Summary with Financial Accounting by Needles & Powers

Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter A. Uses of Accounting Information and the Financial Statements

Accounting is an information system that measures, processes, and communicates financial information about an identifiable economic entity. A business is an economic unit that aims to sell goods and services to customers at prices that will provide an adequate return to its owners. Their need to earn enough income to attract and hold investment capital is the goal of profitability. In addition, business must meet the goal of liquidity: having enough cash available to pays debts when they are due.

Businesses pursue their goals by engaging in the following activities:

• Operating activities such as selling goods and services to customers, and the buying and producing of goods.

• Investing activities such as buying land

• Financing activities like obtaining capital from owners and from creditors such as banks.

An important function of accounting is to provide performance measures, which indicate whether managers are achieving their business goals and whether business activities are well managed. Management accounting is the internal managing of finance. Financial accounting generates reports and communicates them to the external decision makers. These reports are called financial statements. Bookkeeping is only a small part of accounting. As fraudulent financial reports can have serious consequences, ethical financial reporting is important.

The people who use the accounting data are the management, users with direct financial interest and users with indirect financial interest. Users with direct financial interest are for example investors or creditors. Users who have indirect financial interest are tax authorities, regulatory agencies and other groups such as labour unions.

To make an accounting measurement, the accountant must answer four basic questions:

1. What is measured?

2. When should the measurement be made?

3. What value should be placed on what is measured?

4. How should what is measured be classified?

Business transactions are economic events that affect a business’s financial position. Transactions are recorded in terms of money: money measure. For accounting purposes, a business is a separate entity, distinct not only from its creditors and customers but also from its owners. It should have a completely separate set of records, and its financial records and reports should refer only to its own financial affairs.

Three forms of enterprises:

• A sole proprietorship is a business owned by one person. The person is liable for all obligations of the business.

• A partnership has two or more owners. The owners share the profits and losses.

• A corporation is a business unit chartered by the state and legally separated from its owners (the stockholders). Because they have limited involvement in the corporation, their risk of loss is limited to the amount they paid for their shares.

To form a corporation, an application must be signed with the proper state official. This contains the articles of incorporation. The authority to manage the corporation is delegated by the stockholders to the board of directors and then to the management. A unit of ownership in a corporation is called a share of stock. A board of directors is elected by the stockholders. They appoint managers to carry out the day-to-day work. Only the board has the authority to declare dividends. Dividends are distributions of resources, usually in the form of cash, to the stockholders.

Corporate governance is the oversight of a corporation’s management and ethics by its board of directors. To strengthen corporate governance, an audit committee made up of independent directors who have financial expertise, is appointed by the board of directors.

Financial position and the accounting equation.

Financial position refers to the economic resources that belong to a company and the claims against those resources at a particular time. Another term for claims is equities. As every corporation has two types of equities: creditors’ equities and stockholders’ equity, the following equation holds::

Economic Resources = Creditors’ Equities + Stockholders’ Equities.

In accounting terminology the economic resources are also called assets and creditors’ equities are called liabilities. This gives the accounting equation:

Assets = Liabilities + Stockholders’ Equity

Examples of assets are: monetary items as cash and non monetary items such as inventory and land. Liabilities are present obligations of a business to pay cash, transfer assets, or provide services to other entities in the future. Among them are debts, amounts owed to suppliers to borrowed money. The owner’s equity is called the stockholder’s equity. It has two parts, the amount that stockholders invest in the business: contributed capital, and the equity of the stockholders generated from the income-producing activities of the business and kept in use in the business: retained earnings. Revenues and expenses are the increases and decreases in stockholder’s equity that result from operating a business. Retained earnings can therefore increase because of revenues and decrease because of expenses and the payment of dividends.

Four major financial statements:

• The income statement focuses on the company’s profitability. It summarizes the revenue earned and expenses incurred by a business over a period of time. This will give the net income.

• The statement of retained earnings shows the changes in retained earnings over a period of time. It is the difference between the old and the new net income, less the dividends.

• The balance sheet presents a view of the business as the holder of the resources, or assets, that are equal to the claims against those assets. On the left side are the assets, on the right the liabilities and the stockholder’s equity. Both sides should be equal.

• The statement of cash flows is directed toward the company’s liquidity goal. The outcome of the cash flows statement should be equal to the amount of cash on the balance sheet.

To ensure that financial statements are understandable for their users, generally accepted accounting principles (GAAP) have been developed. They provide guidelines for financial accounting.

Chapter B. Analyzing Business Transactions

To measure a business transaction, the accountant must decide when the transaction occurred (the recognition issue), what value to place on the transaction (the valuation issue), and how the components of the transaction should be categorized (the classification issue).

The predetermined time at which a transaction should be recorded is the recognition point. This is when a company receives a product, buys a service or pays an employee. When a company just orders a product and hasn’t received the bill or the product, there is no transaction yet. A monetary value is assigned to a business transaction. This value should be equal to the original cost, the exchange price. The classification issue has to do with assigning transactions to appropriate accounts. Recognition, valuation, and classification are important factors in ethical financial reporting, and GAAP provide direction about their treatment.

The system to record transactions is called the double-entry system. Each transaction must be recorded with at least one debit and one credit equal to each other. This way the whole system is in balance. The T account has three parts: a title, a left side which is called the debit side, and a right side called the credit side.

The accounting equation was:

Assets = Liabilities + Stockholder’s equity

This means that when a debit is made on the assets side, a credit should be made on the liabilities or stockholder’s equity side.

The trial balance adds all the outcomes of balances to see if both sides are equal. It is prepared by listing each account balance in the appropriate Debit or Credit column. The two columns are then added, and the totals compared.

Not all transactions generate immediate cash. Then, there is a holding period in either Accounts Receivable or Accounts Payable before the cash is received or paid.

The chart of accounts is a list of account numbers and titles; it servers as a table of contents for the ledger. The general journal is used to record all transactions chronologically. A separate journal entry is used to record each transaction. It should include:

1. The date

2. The names of accounts debited and the dollar amounts on the same lines in the debit column

3. The names of accounts credited and the dollar amounts on the same lines in the credit column.

4. An explanation of the transaction

5. The account identification numbers, if appropriate.

The general ledger has four columns for dollar amounts unlike the journal, which has only two columns. In addition to the two columns, the ledger states the balance of the separate accounts that have been debited or credited.

Chapter C. Measuring Business Income

Net income is the net increase in stockholders’ equity resulting from the operations of a company. Net income = Revenues – Expenses. When there are more expenses than revenues, a net loss occurs. Revenues are increases in stockholders’ equity resulting from the operations of a company such as selling goods. Expenses are decreases in stockholders’ equity resulting from the operations of a company such as the cost of selling goods.

In measuring business income, the following assumptions are made:

• The continuity assumption: This assumption is about how long the business entity will last. It is normal for an accountant to assume that the business will continue to operate indefinitely. This means that the business is a going concern.

• The periodicity assumption: Some products have effects that extend over many years. Accountants estimate the time the product will be in use and the cost that should be assigned to each year. They make an assumption about periodicity: that although the lifetime of a business is uncertain, it is useful to estimate the business’s net income in terms of accounting periods.

• The matching assumption: Revenues and expenses must be accounted for when cash is received and cash is paid. This is called the cash basis of accounting. The matching rule is the following: Revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the accounting period in which they are used to produce revenue.

As applying the matching rule involves making assumptions, it can lead to earnings management: the manipulation of revenues and expenses to achieve a specific outcome. When the estimates involved are moving outside a reasonable range, the financial statements become misleading – and fraudulent.

Accrual accounting encompasses all the techniques accountants use to apply the matching rule. In accrual accounting, revenues and expenses are recorded in the periods in which they occur rather than in the periods in which they are received of paid. Accrual accounting is accomplished in the following ways:

• Recognizing revenue when they are earned:

The following conditions must exist before revenue is recognized:

• Persuasive evidence of an arrangement exists.
• Delivery has occurred or services have been rendered.
• The seller’s price to the buyer is fixed of determinable.
• Collectibility is reasonably assured.

• Recognizing expenses when they are incurred.

Expenses can be recorded when an agreement is made to purchase goods, the goods have been delivered, a price is established, and the goods or services have been sued to produce revenue.

• Adjusting the accounts.

This is needed because an accounting period ends on a certain day. Some transactions span this cutoff point, and therefore some accounts need adjustments.

Accountants use adjusting entries to apply accrual accounting to transactions that span more than the accounting period. An accrual is the recognition of a revenue or expense that has happened but hasn’t been recorded yet. This could be wages earned by employees in the current accounting period but after the last pay period. It can also be fees earned but not yet billed to customers. A deferral is the postponement of the recognition of an expense already paid or a revenue received in advance. Examples are prepaid rent or payments collected for services yet to be rendered.

