ABA-2 PREPAIRING TO THE EXAM

Chapter 1- Fundamentals of accounting.

Financial statement
1. Balance sheet (statement of financial position).
2. Income statement (or profit and loss statement)
3. Statement of cash flows
1. The Balance Sheet (or Statement of Financial Position) • The BS is a document
designed to show the state of affairs of an entity at a particular date It consists in
two lists:
 A list of resources (assets). It can also be seen as a list of applications (how
the sources have been applied)
 A list of sources(where the assets come from) that will require repayment
or recompense (it can also be seen as a list of claims)
 The two lists must balance!
Balance sheet - ASSETS
1) ASSETS - A present economic resources controlled by the entity as a result of
past events. An economic resources is a right that has the potential to produce
economic benefits.
NON-CURRENT (or FIXED) ASSETS, CURRENT ASSETS- that are expected to
tangible and intangible – intended for be converted to cash within a year.
long-term use in the business
- Property and plant – Inventories
– Production equipment – Receivables from customers
– Furniture – Cash
– Vehicles – Bank and etc.
– Patent rights and etc.

Balance sheet – EQUITY AND LIABILITIES

2) SOURCES - Where the assets came from
• Equity (shareholders’ funds) – book value of the shareholders capital.
– Capital contributed by the shareholders – Profits of the year – Previous profits
(that have been reinvested in the company) – Revaluation of assets, Reserves etc
• Liabilities - A present obligation of the entity to transfer an economic resources
as a result of past events. An obligation is a duty or responsibility that the entity
has no practical ability to avoid.
– Payables – Loans – Expected future obligations and etc.
CURRENT LIABILITY – amounts due to NON-CURRENT LIABILITY – long-term
be paid to creditors within 12 moths liabilities to be paid after the period of
1 year.
accounts payable, debentures,
short-term debt, long-term loans,
dividends, bonds payable,
notes payable deferred tax liabilities,
income taxes owed long-term lease obligations,
pension benefit obligations

BALANCE SHEET
WHAT WE OWN WHAT WE OWE
 Current assets  Current liabilities
 Non-current liabilities  Non-current liabilities
 Equity

shareholders’ equity = assets – liabilities

2. The Income Statement • Is an overview of how much a company has earned

during a period. It includes positive and negative elements of profit calculation:
• Income (+)
– Revenues from sales
– Rents received, …
• Expenses (-) costs that don’t generate assets
– Cost of goods sold or of service provided (purchases of goods and materials,
direct labour, …)
– Costs of administration and management (wages for adm staff, adm expenses,
rents payed, …)
– Cost of marketing and product/service delivery (wages for commercial staff,
advertisement, …)
– Cost of financing the business (interests on debt) – Taxation, …
Profit/Loss = Total Income – Total Expenses

The Accounting Equation:

Assets = Liabilities + Equity

Expanded Accounting Equation:

Fundamental Equations (1):

The Balance Sheet Equation Where:

A1= OE1 + L1 A1= Assets (at time 1)

OE1= Owner’s Equity (at time 1)
L1= Liabilities (at time 1)

Rearranged: Where:

OE1= A1- L1=NA NA =Net Assets

Fundamental Equations (2):

• Two factors can affect the owner’s equity:
 Profit (+) or Loss (-)
 Drawings (-) or additional capital from the owner (+)
Assume that at time 1:
 Profit = P1,
 No drawings nor additional capital from the owner
We have that: OE1- OE0=P1
From which: OE1=OE0+P1
 OE2=OE1+P2
 OE2=OE1+P1+P2 …
Fundamental Equations (3):
 From the balance sheet equation: A1-L1=OE1
Assuming no transactions with owners, we have that: A1-L1=OE0+P1
Given that P1=I1-E1 A1-L1-OE0+I1-E1
Which is equal to: A1+E1=OE0+I1+L1
Fundamental Equations (4):
A1+E1=OE0+I1+L1
Two types of resources: Three types of sources:
1. Assets-those remaining 1. Capital-contributed by the
2. Expenses-those used in the owners
period 2. Liabilities- those due to
outsiders
3. Income-those arising from
operations in the period

CHAPTER 2 Accounting for Business Transactions

Financial Statements
The four financial statements and their purposes are:
1. Income statement — describes a company’s revenues and expenses and
computes net income or loss over a period of time.

2. Statement of retained earnings— explains changes in retained earnings

from net income (or loss) and from any dividends over a period of time.
 3. Balance sheet — describes a company’s financial position (types and
amounts of assets, liabilities, and equity) at a point in time.

4. Statement of cash flows — identifies cash inflows (receipts) and cash

outflows (payments) over a period of time.
ACCOUNTING PROCESS:
 Source document
 Journal
 Ledger
 Trial Balance
 Financial Statement (PL; BS; CF; SOCIE)
An account is a record of increases and decreases in a specific asset, liability,
equity, revenue, or expense.
The general ledger is a record of all accounts used by the company.
PROCESSING TRANSACTIONS:
Double-entry accounting is useful in analyzing and processing transactions.
Analysis of each transaction follows these four steps.
 Step 1 Identify the transaction and any source documents.
 Step 2 Analyze the transaction using the accounting equation.
  Step 3 Record the transaction in journal entry form applying double-entry
accounting.
 Step 4 Post the entry (for simplicity, we use T-accounts to represent ledger
accounts).
The Account and Its
Analysis
ASSET ACCOUNTS LIABILITY ACCOUNTS EQUITY ACCOUNTS
Cash Accounts Payable (+) Common stock
Land Notes Payable (-) Dividends
Buildings Unearned revenue (+) Revenues
Equipment Accrued liabilities (-) Expenses
Supplies
Prepaid accounts
Notes receivable
Accounts receivable

Double-Entry Accounting: Expanded Accounting Equation

The trial balance lists all ledger

accounts and their balances at a point
in time. If the books are in balance, the
total debits will equal the total credits.

CHAPER 3 ADJUSTING ACCOUNTS FOR FINANCIAL STATEMENTS

The Accounting Period

Accrual Basis Cash Basis

Revenues are recorded when products Revenues are recorded when cash is
or services are delivered, and records received and expenses are recorded
expenses when incurred. when cash is paid.
EX: TRANSACTION: Paid 2400 for 24
month insurance beginning 1 Dec.2019
On the accrual basis, $100 of insurance Using the cash basis, the entire $2,400
expense is recognized in 2019, $1,200 would be recognized as insurance
in 2020, and $1,100 in 2021. The expense in 2019. No insurance
expense is matched with the periods expense from this policy would be
benefited by the insurance coverage. recognized in 2020 or 2021, periods
covered by the policy

Four types of adjustments for transactions that extend over more than one
period.
1. Prepaid (deferred) expenses assets paid for in advance of receiving their
benefits. Examples: Prepaid Insurance, Prepaid Rent, Supplies

2. Unearned (deferral) revenue is cash received in advance of providing

products or services.
Adjusting for Unearned Revenues
Step 1: FastForward’s client paid 60-day fee in advance covering the period from
12/27 to 2/24 and recorded:
Dec. 26 Cash 3,000
Unearned Consulting Revenue 3,000
Received advance payment for services

Step 2: FastForward earns payment as time passes. At 12/31, 5 days’ service is

earned or 5/60 × $3,000 = $250.
Step 3: Adjusting entry reduces liability, Unearned Consulting Revenue, by $250
or 5 days’ worth of revenue. Also, Consulting Revenue of $250 is earned.

Adjusting entry recorded on Dec. 31 to transfer $250 from unearned to earned consulting revenue.

Dec. 31 Unearned Consulting Revenue 250

Consulting Revenue 250
To record earned revenue received in advance

3. Accrued expenses - Costs incurred in a period that are both unpaid and
unrecorded.

Adjusting for Accrued Salaries – Steps 1, 2 and 3

Step 1: FastForward pays its employee $70 per day, or $350 for a five-day
work. Salaries are paid every two weeks on a Friday.
Step 2: 12/31 is a Wednesday, so three days’ salaries are owed at year end
which equals $70 × 3 = $210.
Step 3: Adjusting entry increases a liability, Salaries Payable, and increases the
Salaries Expense account for $210 with the following journal entry:
Dec. 31 Salaries Expense 210
Salaries Payable 210
To record three days’ accrued salaries.

Future Payment of Accrued Expenses

 Accrued expenses at the end of one period result in a cash payment in a future
period.
On 12/31, FastForward recorded accrued salaries of $210.
On 1/9 of the next year, the following entry will reduce the accrued liability,
salaries payable, and record the expense for 7 days work in January.
Jan 9 Salaries Payable (3 × $70) 210
Salaries Expense (7 × $70) 490
Cash 700
To record earned revenue received in advance

4. Accrued revenue- is revenue earned in a period that are both unrecorded

and not yet received in cash or other assets.

