external financial reporting decisionfinancial statement overview statement of cash flows (1 of 2)...

Welcome toExternal Financial Reporting Decisions

Financial Statement Overview

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Reporting, Planning, Performance, and Control Financial Statement Overview

Financial Statement OverviewKey Learning Objectives

1. Identify the users of the four main financial statements and their needs.

2. Understand the purpose and uses of the statements.3. Identify the major components, classifications, and

limitations of each financial statement, and the relationships among each statement.

4. Identify the basic disclosures related to each financial statement.

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Who are the Users of theFinancial Statements?

• Before we delve into the statements, it is useful to analyze the users of financial statements.

• There are 2 overlapping types of users: 1. Direct and indirect users. 2. Internal and external users.

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Users of Financial Statements

Internal Users External Users

Direct Users Have an economic interest in the business.

Employees and the Board of Directors.

Shareholders, creditors, customers, suppliers.

Indirect UsersAdvise or represent direct users.

N/A External auditors, Financial advisors, regulatory authorities, SEC.

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Income Statement (1 of 2) 1. Prepared 1st. 2. Key items: Revenue, Cost of Goods Sold,

Expenses, Operating Profit/Loss, Net Profit/Loss.• Revenue – Expenses = Net Profit/(Loss). 3. Time frame: Start to end of fiscal period.

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Income Statement (2 of 2) 4. Relationship with other statements: • Profit/loss is needed to prepare the Statement of Change in Stockholders Equity.

5. Also known as: Statement of Income and Expenses; Profit and Loss Statement; P&L.

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Statement of Change in Stockholders Equity (1 of 2)

1. Prepared 2nd.. 2. Key items: Changes in Common Stock

(issuances of new stock and Treasury Stock activity), Preferred Stock, Other Comprehensive Income, and Retained Earnings (increase from income; decrease from losses and dividends).

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Statement of Change in Stockholders Equity (2 of 2)

3. Time frame: Start to end of fiscal period.4. Relationship with other statements:• Ending balances in stockholders equity are

needed to prepare Balance Sheet.5. Also known as: Statement of Change in Equity.

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Balance Sheet (1 of 2)1. Prepared 3rd: 2. Key items: Ending balances in asset, liability and

stockholders equity accounts. Insight into how assets are funded (capital structure). • Accounting Equation: Assets = Liabilities +

Equity. 3. Time frame: Last date of fiscal period.

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Balance Sheet (2 of 2)4. Relationship with other statements:• Ending cash balance is needed to prepare

Statement of Cash Flows.5. Also known as: Statement of Financial Position.

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Statement of Cash Flows (1 of 2)1. Prepared 4th. 2. Key items: Cash inflows (sources) and cash

outflows (uses) by 3 categories: • Operating. • Investing. • Financing.

3. Time frame: Start to end of fiscal period.

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Statement of Cash Flows (1 of 2)4. Relationship with other statements:• Need all statements to be completed. • Differs from cash budget, an operational

analysis of inflows and outflows. 5. Also known as: Statement of Change in Cash

Flows; Cash Flow Statement.

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Financial Statement Footnotes• Footnotes are additional information provided to further explain and amplify the information in the financial statements. • Footnotes are an integral part of the statements.• Help the user better understand the amounts, timing, and uncertainty of the estimates reported.

• Required to comply with US GAAP (Generally Accepted Accounting Principles) and for SEC (Securities and Exchange Commission) reporting.

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Required Financial Statement Footnotes (1 of 2) • Summary of significant accounting policies: • Method to recognize revenue. • Depreciation methods and rates.

• Income statement information: • Significant customers (% total revenue)• Sales per region.

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Required Financial Statement Footnotes (2 of 2) • Balance sheet information:• Marketable securities.• Inventory (Raw, WIP, finished goods). • Income tax provisions.• Future rental and lease payments.• Pension liabilities or assets.• Contingent losses (lawsuits).• Hedging policy.

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Supplemental Schedules • Supplemental schedules often detail disclosures required by audited statements, including information such as: • Overview of specific business lines.• Segmentation of income or other line items by geographical area or customer type.

• Natural resource reserves (oil and gas).

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Management Discussion and Analysis (MD&A)• The Securities Exchange Commission (SEC) requires all public companies to include a “Management Discussion and Analysis” with quarterly (10‐Q) and annual (10‐K) statements.

• Management's perspective on the firm’s financial performance and business condition. • Compares the current and prior periods.• No mention of future prospects.

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MD&A ComponentsThe main components usually include: • Description of the company's business segments.• Review and discussion of revenues and expenses.• Sales and expense trends.• Review of major transactions such as acquisitions and divestitures.• Includes discontinued operations, business units in process of divestment.

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Reporting, Planning, Performance, and ControlFinancial Statement Overview

Financial Statement Overview Wrap Up

You should be able to: • Identify users of financial statements and their needs. • For the four financial statements:

• Demonstrate an understanding of their purpose and use, major components, classifications, limitations and disclosures.

• Demonstrate an understanding of the relationships among the statements.

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Welcome to External Financial Reporting Decisions

Valuation of Accounts Receivable

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Reporting, Planning, Performance, and ControlValuation of Accounts Receivable

Valuation of Accounts Receivable Key Learning Objectives

1. Identify issues related to the valuation of accounts receivables, including timing of recognition estimation of uncollectible amounts.

2. Determine differences between the percent of sales and percent of receivables approaches in calculating the allowance for uncollectible accounts.

3. Distinguish between receivables factoring with‐recourse and without recourse.

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Reporting, Planning, Performance, and Control Valuation of Accounts Receivable

1st Deep Dive into Assets

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Assets Current Assets Non‐Current Assets

Cash InvestmentsMarketable Securities Property, Plant and

Equipment Accounts Receivable Intangible Assets InventoryPrepaid Items


Accounts Receivable (AR)• Accounts receivable are an asset representing amounts owed to a business by its customers.

• Key accrual accounting concept ‐ recording receivables generally coincides with revenue recognition.

• AR is separated into current and non‐current portions: • Current receivables: Expected to be collected within the greater of 1 year or the operating cycle.

• Non‐current receivables: Expected to be collected after 1 year.

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Allowance for Uncollectible Accounts and Bad Debt Expense (1 of 2)

• Allowance for uncollectible accounts is a reserve that values the estimated receivables that will be not collected. • Asset account with a credit balance (“contra asset”).

• Recorded the same period as the associated revenue, following the matching principle.

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Allowance for Uncollectible Accounts and Bad Debt Expense (2 of 2)

• The allowance is established by debiting bad debt expense, an income statement account.

