocks (par value of issued stocks) 200,000

G. Comprehensive Income - The income statement includes most revenues, expenses, gains, and losses recognized during the year. However, GAAP requires the use of the statement of comprehensive income to report certain items of gains and losses. Comprehensive income includes all changes in equity (net assets) during a year from transactions and other events except those resulting from investments by owners and distributions to owners. This means that the comprehensive income statement includes all items reported on the income statement plus some items that do not appear in it, which are classified as Other Comprehensive Income. Therefore, comprehensive income includes two major sections:

1. The first section is the net income and the components that make up net income. The total of net income section feeds into the retained earnings account on the equity section of the balance sheet.

2. The second section is the other comprehensive income, which includes the gain and loss items that are not reflected in net income. The word “other” refers to the fact that these items are comprehensive income other than net income items. The items reported in this section and classified as other comprehensive income include:

a. Unrealized holding gains or losses on securities that are classified as available for sale.

b. Gains or losses from translating the financial statements of foreign subsidiaries.

c. Effective portion of gains and losses on derivatives held as cash flow hedges.

d. Actuarial gains and losses on defined benefit pension plans recognized.

The sum of the items classified as other comprehensive income is recorded in an account called Accumulated Other Comprehensive Income, which is a component of stockholders’ equity on the balance sheet. The items in the accumulated other comprehensive income account do not affect the income statement or the retained earnings, but they do affect stockholders’ equity directly. The accumulated other comprehensive income account is a balance sheet account, thus it is a permanent account, and it is not closed at the end of the period.



The following is an illustration of the equity section on the balance sheet showing the presentation of accumulated other comprehensive income account (arbitrary numbers):


Paid-in capital Common stock, $5 par value, 10,000 shares issued and 9,000 outstanding $ 50,000 Additional paid-in capital 100,000 Total paid-in capital 150,000 Retained earnings 20,000 Total paid-in capital and retained earnings 170,000 Treasury stock (1,000 shares) (16,000) Accumulated other comprehensive income 3,000 Total stockholders’ equity 157,000



Revenue Recognition A. The revenue recognition principle under current GAAP provides that revenue is recognized when it is

Realized or realizable and

Earned.

1. Revenues are realized when goods and services are exchanged for cash or claims to cash.

2. Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash.

3. Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues, that is, when the earnings process is complete or virtually complete.

4. In accordance with this principle:

a. Revenue from selling products is recognized at the date of sale.

b. Revenue from services rendered is recognized when services have been performed.

c. Revenues from interest, rent, and royalties are recognized as time passes or as the assets are used.

d. Revenue from disposing of assets other than products is recognized at the date of disposal.

5. Therefore, the general rule for revenue recognition is that revenues are recognized at the point of sale (the delivery of the item). However, for certain type of transactions, revenues may be recognized before delivery or after delivery. These different types are discussed in the following text.

IFR

S

Revenue Recognition IAS 18: Revenues from the sale of goods are recognized when all the following conditions are met:

1- The entity has transferred to the buyer the significant risks and rewards of ownership of the goods.

2- The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold.

3- The amount of revenue can be measured reliably.

4- It is probable that the economic benefits associated with the transaction will flow to the entity.

5- The costs incurred or to be incurred in respect of the transaction can be measured reliably.

Revenues from rendering services are recognized when the outcome of a transaction can be estimated reliably. Revenue associated with the transaction is recognized based on the stage of completion of the transaction at the end of the reporting period. The outcome of a transaction can be estimated reliably when all the following conditions are met:

1- The amount of revenue can be measured reliably.

2- It is probable that the economic benefits will flow to the entity.

3- The stage of completion at the end of the reporting period can be measured reliably.

4- The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.



B. Revenue Recognition at Point of Sale – Revenues generally are recognized at the point of sale, which is when the products or services are delivered to the customer. However, there are some situations that need to be considered upon the implementation of this rule:

1. Sales when Right of Return Exists are recognized when ALL the following six conditions are met:

a. Price - Price is substantially fixed or determinable at the date of sale.

b. Payment - The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on the resale of the product.

c. Fixed obligation - The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage to the product.

d. Economic substance - The buyer acquiring the product has economic substance apart from that provided by the seller.

e. Future obligations - The seller does not have significant obligations for future performance.

f. Returns - The amount of future returns can be reasonably estimated.

If these conditions are all met, the seller can recognize sales revenues less an allowance for estimated future return.

If these conditions are not all met, the seller cannot recognize sales revenue until these conditions have been met, or until the expiration of the right of return.

2. Sales With Buyback Agreements – Sometimes, a company may sell a product in one period and agree to buy it back in a future period. In this situation, the legal title of the product has transferred to the buyer, but the question is whether the risks and rewards of ownership have transferred. In order to determine whether a sale has taken place, the terms of the agreement must be analyzed to ascertain whether the seller has transferred the risks and rewards of ownership to the buyer.

a. If the repurchase price is the fair value at the date of repurchase, and the buyer has no restrictions on the use of the purchased product, this indicates that the risks and rewards of ownership are transferred to the buyer and the sales revenue should be recognized.

b. If the repurchase price is predetermined, then the seller retains the risks of ownership. Similarly, if the buyer has restrictions on the use of the purchased product, then the rewards of ownership have not completely transferred to the buyer. Such restrictions may include maintaining the purchased product in a certain condition or insuring it. In this case, the product remains on the seller’s books and no revenues should be recognized.