Adjusting for Accrued Services Revenue – Steps 1, 2, and 3

Step 1: On 12/12, FastForward’s customer agreed to pay $2,700 on 1/10 of the
next year for future services over the next 30 days.
Step 2: 12/31, 20 days’ worth of services have been provided and earned, which
totals $1,800 ($2,700 × 20/30 days).
Step 3: Adjusting entry increases an asset, Accounts Receivable, and increases the
Consulting Revenue account for $1,800 with the following journal entry:
Dec. 31 Accounts Receivable 1,800
Consulting Revenue 1,800
To record 20 days’ accrued revenue.

Future Receipt of Accrued Revenues

Accrued revenue at the end of one period results in a cash receipt in a future
period.
On 12/31, FastForward recorded accrued revenue earned of $1,800.
On 1/10 of the next year, the following entry will reduce the accounts receivable,
record revenue earned for 10 days and receipt of $2,700 cash.
Jan. 10 Cash 2,700
Accounts Receivable (20 days) 1,800
Consulting Revenue (10 days) 900
To record earned revenue received in advance
Summary of Adjustments and Financial Statement Links.

 Depreciation allocate or spread out the cost over their expected useful
lives.
The formula for straight-line depreciation is:
Straight-Line Depreciation Expense= (Asset Cost-Residual Value)/Useful
Life

Useful Life - the period of time that an asset is expected to help produce
revenues. Useful life expires as a result of wear and tear, or because it no longer
satisfies the needs of the business.
Residual Value - The expected market value or selling price of an asset at the end
of its useful life. Also called: Scrap Value or Salvage Value.
Adjusting for Depreciation
• Step 1: FastForward purchased equipment on Dec. 1 for $26,000.
Calculate Net Cost (amount to depreciate).
Net cost=original cost-residual value
$26,000 − $8,000 = $18,000
•Step 2: It has an estimated useful life of 5 years. • The equipment is expected to
be worth about $8,000 at the end of 5 years.
FastForward uses straight-line depreciation. $18,000 ($26,000 − $8,000) of the
cost needs to be spread over the next 60 months.
One month=$18,000/60months=300$
Depreciation adjustment reflected in our T-accounts looks like this:

•Step 3 They purchased the equipment on Dec. 1 but it is now Dec. 31.
Because FastForward expects the equipment to be worth $8,000 when the 5
years are over, only $18,000 of the cost needs to be spread over the next 60
months.
After three months of
depreciation have been taken,
Equipment is shown net of
accumulated depreciation.

Accounting Cycle
The accounting cycle consists of:
1. Analyzing transactions to prepare for journalizing.
2. Journalizing: Record accounts, including debits and credits, in a journal.
3. Posting: Transfer debits and credits from the journal to the ledger.
4. Preparing unadjusted trial balance: Summarize unadjusted ledger accounts
and amounts.
5. Adjusting and posting accounts: Record adjustments to bring account
balances up to date; journalize and post adjustments.
6. Preparing adjusted trial balance: Summarize adjusted ledger accounts and
amounts.
7. Preparing financial statements: Use adjusted trial balance to prepare
financial statements.
8. Closing accounts: Journalize and post entries to close temporary accounts.
9. Preparing post-closing trial balance: Test clerical accuracy of the closing
procedures.
10.Reversing and posting (optional): Reverse certain adjustments in the next
period—optional step; see Appendix 3C.
* Steps 4, 6, and 9 can be done on a work sheet. A work sheet is useful in
planning adjustments, but adjustments (step 5) must always be journalized
and posted. Steps 3, 4, 6, 9 are automatic with a computerized system.
 CHAPTER 4 ACCOUNTING FOR MERCHANDISING
OPERATIONS

Service organizations sell time to earn revenue. Examples: Accounting firms, law
firms, and plumbing services.
Service company
REVENUES-EXPENSES=NET INCOME
Merchandising companies sell products to earn revenue. Examples: sporting
goods, clothing, and auto parts stores.
Merchandiser
NET SALES-COST OF GOODS SOLD=GROSS PROFIT-EXPENSES=NET INCOME
Operating Cycle for a Merchandiser Begins with the purchase of merchandise and
ends with the collection of cash from the sale of merchandise
Perpetual systems • Updates Periodic systems • Updates records
accounting records for each purchase for purchase and sale of inventory only
and sale of inventory. at the end of the accounting period.

Purchase Discounts Credit Terms A deduction from

the invoice price granted to
induce early payment of the
amount due.

a. Purchases without Cash Discounts a. Purchases without Cash Discounts On

November 2, Z-Mart purchased $500 of merchandise inventory for cash.

b. Purchases with Cash Discounts b. Purchases with Cash Discounts

b1. Payment within Discount Period: Journal Entry. On November 12, Z-Mart paid
the amount due on the purchase of November 2

Payment within Discount Period: Ledger Accounts

b2. Payment after Discount Period. On December 2, Z-Mart paid the amount due
on the purchase of November 2.

Purchases with Returns and Allowances

Purchase Allowance: A price reduction to the buyer of defective or unacceptable
merchandise.
Purchase Return: Merchandise returned by the purchaser to the supplier.
c1. Purchases Allowances. On November 5, Z-Mart (buyer) issues a $30 debit
memorandum for an allowance from Trex for defective merchandise.

c2. Purchases Returns. Z-Mart purchases $250 of merchandise on June 1 with

terms 2/10, n/60. On June 3, Z-Mart returns $50 of goods before paying the
invoice. When Z-Mart pays on June 11, it takes the 2% discount only on the $200
remaining balance.

Purchases and Transportation Costs

FOB-FREE ON BOARD
Transportation Costs. Z-Mart purchased merchandise on terms of FOB shipping
point. The transportation charge is $75.

Accounting for Merchandise Sales

a. Sales without Cash Discounts Z-Mart sold $1,000 of merchandise on credit. The
merchandise has a cost basis to Z-Mart of $300.
Revenue side journal entry:

Cost side journal entry:

Sales Discounts
Sales discounts on credit sales can benefit a seller by decreasing the delay in
receiving cash and reducing future collection efforts.

b. Sales with Cash Discounts. Z-Mart completes a $1,000 credit sale with terms of
2/10, n/45.

Buyer pays within discount period:

Buyer pays after discount period:

c. Sales Returns and Allowances
Sales returns and allowances usually involve dissatisfied customers and the
possibility of lost future sales.
Sales returns refer to merchandise that customers return to the seller after a sale.
Sales allowances refer to reductions in the selling price of merchandise sold to
customers.
Sales with Returns and Allowances Customer returns merchandise which sold for
$15 and cost $9.

Returned Goods – Not Defective:

Returned Goods – Are Defective:

Buyer Granted Allowances

Assume that $40 of the merchandise Z-Mart sold on November 12 is defective but
the buyer decides to keep it because Z-Mart offers a $10 price reduction.

Merchandising Cost Flow in the Accounting Cycle

Sales Discounts, Returns and Allowances: New revenue recognition rules require
reporting of sales at net amount expected. Adjusting entries required for: 1.
Expected sales discounts. 2. Expected returns and allowances (revenue side). 3.
Expected returns and allowances (cost side)
Closing Entries for Merchandisers

Multiple-Step Income Statement

Single-Step Income Statement

Classified Balance Sheet

 CHAPTER 5 INVENTORIES AND COST OF SALES

Inventory Items
Merchandise inventory includes all goods that a company owns and holds for
sale, regardless of where the goods are located when inventory is counted. Items
requiring special attention include: Goods in Transit. Goods on Consignment.
Goods Damaged or Obsolete.
1. Goods in Transit
 FOB shipping point – goods included in buyer’s inventory when shipped.
 FOB destination – goods included in buyer’s inventory after arrival at
destination.
2. Goods on Consignment
 Consignor: owner of goods.
 Consignee: sells goods for the owner.
 Merchandise is included in the inventory of the consignor.
 Consignee never reports consigned goods in inventory.
3. Goods Damaged or Obsolete
 Damaged or obsolete goods are not reported in inventory if they cannot
be sold.
 Damaged or obsolete goods which can be sold are included in inventory
at net realizable value.
 Net realizable value = Sales price minus Selling costs.
 Loss is recorded when damage or obsolescence occurs.
Inventory
• Usually the inventory account(asset) is updated only at the end of the period
(e.g. 31/12/n) à closing inventory (n)
• This is the value that you will carry forward to next period (e.g. 1/1/n+1) à
opening inventory (n+1)
Closing inventory period n = Opening inventory period n+1
 During the following period, many transactions will affect the value of the
inventory (mainly purchases and sales).
 At the end of the second period the value of the Inventory must be
assessed again à closing inventory (n+1)
  The Inventory is an important asset of a company and its natural
collocation is on the Balance Sheet (current assets).
 The variations of the inventory are also relevant for the computation of the
profit
 According to the matching principle an expense is reported on the income
statement in the same period as the related revenues
 An application of the matching principle is the computation of the cost of
goods sold (or cost of sales)
Income Statement
REVENUES-INVENTORY=GROSS PROFIT