• Journal entry: Debit: Bad debt expense (IS)

Credit: Allowance for uncollectible accounts (BS)• This results in valuing accounts receivable at net

realizable value (gross accounts receivable lessallowance for uncollectible accounts).

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Presentation of Net Realizable Value • On the balance sheet, Accounts receivables are shown at net realizable value. Net realizable AR value = gross accounts receivable less allowance for uncollectible accounts.• Gross accounts receivable is not disclosed. • The allowance for uncollectible accounts and the net realizable value are disclosed.

• Balance Sheet presentation: • Accounts receivable, net of allowance for uncollectible accounts of $50,000 ……… $200,000

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Developing the Allowance for Uncollectible Accounts

Two methods to develop the allowance for uncollectible accounts receivable

1. Percentage of sales method.• “Income statement” approach.

2. Percentage of receivablesmethod.• “Balance sheet” approach.

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Method 1: Percentage of Sales• “Income statement” approach.• Calculates increase to allowance for uncollectible AR as a percentage of the credit sales (sales on account).

• The percentage is based on experience and the budget. • For example, a company with $1,000,000 of credit sales using 1% as their percentage of credit sales basis would make the following entry: Debit: Bad debt expense $10,000

Credit: Allowance for uncollectible AR $10,00028


Method 2: Percentage of Receivables • “Balance sheet” approach.• Estimates the amount that should be in the allowance for uncollectible accounts based on an analysis of the aged accounts receivable.

• Outstanding accounts receivables are analyzed by an ageing schedule, which analyzes the number of days outstanding for each unpaid invoice. • Ageing schedule identifies potential collection issues at the customer level.

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Percentage of Receivables Example (1 of 2) Aging Interval

Accts Rec Balance

Estimated Uncollectible

A/R Allowance

< 30 days $100,000 1% $1,00031‐60 days $40,000 4% $1,60061‐90 days $25,000 5% $1,250>91 days $10,000 20% $2,000Total $175,000 $5,850

Required: What action is needed if the balance in allowance for uncollectible receivables is $4,000?

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Percentage of Receivables Example (2 of 2) • The amount needed in the allowance for uncollectible AR is $5,850.

• Since the balance is $4,000, an entry is necessary to increase the allowance for uncollectible AR and recognize additional bad debt expense.

• Entry needed: Debit: Bad debt expense $1,850

Credit: Allowance for uncollectible AR $1,850

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Review Problem: Percent of Receivables Method• Taber Co. uses the following AR uncollectible estimates:

• 2%: Less than 30 days outstanding.• 5%: 30‐60 days outstanding.• 7%: 60 to 90 days outstanding.• 10%: greater than 90 days outstanding.

• Taber has the following AR aging: Sold in January $70k; Sold in February $90k; Sold in March $100k; Sold in April $120k. Required: What is the April 30 allowance for uncollectable accounts and AR valuation?

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Solution to Review Problem: Percent of Receivables Method (1 of 3)

AgeingInterval

Accts Rec Balance

Estimated Uncollectible

Allowance

< 30 days $120,000 2% $2,40031‐60 days $100,000 5% $5,000

61‐90 days $90,000 7% $6,300

>91 days $70,000 10% $7,000

Total $380,000 $20,700

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• Net realizable value is $359,300. • Gross receivables of $380,000 less allowance for uncollectible AR of $20,700

• Presentation of accounts receivable on the balance sheet: • Accounts receivable, net of allowance for uncollectible accounts of $20,700…$359,300

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• Following up on the previous two slides, if Taber’s allowance for uncollectable accounts balance prior to the analysis was $24,000, what entry is required to reflect the $20,700 allowance needed?

• The allowance of $24,000 is overvalued and needs to be reduced to $20,700. The entry is:

Debit: Allowance for uncollectible AR $3,300.Credit: Bad debt expense $3,300.

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Writing off Uncollectible Accounts Receivable (1 of 2)

• Once a receivable is identified as uncollected, it needs to be written off.

• AR write offs have no effect on the income statement when either the percentage of sales or percentage of receivables methods are used.

• To write off a receivable, the customer records are adjusted, and the allowance for uncollectible AR and the accounts receivable account are both reduced.

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Writing off Uncollectible Accounts Receivable (2 of 2)

• The entry to write off receivables is: Debit: Allowance for uncollectible AR $xxx

Credit: Accounts receivable $xxx• Writing off receivables has no impact on net

realizable value . • $100,000 gross AR with an allowance of $10,000.• Write off $5,000 receivable, still have $90,000 net

realizable value. 37


Factoring of Receivables• Receivables factoring is a financial transaction where a business sells its accounts receivable to a third party (the factor) at a discount. • The factor provides financing via a cash "advance," often 70‐85% of the A/R balance.

• The factor collects the receivables. • The balance is paid, net of factor's fee and interest on the advance, after the receivables are collected.

• Factoring is a form of outsourcing.38


Factoring Disclosures and Risks• Factoring is an “off‐balance sheet” item• Receivables are “sold” to the factor, and are not on the books of the company that made the original sale.

• Full disclosure requires that the factoring is described in the footnotes of the balance sheet.

• There are two types of factoring arrangements: 1. With recourse.2. Without recourse.

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Factoring: With Recourse and Without Recourse• With recourse: The seller of the receivables retains responsibility for the collection of the funds. • The risk of non‐collection loss remains with the seller if the factor can not collect the funds.

• Without recourse: The seller of the receivables is not responsible for the collection of the funds. • The risk of non‐collection loss passes to the factor if they are not able to collect the funds.

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Reporting, Planning, Performance, and Control ng Valuation of Accounts Receivable

Why Factor Receivables?• Speed up cash collections, better cash flow.• Less fixed costs; no need for collection staff.• The factor is more efficient at collecting receivables than the company. • Factors will have critical mass and economies of scale.

• Credit cards are a form of factoring.

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Reporting, Planning, Performance, and ControlValuation of Accounts Receivable

Valuation of Accounts ReceivableWrap Up

You should be able to: • Identify issues related to the valuation of accounts receivables and estimation of uncollectible receivables.

• Determine financial statement effect of the percentage of sales and percentage of receivables methods of calculating the allowance for uncollectible accounts.

• Distinguish between receivables factored on a with recourse and without recourse basis.

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Inventory Valuation Overview

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Reporting, Planning, Performance, and ControlInventory Valuation Overview

Inventory Valuation OverviewKey Learning Objectives

1. Identify issues in inventory valuation including which goods and costs to include.

2. Identify and compare the periodic and perpetual inventory systems.

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Reporting, Planning, Performance, and Control Inventory Valuation Overview

Start of 2ndDeep Dive into Assets

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Reporting, Planning, Performance, and Control ng Inventory Valuation Overview

Inventory Overview• Inventory ‐ tangible property held for sale in ordinary course of business.