3. Trade Loading and Channel Stuffing – to meet sales targets or to window-dress financial statements, management sometimes exercise trade loading and channel stuffing techniques encouraging customers to purchase bulk quantities towards year end by providing discounts and/or payment facilities. The sales will be distorted since the company will report a significant increase in sales during the affected period, and may not generate any significant sales in following periods.



C. Revenue Recognition Before Delivery - Under certain circumstances, revenue may be recognized prior to delivery. The most common examples include:

1. Completion of Production – In some cases, revenue is recognized upon the completion of production. This method is used for products with assured prices e.g. precious metals, oil, or agricultural products. Revenue is recognized when the crops are harvested or the metals are mined. This method can be used only when all the following conditions are met:

a. There is a ready market for the product.

b. The sales price is reasonably assured.

c. The units of the product are interchangeable (homogeneous).

d. The costs of selling and distributing the product are not significant.

IFR

S

Agricultural Production Measurement IAS 41 on agricultural activity recommends that agricultural production at the point of harvest be measured at its fair value less the estimated selling costs. When the fair value can’t be reasonably estimated, the production is measured at cost less accumulated depreciation and impairment losses.

2. Long-Term Construction Contract accounting may use the percentage-of-completion method, which recognizes revenue before delivery. Accounting for long-term contracts is discussed below.

D. Accounting for Long-Term Contracts

1. Long-term contracts require special treatments for revenue recognition as their execution is usually over an extended period of time. Applying the accrual method of accounting, revenues should be recognized with progress towards completion. There are two accounting methods for long-term contracts:

a. Completed Contract Method – under this method, revenues are recognized at the end of a contract. This method is not preferred by GAAP, and would only be acceptable if applying the %-of-completion method is not cost-justified. For example, if a company has numerous 12-18 month contracts and in each year, there are approximately the same number of contracts starting as there are being completed, the year-on-year effect of this type of activity closes the significant difference that would result if the percentage-of-completion method was used.

b. Percentage-of-Completion Method – under this method, the company is required to recognize revenues with progress toward completion. The percentage of revenues (and associated cost of revenues) to recognize is the percentage of completion. The percentage of completion may be estimated using the costs incurred divided by the costs estimated on the entire contract, experts’ opinions, or any other reasonable method to estimate the % of the contract that has been executed.



2. Special Treatments in Long-term Contract Accounting a. Loss in Current Period on a Profitable Contract – occurs when there is a significant

increase in the estimated total contract costs but the increase does not eliminate all profit on the contract. i. Completed contract – no changes ii. Percentage-of-completion – the estimated cost increase may require a current period

adjustment of excess gross profit recognized on the project in prior periods. This adjustment is recorded as a loss in the current period because it is a change in accounting estimate.

b. Loss on an Unprofitable Contract – current cost estimates may indicate that a loss will result on completion of the entire contract. Under both the percentage-of-completion and the completed-contract methods, the entire expected contract loss must be recognized in the current period (the period in which the loss becomes known).

3. Differences Between Billings and Earned Amounts – a current asset or a current liability is recorded at the end of each year depending on the amounts billed/received to date as compared to the amounts recognized as revenues to date. a. If the amounts received to date are more than the amounts recognized, the excess is recorded

as a current liability. b. If the amounts received are less than the amounts recognized, the excess is recorded as a

current asset.

IFR

S

Revenue Recognition The completed-contract method is not allowed under IFRS.

If the completion of construction contracts cannot be estimated reliably, IAS 11 demands the recognition of costs and an equal amount of revenues, as long as the revenues are recoverable or collectable.



Long-Term Construction Contracts – A Comprehensive Example

Rich Co. signed a $5 Million construction contract to be performed over a period of 4 years. Over the 4-year period, the following facts were computed as of December 31 of each year.

Year 1 2 3 4

Contract amount 5,000,000 5,000,000 5,000,000 5,000,000

Total costs of the contract (Actual or Estimated)

4,000,000 4,300,000 5,100,000 5,250,000

Costs incurred to date 2,000,000 3,440,000 4,335,000 5,250,000

Billings to date 2,250,000 3,000,000 4,500,000 5,000,000

Collections to date 1,700,000 3,250,000 4,000,000 5,000,000

Compute the gross profit recognized by Rich per both the completed contract method and the percentage of completion method: Completed Contract Method

Gross Profit (Loss) 0 0 (100,000) (150,000)

% of Completion Method

Gross Profit (GP) 1,000,000 700,000 (100,000) (250,000)

Costs-to-date 2,000,000 3,440,000 4,335,000 5,250,000

Total costs 4,000,000 4,300,000 5,100,000 5,250,000

% of Completion 50% 80% 85% 100%

% GP (Loss) to be recognized 50% 80% 100% 100%

GP Earned-to-date or (Loss realized to date)

500,000 560,000 (100,000) (250,000)

GP (Loss) for the current year 500,000 60,000 (660,000) (150,000)



Journal Entries Entries to book progress for billings and costs are the same under both methods. The following are the entries for year 2:

Construction in progress 1,440,000 Cash 300,000* Supplies and inventory 550,000* Accounts payable 590,000*

*Assumed amounts To record costs of construction as incurred.

Accounts receivable 750,000

Billings on construction in progress 750,000 To record progress billings on construction contract

Cash 1,550,000

Accounts receivable 1,300,000 Advance on construction contract 250,000

To record collections on account Revenue recognition Completed contract method: The following entry is made at the end of the construction contract.

Billings on construction in progress 5,000,000 Revenue from Long-Term Contracts 5,000,000

Construction costs 5,250,000 Construction in progress 5,250,000

To recognize the total contract amounts as revenues, close the billings on construction in progress, recognize the contract costs, and close the asset account construction in progress.