COST OF GOOD SOLD=OPENING INVENTORY+PURCHASES-CLOSING

INVENTORY

Inventories (IAS 2)

• Inventories are assets: – held for sale in the ordinary course of business à inventory of finished goods;
– in the process of production for such sale à inventory of work-inprogress; or – in the form of materials
or supplies to be consumed in the production process or in the rendering of services à inventory of raw
material

• Counting inventory (before valuing it) – Periodic counting (usually done at the end of accounting
periods) – Perpetual inventory à a record is kept item by item of all inventory movements as they occur,
usually supplemented by occasional counts

• Valuing inventory: -At historical cost - Exit values (measures of exit values would imply anticipation of
profit to the current year)

•Valuation of inventory at historical cost

 For raw material and finished goods of retail companies the cost is the cost of purchase (+ other
direct purchase costs)
 For work-in-progress and finished goods of manufacturing companies the production cost of
one item (or batch) must be computed

– NB: Only production (manufacturing) costs are included (no selling, general and administrative costs)

To compute the unit cost of production: • Direct production costs: raw material, labour – direct
allocation (e.g. cost of raw materials used, wages of direct labour, …) • Manufacturing overheads:
depreciation, rent, indirect labour (supervision, maintenance, …), consumables…

 dedicated to the production line: allocated on the basis of the volume of production (number of
units produced)
 shared with other production lines: indirect allocation (on the basis of e.g. percentage of space
occupied, hours worked, number of units produced, …)
Inventory Costs. Include all expenditures necessary to bring an item to a salable
condition and location.
Inventory cost = Invoice cost − Discounts + Other costs
Other costs include: • Shipping. • Storage. • Insurance. • Import duties.
Internal Controls and Taking a Physical Count
Most companies take a physical count of inventory at least once each year. When
the physical count does not match the Merchandise Inventory account, an
adjustment must be made.
Good internal controls over count include:
1. Prenumbered inventory tickets. 2. Counters have no inventory responsibility. 3.
Counters confirm existence, amount, and condition of inventory. 4. Second count
is taken by a different counter. 5. Manager confirms all items counted only once.
Inventory Costing Methods
Four methods are used to assign costs to inventory and to cost of goods sold:
1. Specific identification.
2. First-in, First-out (FIFO). Costs flow in the order incurred
Oldest Costs: Cost of Goods Sold. Recent Costs: Ending Inventory.
First-In, First-Out (FIFO): Perpetual
3. Last-in, First-out (LIFO). Costs flow in the reverse order incurred
Recent Costs: Cost of Goods Sold. Oldest Costs: Ending Inventory.
Last-In, First-Out (LIFO): Perpetual

4. Weighted average. Costs flow at an average of costs available

Uses total cost of material available for issue divided by the quantity available for
issue.
Cost Flow of Inventory Inventory Costing under a Perpetual System

Financial Statement Effects of Costing Methods

First-In, First-Out Last-In, First-Out Weighted Average
Ending inventory Cost of goods sold on Smoothes out price
approximates current income statement changes.
cost. approximates its current
costs.
Financial Statement Effects of Inventory Costing Methods: Perpetual Method

The Internal Revenue Service (IRS) requires that when LIFO is used for tax
reporting, it must also be used for financial reporting: LIFO conformity rule.
Cost Formula according to IAS 2
IAS 2 forbids to use the LIFO method. LIFO inventory might be based on outdated
and obsolete numbers that does not reflect reality especially when prices are
rising (inflation). In countries were LIFO is allowed it is often use for tax purposes.
The EU 4th Directive allows all the three methods
Valuation of inventory using exit values

• Exit values can be measured as: – Net realizable value (NRV): is the estimated selling price less
costs of completion (for unfinished goods) and less costs of marketing, distribution and selling (no
general and administrative costs). it’s an “entity-specific value”

 Using exit values means that the value of the inventory to the firm is the future receipts which
will arise from selling it
 This implies to anticipate part of the profit in the current accounting period. OPTION NOT GIVEN
IN FINANCIAL ACCOUNTING

Lower of Cost or Market

Inventory must be reported at market value when market is lower than cost.
Defined as current replacement cost(not sales price).
Consistent with the conservatism principle.
Can be applied three ways: (1) Separately to each individual item. (2) To major
categories of assets. (3) To the whole inventory
 CHAPTER 7 ACCOUNTING FOR RECEIVABLES

RECEIVABLES. An amount due from another party.

Sales on Credit. On July 1, TechCom had a credit sale of $950 to CompStore and a collection of $720
from RDA Electronics from a prior credit sale.

BAD DEBTS
Some customers may not pay their account. BAD DEBTS are uncollectible
amounts.
There are two methods of accounting for bad debts:
1. Direct Write-Off Method.
Expense recognition principle requires expenses to be reported in the same
accounting period as the sales they helped produce. Materiality constraint
permits direct write-off method if results are similar to allowance method. The
direct write-off method usually does not best match sales and expenses.
a. Direct Write-Off Method - Recording and Writing Off Bad Debts. TechCom
determines on January 23 that it cannot collect $520 owed to it by its customer J.
Kent. Notice that the specific customer is noted in the transaction so we can make the proper
entry in the customer’s Accounts Receivable subsidiary ledger.

Direct Write-Off Method – Recovering a Bad Debt. On March 11, J. Kent was able
to make full payment to TechCom for the amount previously written off.
 2. Allowance Method.
At the end of each period, estimate total bad debts expected to be realized from
that period’s sales.
Two advantages to the allowance method: 1. It records estimated bad debts
expense in the period when the related sales are recorded. 2. It reports accounts
receivable on the balance sheet at the estimated amount of cash to be collected.
b. Allowance Method - Recording Bad Debts Expense. TechCom had credit sales of
$300,000 during its first year of operations. At the end of the first year, $20,000 of
credit sales remained uncollected. Based on the experience of similar businesses,
TechCom estimated that $1,500 of its accounts receivable would be uncollectible.

Balance Sheet Presentation

Allowance Method – Writing Off a Bad Debt. TechCom has determined that J.
Kent’s $520 account is uncollectible.

The write-off does not affect the realizable value of accounts receivable.
Allowance Method – Recovering a Bad Debt. To help restore credit standing, a
customer sometimes pays all or part of the amount owed on an account even
after it has been written off. On March 11, Kent pays in full his $520 account
previously written off.

Estimating Bad Debts Expense

Two Methods
1. Percent of Sales Method.

Bad debts expense is computed as follows:

Example: Musicland has credit sales of $400,000 in 2019. It is estimated that 0.6%
of credit sales will eventually prove uncollectible.
Estimated bad debts expense=400,000*0,6%=2,400$

2. Accounts Receivable Methods:

a. Percent of Accounts Receivable.
Compute the estimate of Allowance for Doubtful Accounts. Year-end Accounts
Receivable × Bad Debt %
Bad Debts Expense is computed as:
Total Estimated Bad Debts Expense − Previous Balance in Allowance Account =
Current Bad Debts Expense
Example: Musicland has $50,000 in accounts receivable and $200 credit balance
in Allowance for Doubtful Accounts. 5% of receivables are uncollectible. $50,000
×5% = $2,500 ending balance.
The adjusting entry applies three step adjusting entry process:
Step 1: current balance for allowance account is 200$ credit
Step 2: current balance for allowance account should be $50,000 ×5% = $2,500
Step 3: 2500-200=2300$
b. Aging of Accounts Receivable.
Classify each receivable by how long it is past due. Each age group is multiplied by
its estimated bad debts percentage. Estimated bad debts for each group are
totaled.

Adjusting Entry with Credit Balance. Step 1: Determine current balance: $200
credit. Step 2: Determine what the account balance should be: $2,270. Step 3:
Make adjusting entry to get from step 1 to step 2: $2,270 − $200 = $2,070.

Adjusting Entry with Debit Balance. Step 1: Determine what current balance
equals: $500 debit. Step 2: Determine what the account balance should be:
$2,270. Step 3: Make adjusting entry to get from step 1 to step 2: $2,270 + $500 =
$2,770.
Summary of Methods

Notes Receivable.
A promissory note is a written promise to pay a specified amount of money,
usually with interest, either on demand or at a stated future date.
The maturity date of a note is the day the note (principal and interest) must be
repaid. EXAMPLE: On July 10, TechCom received a $1,000, 90-day, 12%
promissory note as a result of a sale to Julia Browne.