• Is a current asset – expected to be sold in less than one year or the normal operating cycle.

• When inventory is sold it becomes “cost of goods sold” on the income statement. • Sales minus cost of goods sold = gross profit.

• Shown at net realizable value; not depreciated. 46


Manufacturing and Retail Inventory• Manufacturing Inventory

1. Raw materials ‐ purchased from vendors to be used in production.

2. Work in process – goods being produced. 3. Finished goods‐ available to be sold to customers.

• Retail Inventory1. Inventory is purchased for resale without

substantial modification.

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Flow of Inventory

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Start Beginning InventoryPlus: Additions

Raw: Purchases.WIP: Transfers from raw, direct labor, overhead.FG: Completed work in process.

Equals Available Less: Transfers or Sales

Raw: Transfers to WIP.WIP: Completed WIP to finished goods.FG: Cost of goods sold.

Equals Ending inventory


Special Category: Inventory in Transit• Ownership is determine when title passes. • “FOB Shipping Point”: Title passes when the seller delivers goods to the freight carrier. • Buyer has title; includes in inventory accounts.

• “FOB Destination”: Title passes when the goods arrive at the specified destination. • Seller has title; includes in inventory accounts.

• Owner normally pays freight; e‐commerce exceptions.

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Special Category: Inventory On Consignment• Consignment in an arrangement between the owner (consignor) and their agent (consignee).

• Goods are transferred to consignee, who makes best efforts to sell. Transportation costs to the consignee are inventory costs, not selling expenses.

• Consignor keeps title and value on financial statements until goods are sold by the consignee. • Consignee does not record inventory on their books. • Goods not sold are returned back to consignor.

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Initial Cost Measurement: Purchased Inventory

• Purchased cost plus costs incurred to get inventory to a location for sale or use.• Includes shipping costs, duties, tariffs, taxes, handling, insurance.

• Outbound freight (costs to ship inventory to customers) is a selling expense. Do notinclude it in inventory.

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Initial Cost Measurement: Manufactured Inventory

3 components: 1. Direct material‐ purchase costs and costs to get

inventory to location. 2. Direct labor –Production to turn direct

materials into finished goods.3. Manufacturing overhead – indirect costs

associated with production.

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Inventory Cost Terminology • Prime costs: • Direct material and direct labor.

• Conversion costs: • Direct labor and manufacturing overhead.

• Direct labor is both a prime and conversion cost• CMA exam questions may present information using these terms.

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Inventory Accounting Systems• There are 2 inventory accounting systems.

1. Periodic Inventory.2. Perpetual Inventory.

• The choice of inventory system impacts the inventory cost flow, which values the movements of inventory (transactions). • Transactions include purchases, issues to work‐in‐process, cost of goods sold.

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Inventory Accounting Systems and Cost Methods• The methods differ in when the inventory is valued and how the movements are costed.

• Periodic system• Inventory is valued at the end of the period.• Inventory transactions are not costed.

• Perpetual system • Inventory is valued throughout the period.• Inventory transactions are costed.

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Periodic Inventory Accounting System• Periodic inventory system ‐ no inventory transactions during the period; inventory is valued at the end of the period. 1. Inventory is counted after period closes. 2. Quantity and cost of items purchased are

tracked during the period3. Back into cost of goods sold.

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Periodic Inventory Valuation

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Start Beginning Inventory• Previous months ending.

Plus: Purchases• Keep track of quantities and costs in a

“purchases” account. Equals Inventory Available Less: Ending inventory

• Counted at the end of the period. Equals Cost of good sold.


Average Cost Methods• Assumes products are indistinguishable. Costs are calculated at the end of the period (periodic) or as new inventory is added (perpetual)

• Periodic basis – costs are the weighted average off all inventory at the start of the period and added during the period

• Perpetual system ‐ Moving average costs are developed as new inventory is added.

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Weighted Average Cost Method• Used with periodic inventory accounting.• The average cost is only calculated at the end of the period.

• The weighted average cost is used to value ending inventory and cost of goods.

Cost of beginning inventory + costs added in periodUnits at beginning of period + units

added in period59


Perpetual Inventory Accounting System • Perpetual system – updates quantities after each transaction on an item by item basis: • Purchase from vendors.• Movements throughout production.• Scrap, damage, etc. • Sale (cost of goods sold).

• Need an integrated system, such as Enterprise Resources Planning (ERP).

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Reporting, Planning, Performance, and ControlInventory Valuation Overview

Inventory Valuation OverviewWrap Up

You should be able to:1. Identify issues in inventory valuation including

which goods and costs to include. 2. Identify and compare the periodic and

perpetual inventory systems.

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Inventory Cost Flows

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Reporting, Planning, Performance, and ControlInventory Cost Flows

Inventory Cost FlowsKey Learning Objectives

1. Identify the advantages and disadvantages of different inventory cost flow methods (specific identification, moving average, FIFO, and LIFO) and calculate their effect on income and assets.

2. Recommend the inventory method and cost flow assumption that should be used given a set of facts.

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Reporting, Planning, Performance, and Control ng Inventory Cost Flows

Perpetual Inventory Cost Flow Methods• There are several methods used with perpetual systems to track the flow of costs as inventory moves (flows) from raw materials to work in process to finished goods to cost of goods sold.

1. Specific identification.2. Moving average cost.3. First‐in, first‐out (FIFO).4. Last‐in, last out (LIFO).

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Specific Identification Method • Requires tracking inventory unit by unit throughout the process (purchase, manufacture, sale).

• Appropriate for items that are not interchangeable and are segregated for specific products or applications.

• Good for automobiles, personal computers, bicycles, pharmaceutical and certain foods. • Batch control – track the source and use of raw materials throughout production.

• Not appropriate for indistinguishable inventory (paint, cereal, milk, etc.)

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Moving Average Method• Requires calculation of a new moving average inventory cost after each purchase or manufacture of inventory.

• The moving average is used for every sale until the next purchase or production run, when a new moving average is developed.

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First‐in, First‐out Method (FIFO)• Assumes that the earliest goods purchased or produced (first in) are the first sold (first out). • Cost of goods sold has the earliest (oldest) purchases and production. • First inventory “in” is the first “out”.

• Ending inventory has the latest (newest) purchases and production.

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FIFO Cost Flow• Govern Co. uses a perpetual inventory system and had the following transactions in June. Using FIFO, what is the June 30 inventory value?