Type 1: Allocating recorded costs between two or more accounting periods. These are called deferred expenses. The expenditures are usually debited to an assent account, and at the end of the period, the amount that has been used will be transferred from the asset account to an expense account.

Example: Adjustment for prepaid rent.

July 31: Expiration of one month’s rent, $ 1600

At the beginning of July, two months’ of rent has been paid in advance. At the end of the month, half of the prepaid rent had expired and should be treated as an expense.

The same can be done for prepaid insurance.

Adjustment for Supplies

July 31: Consumption of supplies, $ 1540

A company can purchase supplies that will be consumed when performing tasks. An example is office supplies. At the end of the month the balance still shows the old amount of office supplies, while inventory shows that a certain amount of supplies has been used.

This should be accounted for in the following way:

Depreciation is also a deferred expense. When office equipment depreciates, a contra account called ‘accumulated depreciation office equipment’, will be created. The balance of this contra account is shown on the financial statement as a deduction from the related account, here the ‘office equipment’ account.

Example:

Type 2: Recognizing unrecorded expenses. This is called an accrued expense. Examples of this kind of expense are accrued wages and estimated income taxes.

Example: By the end of business on July 31, an employee will have worked three days (29, 30 and 31 July) beyond the last pay period. The employee has earned wages for those days - $240 per day - but will not be paid until the first payday in August.

These last days should be accounted for in the following way:

The accrual of unrecorded wages is 3 days x $ 240 = $ 720.

The wages expense account is an equity account. The wages payable is a liability account.

The same can be done for income taxes. A company can estimate the amount that will go to income taxes for that month and record this amount as income taxes payable and income taxes expense.

Type 3: Allocating of recorded unearned revenues between two or more accounting periods. These revenues are called deferred revenues. When a company receives a payment in advance, this payment will be recorded as a liability account. At the end of the month, the company should record the part of the job that has been finished under fees earned, a revenue account. Suppose this company received $1400 as advance payment. By the end of the month it had completed $800 of work. This should be recorded in the following way:

Type 4: Recognizing unrecorded earned revenues. These are called accrued revenues. Suppose that a company agreed to design a website, and to have it operational at July 31. By the end of the month, the company had earned $400 for completing the first section, but had not billed this yet.

This should be recorded in the following way:

Closing entries

Balance sheet accounts are permanent accounts, they carry their end-of-period balance into the next period. Revenue and expense accounts are temporary accounts because they begin each period with a balance of zero. Closing entries are journal entries made at the end of an accounting period. They clear the accounts of their balance and they summarize a period’s revenue and expenses. To do this, the balances of the revenue and expense accounts are transferred to the Income Summary account; another temporary account. It is only used for closing entries and does not appear in financial statements. There are four steps in closing accounts:

1. Closing the credit balances from income statement accounts to the Income Summary account.

2. Closing the debit balances from income statement accounts to the Income Summary account.

3. Closing the Income Summary account balance to the Retained Earnings account.

4. Closing the Dividends account balance to the Retained Earnings account.

Because errors can be made in posting closing entries to the ledger accounts, it is necessary to prepare a post-closing trial balance to determine that all temporary accounts have zero balances and to double check that total debits equal total credits.

The general rule for determining the cash flow received from any revenue or paid for any expense (except depreciation) is to determine the potential cash payments or cash receipts and deduct the amount not paid or received.

Chapter D. Financial Reporting and Analysis

Financial reporting is important for three major reasons:

• To furnish information that is useful in making investment and credit decisions

• To provide information useful in assessing cash flow prospects

• To provide information about business resources, claims to those resources, and changes in them.

To help interpret accounting information, the FASB has described qualitative characteristics. The most important ones are understandability and usefulness. The first one depends on the accountant, who has to prepare the statements in accordance with accepted practices, and the decision maker, who must judge what information to use. When accounting information is useful, it must have the characteristics of relevance and reliability. To be relevant, the information must provide feedback, predict future conditions, and be timely. To be reliable, the information must be credible, verifiable and neutral.

Accountants depend on five conventions to help in the interpretation of the financial statements.

• Comparability and consistency: The information in a financial statement must be provided in such a way that anyone who reads it can recognize similarities, differences, and trends over time. When a company adopts a certain accounting procedure, it must continue working with this procedure from one period to the next, or inform users when a change occurs. This way the statements are consistent.

• Materiality: An item is material if there is a reasonable expectation that knowing about it would influence the decisions of users of the statements. When a small asset is not material, a company could decide to record the asset as an expense, instead of a long-term asset that has to be depreciated.

• Conservatism: When accounts face major uncertainties about procedures that they can use, they choose the one that is least likely to overstate assets and income.

• Full disclosure: It is required that financial statements present all information that is relevant to the users of the statements.

• Cost-benefit: The benefits to be gained from providing accounting information should be greater than the costs of providing it.

Since the passage of the Sarbanes-Oxley Act in 2002, CEO’s and CFO’s have been required to certify the accuracy and completeness of there companies’ financial statements.

The balance sheet

When there are many different accounts in a company, it can be easy to place them into subcategories. Statements that are divided into subcategories are called classified financial statements. Assets are often dividend into:

• Current assets: Cash and other assets that are expected to be converted into cash, sold, or consumed within one year, or within the operating cycle, whichever is longer.

• Investments: Includes assets, usually long-term, that are not used in the normal operation of the business and that are not planned to be converted into cash within one year.

• Property, plant, and equipment: Tangible long-term assets used in the continuing operation of the business. Through depreciation, the costs of the assets are spread over the periods they benefit.

• Intangible assets: Long-term assets with no physical substance.

Sometimes investments, intangible assets, and miscellaneous assets are grouped into a category other assets.

Liabilities are divided into two categories. This depends on when the liabilities are due.

• Current liabilities: All obligations to be paid within one year, or within the normal operating cycle, whichever is longer.

• Long-term liabilities: Debts that fall due more than one year in the future or beyond the normal operating cycle.

The stockholders’ equity section has two parts: contributed capital and retained earnings. When a company is a sole proprietorship, the equity section simply shows the owners’ name at the amount equal to the net assets of the company. There is no need to separate retained earnings and contributed capital. When the company is a partnership, the equity section is divided between the partners.

The income statement

Thus far, the income statement was presented by deducting all expenses from revenue in one step to get to the net income. There is also a multistep income statement. It is used for service companies, merchandise companies, who buy and sell products, and manufacturing companies, who make and sell products. The income statement for the latter two differs from the service company.

Multistep income statement for a service company:

Multistep income statement for a merchandising or manufacturing company:

• Net sales: Consists of all gross sales of merchandise, less sales returns and allowances and any discounts. Gross sales consists of total cash sales and total credit sales during an accounting period

• Cost of goods sold: The amount paid for the merchandise sold or the cost of making the products sold during the accounting period.

• Gross margin: The difference between net sales and cost of goods sold.

• Operating expenses: The expenses other than cost of goods sold that are incurred in running a business. Often operating expenses are grouped into categories such as selling expenses and administrative expenses.

• Income from operations: The difference between gross margin and operating expenses. This is the income from a company’s normal business.

• Other revenues and expenses: Revenues and expenses that are not part of a company’s operating activities. It includes revenues from investments, interest earned on credit or notes, interest expense and other kinds of revenues and expenses.

• Income before taxes: The amount a company has earned from all activities before taxes are paid.

• Income taxes: The expense for federal, state, and local taxes on corporate income.

• Net income: What remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and taxes are deducted. It is the amount that is transferred to retained earnings from all the income-generating activities during the year.

• Earnings per share: The net income earned on each share of common stock. The simplest method is dividing the net income by the average number of outstanding stock.

The single-step income statement simply groups all expenses and all revenues and deducts them to get to the income before income taxes. Income taxes are shown as a separate item and are deducted to get to the net income.

Using classified financial statements

Management has two important goals: maintaining adequate liquidity and achieving satisfactory profitability. Ratios make use of the components in classified financial statements to reflect a company’s performance with respect to these important goals.

Liquidity means having enough money on hand to pay bills when they are due and to take care of unexpected needs for cash.

There are two ways to measure it:

• Working capital: the amount by which total current assets exceed total current liabilities. By definition, current liabilities are paid out of current assets. It is calculated by deducting current liabilities from current assets.

• Current ratio: An indicator of a company’s ability to pay its bills and to repay outstanding loans:

Profitability is the ability to earn a satisfactory income. Liquid assets are not the best profit-producing resources. For example, a company can have enough cash and have purchasing power, but profit can be made only when the purchasing power is used to buy profit-producing (and less liquid) assets, such as inventory and long-term assets. There are five common ways to measure to ability of a company to earn income:

• Profit margin: The percentage of each sales dollar that results in net income.