T
he note is due and payable on October 8.
Interest Computation
Principal of the note*Annual interest rate*Time expressed in fraction of
year=INTEREST

1,000$*12%*(90/360)=30$
Recording Notes Receivable
Notes receivable are usually recorded in a single Notes Receivable account to
simplify recordkeeping. The original notes are kept on file, including information
on the maker, rate of interest, and due date.
EXAMPLE: To illustrate the recording for the receipt of a note, we use the $1,000,
90-day, 12% promissory note from Julia Browne to TechCom. TechCom received
this note at the time of a product sale to Julia Browne.

Recording an Honored Note

The principal and interest of a note are due on its maturity date.
EXAMPLE: J. Cook has a $600, 15%, 60-day note receivable due to TechCom on
December 4.

Recording an Dishonored Note

The act of dishonoring a note does not relieve the maker of the obligation to
repay the principal and interest due.
EXAMPLE: J. Cook has a $600, 15%, 60-day note receivable due to TechCom on
December 4.

Recording End-of-Period Interest Adjustment

EXAMPLE: On December 16, TechCom accepts a $3,000, 60-day, 12% note from a
customer in granting an extension on a past-due account. When TechCom’s
accounting period ends on December 31, $15 of interest has accrued on the note.
$3,000*12%*(15/360)=$15
Recording End-of-Period Interest Adjustment

Recording collection on note at maturity.

3,000*12%*(60/360)= $60
Disposal of Receivables
Companies can convert receivables to cash before they are due. This may be
done: a. selling them b. Using them as security for loans

CHAPTER 8 ACCOUNTING FOR LONG-TERM ASSETS

Previous Definition of an asset:

ASSET * A resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.

Revised Definition of an asset:

ASSET * A present economic resource controlled by the entity as a result of past events. An economic
recourse is a right that has the potential to produce economic benefits.

Statement of Financial Position (IAS 1): Current and Non-current assets

• Assets should be classified as current when: – Is expected to be realized in, or is held for sale or
consumption in, the normal course of the entity’s operating cycle – Is held primarily for trading purposes
– Is expected to be realized within 12 months, or – Is cash or a cash equivalent

• All other assets shall be classified as non-current: • Property, plant and equipment (PPE); (IAS 16) •
Investment property; (IAS 40) • Intangible assets; (IAS 38) • Financial assets

Tangible and intangible non-current assets

Property, Plant and Equipment (PPE) (IAS 16) are tangible items that: • Are held for use in production or
supply of goods or services or for administration • Are expected to be used during more than one period

 Excluded assets to be sold to customers (inventory) even if they are land, buildings or machines.
  Intangible asset is an identifiable non-monetary asset without physical substance (IAS 38)
 Investment properties (held for rental or capital gain) are treated separately (IAS 40)

Recognition: – Future economic benefits associated with the asset – Cost or value reliably measurable
Initial measurement: At cost. Includes: • Purchase price, including all costs involved in getting the asset
into a location and condition where it can be productive, • all the subsequent expenses incurred for
improvements and extensions (capitalization of expenses) • All the expenses incurred for the
construction of fixed assets (including expenses related to own material and labor)
Subsequent measurement:

1. Cost model – After recognition as an asset, it shall be carried at its cost less any accumulated
depreciation and any accumulated impairment losses. The cost model is more verifiable, easy to
compute, and more in line with accounting traditions almost everywhere. It is the most used in
practice
2. Revaluation model (fair value) – The revaluation model allows for revaluations above cost. The
revalued amount is the asset’s fair value less subsequent accumulated depreciation and
impairment. The revaluation model gives more relevant information to the investors, but it can
be adopted only if fair value is reliably measured (i.e. there is an active market for the asset
from which the fair value can be derived)

PLANT ASSETS * Tangible in nature, actively used in operations, expected to benefit future periods,
called property, plant and equipment. It has for issues:

Acquisition:

1. Compute cost

Use:

2. Allocate cost for period benefited

3. Account for subsequent expenditures

Disposal

4. Record disposal

Cost Determination (initial measurement)

Purchase All expenditures needed

price to prepare the asset for its
ACQUISITION intended use
COST

Acquisition cost includes all normal and

reasonable expenditures to get the asset
on place and ready for intended use

Machinery and equipment:*Purchase price *Taxes *Transportation Charges *Installing, assembling,

testing *Insurance while in transit

Ex. Buildings: *Cost of purchase or construction *Tittle fees *Brokerage fees *Taxes *Attorney fees

Ex. Land: *Purchase price *Title insurance premiums *Property taxes *Surveying fees *Title search and
transfer fees *Reel estate commissions. LAND IS NOT DEPRECIABLE
Ex. Land Improvements: Parking lots, driveways, fences, walks, shrubs, and lighting systems. Depreciate
over useful life of improvements.

Ex. Lump-Sum Purchase: The total cost of a combined purchase of land and building is allocated based of
their relative fair market values. EXAMPLE: CarMax paid $90,000 cash to acquire a group of items
consisting of land appraised at $30,000, land improvements appraised at $10,000, and a building
appraised at $60,000. The $90,000 cost will be allocated on the basis of appraised values as shown:

Depreciation (subsequent measurement)

Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods
benefiting from its use.

Factors in Computing Depreciation: The calculation of depreciation requires three amounts for each
asset: 1. Cost 2. Residual Value 3. Useful Life

Depreciation Methods: 1. Straight-line 2. Units-of-production 3. Declining-balance

1. Straight-Line Method: Example

Cost-Salvage value
10,000$-1000$=1,800$ per year
Useful life in periods 5years
2. Units-of-Production Method: Two-Step Process

Step 1: Depreciation per unit= (Cost-Residual Value)/Total units of production

Step 2: Depreciation expense=Depreciation per unit*Number of units produced in the period

Example: Assume that 7,000 units were inspected during the first year. Depreciation would be
calculated as follows:

Depreciation per unit= (Cost-Residual Value)/Total units of production=9000$/36000=0,25$ per unit

Depreciation expense=Depreciation per unit*Number of units produced in the

period=0,25$*7000=1750$

3. Declining-Balance Method: Three Steps

Step 1: Strait-line rate=100%/useful life= 100%/5years=20%

Step 2: Double-declining-balance rate= 2*straight-line rate= 2*20%=40%

Step 3: Depreciation expense=Double-declining-balance rate*beginning-period book value=

40%*10000$=4000$
Comparing Depreciation Methods:

Methods Used by Companies:

Straight-line method, 85% Declining balance method, 4% Units of production, 5% Accelerated and
other,6%

Partial-Year Depreciation

When a plant asset is purchased (or sold) during the year, depreciation is calculated for the fraction of
the year the asset is owned. EXAMPLE: Assume our machinery was purchased on October 1, 2018. Let’s
calculate depreciation expense for 2017 assuming we use straight-line depreciation.

Changes in Estimates

Predicted residual value Depreciation is an estimate Predicted useful life

Over the life of an asset, new information may come to light that indicates the original estimates were
inaccurate.

EXAMPLE: Let’s look at our machinery from the previous examples and assume that at the beginning of
the asset’s third year, its book value is $6,400 ($10,000 cost less $3,600 accumulated depreciation using
straight-line depreciation). At that time, it is determined that the machinery will have a remaining useful
life of 4 years, and the estimated salvage value will be revised downward from $1,000 to $400.

(Book Value-Revised residual value)/Revised remaining useful life= (6400$-400$)/4years=$1,500 per

year

Asset Impairment • Permanent decline in the fair value of an asset requires writing the asset down to its
fair value. • Asset impairment is the process of journalizing this decline.
Cost model: Impairment

• Some negative events can occur that decrease permanently the value of a fixed asset
– E.g. an asset can be physically damaged or can suffer rapid economic obsolescence, the value of land
or buildings can decrease after the approval of certain urban policies, etc.

• The objective of the impairment test is to ensure that the carrying value of an asset (or NBV, cost less
accumulated depreciation and previous impairment) is not higher than its recoverable amount.

• The recoverable amount of an asset is the future benefits that the company obtains from its usage. It
is the higher of its value in use and its net selling price.
– Value in use: present value of future net cash flows generated by the asset.
– Net selling price: current selling price (fair value) less costs of disposal

• The impairment test consists in comparing an asset’s carrying value (as normally calculated for the
balance sheet) with its recoverable amount

• If carrying value > recoverable amount:

– The difference is recognized as “impairment” and will go to the Income Statement as an expense
– The asset is carried to the Balance Sheet at its recoverable amount (less accumulated depreciation and
impairment)
– In double entry the entry is similar to the one of depreciation
• Impairment debits (expense to be recognized in the IS)
• Accumulated Impairment credit (in the BS it decreases the value of the asset)

 If carrying value < recoverable amount: no adjustments are needed

Impairment for assets with indefinite useful life • Depreciation is not applied to assets with indefinite
useful life: – Goodwill – Land – Brands – …

 For these assets, the company has to make an “impairment test” every year in order to account
of any diminution in value

Impairment- EXAMPLE: On January 1, 2005 Company X purchased a building for €2 million. Its estimated
useful life at that date was 20 years and the company uses straight line depreciation method.