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Date Activity Details 1 Beginning 200 units at $20 each 10 Purchase 160 units at $20 each 18 Sale 180 units 20 Purchase 140 units at $24 each 30 Sale 100 units


FIFO Cost Flow

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Date Activity Units Cost per Balance Value1 Beginning 200 $20 200 $4,00010 Purchase 160 $20 360 $7,20018 Sale 180 $20 180 $3,60020 Purchase 140 $24 320 $6,96030 Sale 100 $20 220 $4,960

Sale on 30th • Oldest 100 units ($20)Ending inventory • 80 units at $20 each = $1,600

• 140 units at $24 each = $3,360


Last‐in, First‐out Method (LIFO)• Assumes the most recent goods purchased or produced (last in) are the first sold (first out). • Cost of goods sold has the latest (newest) purchases and production. • Last inventory “in” is the first inventory “out”.

• Ending inventory has the earliest (oldest)purchases and production.

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Rationale for LIFO • Enacted in the late 1930’s during period of high inflation, rising costs, and poor economic conditions which put pressure on business profits.• Provided relief to corporations by reducing taxable profits, and therefore taxes.

• Use of LIFO is outlined in the US tax code. • When prices are rising, charging the most recent and higher costs to cost of goods sold will result in lower taxable profits and lower taxes.

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LIFO Cost Flow• Govern Co. uses a perpetual inventory system and had the following transactions in June. Using LIFO, what is the June 30 inventory value?

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Date Activity Details 1 Beginning 200 units at $20 each 10 Purchase 160 units at $20 each 18 Sale 180 units 20 Purchase 140 units at $24 each 30 Sale 100 units


LIFO Cost Flow

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Date Activity Units Cost per Balance Value1 Beginning 200 $20 200 $4,00010 Purchase 160 $20 360 $7,20018 Sale 180 $20 180 $3,60020 Purchase 140 $24 320 $6,96030 Sale 100 $24 220 $4,560

Sale on 30th • Newest 100 units ($24)Ending inventory • 180 units at $20 each = $3,600

• 40 units at $24 each = $960


FIFO and LIFO DifferencesDifference between 2 cost flow methods is seen with rising input costs, typically raw materials.

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FIFO LIFO

Cost of goods sold Lower HigherProfit Higher LowerEnding inventory value Higher Lower


Cost Flow Comparison

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FIFO LIFO Units Value Balance Value

Beginning 200 @ $20 $4,000 200 @ $20 $4,000+ Purchases 160 @ $20

140 @ $24 $6,560160 @ $20 140 @ $24 $6,560

= Available 500 $10,560 500 $10,560‐ COGS 280 @$20 $5,600 180 @ $20

100 @ $24$6,000

= Ending 220 $4,960 220 $4,560


Use of LIFO Today• US companies may use LIFO for tax and FIFO or any other method for financial reporting:

• “Best of both worlds”: • Higher book profits, good for investors.• Lower taxable profits, pay less tax.

• LIFO is limited to the US. • LIFO is not allowed with International Financial Reporting Standards (IFRS).

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LIFO and Deferred Taxes • The difference between taxable income and book income is a “deferred tax” account, which is presented on the balance sheet.

• Looking ahead, deferred taxes and differences between US GAAP and IFRS are covered later in Section A.

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Reporting, Planning, Performance, and ControlInventory Cost Flows

Inventory Cost FlowsWrap Up

You should be able to: • Identify the advantages and disadvantages of different inventory cost flow methods (specific identification, moving average, FIFO, and LIFO) and calculate their effect on income and assets.

• Recommend the inventory method and cost flow assumption that should be used given a set of facts.

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Inventory Errors and Write‐Downs

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Reporting, Planning, Performance, and ControlInventory Errors and Write‐Downs

Inventory Errors and Write‐DownsKey Learning Objectives

1. Analyze the impact of inventory errors. 2. Develop an understanding of the lower of cost

or market rule.

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Need for Physical Counts• Necessary to assure accuracy of financial statements.1. Periodic system – counts are required to determine

cost of goods sold and ending inventory balances. • “Wall to wall” physical inventory.

2. Perpetual system – physical counts help to detect errors in the transactions recorded or missing transactions. • Wall to wall physical inventory and/or cycle

counts (counts made daily over a period of time). 81


Inventory Errors • Errors are usually related to transaction timing, missing transactions, or incorrect transactions.

• Errors will have an impact on inventory, working capital, COGS, net income, and equity.

• Inventory errors will self‐correct in the following year as long as: 1. Physical inventory counts are taken and2. Inventory records are adjusted to the counts.

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Correction of Inventory Errors (1 of 2) • Common error 1: Goods are valued “in inventory”, however they are no longer on hand.

• Inventory was sold, damaged, used, etc., but the transaction was not recorded correctly. As a result: • Cost of goods sold is too low (understated).• Inventory and net income are too high (overstated).

• Correction of the error will “remove” the incorrect balance from inventory: • Increase cost of goods sold.• Decrease inventory. 83


Correction of Inventory Errors (2 of 2) • Common error 2: Goods are recorded as “used”, however they are still on hand.

• Inventory was incorrectly recorded as sold, used, damaged, etc. As a result: • Cost of goods sold is too high (overstated).• Inventory and net income are too low (understated).

• Correction of the error will “add” balance on hand to the inventory records. • Decrease cost of goods sold.• Increase inventory. 84


Lower of Cost or Market• Regardless of the costing system, year end inventory needs to be valued at the lower of cost or market. • Cost: Cost based on initial valuation, called the “historical cost”: • Purchase cost ‐ inbound freight, taxes, duties, etc. • Manufactured costs – material, labor, overhead.

• Market: Current cost to acquire inventory in the open market or produce internally. • The replacement cost as of the valuation date.

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Lower of Cost or Market Test 1. If market is higher than the cost, no adjustment is

allowed. 2. If the market is lower than the cost, the inventory is

written down to the market. • The market becomes the cost going forward. • Once written down, inventory costs can not be increased, even if the market is higher in subsequent periods.

• Remember, the rule is the lower of cost or market.86


Inventory Errors and Write‐DownsWrap Up

You should be able to: • Analyze the impact of inventory errors. • Develop an understanding of the lower of cost or market rule.

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Security Classifications

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Security ClassificationsKey Learning Objectives

1. Demonstrate an understanding of the characteristics of debt and equity securities.

2. Demonstrate an understanding of the 3 types of security classifications: Held‐to‐maturity, trading, and available‐for‐sale.

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Reporting, Planning, Performance, and Control Security Classifications

3rd Deep Dive into Assets

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Reporting, Planning, Performance, and Control ng Security Classifications

Why Do Firms Own Other Firms Stocks or Bonds? • Short‐term – have cash in excess of short term needs and seek to generate a higher return than other options. • Passive investment, usually marketable securities.

• Long‐term –investment will earn a greater return than investing in the business. • Can be an active investment.