• Asset turnover: Measures how efficiently assets are used to produce sales. It shows how many dollars of sales were generated by each dollar of assets:

The profit margin does not look at the assets that are necessary to produce income, and the asset turnover does not look at the amount of income produced. To overcome these limitations, there is the return on assets ratio:

• Return on assets: Relates the net income to average total assets. It shows how much net income is generated for each dollar invested.

Or:

Debt to equity ratio: Shows the proportion of the company financed by creditors compared to the proportion financed by stockholders. When total liabilities is not stated on the balance sheet, it can be determined by deducting the total stockholders’ equity from total assets.

Assume that the debt to equity percentage is 60%, this means that less than half the financing is from creditors and more than half from investors.

• Return on equity: Measures how much stockholders have earned with their investments.

Chapter E. The Operating Cycle and Merchandising operations

A merchandising business earns income by buying and selling goods, which are called merchandise inventory. They use the same basic accounting methods as service companies, but the buying and selling of goods adds to the complexity of the process.

Merchandising businesses engage in a series of transactions called the operating cycle:

1. Purchase of merchandise inventory for cash or on credit

2. Payment for purchases made on credit

3. Sales of merchandise inventory for cash or on credit

4. Collection of cash from credit sales

Purchases of merchandise are usually made on credit, so the merchandiser has a period of time before payment is due, but this period is generally less than the time it takes to sell the merchandise. To finance the inventory until it is sold and the resulting revenue is collected, management must plan for cash flows from within the company or from borrowing.

The financing period is the amount of time from the purchase of inventory until it is sold and payment is collected, less the amount of time creditors give the company to pay for the inventory. When a company sells most of its inventory for cash, they have very low receivables, and this decreases the financing period. Example:

• Day 0: inventory is purchased

• Day 40: Cash paid

• Day 60: Inventory sold

• Day 120: Cash received

Management must choose the inventory system or combination of systems that is best for achieving the company’s goals. There are two basic systems of accounting for the many items in the merchandise inventory:

• The Perpetual inventory system: continuous records are kept of the quantity and, usually, the cost of individual items as they are bought and sold. The cost of each item is recorded in the Merchandise Inventory account when it is purchased. When it is sold, its cost is transferred to the Cost of Goods Sold account.

• The periodic inventory system: the inventory not yet sold is counted periodically, usually at the end of the accounting period. No detailed records of the inventory on hand are maintained during the accounting period.

Because of the difficulty and expense of accounting for the purchase and sale of each item, companies that sell items of low value in high volume have traditionally used the periodic inventory system. In contrast, companies that sell items of high unit value have tended to use the perpetual inventory system.

If a company is engaged in international transactions, it must deal with changing exchange rates.

Management’s responsibility is to establish an environment, accounting systems, and control procedures that will protect the company’s assets against theft and embezzlement. These systems are called internal controls. Maintaining control over merchandise inventory is facilitated by taking a physical inventory. This process involves an actual count of all merchandise on hand. Merchandise inventory includes all goods intended for sale that are owned by a business, regardless of where they are located. It also includes goods in transit from suppliers if title to the goods has passed to the merchant. The actual count is usually taken after the close of business on the last day of the fiscal year.

When losses of goods occur (because of spoilage or shoplifting), the cost of goods sold is inflated by the amount of the merchandise that has been lost. The perpetual inventory system makes it easier to identify such losses. Because the Merchandise Inventory account is continuously updated for sales, purchases, and returns, the loss will show up as the difference between the inventory records and the physical inventory taken at the end of the accounting period. Once the amount of the loss has been identified, the ending inventory is updated by crediting the Merchandise Inventory account. The offsetting debit is usually an increase in Cost of Goods Sold because the loss is considered a cost that reduces the company’s gross margin.

Terms of sale

Manufacturers and wholesalers quote prices as a percentage off their list or catalogue prices. Such a reduction is called a trade discount. The list or catalogue price and related trade discount are used only to arrive at the agreed-upon price; they do not appear in the accounting records. On the invoice, the terms of sale are printed. The invoice can be marked “n/10” (“net 10”) which means that the amount of the invoice is due 10 days after the invoice date.

A sales discount is a discount for early payment. It can be labelled “2/10, n/30” which means that the buyer either can pay the invoice within 10 days of the invoice date and take a 2 percent discount or can wait 30 days and pay the full amount.

Special terms designate whether the seller or the purchaser pays the freight charges. FOB shipping profit means that the seller places the merchandise “free on board” at the point of origin and the buyer bears the shipping costs. The title to the merchandise passes to the buyer at that point. FOB destination means that the seller bears the transportation cost to the place where the merchandise is delivered. The seller retains title until the merchandise reaches its destination.

Applying the perpetual inventory system

Freight in, also called transportation in, is the transportation cost of receiving merchandise. The costs are accumulated in a Freight in account. Theoretically, freight in should be allocated between ending inventory and cost of goods sold, but most companies choose to include the cost of freight in with the cost of goods sold on the income statement because it is a relatively small amount.

Freight out expense, or delivery expense, absorb delivery costs.

When an item is returned from the merchandiser to the company it bought the merchandise from, the returned merchandise is removed from the Merchandise inventory account. P296.

Under the perpetual inventory system, at the time of a sale, the cost of the merchandise is transferred from the Merchandise Inventory account to the Cost of Goods Sold account. In the case of a return of sold merchandise, this works the other way.

Returns and allowances to customers for unsatisfactory merchandise are often an indicator of customer dissatisfaction. Such amounts are accumulated in a Sales Returns and Allowances (stockholders equity).

Examples:

Record the following transactions:

Purchases of merchandise:

Oct 3 Merchandise received on credit, invoice dated Oct 1, terms n/10, $9780

Oct 6 Returned part of merchandise received on Oct 3 for credit, $960

Oct 10 Paid amount in full due for purchase of Oct 3, part of which was returned on Oct 6, $8820

Sales of merchandise:

Oct 7 Merchandise sold on credit, n/30, FOB destination $2400; cost of merchandise $1440

Oct 9 Accepted return of part of merchandise sold on Oct 7 for full credit and returned it to merchandise inventory, $600; the cost of the merchandise was $360.

Nov 5 Collected in full for sale of merchandise on Oct 7, less the return on Oct 9, $1800.

Applying the periodic inventory system

In this system, the cost of goods sold must be computed because it is not updated during the accounting period. To calculate this, goods available for sale must be determined.

Goods available for sale = beginning inventory + net cost of purchases during the year.

Cost of goods sold = goods available for sale – end inventory.

An important part of cost of goods sold is the net cost of purchases. This consists of net purchases plus freight charges on the purchases. Net purchases equal total purchases less any deductions, such as returns and discounts for early payment.

Because in the periodic inventory system the Merchandise inventory account is not adjusted after each inventory transaction, a Purchases or Sales account is used to accumulate the purchases or sales of merchandise during the accounting period. A Purchases or Sales Returns and Allowances account is used to accumulate returns on purchases or sales.

Examples:

Record the following transactions:

Purchases of Merchandise:

Oct 3 Received merchandise purchased on credit, invoice date Oct 1, terms n/10, $9780

Oct 6 Returned part of merchandise received on Oct 3 for credit, $960

Oct 10 Paid amount in full due for the purchase of Oct 3, part of which was returned on Oct6, $8820.

Sales of merchandise:

Oct 7 Sold merchandise on credit, terms n/30, FOB destination, $2400 cost of merchandise was $1440.

Oct 9 Accepted return of part of merchandise sold on Oct 7 for full credit and returned it to merchandise inventory, $600, the cost of the merchandise was $360.

Nov 5 Collected in full for sale on Oct 7, less the return on Oct 9, $1800

An effective system of internal control has five interrelated components:

• Control environment – this involves the company’s ethics, operating style, structure, personnel policy, etc.

• Risk assessment – this involves identifying areas in which risks are high.

• Information and communication - This pertains to the accounting system established by the management.

• Control activities – the policies and procedures management puts in place to see that its directives are carried out.

• Monitoring – this includes the management’s regular assessment of the quality of internal control.

Control activities involve: having managers authorize certain transactions, recording all transactions to establish accountability for assets, using well-designed documents to ensure proper recording of transactions, instituting physical controls, periodically checking records and assets, separation of duties, and using sound personnel practices.

The effectiveness of internal control is limited by the people involved. Human error, collusion, and failure to recognize changed conditions can contribute to a systems failure.

Internal control over merchandising transactions

For an effective internal control, most firms should use the following procedures:

• Separate the functions of authorization, recordkeeping, custodianship of cash.

• Limit the number of people who have access to cash, and designate who those people are

• Bond all employees who have access to cash.

• Keep the amount of cash on hand to a minimum by using banking facilities as much as possible.