Percentage of completion method: An entry is made at the end of each year to recognize related gross profit (or loss) on the current construction contracts based on the percentage of completion calculations above. Year 2

Construction in progress (Gross Profit) 60,000 Costs of construction in progress 1,440,000

Revenues from construction contract 1,500,000 To recognize revenues (and thus gross profit) at the end of year 2.



E. Revenue Recognition After Delivery 1. Installment Sales Method – Installment sales refers to any type of sale for which payment is

made in periodic installments over an extended period of time. Installment sale accounting method recognizes profits in the periods of collection not in the period of sale, thus, gross profit is recognized as the payments are received. This method is used only when there is reasonable doubt about collectability, i.e. when the degree of collectability cannot be reasonably estimated. When the collectability can be reasonably estimated, installment sales method cannot be used, and revenues are recognized at the date of sale along with an allowance for doubtful accounts. To implement installment sales method, the seller should: a. Compute gross profit as a % of the original sales. b. Recognize gross profit in the % computed above as collections are made.

Illustration of Installment Sales Method

On May 1, year 1, a company sold a machine for $3,000 on the installment basis with a down payment of $1,000. The remainder is payable in two equal installments of $1,000 every 6 months. The cost of the machine is $2,400. The company is uncertain if the remaining amounts are collectable.

The entry to record this sale under the installment method is: on May 1, year 1,

Cash 1,000 Installment Receivable 2,000 Inventory 2,400 Deferred Gross Profit 600

The gross profit percentage on the machine is 20% ($600 ÷ 3,000). For each installment received, the company will recognize 20% of that installment as profit. Therefore, a 20% of each amount received will be transferred from the deferred profit account into the realized profit account.

The entry to recognize 20% of the down payment as profit: on May 1, year 1,

Deferred Gross Profit 200 Realized Gross Profit 200

The entry to record the second payment: on November 1, year 1,

Cash 1,000 Installment Receivable 1,000

The entry to recognize 20% of the second payment as profit: on November 1, year 1,

Deferred Gross Profit 200 Realized Gross Profit 200

On December 31, year 1, the income statement should include only the $400 realized gross profit for the year. The installment receivable remaining balance is presented on the balance sheet net of the deferred gross profit:

Installment Receivable 1,000 Deferred Gross Profit (200) Net Installment Receivables 800



2. Cost Recovery Method – Under the cost recovery method, total gross profit on the sale is recognized only after the book value has been recovered (i.e. collected). Similar to installment method, cost recovery method can be used only when there is no reasonable basis for estimating collectability. Cost recovery method is more conservative than installment method because it does not recognize any profit until cash proceeds exceed the cost of the products sold. To illustrate the difference between the installment method and the cost recovery method, we will use the same example above.

Illustration of Cost Recovery Method

On May 1, year 1, a company sold a machine for $3,000 on the installment basis with a down payment of $1,000. The remainder is payable in two equal installments of $1,000 every 6 months. The cost of the machine is $2,400. The company is uncertain if the remaining amounts are collectable.

In year 1: The entry to record this sale under the cost recovery method is: on May 1, year 1,

Cash 1,000 Cost Recovery Receivable 2,000 Inventory 2,400 Deferred Gross Profit 600

The entry to record the second payment: on November 1, year 1,

Cash 1,000 Installment Receivable 1,000

No entries to recognize profits for the first two payments because the cash received has not yet covered the cost of the sold machine. Therefore, On December 31, year 1, the deferred gross profit of $600 and the cost recovery receivable remaining balance of $1,000 will appear on the balance sheet.

In year 2: When the last payment is received on May 1, year 2, the following entry is made to record the collection of the last payments and to recognize the profit:

Cash 1,000 Deferred Gross Profit 600 Realized Gross Profit 600 Cost Recovery Receivable 1,000

On December 31, year 2, the income statement will include the $600 realized gross profit.

F. Deposit Method (Unearned Revenues) – In some situations, a seller receives cash from the buyer before the sale process is completed. In other words, the seller receives cash before the transfer of the risks and rewards of ownership for a sale transaction to be recorded. In such cases, the received cash is accounted for as unearned revenues (deposit) and reported as current liability on the balance sheet. Moreover, the seller continues to account for the property in its books as an asset. 1. No revenue is recognized until the sale transaction is complete, in which case, the unearned

revenue account is closed and the sale is recorded using one of the revenue recognition methods discussed above.

2. The difference between the deposit method and the previous two methods (installment sales and cost recovery) is that in the previous two methods, the seller has completed the required performance in order to earn the revenue but cash collection is uncertain. While in the deposit method, the seller has not yet performed and earned the revenues.



New Revenue Recognition Standard

In May 2014, the FASB and IASB jointly issued their converged standard on revenue recognition, “Revenue from Contracts with Customers.” The new standard replaces many standards and guidance of today’s accounting literature. The new standard is effective for the annual reporting period beginning after January 1, 2018. The IMA usually includes new accounting standards in the CMA exams after they have been in effect for at least one year. Therefore, CMA candidates will be tested on the new revenue recognition standard after the beginning of 2019.

Revenue recognition practices described in this book are in conformance with the accounting standards currently effective. PRC will update revenue recognition information in this book in accordance with the new standards as they become required of CMA candidates. However, a summary of the new standard is included below.