 Annual depreciation charge=depreciable amount/useful life=2,000,000/20=100,000

On December 31, 2009 a flood damaged the building.

 Carrying amount (2019) =cost-accumulated depreciation=2,000,000-(100,000*5) = 1,500,000

The company estimated that it can sell the building for €1 million but it has to incur costs of €50,000.
Alternatively, it if continues to use it the present value of the net cash flows the building will help in
generating is €1.2 million.

 Recoverable amount (2009) =higher of:

 Net selling price=current selling price-cost of disposal=1,000,000-50,000=950,000
 Value in use=present value of future net cash flows generated be the asset 1,200,000
 Impairment = carrying amount – recoverable amount = 1.500.000-1.200.000=300.000

Debits: 300.000 Impairment (expense)

Credits: 300.000 Accumulated impairment

Carrying amount year 2009: Cost-Accumulated depreciation-Accumulated impairment=2,000,000-

500,000-300,000=1,200,000
Additional Expenditures

Revenue expenditures.
• Do not materially increase the plant asset’s life or capabilities.
• Recorded as an expense in the current period.
• Reported on the income statement.

Capital expenditures.
• Provide benefits for longer than the current period.
• Recorded as an addition to the asset account.
• Reported on the balance sheet.

Type of Expenditure Capital or Revenue Identifying Characteristics

Ordinary Repairs Revenue 1. Maintains normal operating
condition. 2. Does not increase
productivity. 3. Does not extend
life beyond original estimate.
Betterments and Extraordinary Capital 1. Major overhauls or partial
Repairs replacements. 2. Extends life
beyond original estimate.
Ordinary Repairs

Betterments (Improvements)

Learning Objective P2: Account for asset disposal through discarding or selling an
asset.
Disposals of Plant Assets
Selling Plant Assets – At Book Value
• 3/31, BTO sells equipment that originally cost $16,000 and has accumulated depreciation of $12,000
at 12/31 of the prior year.
• BTO uses straight-line depreciation at $4,000 per year.
• The equipment is sold for $3,000 cash.
Step 1: Update depreciation to March 31.

Step 2: Record sale of asset at book value ($16,000 − $13,000 = $3,000).

Selling Plant Assets – Above Book Value

• 3/31, BTO sells equipment that originally cost $16,000 and has accumulated depreciation of $12,000
at 12/31 of the prior year.
• BTO uses straight-line depreciation at $4,000 per year.
• The equipment is sold for $3,000 cash.
Step 1: Update depreciation to March 31.

Step 2: Record sale of asset at a gain ($7,000 − $3,000 = $4,000 gain).

Selling Plant Assets – Below Book Value

• 3/31, BTO sells equipment that originally cost $16,000 and has accumulated depreciation of $12,000
at 12/31 of the prior year.
• BTO uses straight-line depreciation at $4,000 per year.
• The equipment is sold for $2,500 cash.
Step 1: Update depreciation to March 31.

Step 2: Record sale of asset at a loss ($3,000 − $2,500 = $500 loss).

Learning Objective P4: Account for intangible assets
INTANGIBLE ASSETS * Noncurrent assets without physical substance; often
provide exclusive rights or privileges; useful life is often difficult to determine;
usually acquired for operational use.
Cost Determination and Amortization
Record at cost, including purchase price, legal fees, and filing fees.
• Patents. • Copyrights. • Franchises and Licenses. • Trademarks and Trade Names. • Goodwill. • Right-
of-Use Asset (Lease). • Leasehold Improvements. • Research and Development. • Other Intangibles.

Revaluation model: fair value

• The cost model does not allow for revaluations above cost (the value of an asset can only decrease,
due to depreciation and impairment)
– It is the most used also because many countries do not allow for revaluations, or they allow it only in
specific cases recognized by law
• The revaluation model of the IFRSs allows for revaluations above cost.
– The ratio behind the revaluation model is that fair value give information of greater relevance
• According to the revaluation model, any re-measurement must be at fair value
– Recall: Fair value is defined as the price that would be received for an asset sold in an orderly
transaction between participants in a market at the measurement date.

Revaluation model: revalued amount

•After recognition as an asset, an item of PPE and an intangible asset, shall be carried at a revalued
amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation
and subsequent accumulated impairment losses.
•For intangible assets: only if there is an active market
•For PPE: only if fair value can be measured reliably (according to IFRS 13: exit price, replacement cost,
value in use)

Revaluation model: revaluation gain

•The carrying amount of the asset being revaluated can be either increased or decreased by the
revaluation (it should not differ materially from its fair value).
• If the carrying amount is decreased similar to impairment (the decrease should be recognized in the
income statement)
•If the carrying amount is increased, the company has a “revaluation gain”.
•A revaluation gain is a “not realized income”, computed on the basis of a hypothetical transactions
that did not take place. For PPE and intangible asset, it cannot appear as income in the profit and loss
statement (under IFRSs it appears to the Other Comprehensive Income Statement, OCI)
• In the balance sheet the revaluation gain is credited to a “revaluation reserve” in shareholders’ equity.
It cannot be distributed to shareholder, as long as the asset is not sold.
• A revalued asset is depreciated as usual in following years, but the value to be depreciated is now
higher

Gains/losses on sale

When a company sells an asset:

•The carrying value of the asset falls to zero (close down both the accumulated depreciation and
impairment accounts AND the asset account)
•Cash or receivable increases (a debit entry equal to the selling price)
•A Gain (credit) or a Loss (debit) is recognized (for the difference between carrying value and selling
price)

 When an asset is sold at a price higher than its carrying value, the company recognizes a gain
(realized income, to be included in the profit and loss statement)
 When an asset is sold at a price lower than its carrying value, the company recognizes a loss (to
be included in the profit and loss statement)

Intangible and tangible non-current assets – according to IFRSs

• Initial measurement? • At cost (purchase or construction)

• Which methods are allowed for subsequent measurements? • Cost model or Revaluation model

• What is depreciation? • The allocation of the depreciable amount of an asset over its useful life

• Is depreciation made for all tangible and intangible non-current assets? • No, only for those with a
definite life. General exception for investment properties

• What is impairment? • Is the loss of value of an asset below its carrying amount, computed as the
difference between recoverable amount and carrying value

• What is revaluation? • Is the subsequent measurement of an asset at its fair value

• What is a revaluation gain? • Is a non-realized income arising from a revaluation above cost

• How shall revaluation gains for PPEs and Intangible assets be treated? • Revaluation gains increase
the Shareholders’ Equity, but they are not allowed for distribution (recognized in a revaluation reserve)

• How is the carrying value of an asset computed in each of the two measurement methods? • Cost
model: cost less any accumulated depreciation and any accumulated impairment losses • Revaluation
model: fair value less any subsequent accumulated depreciation and subsequent accumulated
impairment losses

Assets Initial Methods Subsequent Methods Notes

measurement measurement
Non-current At cost (of Purchase price Cost model: Depreciation: revaluation
tangible purchase or including all costs Indefinite life: straight-line gains shown
assets (PPE) construction) involved in getting Cost less method, in the OCI
the asset into a accumulated declining and go to
location and impairment charge, equity as
condition where it Definite life: usage revaluation
can be productive Cost less reserve
accumulated Impairment:
Construction depreciation and carrying
costs, including impairment value less
capitalization of recoverable
internal costs Revaluation amount
model: fair value (higher of
Subsequent costs less accumulated net selling
for improvements depreciation and price and
and extensions impairment value in use)
Non-current At cost Purchase price Cost model: Depreciation: revaluation
intangible Development Indefinite life: straight-line gains shown
assets costs (only Cost less method, in the OCI
software and few accumulated declining and included
 other impairment charge, to equity as
development Definite life: usage revaluation
projects) Cost less reserve
accumulated Impairment:
Difference depreciation and carrying
between purchase impairment value less
price and net recoverable
assets (goodwill) Revaluation amount
model: fair value (higher of
less accumulated net selling
depreciation and price and
Property At cost Fair value Revaluation
investment gains to the
profit and
loss
statement
Financial Fair value (at Fair value Revaluation
assets cost for (amortized cost gains:
assets held to of assets held to − assets held
maturity) maturity) to maturity:
not
recognized
− assets
available for
sale: shown
in OCI and
included in
equity
− assets held
for trading:
to profit and
loss
statement
Inventory Lower of Cost (single item):
historical cost Purchase price +
and net costs incurred in
realizable bringing the
value inventories to
their present
location and
condition

Production cost
(direct costs +
direct
manufacturing
overheads+
appropriate
proportion of
indirect
manufacturing
overheads)
 Cost (closing
inventory): FIFO –
First In First Out

Weighted average
cost

Net realizable
value: Estimated
current selling
price less cost of
completion and
marketing,
distribution and
selling costs

CHAPTER 9 ACCOUNTING FOR CURRENT LIABILITIES

Statement of Financial Position (IAS 1): Current and Non-current liabilities

• A liability should be classified as Current liability when it:

– Is expected to be settled in the normal course of the entity’s operating cycle;
– It is held for trading; or
– Is due to be settled within 12 months of the balance sheet date

• All other liabilities shall be classified as non-current

Previous definition of liability:

A present obligation of the entity arising from past events, the settlement of which is expected to result
in an outflow from the entity of resources embodying economic benefits

Revised definition of liability:

A present obligation of the entity to transfer an economic resource as a result of past events. An
obligation is a duty or responsibility that the entity has no practical ability to avoid.