• Physically protect cash on hand by using cash registers, cashiers’ cages, and safes.

• Record and deposit all cash receipts promptly, and make payments by check rather than by currency.

• Have a person who does not handle or record cash make unannounced audits of the cash on hand.

• Have a person who does not authorize, handle, or record cash transactions reconcile the Cash account every month.

Chapter F. Inventories

Merchandise inventory consist of all goods owned and held for sale. There are three kinds of inventory:

• Raw materials

• Partially completed products

• Finished goods

The costs of the goods includes raw materials, the cost of labour and the overhead costs. (indirect materials and labour, rent, depreciation and insurance).

The primary objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues. In accounting for inventories, management must choose among different processing systems, costing methods, and valuation methods. These different systems usually result in different amounts of reported net income.

Inventory turnover is a measure similar to receivable turnover. It measures the number of times a company’s average inventory is sold during an accounting period.

Inventory turnover = Cost of goods sold / average inventory

The days’ inventory on hand calculates the average number of days required to sell the inventory on hand.

days’ inventory on hand = number of days in a year / inventory turnover

There are several options to reduce the level of inventory. With supply-chain management a company manages its inventory and purchasing through business-to-business transactions that it conducts over the internet. In a just-in-time operating environment, the company makes sure that shipments arrive just at the time they are needed.

The gross margin is the difference between net sales and cost of goods sold. The higher the cost of ending inventory, the lower the cost of goods sold and the higher the resulting gross margin. Because the amount of gross margin has a direct effect on the amount of net income, the amount assigned to ending inventory directly affects the net income. Therefore it is important to correctly determine the ending inventory.

The effects of misstatements in inventory on income before income taxes are as follows:

The inventory cost includes the invoice price less purchases discounts, fright in and applicable taxes and tariffs. Goods flow refers to the actual physical flow of merchandise, whereas cost flow refers to the assumed flow of costs. Merchandise in transit can be included in the seller’s merchandise inventory when the goods are shipped FOB destination. When the goods are sold FOB shipping point, they are included in the buyer’s inventory. A consignment is merchandise that its owner (the consignor) places on the premises of another company (the consignee) with the understanding that payment is only expected when the merchandise is sold. Unsold items may be returned to the consignor. The lower-of-cost-or-market (LCM) rule states that if the replacement cost is lower than the original cost, the lower figure should be used.

Inventory cost under the Periodic Inventory System

There are four different ways to price inventory. They can be explained with the following data:

Specific identification method:

This method prices the inventory by identifying the cost of each item in ending inventory. If the inventory of June 30 consists of 50 units from the June 1 inventory, 100 units from the June 6 purchase, and 70 units from the June 25 purchase, then the cost of goods sold with the specific identification method are:

The method has two disadvantages: it is difficult to keep track of items and when items are identical, it is hard to say at which price they were bought.

Average-cost method

Under this method, the inventory is priced at the average cost of the goods available for sale during the period.

Cost of goods available for sale / Units available for sale = average unit cost

€6350 / 500 units = $12.70

First-in, First-out method (FIFO)

This method assumes that the costs of the first items acquired should be assigned to the first items sold. The costs of the goods on hand at he end of a period are assumed to be from the most recent purchase.

Example:

This method gives the highest net income, because cost of goods sold will show the earliest cost incurred, which are usually lower.

Last-in, First-out method (LIFO)

This method assumes that the costs of the last items acquired should be assigned to the first items sold. The cost of ending inventory reflects the cost of the oldest purchases.

This method does not reflect the actual physical movement of goods in businesses. The argument that supports LIFO is that when goods are sold in a business, they are replaced with new goods. These new goods have usually higher purchase prices. The LIFO method shows the cost of goods sold at the price level when goods were sold.

Impact on Inventory Decisions

During a period of increasing prices, the LIFO method produces a lower gross margin than the FIFO method. The opposite occurs when there is a period of declining prices.

Each of the four methods is acceptable for use in published financial statements. A basic problem in determining the best inventory measure for a particular company is that inventory affects both the balance sheet and the income statement. LIFO is best suited for the income statement because it matches revenues and cost of goods sold. FIFO is best suited to the balance sheet because the ending inventory is closest to current values.

Over a period of rising prices, a company that uses LIFO may find that its inventory is valued at a cost far below what it currently pays for the same items. When inventory at the end of the year is less than at the beginning of the year, the company has to pay higher income taxes. This is called LIFO liquidation.

Inventory cost under the Perpetual Inventory System

Under the perpetual system, cost of goods sold is accumulated as sales are made and cost are transferred from the Inventory account to the Cost of Goods Sold account. Assume that this is the movement of inventory in a company:

Under the perpetual system, the average is computed after each purchase:

* new average computed

Under the FIFO method, instead of calculating an average after each purchase, the price of the first purchase price is used when a sale occurs.

Under the LIFO method, the last purchase price is used when a sale occurs. See p.352 for an example.

Valuing inventory by estimation

Sometimes the value of ending inventory has to be estimated. Two methods are commonly used:

• Retail method: is used in retail merchandising. It uses the ratio of cost to retail price. At retail means the amount of the inventory at the marked selling prices of the inventory items. The value of goods available for sale at cost is divided by the value of goods available for sale at retail. (this gives the ratio of cost to retail price) The ending inventory at retail is determined by subtracting the net sales during the period from the goods available for sale at retail. This amount is multiplied by the ratio. This gives the estimated cost of ending inventory.

• Gross profit method: assumes that the ratio of gross margin remains stable from year to year. The cost of goods available for sale should be established in the usual way. The cost of goods sold should be calculated by deducting the estimated gross margin of 30 percent from sales. Then, deduct the estimated cost of goods sold from the goods available for sale to get the estimated cost of ending inventory.

Chapter G. Cash and Receivables

Management issues related to cash and receivables

The management of cash and receivables is critical to maintaining adequate liquidity. In dealing with cash and receivables, management must address five key issues:

1. Managing cash needs

Management must consider the need for short-term investing and borrowing during seasonal cycles.

2. Setting credit policies that balance the need for sales with the ability to collect

3. Evaluating the level of accounts receivable

Two methods that are often used to measure the effect of a companies credit policies are receivable turnover and average days’ sales uncollected. The first is the relative size of accounts receivable and the success of its credit and collection policies. It should be calculated in the following way:

Receivable turnover = net sales / average net accounts receivable

The second is how long it takes to collect accounts receivable:

Average days’ sales uncollected = days in a year / receivable turnover

4. Financing receivables

Companies can raise funds by selling or transferring accounts receivable to another entity, called a factor. The sale can be done with recourse which means that the seller of the receivables is liable to the purchaser if a receivable is not collected. Without recourse means the seller is not liable. A potential liability that can develop into a real liability is called a contingent liability. In this case it would be non-payment of the receivable by the customer.

Another thing a company can do is securitization. This means the company groups its receivables in batches and sells them at a discount to companies and investors.

A third method is called discounting. This is the selling of promissory notes held as notes receivable. The back deducts the interest from the maturity value of the note to determine the proceeds. The seller has a contingent liability in the amount of the discounted notes plus interest.

5. Understanding the importance of ethics in estimating credit losses.

Cash equivalents and cash control

Cash can include cash equivalents. These are investments of less than 90 days. Coins on hand can be controlled through an imprest system. A common form is a petty cash fund. It is set at a fixed amount and all receipts of cash payments must be collected. The fund is periodically reimbursed by the exact amount necessary to restore its original cash balance. Many companies conduct transactions through electronic transportation called electronic funds transfer (EFT).

A bank reconciliation is the process of accounting for the difference between the balance on the company’s bank statement and the balance on its Cash account. It involves adjusting for outstanding checks, deposits in transit, service charges, NSF (non sufficient funds) checks, miscellaneous debts and credits, and interest income.

Uncollectible accounts

Accounts receivable arise from sales on credit. Accounts owed by customers who cannot or will not pay their debts are called uncollectible accounts. The direct charge-off method is often used by small companies. They reduce Accounts Receivable directly and increase Uncollectible Accounts Expense.

Companies that follow GAAP prefer the allowance method. Here, bad debt losses are matched against the sales they help to produce. Because at the time sales are made, it can not be identified which customers will not pay their debits, losses must be estimated. A new account called ‘Allowance for Uncollectible Accounts’ will appear on the balance as a contra account from accounts receivable. Example: From the $100,000 in accounts receivable, $6,000 is estimated to be uncollectible at the end of the year:

There are two common methods for estimating uncollectible accounts expense:

• Percentage of Net Sales Method: Management establishes a percentage of net sales that they think will not be collected. This can be an average of the past few years. This amount will be recorded as follows:

The allowance for uncollectible accounts will be added to the amount from previous years.