Revenue from Contracts with Customers – the IASB’s code for this standard is “IFRS 15” and the FASB’s code is “ASC 606.” The core principle of this standard is:

“An entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”

A. Applying this principle is achieved by following these five steps: 1. Identify the contract with a customer. 2. Identify the performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

B. Identify the Contract with a Customer - A contract is an agreement between two or more parties that creates enforceable rights and obligations. Contracts can be written, oral, or implied. In order to account for a contract under this standard, the contract should meet the following criteria: 1. The parties to the contract have approved the contract and are committed to perform their

obligations. 2. The entity can identify each party’s rights regarding the goods or services to be transferred. 3. The entity can identify the payment terms for the goods or services to be transferred. 4. The contract has commercial substance (the risk, timing or amount of the entity’s future cash flows

is expected to change as a result of the contract). 5. It is probable that the entity will collect the consideration to which it will be entitled in exchange for

the goods or services. C. Identifying Performance Obligations - At contract inception, an entity shall assess the goods or

services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: 1. A good or service (or a bundle of goods or services) that is distinct; or 2. A series of distinct goods or services that are substantially the same and that have the same

pattern of transfer to the customer. D. Determine the Transaction Price - The transaction price is the amount of consideration to which an

entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (such as sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.



E. Allocate the Transaction Price to the Performance Obligations – The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.

F. Recognize Revenue as the Entity Satisfies Obligations - An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. 1. An asset is transferred when (or as) the customer obtains control of that asset. 2. The amount of revenue recognized is the amount allocated to the satisfied performance obligation. 3. A performance obligation may be satisfied at a point in time (typically for promises to transfer

goods to a customer) or over time (typically for promises to transfer services to a customer). 4. For performance obligations satisfied over time, an entity recognizes revenue over time by

selecting an appropriate method for measuring the entity’s progress towards complete satisfaction of that performance obligation.



Expense Recognition

As indicated earlier, expenses are defined as outflows or other using up of assets or incurrence of liabilities during a period from producing goods or rendering services. Recognizing an expense is the process of formally recording an item into the financial statements as an expense, consequently, including its effect on the entity’s net income. Generally, there are three methods to recognized expenses:

A. Associating Cause and Effect – This method, also called the matching principle, is the major method for expense recognition. Matching principle states that efforts (expenses) should be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. Under this principle, expense recognition is linked to revenues recognized during the period. Thus, expenses are recognized upon the recognition of revenues that result directly from the consumption of those expenses. In this case, the expense is the “cause” and the revenue is the “effect.” Examples on this principle include: 1. The cost of goods sold is recognized in the same period as the revenue from the sale of the goods. 2. An allowance for sales returns is established (expensed) in the same period in which the sale

revenue of the related goods is recognized. 3. An allowance for doubtful accounts is established (expensed) in the same period in which the

related accounts receivable arise, that is, on the day the sale of the related goods is recognized. 4. Warranty costs should be accrued as expense in the same period in which the related product

sales are recognized. B. Systematic and Rational Allocation – Some costs have no direct cause-and-effect relationship with

revenues. However, a “rational and systematic” allocation approach can be established to allocate those costs over the periods during which they provide benefits to the entity. Examples include: 1. The costs of long-lived assets are allocated over the periods during which the asset is used. This

allocation takes place through depreciation expenses. 2. Insurance costs paid in advance are allocated over all of the accounting periods that the insurance

covers. 3. Interest and operating lease costs are recognized based on the passage of time.

C. Immediate Recognition – Some costs neither provide distinguishable future benefits, nor do they have direct cause-and-effect relationship with revenues. Such costs are recognized as expenses immediately in the current accounting period. Examples include: 1. Officers’ salaries and other general and administrative expenses. 2. Costs previously recorded as assets that no longer generate benefits to the entity, such as a patent

that is determined to be worthless.



Differences between U.S. GAAP and IFRS

U.S. Generally Accepted Accounting Principles (GAAP) are a set of accounting standards established and communicated by the Financial Accounting Standards Board (FASB) in the United States. International Financial Reporting Standards (IFRS) are a set of international accounting standards issued by the International Accounting Standards Board (IASB). The use of GAAP is required in the United States while the use of IFRS is required in most countries outside the USA. The IASB and the US FASB have been working together to achieve convergence of IFRS Standards and US GAAP. However, IFRS and US GAAP still have some differences in accounting and reporting treatments. In the following discussion, we will cover some common financial statement elements and transactions for which the IFRS Standards are different from U.S. GAAP.

A. Revenue Recognition – Sale of Goods

1. GAAP – The general rule is that revenue is recognized when (1) realized or realizable and (2) earned. This means that revenue is recognized when all of the following conditions are met:

a. Delivery has occurred.

b. There is persuasive evidence of a sale.

c. The amount of revenue is determinable.

d. Collectability is reasonably assured.

2. IFRS – Revenue from the sale of goods is recognized when all the following conditions are met:

a. Risks and rewards of ownership have been transferred.

b. The buyer has control over the goods.

c. The amount of revenue can be measured reliably.

d. It is probable that economic benefits will flow to the entity.

e. The costs incurred in respect of the transaction can be measured reliably.

B. Revenue Recognition – Rendering Long-term Services

1. GAAP

a. The use of the percentage-of-completion method for long-term service arrangements is prohibited unless the arrangement is within the scope of an industry specific standard (such as software or construction contracts).

b. Generally, the proportional-performance method or the completed-performance method can be used to measure output and recognize revenues. If output measures do not exist, the straight-line approach may be applied.

c. The percentage-of-completion method is different from the proportional-performance method. The percentage-of-completion method uses a cost-to-cost approach to measure the completed percentage, while the proportional-performance method uses a value-based measure of progress.