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Debt and Equity Securities• Debt security: Represents a creditor relationship with the issuer. • Typically bonds, which pay interest based on “coupon rate”.

• Equity security: Represents an ownership interest or the right to acquire ownership. • Typically common and preferred stocks.

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Classification of Debt and Equity Securities (1 of 2)

• The classification of debt and equity securities is determined at acquisition, based on the likely holding period and the intended use.

• Intend to hold less than 1 year? Current marketable security, typically equity. • “Trading” security. • “Available for sale” security.

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Classification of Debt and Equity Securities (2 of 2)

• Intend to hold greater than 1 year? If yes, it is a non‐current investment. Can be debt or equity.

• Debt – Held‐to‐maturity. • Equity: • Available‐for‐sale security. • Investment. • Subsidiary.

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Interest and DividendsRegardless of the security classification, interest and dividends are always recorded on the income statement in the period they are received.• Interest – from debt securities (bonds).• Dividends – from equity securities.

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Reporting, Planning, Performance, and ControlSecurity Classifications

Realized Gains and Losses• Realized gains and losses are recognized ("realized") when a security is sold.

• The gain or loss is the difference between the value received from the sale and value on the books.

• Realized gains and losses are always recorded on the income statement.

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Unrealized Gains and Losses (1 of 2)• Unrealized gains and loses occur when a security’s market price differs from the purchase price and the security has not been sold.

• Trading securities and available for sale securities are re‐valued at “fair market value” each period.

• The asset values are increased (gains) or decreased (losses). What is the other side of the re‐valuation entry?

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Unrealized Gains and Losses (2 of 2) Treatment of unrealized gains and losses: • Trading security unrealized gains and losses are recorded in the income statement.

• Available for sale securities unrealized gains and losses are recorded in other comprehensive income (equity section of balance sheet).

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Debt Securities and Equity Securities• The next group of slides covers 3 categories of debt and equity securities.

• Debt Securities1. Held‐to‐maturity securities.

• Equity Securities (less than 20% ownership). 2. Trading securities.3. Available‐for‐sale securities.

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Category 1: Held‐to‐Maturity Securities • Debt securities (Bonds). • Holder has the intent and ability to hold security until

maturity date.• Balance sheet presentation: Acquisition cost, net of

discount or premium amortization, if any. • Income statement presentation:

• Realized gains and losses, interest income, and discount/premium amortization are included.

• Unrealized gains and losses are ignored. 100


Category 2: Trading Securities • Securities bought with the intention of a short‐term

sale (typically equity).• Plan is to hold for less than one year.

• Balance sheet presentation: Each holding is initially valued at cost, re‐measured to fair value every period, creating an unrealized gain or loss.

• Income statement presentation: Realized and unrealized gains are included in earnings, along with dividends and interest.

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Category 3: Available‐for‐Sale Securities• Securities not classified as held‐to‐maturity or trading;

typically equity. • Balance sheet presentation: Each holding is initially

valued at cost, re‐measured to fair value every period. • Unrealized holding gains and losses from fair value re‐

measurement are reported in other comprehensive income (OCI), a section of stockholders equity

• Income statement presentation: Realized gains and losses, dividends, and interest are included in earnings.

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Security ClassificationsWrap Up

You should be able to: • Demonstrate an understanding of the characteristics of debt and equity securities.

• Demonstrate and understanding of the 3 types of security classifications: Held‐to‐maturity, trading, and available‐for‐sale.

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Equity Investments

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Reporting, Planning, Performance, and ControlEquity Investments

Equity Investments Key Learning Objective

1. Demonstrate an understanding of the fair‐value, equity, and consolidated methods to account for equity investments.

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4th Deep Dive into Assets

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Cash Securities andInvestments

Marketable Securities Property, Plant and Equipment

Accounts Receivable Intangible Assets Inventory


Accounting Methods for Equity Investments• 3 methods to account for equity investments:

1. Fair value method 2. Equity method 3. Consolidated method

• The method is determined by the ownership percentage. It is presumed that ownership determines the amount of influence the owner has over the investment (“investee”).

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Method Used Depends on Ownership % (1 of 2)• Less than 20% ownership: • Use fair value method. • Trading (current) and available for sale (non‐

current) classifications. • No influence.

• 20%‐50% ownership: • Use the equity method.• Significant influence of the “investee”.

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Method Used Depends on Ownership % (2 of 2)• Greater than 50% ownership: • Use the consolidated method.• Control the investment. • Considered a subsidiary, not a security.

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Equity Valuation #1: Fair Value Method• Under US GAAP significant influence can not exist until

investors own 20% or greater of the voting shares. • Less than 20% ownership ‐ revaluation to fair value. • Treatment of unrealized gains and losses:• Trading securities: Revaluation changes are gains

and losses on the income statement. • Available‐for‐sale securities: Revaluation changes

are recorded in other comprehensive income on the balance sheet.

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Equity Valuation #2: Equity Method • Used for ownership between 20% and 50% of the

voting shares, which is considered “significant influence”.

• Shown on balance sheet as an equity investment and not a security. • Book the applicable portion of the investee’s income

or loss on income statement and update the asset book value accordingly.

• Dividends are a “return of capital” and subtractedfrom the book value of the investment.

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Equity Valuation #2: Equity MethodJournal Entries (1 of 2)

• Scenario:• Company K has a 30% interest in Company T. • Company T is an “investee” of Company K. • At the end of the year: • Company T reported total net income of

$500k• Company T declared a total $100k dividend

to all shareholders. 112


Equity Valuation #2: Equity MethodJournal Entries (2 of 2)

• Journal entries: • Debit: Investment in T: $150k (30% of $500k)

• Credit: Earnings of subsidiary T: $150k • Debit: Cash $30k (30% share of total

dividend). • Credit: Investment in T: $30k (30% share

of total dividend). • “Earnings of subsidiary T” is an income

statement account. 113


Equity Valuation #3: Consolidated Method (1 of 5)

• A company has a controlling interest in a company if they own greater than 50% of its voting shares. • US GAAP only; not IFRS.

• Consolidated method is used for ownership of greater than 50% of the voting shares.

• Greater than 50% ‐ parent/subsidiary relationship. • Parent (investor), subsidiary (investee).

• Companies fully consolidate their subsidiaries at 100%. 114



• All of the subsidiary’s assets and liabilities are on the parent’s balance sheet.

• All of the subsidiary’s revenue, expenses, gains and losses are on the parent’s income statement.

• Minority Interest –account that tracks the value of the non‐controlling interest in the subsidiary. • Own 70%; other 30% is minority interest.• Minority interest is equity or liability under US GAAP.