• Accounts receivable aging method: The year-end balance of Allowance for Uncollectible Accounts is determined directly by an analysis of accounts receivable. The difference between the amount determined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the year. The aging of accounts receivable is the process of listing each customer’s receivable account according to the due date of the account.

• Each due date has its own percentage that will not be collected.
  When the Allowance for Uncollectible Accounts has a credit balance, the difference between the amount calculated and the credit balance should be added to the account.
  When the Allowance for Uncollectible Accounts has a debit balance, the calculated amount and the debit amount should be added together before adding the total to the account.

When it becomes clear that a specific account receivable will not be collected, the amount should be written off to Allowance for Uncollectible Accounts. For example, when a company goes bankrupt, and its still owes you $300, it will be recorded in the following way:

Suppose that all of a sudden the company does find a way to pay you, the following journal entries must be made:

Notes receivable

A promissory note is an unconditional promise to pay a definite sum of money on demand or a future date. The entity who signs the note and promises to pay is called the maker of the note. The entity to whom the payment is to be made is called the payee.

They maturity date is the date on which a promissory note must be paid. The duration of note is the length of time in days between a promissory note’s issue date and its maturity date, Interest is the cost of borrowing money or the return for lending money. The maturity value is the total proceeds of a promissory note –face value plus interest-at the maturity date. When the maker of a note does not pay the note at maturity, it is said to be an dishonoured note.

Chapter H. Long-term assets

Long term assets are assets that:

• Have a useful life of more than one year

• Are acquired for use in the operation of a business (assets not used in the normal course of business, such as land held for speculative reasons, should not be included)

• Are not intended for resale to customers

Long-term assets are reported at carrying value, this is the unexpired part of the cost of an asset, also called book value. It is not the market value of an item. Asset impairment occurs when the sum of the expected cash flows from the asset is less than the carrying value of the asset. A reduction in carrying value as a result of impairment is recorded as a loss.

The decision to acquire a long-term asset includes a complex process. First the purchasing costs of the asset have to be determined. Then, the savings which the asset generates in its life time have to be written in present value. Third, the disposal price (if any) has to be written in present value. When adding all of them together, and the outcome is positive, the asset will be profitable. Example: A $50,000 software package, making the company save $20,000 for four years, with a disposal price of $10,000 and a 10% interest rate:

There are a few issues when accounting for long-term assets. The first one is how much of the total cost has to be allocated to expense in the current accounting period. The second is how much to retain on the balance sheet as an asset to benefit future periods.

There are four questions that have to be answered before accounting for the long-term asset.

• How is the cost of the long-term asset determined?

• How should the expired portion of the cost of the long-term asset be allocated against revenues over time?

• How should subsequent expenditures, such as repairs, be treated?

• How should disposal of the asset be recorded?

The accounting problem is to spread the cost of the services of the asset over its useful life.

Acquisition cost of property, plant and equipment

Expenditure refers to a payment or an obligation to make future payment for an asset or a service. A capital expenditure is an expenditure for the purchase or expansion. They are recorded in the asset accounts. Revenue expenditure is related to the repair and maintenance of a long-term asset. They are recorded in an expense account because their benefits are realized in the current period.

Capital expenditures include outlays for plant assets, natural resources, and tangible assets. They also include expenditures for additions, betterments and extraordinary repairs.

An addition is an enlargement to the physical layout of a plant asset. A betterment is an improvement that does not ad to the physical layout of a plant asset. They should both be debited to the asset account. Ordinary repairs are necessary to maintain an asset in good operating condition. These repairs are current expense. Extraordinary repairs are repairs that affect the estimated residual value. They are recorded by debiting the Accumulated Depreciation account, assuming that some of the depreciation previously recorded has now been eliminated.

Cost of the asset is equal to the cash paid for the asset plus expenditures such as freight. If a debt is incurred in the purchase of the asset, the interest charges are not a cost of the asset, but a cost of borrowing money to buy the asset. This makes is an operating expense. Many companies establish policies explaining when an expenditure is an expense or an asset.

• Land: Expenditures that should be debited to the Land account are commissions to real estate agents, accrued taxes paid by the purchaser and assessments for local improvements. Land is not subject to depreciation.

• Land Improvements: Some improvements to real estate that are subject to depreciation should be recorded in an account called Land Improvement.

• Buildings: The new contract price plus other expenditures necessary to put the building in usable condition are included in the cost.

• Equipment: The cost include all expenditures that have to do with purchasing the equipment and preparing it for use.

• Group purchases: When land and other assets are purchased for a lump sum, they must have a separate ledger account because land is depreciable asset. The lump-sum purchase price must be apportioned between land and other assets.

Depreciation

All tangible assets except land have a limited useful life. The physical deterioration of tangible assets results from use and from exposure to the elements. Obsolescence is the process of becoming out of date. Depreciation does not refer to an asset’s physical deterioration or decrease in market value over time. It is not a process of valuation.

Four factors affect the computation of depreciation:

• Cost. This is the net purchase price plus all necessary expenditures

• Residual value: This is the trade-in value as of the estimated date of disposal

• Depreciation cost: The cost less its residual value

• Estimated useful life: The total number of service units expected from the asset.

Methods of computing depreciation:

• Straight-line method:

The depreciation is the same each year, the accumulated depreciation increases uniformly and the carrying value decreases uniformly until it reaches the estimated residual value.

• Production method: This method assumes that depreciation is the result of use and that time plays no role in the depreciation process.

This method should only be used when the output of an asset over its useful life an be estimated with reasonable accuracy.

• Declining-balance method: An accelerated method of depreciation results in relatively large amounts of depreciation in the early years of an asset’s life and smaller amounts in later years. It assumes that assets are most efficient when new. It also recognizes that because of fast-changing technology, equipment can become obsolescent. With the declining-balance method depreciation is computed by applying a fixed rate to the carrying value of an asset. The most common rate is a percentage that is equal to twice the straight-line depreciation percentage. This is called the double-declining-balance method.

Group depreciation: When some pieces last longer than others pieces of the same kind, companies can groups similar items and take the average to calculate depreciation.

Revision of depreciation rates: Assume an asset is worth $7000 with a residual value of $1000 and an estimated useful life of six years. After two years of straight line depreciation, $2000 is the accumulated depreciation and $4000 is the remaining depreciable cost.

Assume that after these two years, the company finds out the truck only has a useful life left of two years, instead of the assumed remaining four. The next two years, the depreciation should be $4000 – 2 years = $2000 each year.

Disposal of depreciable assets

Discarded plant assets: When machinery is discarded, the proper amount of depreciation should be computed until the month in which the item is discarded. This amount should be accounted for under ‘Accumulated Depreciation, Machinery’. The carrying value is the machinery cost less accumulated depreciation. This should be recorded as ‘Loss on Disposal of Machinery’. Assume machinery has accumulated depreciation of $4650, and the amount in the Machinery account is $6500:

Plant assets sold for cash: Assume the cash received is $1850:

Assume the cash received is $1000

The opposite occurs when more than the carrying value is received in cash

Exchanges of plant assets: For both financial accounting and income tax purposes both gains and losses are recognized when a company exchanges dissimilar assets. When items are similar, only losses are recognized for financial accounting purposes.

Accounting for natural resources

Natural resources are recorded at acquisition cost. When the resource is converted into inventory, the asset account must be reduced when inventory increases. This way, the original cost is gradually reduced, and depletion is recognized in the amount of the decrease. The depletion cost per unit is determined by dividing the cost of the natural resource less residual value) by the estimated number of units available. When machinery with a useful life of twelve years is build on a coal mine that is expected to be depleted in ten years, the machinery should be depreciated over the ten-year period, using the production method.

Under successful efforts accounting only the cost of a successful exploration are recorded as cost of the resources. Failures such as dry wells are written off as being a loss. With the full-costing method, all costs, including failures, are recorded as assets and depleted.

Accounting for intangible items

The purchase of an intangible asset should be treated as a capital expenditure and recorded at acquisition cost, and should be amortized over the useful life of the asset.

Special costs:

• All costs that have to do with Research and Development should be treated as revenue expenditures and charged to expense in the period in which they are incurred.

• Costs that have to do with developing computer software for sale are research and development costs until the product has proved technologically feasible.

• Goodwill is the amount that people are willing to pay for a company more than the value of the net assets if purchased individually. It should be reported separately on the balance sheet.

Chapter I. Current Liabilities and the Time Value of Money

Failure to manage a companies cash flows related to current liabilities can have serious consequences for a business. Shipments from suppliers may be withhold and it can even lead to bankruptcy. Common ways to measure liquidity are the payables turnover and the days’ payable. The first one measures the number of times, on average, accounts payable are paid in an accounting period. It also shows the relative size of a company’s accounts payable. It is computed in the following way:

Payables turnover = (Cost of goods sold ± Change in Merchandise inventory) / Average accounts payable

The days’ payable shows how long, on average, a company takes to pay its accounts receivable.