2. IFRS

a. Revenues from-long term services arrangements can be recognized using the percentage-of-completion method.

b. The stage of completion at the end of the reporting period may be determined by the cost-to-cost method.



C. Revenue Recognition – Construction Contracts

1. GAAP

a. Revenue is recognized based on the percentage-of-completion method if the stage of completion can be estimated reliably. When reliable estimates about the percentage of completion cannot be made, the use of completed contract method is required.

b. Within the percentage of completion method, revenues are recognized using two approaches, the revenue approach and the gross-margin approach.

2. IFRS

a. Revenue is recognized based on the percentage-of-completion method if the stage of completion can be estimated reliably. When reliable estimates about the percentage of completion cannot be made, revenue is recognized using cost recovery method.

b. Under cost recovery method, revenue is recognized to the extent of costs incurred if the entity expects to recover those costs.

c. The gross-margin approach and the completed contract method are not allowed under IFRS.

D. Revenue Recognition – Deferred Receipts

1. GAAP – Discounting revenues is required in limited situations such as receivables due in more than one year.

2. IFRS – When the inflow of cash is deferred, the future receipts are discounted to present value in order to determine the revenue to be recognized and the interest income to be recorded over time.

E. Expense Recognition – Share-based Payments: Share-based payments are transactions in which the entity receives goods or services for equity-based payments. Examples include employee share purchase plans, employee share ownership plans, and payments for goods or services made to external parties based on the entity’s equity shares.

1. GAAP

a. Transactions with non-employee parties are measured at the fair value of the goods or services received or the fair value of the equity instrument used as payment, whichever is more reliable.

b. In employee awards with graded vesting features (tranches), the compensation cost can be recognized either on a straight-line basis or on an accelerated basis.

2. IFRS

a. Transactions with non-employee parties are measured at the fair value of the goods or services received. If the fair value of the goods and services cannot be determined reliably, the fair value of the equity instrument used as payment can be used as measurement base.

b. In employee awards with graded vesting features (tranches), the compensation cost is recognized on an accelerated basis only.



F. Intangible Assets – Development Costs and Revaluation

1. GAAP

a. Generally, internally generated intangible assets are not recognized. Therefore, research and development costs are expensed as incurred. However, costs incurred in the development of software for sale to third parties or for internal use can be capitalized under specific conditions.

b. Revaluation for intangible assets is prohibited.

2. IFRS

a. Costs related to the generation of intangible assets are divided into research costs and development costs. Research stage costs are expensed as incurred. Development stage costs can be capitalized if the following conditions are met:

i. The entity has the technical feasibility and intent to complete the asset and the ability to use or sell it.

ii. The asset can generate probable future economic benefits.

iii. The entity has the resources required to complete and use or sell the asset.

iv. Expenditures related to the asset can be measured reliably.

b. For some intangible assets other than goodwill, revaluation to fair value is allowed if the asset has an active market.

G. Inventories – Costing Methods, Valuation, and Write-downs

1. GAAP

a. Permitted costing methods include weighted-average, FIFO, and LIFO.

b. Inventory is valued at the lower of cost or market. The market value is the median of the following values:

i. Replacement Cost is the current cost to repurchase the inventory item.

ii. Market Ceiling is the net realizable value which is the selling price less the costs to complete and sell.

iii. Market Floor is the net realizable value less a normal profit margin.

c. Inventory write-downs due to value impairment cannot be reversed.

2. IFRS

a. Permitted costing methods include weighted-average, FIFO. The use of LIFO is prohibited.

b. Inventory is valued at the lower of cost or net realizable value. Net realizable value is the selling price less the costs to complete and sell.

c. Inventory write-downs can be reversed up to the original value if the impairment reasons no longer exist.



H. Leases of Land and Buildings

1. GAAP – For the purpose of classifying a lease as an operating lease or a capital lease, land and building elements of a lease are considered jointly as a single unit unless the value of the land element is more than 25% of the total fair value of the leased property. If the land element represents more than 25% of the total fair value of the leased property, it is accounted for as a separate unit and classified as an operating lease unless the lease transfers ownership or contains bargain purchase option. If the lease for land or buildings transfers ownership or contains a bargain purchase option, the lease is classified as a capital lease regardless of the relative value of the land element.

2. IFRS – For the purpose of classifying a lease as an operating lease or a capital lease, land and building elements are considered separately, unless the value of the land element is immaterial.

I. Long-lived Assets – Revaluation, Depreciation, and Borrowing Costs: Long-lived assets are tangible assets that are held for use in production of goods or services and are expected to last for more than one period. The differences between GAAP and IFRS in respect to long-lived assets include:

1. GAAP

a. The carrying basis for long-lived assets is generally the historical cost. Revaluation of long-lived assets is prohibited.

b. Component depreciation is not required.

c. Reviewing residual values and useful lives is not required unless events or other circumstances indicate that the current estimates became inappropriate.

d. Overhaul costs are accounted for using one of three alternatives: expensed as incurred, included in the cost of the asset, or capitalized and amortized over the benefited periods.

e. Borrowing costs associated with the acquisition or construction of a qualifying asset must be capitalized as part of the asset’s cost. Borrowing costs to be capitalized include interest costs only, and do not include exchange rate differences from foreign borrowings. Qualifying assets include assets that take a substantial period of time to be prepared for their intended use, and investments accounted for under the equity method.