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• When the subsidiary net income is consolidated on the parent company books, it is apportioned between the controlling parent and the non‐controllingminority interest. For example:

1. Company X has a 75% percent stake in Company Y. • X is the parent; Y is the subsidiary (investee).

2. Company Y has $1 million net income, so the full $1 million is consolidated on Company X’s books since they own greater than 50% of Y.

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3. However Company X can only include $750,000 (75% of $1 million) as income and increase assets by $750,000 since it only owns 75% of Y.

4. The remaining $250,000 (25% of $1 million) would be reported on X’s books as the subsidiary's "minority interest" or "non‐controlling interest.“• The minority interest is either an equity or liability account.

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• Journal entry: • Debit: Investment in Y ‐ $1,000,000.• Credit: Minority interest in Y ‐ $250,000. • Credit: Net income from Y ‐ $750,000 *

• * X’s 75% share of Y’s net income ($750,000) is shown on X’s income statement.

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Equity Investments Wrap Up

You should be able to: • Demonstrate an understanding of the fair‐value, equity, and consolidated methods to account for equity investments.

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Depreciation Methods

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Reporting, Planning, Performance, and ControlDepreciation Methods

Depreciation Methods Key Learning Objectives

1. Determine the effect on the financial statements of using the straight‐line, declining balance, sum of years digits, and units of output depreciation methods.

2. Recommend a depreciation method for a given set of data.

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Reporting, Planning, Performance, and Control Depreciation Methods

Property, Plant and Equipment (PPE) (1 of 2) • Tangible property that will provide benefits for

multiple years. Non‐current, fixed assets. • Initial measurement: Purchased or manufactured

cost, includes costs necessary to bring the asset to the location and condition for intended use.

• Carrying value: • Initial measurement (acquisition cost).• Less: Accumulated depreciation (if any). • Less: Impairment losses (if any).

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Property, Plant and Equipment (PPE) (2 of 2) • Depreciation – process of systematically and rationally

charging the income statement with the benefit a fixed asset provided during the period.

Debit: Depreciation expense $xxxCredit: Accumulated depreciation $xxx

• Depreciation is an expense.• Accumulated depreciation is an asset (“contra‐asset”).• PPE is generally depreciated. Land is “property”,

however it is not depreciated.123


Depreciation Relies on Estimates There are 2 estimates used to determine

depreciation expense: 1. Estimated life – time period the asset will

provide a benefit. 2. Estimated salvage value – estimated amount

the firm will receive when the asset is disposed of.

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Key Depreciation Terms1. Depreciable Base: Amount to be depreciated.

Initial measurement (historical cost)Less: estimated salvage value= Depreciable base

2. Salvage value. 3. Estimated useful life. 4. Deprecation method ‐ basis for depreciation

expense. 125


Depreciation Methods• The method should allocate the depreciable base to

the income statement as equitably as possible over the useful life, reflecting the usage pattern that reflects how the economic benefits will be received.

• 3 time based depreciation methods: 1. Straight line2. Declining balance3. Sum of years digits

• 1 usage depreciation method: Units of output126


Time Based Method 1: Straight Line• An equal amount of depreciation is charged each period of the asset’s useful life.

• Uses salvage value. Straight line depreciation expense =

Depreciable base/estimated life• Used for assets with no decrease in benefit over the asset life. E.g. buildings.

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Straight Line Example• Purchase price ‐ $800,000• Plus: Freight and start up costs ‐ $100,000• Less: Salvage value ‐ $100,000• = Depreciable base of $800,000.• If estimated useful life is 8 years, the annual depreciation expense is $100,000.

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Recurring Depreciation Example• We will use a recurring example to illustrate the 3 time based depreciation methods • Purchase price = $400,000.• Freight and start‐up costs ‐ $20,000.• Estimated salvage ‐ $20,000. • Estimated life – 4 years.• For each method ‐ what is the depreciable base and the depreciation rate?

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Recurring Example: Straight Line

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• $420,000 historical cost less $20,000 salvage= $400,000 depreciable base.

• 4 year life; straight line rate = 25%$000 Year 1 Year 2 Year 3 Year 4

Depreciable base $400 $400 $400 $400Rate 25% 25% 25% 25%Depreciation $ $100 $100 $100 $100Beg carrying value $420 $320 $220 $120End carrying value $320 $220 $120 $20


Time Based Method 2: Declining Balance (1 of 2) • Accelerated, time based method. • Ignores salvage value.• Rate is based on a percentage of the straight line rate (double, 150%, etc.)

• Rate is constant, applied to a declining carrying value; expense decreases every year.

• Used for assets that are more productive early in their life.

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Time Based Method 2: Declining Balance (2 of 4) Declining balance depreciation expense =

Carrying value x depreciation rate • Example: • Straight line 10 year life = 10% per year.• Double declining balance method for ten years is “double” 10% rate = 20% rate per year.

• Depreciation is 20% of the carrying value each year until the asset is completely depreciated.

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Recurring Example: Double Declining Balance

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• $420,000 historical cost less $0 salvage= $420,000 starting depreciable base. Double straight line = 50%

$000 Year 1 Year 2 Year 3 Year 4Depreciable base $420 $210 $105 $52.5Rate 50% 50% 50% 50%Depreciation $ $210 $105 $52.5 $26.25Beg carrying value $420 $210 $105 $52.5End carrying value $210 $105 $52.5 $26.5


Recurring Example: 150% Declining Balance

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• $420,000 historical cost less $0 salvage= $420,000 starting depreciable base. 150% straight line = 37.5%

$000 Year 1 Year 2 Year 3 Year 4Depreciable base $420 $262 $164.1 $102.5Rate 37.5% 37.5% 37.5% 37.5%Depreciation $ $157.5 $98.4 $61.5 $38.5Beg carrying value $420 $262.5 $164.1 $102.5End carrying value $262.5 $164.1 $102.5 $64.1


Time Based Method 3: Sum of Years Digits (1 of 2)• Accelerated time based depreciation method.• Uses salvage value. • Multiplies the depreciable base by a declining percentage, resulting in higher depreciationearly in the assets life.

• Appropriate for assets that will decline in productivity over their useful life.

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Time Based Method 3: Sum of Years Digits (2 of 2)Sum of years depreciation expense =

Depreciable base x (year of asset life / sum of years of useful life)

• An asset with 5 years of estimated useful life: • Sum of all years of life: 5+4+3+2+1 = 15.• Year 1: 5/15 = 33%; year 2: 4/15 = 27%; year 3: 3/15 = 20%; year 4: 2/15 = 13%; year 5: 1/15 = 7%.

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Recurring Example: Sum of Years Digits

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• $420,000 asset with a 5 year life and $20,000 Salvage• Rate depends on year.