Days’ Payable = 365 days / Payables Turnover

Timing is very important when it comes to the recognition of liabilities. Failure to record a liability in an accounting period very often goes along with failure to record an expense. The liability should be recorded when an obligation occurs. One of the main reasons for making adjusting entries at the end of an accounting period is to recognize unrecorded (accrued) liabilities, such as salaries payable and interest payable. Liabilities that can only be estimated must also be recognised. An example is taxes payable. The liability is valued at the amount needed to pay the debt or at the fair market value of goods to be delivered.

Current liabilities are debts and obligations expected to be satisfied within the normal operating cycle or within one year, depending on which one is longer. They are normally paid out of current assets or with cash generated from operations. Long-term liabilities are due beyond one year. They are used to finance the long-term assets. To explain some accounts, supplemental disclosure to the financial statements may be required. The disclosure can include balances, maturities and interest rates. This helps in assessing whether a company has additional borrowing power.

Common types of current liabilities

Current liabilities fall into two major groups:

1. Definitely determinable liabilities. These are liabilities that are set by contract or by statute and can be measured exactly. The related accounting problems are to determine the existence and amount of each such liability and to make sure that it is recorded in the right way.

2. Estimated liabilities are definite debts or obligations whose exact dollar amount cannot be known until a later date. The primary accounting problem is to estimate and record the amount of the liability.

1. Definitely determinable liabilities:

• Accounts payable are short-term obligations to suppliers for goods and services.

• Bank loans and Commercial Paper. Management often establishes a line of credit with a bank, which means that the company can borrow funds when they are needed to finance current operations. A promissory note for the full amount of the line of credit is signed, but the company has great flexibility in using the available funds. A company with excellent credit ratings can borrow short-term funds by issuing commercial paper, unsecured loans that are sold to the public.
  The two amounts are usually combined with notes payable.

• Notes payable are obligations represented by promissory notes. The interest is usually stated on the face of the note. They should be recorded in the following way:
   

When the note is paid it should be recorded as follows:

Interest stated separately:

• Accrued liabilities: Liabilities that are not already in the accounting records should have an adjusting entry. An example is interest payable. When we assume that the accounting period ends 30 days after the issuance of the 60-day note, the adjusting entries would be:

• Dividends Payable. A liability does not exist until the board declares the dividends. The short time between the declaration and the payment of the dividends, the dividends declared are considered current liabilities.

• Sales and excise taxes payable. The amount of sales tax collected by the company represents a current liability until; it is remitted to the government.

• Current portions of long-term debt: When a portion of a long-term debt is due within the next tear and is to be paid from current assets, that current portion is properly classified as a current liability. When a $10000 debt should be paid in instalments of $20000 for the next five years, after one year $20000 should be reclassified from the long-term liabilities to the current liabilities.

• Payroll liabilities. Wages refers to payment for the services of employees at an hourly rate. Salaries refers to the compensation of employees who are paid at a monthly or yearly rate. All the taxes that are withhold should be accounted for as liabilities.

• Unearned revenues represent obligations for goods or services that the company must provide in a future accounting period in return for an advance payment from a customer.

2. Estimated liabilities

• Income taxes payable depend on the results of an operation. Because income taxes are an expense in the year in which income is earned, an adjusting entry is necessary

• Property tax payable are levied on real property and on personal property. Because the fiscal years of local governments rarely correspond to a firm’s fiscal year, it is necessary to estimate the amount.

• Promotional Costs

• Product warranty liability: The cost of a warranty is properly debited to an expense account in the period of sale because it is a feature of the product sold and thus is included in the price the customer pays for the product. A company can calculate the average cost it has per product. When they multiply this with the number of units sold and the rate of replacement under warranty, they have the amount that ahs to be set aside as Estimated Product Warranty Liability.

• Vacation Pay Liability: Employees accrue paid vacation as they work during they year. The computation of vacation pay expense should be the payroll x vacation pay percentage x percent of employees that will collect vacation pay.

Contingent liabilities and commitments

A contingent liability is not an existing obligation. It depends on a future event arising out of past transactions whether it will become a liability. The FASB has two conditions for determining when a contingency should be entered in the accounting records:

1. The liability must be probable

2. The liability can be reasonably estimated

The most common types of contingencies were litigation and environmental concerns.

A commitment is a legal obligation that does not meet the technical requirements for recognition as a liability. Examples are purchase agreements and leases.

The time value of money

Simple interest is the interest cost for one or more periods if we assume that the amount on which the interest is computed stays the same from period to period. Compound interest is the interest cost for two or more periods if we assume that after each period, the interest of that period is added to the amount on which interest is computed in future periods. The Future value is the amount an investment will be worth at a future date if invested at compound interest. You can calculate the future value of a single, which means that each period only the interest is added. You can also calculate the future value of an ordinary annuity, which is a series of equal payments made at the end of equal intervals of time, with compound interest on these payments. An example: The first year you put $100 in a savings account for 4% interest. After 1 year, you get $4. Then, you add another $100, making the total $204. At the end of that year, you get $8.16 interest, and you add another $100.

Present value is the amount that must be invested now at a given rate of interest to produce a given future value. Again, this can be calculated for a single sum and for an ordinary annuity.

Chapter J. Long-term liabilities

Two sources of long-term funds are the issuance of capital stock and the issuance of long-term debt in the form of bonds, notes, etc. There are a few issues related to issuing long-term-debt:

• Whether to take on a long-term debt. The disadvantages of long-term debts are that it represent financial commitments that have to be paid periodically. Common stock does not have to be paid back, and dividends are only declared when the company earns sufficient income. The advantages of long-term debt are that common stockholders do not have any control of the company, the interest on debt is tax-deductible and when a company earns more on its assets than it pays in interest on debt, the excess will increase its earnings for stockholders. This is called financial leverage.

• How much long-term debt to carry. The level of debt can be evaluated using the debt to equity ratio and the interest coverage ratio.

An outcome of 9.9 shows that the interest expense of a company was covered 9.9 times in its financial year.

• What types of long-term debt to take on

Common types of long-term debt are bonds, notes, mortgages, long-term leases, pension liabilities, other post retirement benefits, and deferred income taxes.

Mortgage: A mortgage is a long-term debt secured by real property. Each monthly payment includes the interest on the debt and a reduction in the debt.

Long-term leases: An operating lease is a lease that is short term in relation to the useful life of the asset, and the risk of ownership remains with the lessor. The duration of a long-term lease is about the same as its useful life. The risks of ownership are transferred to the lessee. This is called a capital lease. See p.519 for an example.

Pensions: A pension plan is a contract between a company and its employees in which the company agrees to pay benefits to the employees after they retire.

The nature of bonds

A bond is a security, usually long term, representing money that a corporation or other entity borrows from the investing public. Interest is usually paid semi-annually. Stocks are shares of ownership, which makes stockholders owners. Bondholders are creditors. The bond indenture defines the rights, privileges, and limitations of the bondholders. A bond issue is the total value of bonds issued at one time. The face interest rate is the fixed rate of interest paid to bondholders based on the face value. The market interest rate is the rate of interest paid in the market on bonds of a similar risk. If the market rate fluctuates from the face interest rate before the bond issue rate, the bonds will sell at either a discount (market > face) or a premium (market < face).

A secured bond gives the owner a pledge of certain assets as a guarantee of repayment. When a bond is issued only on the general credit of a company, it is an unsecured bond.

When all bonds of an issue mature on the same time, they are called term bonds. When the maturity dates are different, they are serial bonds. Callable bonds give the issuer the right to buy back and retire the bonds before maturity at a specified call price. Convertible bonds allow the bondholder to exchange a bond for a specified number of shares of common stock. With registered bonds , the names and addresses of the owners of the bond must be recorded with the company. Coupon bonds are not registered.

Accounting for the issuance of bonds

Bonds payable are usually shown on the balance sheet as long-term assets. Only when the maturity date is less than one year and the bonds will be retired using current assets, they should be listed as a current liability. When bonds are issued and interest is paid, the following entry should be made:

As mentioned before, when the market interest rate is higher than the face interest rate, the bonds will be issued at a discount. Buyers will have to pay less than the face value. When the opposite occurs, the market interest rate is lower, the bonds are issued at a premium.

Assume that a company issues $100.000 of 9%, five-year bonds at $96.149 when the market interest rate is 10 percent.

The unamortized bond discount is a contra-liability account and is deducted from the face amount of the bond. The discount will be written off over the life of the bond. Bond issue cost, which are fees received by underwriters who sell the bonds, increase the discount of decrease the premiums of bond issues.