Learning Objective C1: Describe current and long-term liabilities and their
characteristics.
Current Liabilities * Due within one year or the company’s operating cycle if longer.

Long-Term Liabilities * Due after one year or the company’s operating cycle if longer.

Uncertainty In Liabilities: Uncertainty in Whom to Pay; Uncertainty in When to Pay; Uncertainty in How
Much to Pay

Learning Objective C2: Identify and describe known current liabilities.

Known Liabilities: Accounts Payable; Sales Taxes Payable; Unearned Revenues; (Short-Term Notes
Payable); (Payroll Liabilities); (Multi-Period Known Liabilities);
Sales Taxes Payable. On August 31, Home Depot sold materials for $6,000 that are subject to a 5% sales
tax.

6,000$*5%=300$
Unearned Revenues. On June 30, Selena Gomez sells $5,000,000 in tickets for eight concerts.

On Oct. 31, Selena performs a concert.

5,000,000$*1/8=625,000$
Payroll liabilities are from salaries and wages, employee benefits, and payroll taxes levied on the
employer.

Multi-Period Known Liabilities Includes Unearned Revenues and Notes Payable.

Unearned Revenues from magazine subscriptions often cover more than one accounting period. A
portion of the earned revenue is recognized each period and the Unearned Revenue account is reduced

 A three-year liability would be classified as a current liability for one year and a long-term
liability for two years.
Estimated Liabilities

• An estimated liability is a known obligation of an uncertain amount that can be reasonably estimated.
• Examples: pensions, health care, vacation pay, warranties

Learning Objective C3: Explain how to account for contingent liabilities.

Reasonably Possible Contingent Liabilities:

Potential Legal Claims – A potential claim is recorded if the amount can be reasonably estimated and
payment for damages is probable.

Debt Guarantees – The guarantor usually discloses the guarantee in its financial statement notes. If it is
probable that the debtor will default, the guarantor reports the guarantee as a liability.

Other Contingencies – Include environmental damages, possible tax assessments, insurance losses, and
government investigations.

Uncertainties – Uncertainties from future events are not contingent liabilities because they are future
events and do not arise from past transactions. These are not disclosed.

IAS 37 - Provisions, Contingent Liabilities and Contingent Assets

• A contingent liability either a:

– possible obligation arising from past events whose existence will be confirmed only by the occurrence
or non-occurrence of some uncertain future event not wholly within the entity’s control, or
– present obligation that arises from a past event but is not recognized because either:
• (i) it is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation, or
• (ii) the amount of the obligation cannot be measured with sufficient reliability.

Contingent liabilities - Recognition requirements

Contingent liabilities- Presentation and disclosure

• A contingent liability, being a possible obligation, is not recognized but is disclosed unless the
possibility of an outflow of economic benefits is remote.

•Now (CF 2018): the revised criteria about liability definition refers to the qualitative characteristics of
useful information

• Unless the possibility of any outflow in settlement is remote, an entity shall disclose for each class of
contingent liability at the end of the financial reporting period a brief description of the nature of the
contingent liability and, where practicable:
– (i) an estimate of its financial effect; – (ii) an indication of the uncertainties relating to the amount or
timing of any outflow; and – (iii) the possibility of any reimbursement

Corporate Income Taxes. Corporations must pay taxes on income. Adjusting entry for income tax
liabilities:

Assume $25,000 of income taxes expense; $21,000 currently due and $4,000 deferred:

CHAPTER 12 REPORTING CASH FLOWS

Purposes of the Statement of Cash Flows:

1. How does a company receive its cash?

2. What explains the change in cash balance?
3. Why do income and cash flows differ?
4. Where does a company spend its cash?

Importance of Cash Flows. Cash flows helps:

 users decide if a company has cash to pay its debts.

 users evaluate company’s ability to pursue unexpected opportunities.
 managers plan day-to-day operations.
 managers make long-term investment decisions
Measurement of Cash Flows. Cash equivalents are:

 short-term, highly liquid investments.

 readily convertible into cash.
 sufficiently close to maturity so that market value is unaffected by interest rate changes.

Classification of Cash Flows. The statement of cash flows includes the following three sections:

 Operating Activities

 Investing Activities

 Financing Activities

Noncash Investing and Financing. Examples of Noncash Investing and Financing Activities: • Retirement
of debt by issuing equity stock. • Conversion of preferred stock to common stock. • Lease of assets in a
capital lease transaction. • Purchase of long-term assets by issuing a note or bond. • Exchange of
noncash assets for other noncash assets. • Purchase of noncash assets by issuing equity or debt.
Preparing the Statement of Cash Flows:

1. Compute net increase or decrease in cash

2. Compute net cash from or for operating activities
3. Compute net cash from or for investing activities
4. Compute net cash from or for financing activities
5. Compute net cash from all sources; then prove it by adding it to beginning cash to get ending
cash.

a. Analyzing the Cash Account. The Cash account is a natural place to look for information about cash
flows from operating, investing, and financing activities.

b. Analyzing Noncash Account. A second approach to preparing the statement of cash flows is analyzing
noncash accounts.

Cash = Liabilities + Equity − Noncash assets

Information to prepare the statement of cash flows comes from three sources:

1. Comparative balance sheets

2. Current Income Statement
3. Additional Information

A. Cash Flows from Operating: 1. Indirect and 2. Direct Methods of Reporting

Adjustments for Changes in Current Assets and Current Liabilities: Table Use this table when adjusting
Net Income to Operating Cash Flows.
B. Cash Flows from Investing: Three-Step Analysis. A three-step process to determine cash provided or
used by investing activities:

 Identify changes in investing-related accounts

 Explain these changes using T-accounts and reconstruction entries
 Report their cash flow effects

STEP 1: This analysis reveals a $40,000 increase in plant assets from $210,000 to $250,000 and a $12,000
increase in accumulated depreciation from $48,000 to $60,000

STEP 2: Item b: Genesis purchased plant assets of $60,000 by issuing $60,000 in notes payable to the

seller.

Item c reports that Genesis sold plant assets costing $20,000 (with $12,000 of accumulated
depreciation) for $2,000 cash, resulting in a $6,000 loss.

We also reconstruct the entry for Depreciation Expense using information from the income statement.

STEP 3: Reconstructed T-accounts show changes in long-term assets.

The identified cash flows are reported in the investing section:

The $60,000 purchase in item b paid using a note payable is a noncash investing and financing activity.

C. Cash Flows from Financing: Three-Step Analysis. A three-step process to determine cash provided or
used by financing activities:

 Identify changes in financing-related accounts

 Explain these changes using T-accounts and reconstruction entries
 Report the cash flow effects

STEP 1: This analysis reveals: an increase in notes payable from $64,000 to $90,000.

STEP 2: Step two explains the change in item e. Notes with a carrying value of $34,000 are retired for
$18,000 cash, resulting in a $16,000 gain.

STEP 3: Step three reports cash paid for the notes retirement in the financing activities section
Proving Cash Balances

Analyzing Cash Sources and Uses • Managers review cash flows for business decisions. • Creditors
evaluate a company’s ability to generate enough cash to pay debt. • Investors assess cash flows before
buying and selling stock.

CHAPTER 13 ANALYSIS OF FINANCIAL STATEMENTS

Learning Objective C1: Explain the purpose and identify the building blocks of analysis.

Purpose of Analysis

Common goal of financial statement analysis for both external and internal users is evaluate company
performance and financial condition and to assist in evaluating: 1. Past and current performance. 2.
Current financial position. 3. Future performance and risk.
Internal Users: Managers Officers Internal Auditors
External Users: Shareholders Lenders Suppliers

How to analyze the financial statements?