2. IFRS

a. The carrying basis for long-lived assets is the historical cost or the periodic revaluation. Revaluation of long-lived assets to their fair value is performed on regular basis. After revaluation, the new book value will become the revaluated amount less any subsequent accumulated depreciation from the date of re-measurement.

b. Component depreciation is required when components of property, plant, and equipment differ in useful lives.

c. Reviewing residual values and useful lives is required at each balance sheet date.

d. Overhaul costs are generally capitalized by including them in the cost of the asset.

e. Borrowing costs associated with the acquisition or construction of a qualifying asset must be capitalized as part of the asset’s cost. Borrowing costs to be capitalized include interest costs and exchange rate differences from foreign borrowings. Qualifying assets include assets that take a significant period of time to be prepared for their intended use. Investments accounted for under the equity method are not considered qualifying assets.



J. Impairment of Long-lived Assets – Determination, Calculation, and Loss Reversal

1. GAAP

a. Determining the existence of impairment and measuring the impairment amount require two different calculations.

i. Determining the existence of impairment – the carrying amount of the asset is compared with the undiscounted future cash flows expected from the asset. If the carrying amount is lower than the undiscounted cash flows, no impairment loss is recognized.

ii. Measuring the impairment amount – if the carrying amount is higher than the undiscounted cash flows, an impairment loss is recognized as the difference between the carrying amount and the fair value of the asset.

b. Previously recognized impairment loss cannot be reversed.

2. IFRS

a. Determining the existence of impairment and measuring the impairment amount require a one-step test. The carrying amount of the asset is compared with the recoverable amount. The recoverable amount is the higher of (1) the fair value less costs of disposal, and (2) the value in use. The value in use is the discounted future cash flows expected from the asset. If the carrying amount is higher than the recoverable amount, the difference is recognized as impairment loss.

b. Previously recognized impairment loss on assets, other than goodwill, may be reversed under certain conditions.

K. Financial Statement Presentation – Extraordinary Items and Changes in Equity

1. GAAP

a. Presenting items as extraordinary items in the income statement is permitted for items that are both unusual and infrequent.

b. Changes in equity are presented either in a separate statement or in the notes to the financial statements.

2. IFRS

a. Presenting items as extraordinary items in the income statement is prohibited.

b. Changes in equity are presented in the Statement of Changes in Equity, which is a primary statement for all entities.



Summary of the Differences between U.S. GAAP and IFRS GAAP IFRS Revenue Recognition: Sale of Goods

Revenue is recognized when (1) realized or realizable and (2) earned:

1. Delivery has occurred. 2. There is persuasive evidence of a

sale. 3. The amount of revenue is

determinable. 4. Collectability is reasonably

assured.

Revenue is recognized when: 1. Risks and rewards of ownership

have been transferred. 2. Buyer has control over the goods. 3. The amount of revenue can be

measured reliably. 4. It is probable that economic

benefits will flow to the entity. 5. The costs incurred in respect of

the transaction can be measured reliably.

Revenue Recognition: Rendering Long-term Services

The percentage-of-completion method is prohibited.

The proportional-performance method or the completed-performance method can be used.

If output measures do not exist, the straight-line approach can be applied.

The percentage-of-completion method is permitted.

Using the cost-to-cost method to determine the stage of completion is permitted.

Revenue Recognition: Construction Contracts

The percentage-of-completion method is used when the stage of completion can be estimated reliably.

The completed-contract method is required when reliable estimates cannot be made.

In the percentage of completion method, revenues are recognized using two approaches, the revenue approach and the gross-margin approach.

The percentage-of-completion method is used when the stage of completion can be estimated reliably.

The cost-recovery method is used when reliable estimates cannot be made.

The gross-margin approach and the completed-contract method are not allowed.

Revenue Recognition: Deferred Receipts

Discounting revenues is required in limited situations.

Discounting revenues is required for all deferred receipts.

Expense Recognition: Share-based Payments

Transactions with non-employee parties are measured at the fair value of the goods or services received or the fair value of the equity instrument used as payment.

Compensation cost for employee

awards with tranches can be recognized either on a straight-line or on an accelerated basis.

Transactions with non-employee parties are measured at the fair value of the goods or services received. The fair value of the equity used as payment can be used only when the fair value of the goods and services cannot be determined reliably.

Compensation cost for employee awards with tranches is recognized on an accelerated basis only.



GAAP IFRS

Intangible Assets: Development Costs and Revaluation

Generally, internally generated intangible assets are not recognized. Therefore, research and development costs are expensed as incurred.

Costs incurred in the development of software can be capitalized under specific conditions.

Revaluation for intangible assets is prohibited.

Research stage costs are expensed as incurred.

Development stage costs can be capitalized under specific conditions.

Revaluation for intangible assets other than goodwill is allowed.

Inventories: Costing Methods, Valuation, and Write-downs

Permitted costing methods include weighted-average, FIFO, and LIFO.

Inventory is valued at the lower of

cost or market.

Inventory write-downs due to value impairment cannot be reversed.

Permitted costing methods include weighted-average, FIFO. The use of LIFO is prohibited.

Inventory is valued at the lower of cost or net realizable value.

Inventory write-downs can be reversed.

Leases of Land and Buildings

Land and building elements of a lease are considered jointly as a single unit unless the value of the land element is more than 25% of the fair value of the leased property.

Land and building elements are considered separately, unless the value of the land element is immaterial.

Long-lived Assets: Revaluation, Depreciation, and Borrowing Costs

Revaluation of long-lived assets is prohibited.

Component depreciation is not required.