Using present value to bond

The value of a bond is determined by summing the present values of the series of fixed interest payments and the payment of the bond issue, and the single payment of the face value at maturity. They have to be calculated separately and then added to find the present value of the bond.

Amortization of bond discounts and premiums

A bond discount or premium represents the amount by which the total interest cost is higher or lower than the total interest payment. The discount or premium has to be amortized over the life of the bonds in order to make sure that at maturity, the carrying value equals its face value. The full cost of issuing bonds at a discount is as follows:

The market interest rate is the real interest cost of the bond over its life. In this case it is $48.851. The face interest rate is .000. In order to make each year’s interest expense equal to the market interest rate, the discount must be allocated over the remaining life of the bonds as an increase in the interest expense period.

Straight-line method: This method assumes equal amortization of the bond discount for each interest period. It is calculated in four steps:

1. Total interest payments = Interest payments per year x Life of bonds

The previous example gives the following outcome: 2 times a year x 5 years = 10

2. Amortization of Bond discount per interest period =
    

   Bond discount		$ 3.851	=	$ 385
   Total interest payments		10

3. Cash interest payment = Face value x Face interest Rate x Time
   $100.000 x 0.9 x 6/12= $4.500

4. Interest expense per interest period= Interest payment+amortization of bond discount
   $4.500 + $385 = $4.885

This would give the following entry on the interest date:

Effective interest method: With this method a constant interest rate is applied to the carrying value of the bonds at the beginning of the interest period. This rate equals the market rate at the time the bonds were issued. The amount that has to amortized each period is the difference between the interest computed by using the market rate and the actual interest paid to bondholders. See p.534 for an example.

The amortization of a bond premium is the same as the bond discount. The only difference in the straight line method is that step four should be as follows:

4. Interest expense per interest period= Interest payment - amortization of bond discount

For an example of the amortizing of a bond premium with the effective interest method see p.537.

Retirement of bonds

Callable bonds give the issuer the right to buy back and retire the bonds at a specified call price, usually above the face value. The retirement of a bond issue before the maturity date is called early extinguishment of debt. When retiring a bond, the cash price that has to be paid is the face value times the call price. The difference between the face price plus the unamortized bond premium (as calculated with the effective interest method) is the loss or gain on retirement of bonds.

Convertible bonds are bonds that can be exchanged for common stock or other securities of the corporation. They enable an investor to make more money when the market price of the common stock rises. When the stock price stays the same, the investor still holds the bond and receives both the periodic interest payments and the principal on the maturity date.

Other bonds payable issues

• Sale of bonds between interest dates: When bonds are sold between interest dates it is common to collect from investors the interest that would have accrued for the partial period preceding the issue date. When the first interest period is completed, the new corporation pays bond-holders the interest for the entire period.

• Year end accrual of bond interest expense: An adjustment has to be made at the end of the accounting period to accrue the interest expense on the bonds from the last payment date to the end of the fiscal year. See p.513 for an example.

Chapter K. Contributed capital

Management issues related to contributed capital

A corporation is a legal entity separate and distinct from its owners. The advantages of a corporation are :

• it is a separate legal entity

• there is limited liability for the owners

• there is ease of capital generation because shares of ownership in the business are available to many people

• there is the ease of transfer of ownership

• lack of mutual agency

• continuous existence: the life of the corporation is set by its charter and regulated by state laws

• centralized authority and responsibility: the board of directors represents the stockholders and they delegate the responsibility and authority for every-day operation to a single person, usually the president.

• professional management

The disadvantages are

• government regulation. The corporation must meet the requirements of state laws.

• Taxation. The earnings are subject to double taxation: the federal and state income taxes.

• Limited liability. It restricts the ability of small companies to borrow money from creditors.

• Separation of ownership and control. In case the management makes a decision that the stockholders disagree with, it is hard for them to exercise control.

A share of stock is a unit of ownership in a corporation. When someone buys a stock a stock certificate is issued to the owner. The authorized stock is the maximum number of shares the corporation is allowed to issue and the par value is an arbitrary amount assigned to each share of stock. Legal capital equals the number of shares issued times the par value.

An underwriter is an intermediary between the corporation and the investing public. He or she can help the company with the initial issue of capital stock. This is called initial public offering (IPO).

When a corporation is formed, incorporation fees and attorneys’ fees have to be paid. These costs are called start-up and organization cost.

A dividend is a distribution among stockholders of the assets that a corporation’s earnings have generated. The only one who can declare a dividend is the board of directors. A liquidating dividend is a dividend that exceeds trained earnings. The corporation is, in essence, returning to the stockholders part of their contributed capital. There are three dates that are associated with dividends:

• Date of declaration: The board of directors formally declares a dividend is going to be paid.

• Date of record: The date on which ownership of the stock is determined. Between that date and the date of payment, the stock is said to be ex-dividend. When a stock is sold after this date, the right to the cash dividend remains with the original owner.

• Date of payment: Date on which the dividend is paid to the stockholder of record.

The liability for payment of dividends arises on the date the board of directors declares a dividend. The declaration is recorded with a debit to Dividends and a credit to Dividends Payable. The record date – the date on which ownership of stock is determined – requires no entry. On the date of payment, the Dividends Payable Account is eliminated and the Cash Account is reduced.

The ratio dividends yield evaluates the amount of dividends received. It is computed as follows:

Return on equity is the most important ratio associated with stockholders´ equity. It measures management’s performance. The stockholders’ equity depends on management decisions about the amount of stock the company sells to the public.

The confidence of investors in a company’s future can be calculated with the price/earnings (P/E) ratio:

When a company wants to encourage employees to buy stock, it can make a stock option plan. This plan is an agreement to issue stock to employees according to specified terms such as the right to buy stock in the future at a fixed price. On the date the stock options are granted, the fair value of the options must be estimated, and the amount in excess must be either recorded as compensation expense or reported in the notes to the financial statements.

Components of stockholders’ equity

All owners’ claims to the company are called stockholders’ equity. The stockholders’ equity consists of contributed capital (the stockholders’ investments in the corporation) and the retained earnings (the earnings of the corporation since its inception, less any losses, dividends, or transfers to contributed capital).

A corporation can issue two basic types of stock:

• Common stock; this is the company’s residual equity. This means that in case of liquidation, all claims to the company from preferred stockholders and creditors rank ahead of common stockholders. It is usually the only stock that carries voting rights

• Preferred stock. Investors in preferred stock place more value on one or more of the preferences attached to the preferred stock.

The issued stock is the shares sold or transferred to stockholders. Outstanding stock is stock that has been issued and is still in circulation. A share is not outstanding if the issuing corporation has repurchased it.

Preferred stock

Most preferred stock has one or more of the following characteristics:

• Preference as to dividends: The holders of preferred shares must receive a certain amount of dividends before the holders of common shares. The amount is usually stated in dollars per share or as a percentage of the par value.
  With a noncumulative preferred stock, the company is not obligated to make up for a dividend in future years, when if fails to declare one in a year. With a cumulative preferred stock, the fixed dividend amount per share accumulates from year to year, and the whole amount must be paid before any dividends on common stock can be paid. Dividends not paid in the year they are due are called dividends in arrears. The dividends in arrears are not recognized as liabilities but the amount should be reported in the body of the financial statements. See p.546 for an example.

• Preference as to assets: When the corporation’s existence is terminated, the preferred stockholders have a right to receive the par value or a larger stated liquidation value per share before the common stockholders.

• Convertibe preferred stock: People who have convertible preferred stock can exchange their shares for shares of the company’s common stock at a ratio stated in the contract.

• Callable preferred stock: The stock can be redeemed or retired at the option of the issuing corporation at a price stated in the preferred contract. When the stock is convertible, the stockholder can also convert the stock into common stock.

Accounting for stock issuance

No-par stock is capital stock that does not have a par value. The corporation issuing no-par stock may be required by state law to place a stated value on each share of stock. When a company issues no-par stock without a stated value, all proceeds are recorded in the Capital Stock account.

When no-par stock with a stated value is issued, the shares are recorded in the Capital Stock account at stated value. Any amount received in excess of the stated value is recorded in the in Excess of Stated value account.

Par Value stock: Assume this company issues 10.000 shares at $10 per share, and sells them for $12 per share. This would give the following entry:

No-Par stock

Assume this company issues no-par stock, 10.000 shares at $15 per share, without stated value:

Assume the company puts a $10 stated value on its no-par stock. This would give the following entry:

Stock can be issued for assets or services other than cash. The generally preferred rule is to record the transaction at the fair market value of what the corporation is giving up, in this case the stock. When the fair market value of the stock can not be determined, the fair market value of the asset of service is used. When the fair market value of the asset is higher than the par-value of the stock, the excess is recorded as Paid –in Capital in Excess of Par Value, Common. See p.586 for an example.