Building Blocks of Analysis:

1. Liquidity and efficiency

2. Solvency
3. Profitability
 4. Market prospects

Information for Analysis

1. Income Statement 2. Balance Sheet 3. Statement of Stockholders’ Equity (Statement of changes in

equity) 4. Statement of Cash Flows 5. Notes to the Financial Statements

Standards for Comparison

When we interpret our analysis, it is essential to compare the results we obtained to other standards or
benchmarks. • Intracompany • Competitors • Industry • Guidelines

Tools of Analysis

A. Horizontal Analysis. Comparing the financial condition and performance across time.

B. Vertical Analysis. Comparing the financial condition and performance to a base amount.

C. Ratio Analysis. Measurement of key relations between financial statement items.

Learning Objective P1: Explain and apply methods of horizontal analysis

A. Horizontal Analysis is the review of financial statement data across time.

1. Comparative Statements: Dollar Change

Dollar change= Analysis period amount - Base period amount

• When measuring the amount of the change in dollar amounts, compare the analysis period to the
base period. • The analysis period refers to the financial statements under analysis. • The base period
refers to the financial statements used for comparison.

2. Comparative Statements: Percent Change

Percent Change=((Analysis period amount-Base period amount)/Base period amount)*100

When calculating the change as a percentage, divide the amount of the dollar change by the base period
amount, and then multiply by 100 to convert to a percentage.

Comparative Balance Sheets Comparative Income Statements

3. Trend Analysis. Trend analysis is used to reveal patterns in data across periods.

Trend percent (%)= (Analysis period amount/Base period amount)*100

Using the number reported 4 years ago as the base year, we will get the following trend percents:

We can use the trend percentages to construct a graph so we can see the trend over time.

Learning Objective P2: Describe and apply methods of vertical analysis.

B. Vertical Analysis. Common-Size Statements

Common-size percent ( %) = (Analysis amount/Base amount)*100

Financial Statement Base amount

Balance sheet Total assets

Income statement Revenues

Common-Size Balance Sheets Common-Size Income Statement

Common-Size Graphics
Learning Objective P3: Define and apply ratio analysis.

C. Ratio Analysis

1. Liquidity and Efficiency. Assumption: current assets will provide the cash to pay for current liabilities
in the next year. Current ration; Acid-test ratio; Accounts receivables turnover; Total asset turnover;
Inventory turnover, Days’ Sales Uncollected; Inventory turnover.

Working Capital is the amount of current assets minus current liabilities.

Working Capital=Current assets-Current Liabilities

More working capital suggests a strong liquidity position and an ability to pay debts or continue
operating.

Current Ratio. • This ratio measures the short-term debt-paying ability of the company. • A higher
current ratio suggests a strong ability to meet current obligations.

Current ratio= Current assets/ Current liabilities

Acid-Test Ratio. This ratio is like the current ratio but excludes current assets such as inventories and
prepaid expenses that may be difficult to quickly convert into cash.

Acid-test ratio= (Cash + Short-term investments+ Current receivables)/Current liabilities.

2. Solvency. Consist of: Debt Ratio; Equity Ratio; Debt-to-equity Ratio; Times interest earned
Debt Ratio and Equity Ratio

• The debt ratio shows total liabilities as a percent of total assets.

• The equity ratio shows total equity as a percent of total assets.

Debt-to-Equity Ratio. This ratio measures what portion of a company’s assets are contributed by
creditors. A larger debt-to-equity ratio implies less opportunity to expand through use of debt financing.

Debt-to-equity ratio= Total liabilities/ Total equity

3. Profitability. Consist of:

 Profit Margin. This ratio measures a company’s ability to earn net income from each sales dollar

Profit margin= Net income/ Net sales

 Net Profit Margin. It says how much revenues are left from 1€ of sales after all operating

Net Profit Margin(NPM)= Net Profit Before Tax/Sales= EBT/S

It’s better to use profit before taxes if you want to evaluate the performance of the company, taxes are
independent on the efficiency and effectiveness of the company

 Net Operating Margin. It shows how much of the revenues (for 1€ of sales or in % of sales) is left
(after all operating expenses are deducted) to cover interest expenses

Net Operating Margin(NOM)= Net Operating Profit/Sales= EBIT/S

 Return on Total Assets (ROA).

Return on Total Assets (ROA)= Net Profit Before Tax/Total assets

• The return on assets (ROA) ratio illustrates how well management is employing the company's total
assets to make a profit. • It measures the amount of profit made by a company per 1€ of its assets. •
The higher the ROA, the more efficient management is in utilizing its asset base.

• Variations to the ROA might consist in substituting the denominator with – Fixed Assets – Net Assets
(Total Assets – Liabilities)

 Return on Equity (ROE)

Return on Equity (ROE)= (Net Profit (Before or After Tax)/Owner’s Equity)*100

• The ROE reveals how much profit a company generates with the money shareholders have invested.
The higher it is the more efficient management is in utilizing its equity base.
• It is a very important indicator from the investors’ point of view since it measures how efficiently their
capital is being used, and it is a valuable indicator to assess the return on their investment (even if not
all the profit is distributed).
• If the focus is on the return available for distribution it is more useful to use the after-tax profit; if the
efficiency of the management is the focus, it is better to use pre-tax profit
• Weakness: it doesn’t look at the whole capital structure. The Equity base can be larger or smaller in
comparison with the total capital, hence ROE needs to be interpreted in the context of a company’s
debt equity relationship

 Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE)=Net Operating profit/(Owner’s Equty + Long term

borrowings)*100
• The ROCE compares the profit made with two sources of finance: equity (from shareholders) and long
term borrowings (lenders or bondholders).
• ROCE must be higher than the cost of capital (interest rate), i.e. operating activities increase the value
of the investments made by shareholders.
• Since the investors use this ratio to measure the return on their investment, the interests on long-term
debt (which is the return for lenders and bondholders) must be removed from the numerator
(dividends, which are the return for shareholders, are never included).

 Profit ratios: the Mark-Up

Markup= (Gross profit/Cost of sales)*100= (GP/COGS)*100

•From the comparison between the gross profit and the cost of sales you can derive the mark-up, i.e.
the percentage that the managers applied to direct production costs in order to define the selling price.
•In absolute numbers the mark-up is the difference between the production’ costs and the selling
price, i.e. it is equal to the gross margin.
•However it is useful to express it as a percentage of costs to understand (a part of) the pricing policy of
the company

4. Market Prospects. Consists of:

 Price-Earnings Ratio

Price-earnings ratio = Market price per common share/Earnings per share

This measure measures market expectations for future growth.

 Dividend Yield

Dividend Yield= Annual cash dividends per share/ Market price per share
This ratio is used to compare the dividend-paying performance of different companies.
Summary of Ratios

EXAMPLE:

Compute: total shareholders’ fund, total current assets, total current liabilities, current ratio, return on
capital employed, ROA, ROE.
Solution

• total shareholders’ fund (equity) = 145 + 174= 319

• total current assets = 135 +80 +30= 250

• total current liabilities= 65 + 14 + 67= 146

• Current ratio= cur. assets/cur. liabilities=250/146= 1.7

• Return on capital employed= net operating profit /(owner’s equity + long term borrowing) = (1600 -
1300)/(319+305)= 48%

• ROA= net profit before tax/tot. assets= 280/770= 36, 36%

• ROE= net profit (before) after tax/equity= 220/319=68,96% à it is extremely high in general a company
is doing great when ROE>= 20%

EXAMPLE: A look to the real world: (30’)

Let’s divide in groups and look at the Financial Statements of the following companies:

Group 1: COMPANY A 2018 VS. COMPANY B 2018

Group 2: COMPANY B 2017 VS. COMPANY B 2018

Group 3: COMPANY B 2017 VS. COMPANY C 2017

Group 4: COMPANY D 2012 VS. COMPANY D 2013

1. Compute the following ratios: Net profit margin, Net operating margin, Mark-up, ROA, ROE,
Leverage, Current ratio 2. Groups 1 & 3: If you were an investor would you invest in the company you
analyzed? Groups 2 & 4: If you were an investor in which company would you prefer to invest?
 CHAPTER 11 CORPORATE REPORTING AND ANALYSIS

Learning Objective C1: Identify characteristics of corporations and

their organization.

Characteristics of Corporations

Advantages: • Separate legal entity. • Limited liability. • Transferable ownership rights. • Continuous
life. • No mutual agency for stockholders. • Easier capital accumulation.

Disadvantages: • Governmental regulation. • Corporate taxation.

Corporate Organization and Management

Corporate governance is the

system by which companies
are directed and controlled.

Rights of Stockholders

1. Vote at stockholders’ meetings (or register proxy votes). 2. Sell stock. 3. Purchase additional shares of
stock. 4. Receive dividends, if any. 5. Share in any assets remaining after creditors are paid in a
liquidation.

Stock Certificates and Transfer

Each unit of ownership is called a share of stock. A stock certificate serves as proof that a stockholder
has purchased shares.
When the stock is sold, the stockholder signs a transfer endorsement on the back of the stock
certificate.

Basics of Capital Stock: Par Value vs. Market Price

Par value is an arbitrary amount assigned to each share of stock when it is authorized.