Reviewing residual values and useful lives generally is not required.

Overhaul costs are expensed as incurred, included in the cost of the asset, or capitalized and amortized over the benefited periods.

Borrowing costs to be capitalized include interest costs only. Qualifying assets include assets that take a substantial period of time to be prepared for their intended use, and equity method investments.

Revaluation of long-lived assets to their fair value is performed on regular basis.

Component depreciation is required when components of property, plant, and equipment differ in useful lives.

Reviewing residual values and useful lives is required.

Overhaul costs are generally capitalized by including them in the cost of the asset.

Borrowing costs to be capitalized include interest costs and exchange rate differences. Qualifying assets include assets that take a significant period of time to be prepared for their intended use.



GAAP IFRS

Impairment of Long-lived Assets: Determination, Calculation, and Loss Reversal

Determining the existence of impairment and measuring the impairment amount require two different calculations.

1. The carrying amount of the asset is compared with the undiscounted future cash flows expected from the asset.

2. The impairment loss is the difference between the carrying amount and the fair value of the asset.

Previously recognized impairment loss cannot be reversed.

Determining the existence of impairment and measuring the impairment amount require a one-step test.

1. The carrying amount of the asset is compared with the recoverable amount. If the carrying amount is higher, the difference is recognized as impairment loss.

Previously recognized impairment loss on assets other than goodwill may be reversed.

Financial Statement Presentation: Extraordinary Items and Changes in Equity

Presenting extraordinary items in the income statement is permitted.

Changes in equity are presented either in a separate statement or in the notes to the financial statements.

Presenting extraordinary items in the income statement is prohibited.

Changes in equity are presented in the Statement of Changes in Equity.




1. Wydner Company has decided to change in the current year from the straight-line method to the sum-of the-years-digits method for recording depreciation expense for certain assets. The cumulative effect of this change should be:

a. Reflected in the income of the current period.

b. Reflected in the income of both current and prior periods.

c. Spread over the remaining life of the assets involved.

d. Recorded as an adjustment to the beginning balance of retained earnings.

2. Temporary and permanent differences between taxable income and pre-tax financial income differ in that:

a. Temporary differences do not give rise to future taxable or deductible amounts.

b. Only permanent differences have deferred tax consequences.

c. Only temporary differences have deferred tax consequences.

d. Temporary differences include items that enter into pre-tax financial income but never into taxable income.

3. The percentage-of-completion method is acceptable under the revenue recognition principle because

a. The assets are readily convertible into cash.

b. The production process can be readily divided.

c. Cash has been received for the customer.

d. The earnings process is completed at various stages.

4. When shall a company consider that revenue is realizable?

a. When products are exchanged for cash or claims to cash.

b. When products are exchanged for assets that are readily convertible into cash or claims to cash.

c. When the company substantially accomplishes what it must to do to be entitled for the revenue.

d. When the company accomplishes more than 50% of what it must do to be entitled for the revenue.

5. Leases should be classified by the lessee as either operating leases or capital leases. Which of the following statements best characterizes operating leases?

a. The benefits and risks of ownership are transferred from the lessor to the lessee.

b. The lessee records leased property as an asset and the present value of the lease payments as a liability.

c. Operating leases transfer ownership to the lessee, contain a bargain purchase option, are for more than 75% of the leased asset’s useful life, or have minimum lease payments with a present value in excess of 90% of the fair value of the leased asset.

d. The lessor records lease revenue, asset depreciation, maintenance, etc., and the lessee records lease payments as rental expense.



6. How would a 5% stock dividend affect a company’s additional paid-in capital and retained earnings when declared?

Additional Paid-in Capital Retained Earnings

a. No change Increase

b. No change Decrease

c. Increase Increase

d. Increase Decrease



Feedback:

1. Answer (d) is correct. Prior to 2006, a change in accounting principle was recorded in the income statement as the cumulative effect of change in accounting principle (net of tax) after extraordinary items.

Not (a) because although this would have been the correct treatment prior to 2006, effective 2006, a change in accounting principle is recorded as an adjustment to beginning retained earnings.

Not (b) because effective 2006, a change in accounting principle is only reflected in the income of prior years.

Not (c) because only a change in estimate is spread over the remaining life of the assets involved. This is a change in principle not a change in estimate.

2. Answer (c) is correct. Permanent differences have no deferred tax consequences because they affect only the period in which they occur. Permanent differences include (1) items that enter into pre-tax financial income but never into taxable income and (2) items that enter into taxable income but never into pre-tax financial income. In contrast, temporary differences result in taxable or deductible amounts in some future year(s), when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. Temporary differences therefore do have deferred tax consequences while permanent differences do not.

Not (a) because it is temporary differences that result in taxable or deductible amounts in some future year(s), when the reported amounts of assets are recovered and the reported amounts of liabilities are settled.

Not (b) because temporary differences have deferred tax consequences while the permanent differences do not. Permanent differences affect only the period in which they occur.

Not (d) because permanent differences, not temporary differences, include items that enter into pre-tax financial income but never into taxable income.

3. Answer (d) is correct. According to the accrual method of accounting, revenues should be recognized with progress towards completion, when possible.

4. Answer (b) is correct. The revenue is deemed realizable when products are exchanged for assets that are readily convertible into cash or claims to cash.

5. Answer (d) is correct. Operating leases are transactions whereby lessees rent the right to use lessor assets without acquiring a substantial portion of the benefits and risks of ownership of those assets.