Accounting for treasury stock

Treasury stock is capital stock that the issuing company has reacquired. The purchase of treasury stock is recorded as cost. When a company purchases 1.000 shares at a price of $50 per share, $50.000 is deducted from the Total contributed capital and retained earnings. This way it decreases the total stockholders’ equity.

The number of outstanding shares decreases when a company purchases its stock back, but the number of shares issued (and with this the legal capital) does not.

The total stockholders’ equity is calculated in the following way.

Sale of treasury stock.

When treasury shares are sold below their cost, the difference is deducted from Paid-in Capital, Treasury Stock. When the balance of this account is not enough to cover the cost, Retained Earnings absorbs the excess.

The statement of stockholder equity

The statement of stockholder equity summarizes the changes in the components of the stockholders’ equity section in the balance sheet. The retained earnings of a company are the part of the stockholders’ equity that represent stockholders’ claims to assets arising from the earnings of the business. They equal the profit, less any losses, dividends to stockholders, or transfers to contributed capital. A company is said to have a deficit when retained earnings has a debit balance. This can occur when dividends and losses are greater than profit from operations. A restriction on retained earnings means that dividends can be declared only to the extent of the unrestricted retained earnings. It does not change the total retained earnings but divides it into two parts: restricted and unrestricted.

Stock dividends and stock splits

A stock dividend is a proportional distribution of shares among a corporation’s stockholders. It involves no distribution of assets and has no effect on a firm’s assets and liabilities. The stock dividend transfers an amount from retained earnings to contributed capital. The amount is the fair market value of the additional shares to be issued.

Suppose the board of directors declares a 10% stock dividend on February 24, distributable on March 31 to stockholders of record on March 15, market price of the stock is $20 per share.

Entries are as follows:

Retained Earnings is reduced by the amount of the stock dividend when the Stock Dividends Declared account is closed to Retained Earnings at the end of the accounting period. Assume a stockholder owns 1.000 shares before the stock dividend. After the 10 percent stock dividend is distributed, this stockholder would own 1.100 shares, as illustrated on the next page.

A stock split occurs when a corporation increases the number of issued shares of stock and reduces the par or stated value proportionally. The split does not increase the number of shares authorized. It does change the number of shares issued. This makes an entry unnecessary. It is appropriate to make a memorandum entry in the general journal.

Book value

The book value of a company’s stock represents the total assets of the company less its liabilities, or: its net assets. The book value per share represents the equity of the owner of one share of stock in the net assets of the corporation. When only common stock is outstanding, it is calculated by dividing the total stockholders’ equity by the total common shares outstanding. When there are both preferred stock and common stock it is common that the call value (or par value) of the preferred stock plus any dividends in arrears is subtracted from the total stockholders’ equity to determined the equity pertaining to common stock.

Example:

Chapter L. The Statement of Cash Flows

The statement of cash flows shows how a company’s operating, investing, and financing activities have affected cash during an accounting period. The statement explains the net increase or decrease in cash during the period. On the statement, cash is both cash and cash equivalents - short-term, highly liquid investment, including money market accounts, commercial paper and treasury bills. A company has cash equivalents to earn interest on cash that would otherwise remain unused temporarily. The two are combined on the statement of cash flows.

Management uses the statement of cash flows to assess liquidity, determine dividend policy, and plan investing and financing activities. Investors and creditors use it to assess the company’s cash-generating ability.

The statement of Cash Flows has three major classifications:

• Operating activities: The cash effects of transactions and other events that enter into the determination of net income. Examples: sale or purchases of goods and inventory, expenses, interest and dividends received on loans and investments, taxes, and wages.

• Investing activities: The acquisition and sale of long-term assets and marketable securities, other than trading securities or cash equivalents, and the making and collecting of loans.

• Financing activities: Obtaining resources from stockholders, issuance and repayment of debt, payment of dividends, and reacquiring of stock.

Noncash investing and financing transactions involving only long-term assets, long-term liabilities, or stockholders’ equity, do not involve cash flows. Because they will affect future cash flows, they should be stated in a separate schedule on the cash flow statement.

Analyzing Cash Flows

When studying a company, two areas that are examined are:

• Cash generating efficiency: The ability of a company to generate cash from its current or continuing operations. The cash flow yield is the ratio of net cash flows from operating activities to net income. A cash flow yield of 1.9 means that the company is generating 90% more cash flow than net income.

Cash flows to sales is the ratio of net cash flows from operating activities to sales. A cash flows to sales of 0.09 means that the company generates 9% of net cash from sales.

Cash flows to assets is the ratio of net cash flow from operating activities to average total assets.

• Free cash flow: The amount of cash hat remains after deducting the funds a company must commit to continue operating at its planned level. These commitments cover current or continuing operations, income taxes, interest, dividends, and net capital expenditures. When a company’s free cash flow is positive, it has cash available to reduce debt or to expand because it has paid all its cash commitments.

Operating activities

The first step is to determine cash flows from operating activities. The income statement shows the earning of income from a business operating activities. Because the income statement is on an accrual basis, the figures must be converted to a cash basis. There are two ways to do this. The direct method converts each item from the accrual basis to the cash basis. The indirect method lists only those adjustments necessary to convert net income to cash flows from operations. The items that require adjustment are those that affect net income but not net cash flows from operating activities. Examples are depreciation, gains and losses, and changes in the balances of current assets and current liabilities accounts.

• Depreciation: To derive cash flows from operations, and adjustment for depreciations is needed to increase net income by the amount of depreciation recorded. This amount can be found on the income statement at Depreciation Expense.

• Gains and losses: The gains of the company have to be subtracted in order to prevent double counting because the gain is already included in the net income. Losses have to be added because losses are already included in the sale of the item.

• Changes in current assets: Decreases in current assets have positive effects on cash flows and the other way around. When the Accounts Receivable account decreased in the accounting year by an amount X, this amount has to be added to net income. The increase of the Inventory account has to be subtracted and the decrease in Prepaid Expenses has to be added because of the same reason.

• Changes in current liabilities: These changes have the opposite effect from those in current assets. Increases in current liability accounts are added to net income, and decreases are subtracted.

Investing activities

When cash flows from investing activities are determined, each account that involves cash payments and receipts from investing activities has to be examined separately. The income statement on exhibit 2 on p.666 shows a Gain on sale of investments of $6,000. The objective is to explain this gain. The exhibit also gives the following information on the income statement:

1. Purchased investments in the amount if $39,000
2. Sold investments that cost $45,000 for $51,000

3. Purchased plant assets in the amount of $60,000

4. Sold plant assets that cost $5,000 with accumulated depreciation of $1,000 for $2,500.

5. Issued $50,000 of bonds at face value in a noncash exchange for plant assets.

• Investments: Assume the investments account had a beginning balance of $63,500. The account was debited for $39,000 (nr.1) and credited for $45,000 (nr.2) The gain on nr. 2 ($6,000) has already been accounted for as an increase in cash flows, and does not have to be counted again. The ending balance of the Investments account is $57,500. This is a difference of $6,000. (This is unrelated to the gain of $6,000 on nr.2)

The cash flow effects from these transactions that are shown in the investing activities section are as follows:

Purchase of investments -$39,000 Sale of investments $51,000

• Plant assets: Both the Plant Assets account and the Accumulated Depreciation account have to be explained. Nr. 3 shows a cash decrease of $60,000 and nr.4 a cash increase of $2,500. Nr.5 is a non cash exchange but does show a significant transaction involving a investing and a financing activity, it is listed at the bottom of the cash flow statement.
  Purchase of plant assets: -$60,000 Sale of plant assets $2,500

The total balance on cash flows from investing activities is: -39,000 + 51,000 – 60,000 + 2,500 = -$45,500

Financing activities

To determine cash flows from financing activities almost the same procedure is followed as when determining cash flows from investments. The accounts analyzed are short-term borrowings, long-term liabilities, and stockholders’ equity accounts.

1. Issued $50,000 of bonds at face value in a noncash exchange for plant assets.

2. Repaid $25,000 of bonds at face value at maturity.

3. Issued 7,600 shares of $5 par value common stock for $87,500.

4. Paid cash dividends in the amount of $4.000.

5. Purchased treasury stock for $12,500.

• Bonds payable: Nr. 1 is credited to the Bonds Payable account. Nr. 2 is debited to this account. The balance is a credit of $25,000

• Common stock: Issuing 7,600 shares of $5 par value credits $38,000 to the Common stock account. To excess, $49,500 (87,500-38,000) is credited to the Paid-in Capital in excess of Par Value, Common account. This is a cash increase of $87,500.

• Retained earnings: Nr. 4 shows a decrease of $4,000 because of the payment of dividends. This is a cash decrease.

• Treasury stock: Nr. 5 shows a decrease of cash of $12,500 because of the purchase of treasury stock.