$000 Year 1 Year 2 Year 3 Year 4Depreciable base $400 $400 $400 $400Rate 40% 30% 20% 10%Depreciation $ $160 $120 $80 $40Beg carrying value $420 $260 $140 $60End carrying value $260 $140 $60 $20


Comparison of Time Based Depreciation MethodsAcquisition cost of $900,000; salvage of $50,000; 5 year

useful life. What is the year 2 depreciation?

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Method Depreciation CalculationSL $170,000 $850,000 / 5 years = $170,000DDB $216,000 Year 1: $900,000 x 40% =

$360,000; Year 2: $540,000 x 40% = $216,000

SYD $229,500 Year 2 is 4/15. 4/15 = .27 x $850,000 = $229,500


Usage Method: Units of Output• Depreciation is the annual usage as a percentage of asset’s total capacity.

• Uses salvage value Depreciation per unit of usage = Depreciable base

/ total estimated lifetime usage.

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Units of Output Example• Depreciable base = $800,000.• Total estimated units of output = 4,000 hours• Depreciation per hour = $200 ($800,000/4,000)

• If 100 hours are used in a period, the depreciation is $20,000. ($200/hour x 100 hours).

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Depreciation Method Summary

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Method Salvage in depreciation

base?

Depreciationends at

Straight line Yes Salvage value

Declining balance No Zero value

Sum of years digits Yes Salvage value

Units of output Yes Salvage value


Tax Depreciation The US government allows accelerated depreciation to be used for tax purposes for new investments. Accelerated depreciation: • Stimulates capital spending. • Reduces corporate tax income, which in turn reduces taxes.

• MACRS – modified accelerated cost recovery system; part of tax reform act of 1986.

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Reporting, Planning, Performance, and ControlDepreciation Methods

Depreciation Methods Wrap Up

You should be able to: • Recommend a depreciation method for a given set of data.

• Determine the effect on the financial statements of using different depreciation methods.

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Impairment of Long‐Term Assets

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Impairment of Long‐Term AssetsKey Learning Objectives

1. Demonstrate an understanding of how to account for the impairment of long‐term tangible assets.

2. Demonstrate an understanding of the accounting for the impairment of intangible assets, including goodwill.

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Reporting, Planning, Performance, and Control Impairment of Long‐Term Assets

Tangible Long‐Term Assets • Physical assets such as vehicles, equipment, machinery, buildings, etc.

• Provide long‐term value; use is expensed over time via depreciation. • Land is not depreciated.

• Asset is impaired if the expected future benefit is less than the value. • For example, obsolete equipment.

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Intangible Long‐Term Assets • Non‐physical assets. • Includes patents, trademarks, franchises, copyrights, Internet domain names, licensing agreements, service contracts, blueprints, trade secrets, permits, manuscripts, and goodwill.

• If they have a finite life, intangible assets are amortized over their life. • Goodwill is not amortized; can be impaired.

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Testing Long‐Term Asset For Impairment • All long‐term assets should be tested for impairment of the carrying value (book value), in particular when events or changes in business circumstances indicate that the asset value may not be fully recoverable.

• All assets except for goodwill use the same impairment test.

• Goodwill has its own impairment test.148


Long‐Term Asset Impairment (1 of 3)4 steps: Steps 1 and 2 are a “recoverability test”: 1. Determine the asset fair value by calculating

the undiscounted cash flows from the asset’s use and eventual disposition.

2. The carrying value of the asset is impaired if it exceeds the asset fair value.

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Long‐Term Asset Impairment (2 of 3)3. Write down: If the asset is impaired, it needs to

be written down to the fair value. Debit: Impairment loss (income statement).

Credit: Accumulated depreciation or amortization (balance sheet).

• This entry recognizes the decline in asset value versus the carrying value, and resets the new carrying value.

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Long‐Term Asset Impairment (3 of 3)4. After impairment write‐down: • Future depreciation or amortization needs to be adjusted to reflect the new carrying value.

• Once recognized, impairment losses are not reversed if the fair value later increases.

• Same concept as “lower of cost or market”, once written down, carrying values are not written up in subsequent periods.

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Goodwill (1 of 2)• Business combination ‐ acquisitions of companies, business units, etc..

• Goodwill can only come from an acquisition of a “cash generating unit” with identifiable revenue.

• Goodwill is the excess of the “consideration” (assets exchanged) for a business acquisition over the fair market value of the individual net assets acquired.

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Goodwill (2 of 2) • Net assets = assets – liabilities. • The underlying premise is the net assets as a whole provide value in excess of the value of the individual assets.

• Goodwill: “Asset representing future economic benefits arising from net assets acquired in a business combination that are not individually identified and separately recognized”

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Initial Measurement of Goodwill (1 of 2)• Goodwill results when the purchase price is higher than the fair values of the identifiable assets and liabilities acquired.

• Example: A business with $700 million of assets was acquired for $900 million cash and assumption of $100 million of debt. • Pay $900 million for $600 million net assets = $300 million of goodwill.

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Initial Measurement of Goodwill (2 of 2)• Journal entry: • Debit: Assets $700 million• Debit: Goodwill $300 million

• Credit: Cash $900 million• Credit: Liabilities $100 million

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Goodwill Impairment (1 of 2) • Unlike other long‐term assets, goodwill is not depreciated or amortized.

• On a periodic basis, the book value of goodwill is reviewed for impairment. • Basically a determination if the benefit from the acquisition is still being realized.

• If the benefit from the acquisition is not being realized, the goodwill should be written down.

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Goodwill Impairment (2 of 2)• Goodwill impairment is a recognition of a decline in value of the goodwill on the books.

• US GAAP and IFRS have different methods to account for goodwill impairment.• US GAAP – 2 step method.• IFRS – 1 step method. This is covered in module “US GAAP and IFRS differences”.

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US GAAP Goodwill Impairment Test (1 of 4)US GAAP requires a two‐step method, which In essence is lower of cost or market. • Step 1: Determine the business fair value and compare it to the business carrying value (book value), including goodwill.

• The fair value is the business market value, which may not be available. In this case, a model is developed to estimate the fair value.

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US GAAP Goodwill Impairment Test (2 of 4)• Step 1 continued: • If the business fair value exceeds the business carrying value, there is no impairment and no further testing is needed.

• If the business fair value is less than the carrying value, go to step 2 to determine the amount of goodwill impairment.

159


US GAAP Goodwill Impairment Test (3 of 4)• Step 2: Compare the business fair value to the fair value of the identifiable assets and liabilities. • The difference is the new goodwill, the “implied fair value”.

• “Implied fair value” of goodwill is essentially the same concept that was used to determine the initial goodwill value.

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US GAAP Goodwill Impairment Test (4 of 4)• Goodwill impairment is the excess of the carrying value of the goodwill versus the implied fair value of the goodwill.