Market price is the amount that each share of stock will sell for in the market.

Classes of Stock: • Par Value • No-Par Value • Stated Value

Stockholders’ Equity

Corporations’ equity (or shareholders’ equity or corporate equity) consists of:

• Paid-in (contributed) capital – cash and other assets received in exchange for stock.

• Retained earnings – cumulative net income (loss) not distributed as dividends.

Learning Objective P1: Record the issuance of corporate stock.

Issuing Par Value Stock at Par. Par Value Stock. On June 5, Dillon Snowboard’s, Inc. issued 30,000
shares of $10 par value stock for $300,000. Let’s record this transaction.

Learning Objective P2: Record transactions involving cash dividends,

stock dividends, and stock splits.
1. Cash Dividends

Cash dividends provide a return to investors and almost always affect the stock’s market value.

To pay a cash dividend, the corporation must have: 1. A sufficient balance in retained earnings; and
2. The cash necessary to pay the dividend.

Accounting for Cash Dividends

Three Important Dates: 1. Date of Declaration: Record liability for dividend. 2.Date of Record: No entry
required. 3. Date of Payment: Record payment of cash to stockholders
 Accounting for Cash Dividends: Date of Declaration. On January 9, a $1 per share cash dividend
is declared on Z-Tech, Inc.’s 5,000 common shares outstanding. The dividend will be paid on February 1
to stockholders of record on January 22. Record liability for dividend.

Accounting for Cash Dividends: Date of Payment. On January 9, a $1 per share cash dividend is
declared on Z-Tech, Inc.’s 5,000 common shares outstanding. The dividend will be paid on February 1 to
stockholders of record on January 22. No entry required on January 22, the date of record. Record
payment of cash to stockholders.

Deficits and Cash Dividends

A deficit is created when a company incurs cumulative losses or pays dividends greater than total profits
earned in other years. NOT ALLOWED IN EU

2. Stock Dividends
Stock dividend is a distribution of a corporation’s own shares to its stockholders without receiving any
payment in return.

• A stock dividend (≠ cash dividend) does not reduce assets and equity but instead transfers a portion of
equity from retained earnings to contributed capital.

Why a stock dividend? • Can be used to keep the market price on the stock affordable. • Can provide
evidence of management’s confidence thatthe company is doing well.

Learning Objective C2: Explain characteristics of, and distribute dividends

between, common and preferred stock.
1. Preferred Stock

Preferred stock is a separate class of stock, typically having priority over common shares in dividend
distributions and distribution of assets in case of liquidation. Usually has a stated dividend rate and
Normally has no voting rights

No Preferred Stock: 73% Issued preferred stock: 27%

 2. Treasury Stock

Treasury stock represents shares of a company’s own stock that has been acquired. A corporation might
acquire its own stock to: 1. Use its shares to buy other companies. 2. Avoid a hostile takeover. 3. Reissue
to employees as compensation. 4. Maintain a strong market.

With Treasury Stock: 62% No Treasury Stock: 38%

Learning Objective C3: Explain the items reported in retained earning

Retained earnings is the total cumulative amount of reported net income less any net losses and
dividends declared since the company started operating.

Restricted Retained Earnings:

Legal Restriction. Most states restrict the amount of treasury stock purchases to the amount of
retained earnings.

Contractual Restriction. Loan agreements can include restrictions on paying dividends below a certain
amount of retained earnings.

Statement of Stockholders’ Equity is a more inclusive statement than the statement of retained
earnings.

CHAPTER 6 CASH, FRAUD AND INTERNAL CONTROL

Learning Objective C1: Define internal control and identify its purpose and
principles.
Internal Control

System Policies and procedures used to: • Protect assets. • Ensure reliable accounting. • Uphold
company policies. • Promote efficient operations.

The Sarbanes-Oxley Act(SOX) requires managers and auditors of public companies to document and
certify the system of internal controls. Section 404 of SOX requires that managers document and assess
the effectiveness of all internal control processes that can impact financial reporting

Committee of Sponsoring Organizations(COSO) provides five ingredients of internal control which add
quality to accounting information: 1. Control environment. 2. Risk assessment. 3. Control activities. 4.
Information & communication. 5. Monitoring.
Principles of Internal Control: 1. Establish responsibilities. 2. Maintain adequate records. 3. Insure
assets and bond key employees. 4. Separate recordkeeping from custody of assets. 5. Divide
responsibility for related transactions. 6. Apply technological controls. 7. Perform regular and
independent reviews.

1. Establish Responsibilities: 1. Tasks should be clearly established. 2. Tasks should be assigned to one
person. 3. Can then determine who is at fault

2. Maintain Adequate Records: 1. Protects assets. 2. Helps managers monitor company activities.
3. Includes: 1. Detailed records. 2. Use of chart of accounts. 3. Preprinted forms. 4. Prenumbered sales
slips. 5. Computerized point-of-sale systems.

3. Insure Assets and Bond Key Employees: 1. Assets should be insured against losses. 2. Employees
handling a lot of cash and other assets should be bonded. 3. Bonded means the company has purchased
an insurance policy against theft by that employee.

4. Separate Recordkeeping from Custody of Assets: 1. Person who controls or has access to assets must
not have access to that asset’s accounting records. 2. Reduces risk of theft or waste of an asset. 3.
Employees would need to collude, agree in secret to commit fraud under this control.

5. Divide Responsibility for Related Transactions: 1. Responsibility for a transactions should be divided
between two or more individuals. 2. Ensures work of one person acts as a check on the other to prevent
fraud or errors. 3. Called separation of duties.

6. Apply Technological Controls: 1. Cash registers make an electronic file/record of each sale. 2. Time
clock records exact time employee works. 3. Personal scanners limit access to authorized individuals

7. Perform Regular and Independent Reviews: 1. Helps ensure that procedures are followed. 2.
Preferably done by auditors not directly involved in the activities. 3. Auditors evaluate the efficiency and
effectiveness of internal controls.

Technology, Fraud, and Internal Control :

 Reduced Processing Errors

 More extensive testing of records
 New evidence of processing
 Increased e-commerce
 Separation of duties

Limitations of Internal Control;

Human Error: Carelessness; Misjudgment; Confusion.

Human Fraud: Intentionally defeating; internal controls for personal gain

Human fraud triple-threat: Opportunity, Financial Pressure, Rationalization

Cost-benefit principle: Costs of internal controls must not exceed their benefits.

Learning Objective C2: Define cash and cash equivalents and explain how to
report them.
Control of Cash is an effective system of internal control that protects cash and cash equivalents should
meet three basic guidelines:
 1. Handling cash is separated from recordkeeping of cash
2. Cash receipts are promptly deposited in a bank
3. Cash disbursements are made by check

Cash and similar assets are called liquid assets because they can be readily used to pay current liabilities.

Cash. Currency, coins, and deposits in bank accounts. Also includes items such as customer checks,
cashier checks, certified checks, and money orders.

Cash Equivalents. Short-term, highly liquid investments that are: 1. Readily convertible to a known cash
amount. 2. Close to maturity date and not sensitive to changes.

Cash Management. The goals of cash management are twofold: 1. Plan cash receipts to meet cash
payments when due. 2. Keep a minimum level of cash necessary to operate.

Effective cash management involves applying the following cash management strategies: • Encourage
collection of receivables. • Delay payment of liabilities. • Keep only necessary assets. • Plan
expenditures. • Invest excess cash.

Learning Objective P2: Explain and record petty cash fund transactions.
Basic Bank Services: Signature cards; Deposit tickets; Bank Statements; Electronic fund transfer; Checks;
Bank accounts.

Deposit Ticket. 1. Used to deposit money in the bank. 2. Lists cash and checks along with the amounts.
3. Serves as proof of deposit.

Check. 1. Used to withdraw money from the bank. 2. Includes maker, signor of check; payee; and payer
(bank).

Bank Statement. Usually once a month, the bank sends each depositor a bank statement showing the
activity in the account.

Bank Reconciliation is prepared periodically to explain the difference between cash reported on the
bank statement and the cash balance on company’s books.

Bank Balance adjustments: Add deposit in transit; Subtract outstanding checks; Add or subtract
corrections of bank errors.

Book balance adjustments: Add interest earned and unrecorded cash receipts; Subtract bank fees and
NFS checks; Add or subtract corrections of bank errors.

Documentation and Verification: Purchase Requisition > Purchase Order> Invoice> Receiving Report

Invoice Approval • Accounting department will record purchase and approve payment after all
documents are in order. • Information across all documents are verified. • Invoice approval also called
check authorization. • Checklist of steps necessary for approving invoice and payment.

Voucher is complete after invoice has been checked and approved. • Used to authorize recording
obligation. • Certain information is required on the inside of a voucher. • Certain information is also
required on the outside of a voucher.