6. Answer (d) is correct. This stock dividends are small (less than 20-25%). Therefore, at stock dividends declaration, the company will reduce the retained earnings since it will go out from this pool, plus the capital and additional paid in capital will increase in the same time by the related portions of them. If the stock dividends are large, the accounts affected at declaration will be the retained earnings and the capital account only. If the dividends are cash dividends, at the declaration phase, the company will reduce the retained earnings and increase current payables by the declared dividends value.



Sample Financial Statements

Comprehensive Example - Comparative Balance Sheets

Future Tech Company Balance Sheet

As of December 31,

2011 2012 2013ASSETS

CURRENT ASSETS

Cash 9,819,206 7,329,405 6,052,754 Inventories 8,341,092 17,304,624 35,572,405 Accounts receivable 1,867,869 3,758,779 11,008,546 Other receivables 276,986 598,214 10,313,047 Advances and prepayments 143,587 340,823 17,921,150

Other debit balances 3,968,589 6,816,175 3,194,441

Total Current Assets 24,417,329 36,148,020 84,062,343

FIXED ASSETS 15,174,832 14,912,847 24,219,521

TOTAL ASSETS 39,592,161 51,060,867 108,281,864

LIABILITIES AND PARTNERS' EQUITY

CURRENT LIABILITIES

Accounts payable 626,402 189,984 26,592,825 Bank overdrafts 145,634 218,932 13,377,466

Current portion of long-term debt 3,599,980 3,937,690 4,307,080

Total Current Liabilities 4,372,016 4,346,606 44,277,371

LONG-TERM LIABILITIES 18,108,770 14,171,080 9,864,000

TOTAL LIABILITIES 22,480,786 18,517,686 54,141,371

SHAREHOLDERS’ EQUITY

Paid-in Capital 12,213,134 12,213,134 30,790,634

Retained Earnings 4,898,241 20,330,047 23,349,859

Total Shareholder's Equity 17,111,375 32,543,181 54,140,493

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 39,592,161 51,060,867 108,281,864



Comprehensive Example - Comparative Income Statements

Future Tech Company Income Statement

For the Year Ended December 31,

2011 2012 2013

Sales 95,217,059 246,867,314 267,621,574

Less: Cost of sales (71,737,302) (193,200,932) (218,060,917) Gross Margin 23,479,757 53,666,382 49,560,657

Selling Expenses (2,909,848) (12,386,993) (13,234,362) General and administrative expenses (3,187,398) (6,528,463) (18,636,785) Depreciation (1,845,800) (2,557,028) (3,200,034)

EBIT 15,536,711 32,193,898 14,489,476 Interest (2,116,430) (1,807,700) (2,941,511)

EBT 13,420,281 30,386,198 11,547,965

Tax (4,026,084) (9,115,859) (3,464,390)

Net Income for the period 9,394,197 21,270,339 8,083,576

Comprehensive Example - Comparative Statements of Changes in Equity

Future Tech Company Statement of Changes in Equity

For the Year Ended December 31, 2011 2012 2013

Beginning balance as of January 1, - 17,111,375 32,543,181

Prior period adjustment - - (400,000) Adjusted Beginning Balance - 17,111,375 32,143,181 Issuance of Shares 12,213,134 - 18,577,500 Net income for the period 9,394,197 21,270,339 8,083,576 Dividends (4,495,956) (5,838,532) (4,663,764)

Ending balance as of December 31, 17,111,375 32,543,181 54,140,493



Comprehensive Example - Comparative Statement of Cash flows

Future Tech Company Statement of Cash Flows

For the Year Ended December 31, 2011 2012 2013

CASH FLOWS FROM OPERATING ACTIVITIES

Net income 9,394,197 21,270,339 8,083,576

Adjustments to reconcile net income to net cash

flows from operating activities

Depreciation 1,845,800 2,557,028 3,200,034

Losses (Gains)

Operating gain (loss) before changes in assets and

liabilities used in operating activities 11,239,997 23,827,367 11,283,610

Net (increase) decrease in assets

Inventories (8,341,092) (8,963,532) (18,267,781)

Accounts receivable (1,867,869) (1,890,910) (6,310,730)

Other Receivables (276,986) (321,228) (10,313,047)

Advances and prepayments (143,587) (197,236) -17921150

Other debit balances (3,968,589) (2,847,586) 3,621,734

Net increase (decrease) in liabilities

Current liabilities 626,402 (436,418) 26,183,909

Bank overdrafts 145,634 73,298 13,377,466

Net cash provided by operating activities (2,586,090) 9,243,755 1,654,011

CASH FLOWS FROM INVESTING ACTIVITIES

Fixed assets (17,020,632) (2,295,043) (12,906,708)

Net cash used in investing activities (17,020,632) (2,295,043) (12,906,708)

CASH FLOWS FROM FINANCING ACTIVITIES

Issuance of Shares 12,213,134 - 18,577,500

Long-term Loan 25,000,000 - -

Repayment of long-term debt (3,291,250) (3,599,980) (3,937,690)

Dividends (4,495,956) (5,838,532) (4,663,764)

Net cash provided by financing activities 29,425,928 (9,438,512) 9,976,046

NET INCREASE IN CASH AND CASH EQUIVALENTS 9,819,206 (2,489,800) (1,276,652)

Cash and cash equivalents, January 1 - 9,819,206 7,329,406

CASH AND CASH EQUIVALENTS, DECEMBER 31 9,819,206 7,329,406 6,052,754

SMART STARTER - PRC Exam Review, CIA & CMA Exam · PDF fileFinancial Reporting Planning...

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