• If the carrying value is greater than the implied fair value, the goodwill is impaired, and should be written down to the amount of the fair value.

161

Reporting, Planning, Performance, and ControlImpairment of Long‐Term Assets

162

Goodwill Impairment Example ($000) (1 of 3)• A business unit has $900 of assets, including goodwill of $300 and liabilities of $125.

• The fair value of the unit is $700 and the fair value of the assets and liabilities is $650 (net)

• Step 1: • The business carrying value is $775 ($900 assets ‐ $125 liabilities). It is more than the $700 business fair value. Proceed to step 2.


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Goodwill Impairment Example ($000) (2 of 3)• Step 2:• The business fair value is $700, the fair value of the assets and liabilities is $650, so the implied goodwill fair value is $50.

• The $50 implied fair value is than the $300 goodwill carrying value, resulting in a $250 goodwill impairment. Goodwill needs to be written down to $50, the implied fair value.


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Goodwill Impairment Example ($000) (3 of 3)• Journal entry: • Debit: Goodwill impairment $250

• Credit: Goodwill $250 • This results in a $250 charge to the income statement.


Changes to US GAAP Goodwill Impairment • Effective for years ending after Dec 2019, the 2‐step method is changed to 1‐step.

• The goodwill impairment test will compare the fair value of a reporting unit with its carrying amount.

• Impairment will be the amount the carrying amount exceeds the reporting unit’s fair value.

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HP Goodwill Impairment• Hewlett‐Packard (NYSE:HPQ): In 2012 wrote off $8.8 billion related to acquisition of Autonomy. • Autonomy was acquired in 2011 for $10.2 billion, a 58% premium over Autonomy's share price

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Microsoft Goodwill Write Off • In 2007 Microsoft acquired digital marketing company aQuantive for $6.3 billion in cash to accelerate the growth of Microsoft's online advertising business.• At the time aQuantitve was the Microsoft’s largest acquisition.

• In 2013 Microsoft announced it took a $6.2 billion write‐down on the aQuantive acquisition.

• In a press release announcing the write down, Microsoft stated that “the acquisition did not accelerate growth to the degree anticipated.”

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Impairment of Long‐Term AssetsWrap up

You should be able to: • Demonstrate an understanding of how to account for the impairment of long‐term tangible assets.

• Demonstrate an understanding of the accounting for the impairment of intangible assets, including goodwill.

168


Special Topics: Valuation of Liabilities

169

Reporting, Planning, Performance, and ControlSpecial Topics: Valuation of Liabilities

Special Topics: Valuation of Liabilities Key Learning Objectives

1. Identify classification issues related to short‐term debt that is expected to be refinanced.

2. Develop an understanding of the expense warranty and sales warranty approaches to accounting for warranties.

3. Define off‐balance sheet financing.

170

Liability Valuation TopicsThis module addresses three unrelated special topics in liability valuation. 1. Classification of short‐term debt that is

expected to be refinanced for the long‐term. 2. Accounting for warranty and extended

warranty.3. Off‐balance sheet financing.

171


Liability Valuation #1: Refinancing Short‐Term Debt • Long‐term debt is expected to be paid back in a period greater than 1 year. • For example, a 30 year bond.

• The last year of long‐term debt is classified as short term debt since the debt is expected to be repaid in the next 12 months.

• However, this drastically changes financial ratios.• Current ratio = current assets/current liabilities.

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Refinancing Short‐Term Debt • Short‐term obligations expected to be refinanced on a long‐term basis can be excluded from current liabilities if the both of the following exist: 1. The company intends to refinance the debt on

a long‐term basis AND2. The company has reasonably demonstrated

the ability to accomplish the refinancing• Reference FASB Statement No. 6

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Refinancing Short‐Term Debt Example• 30 year $10 million bond was issued in December 1995; matures in December 2025. • The bond is long‐term debt for 29 years, and becomes a current liability in 2024.

• However, it can be still be classified as long‐term debt as long as the company intends to refinance the bond on a long‐term basis and has the ability to do so.

• The long‐term classification is appropriate even if the refinancing has not taken place.

174


Liability Valuation #2: Warranties (1 of 2) • Warranty: Express guarantee of the integrity of a product or service that requires seller to repair/replace product, refund all or part of price, or provide additional service. • There is a time frame for the when the warranty is in force – 30 days, 60 days, etc.

• Included as part of the sale of the good or service; inseparable from sale.

175


Liability Valuation #2: Warranties (2 of 2) • Separable warranty: A warranty for an extended period beyond the warranty period attached to the sale of the good or service.

• These are extended warranties, where the seller provides additional warranty beyond the normal warranty period for a fee.

• The amounts paid for extended warranties are deferred revenue that is earned over the extended warranty period.

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Inseparable Warranty Accounting When the warranty is part of the good or service sold (inseparable), there are 2 accounting methods to recognize the warranty expense. 1. Actual warranty claims (cash basis). 2. Expense warranty approach (accrual).

177


Inseparable Warranty Method 1: Cash Basis• A reserve (liability) is not established for future warranty costs arising from current sales.

• The cash basis for warranties must be used when:1. It is not probable that a liability has been incurred

or2. The amount of the liability cannot be reasonably

estimated. • Under the cash‐basis method, warranty costs are charged to expense as they are incurred.

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Inseparable Warranty Method 2:Expense Warranty Approach (1 of 2)

• Used when the warranty is an integral and inseparable part of the sale, and: 1. Incurrence is probable 2. The amount can be reasonably estimated

• A reserve or allowance for warranty (liability account) for future warranty costs is established at the time of the sale.

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Inseparable Warranty Method 2:Expense Warranty Approach (2 of 2)

Journal entry: Debit: Warranty expense $10,000

Credit: Reserve for warranty $10,000 • When the warranty costs are paid in later periods, the liability is reduced by the expenditure, with no income statement impact.

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Extended Warranty: Sales Warranty Method

• Extended warranties are sold separately, and cover periods beyond the warranty period that is included with the sale.

• Extended warranty has one method ‐ Sales warranty method (accrual).

• Defers a percentage of the revenue from the extended warranty until actual costs are incurred or the warranty period expires.

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Extended Warranty: Sales Warranty Method Example (1 of 2)

• 3 year, $21,000 extended warranty• Revenue is deferred and recognized over the 3 year warranty period $7,00 per year.

• Deferred revenue is a liability. • Entry when sold:

Debit: Cash $21,000 Credit: Deferred Revenue $21,000

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Extended Warranty: Sales Warranty Method Example (2 of 2)

• Entries for years 1‐3 Debit: Deferred Revenue $7,000

Credit: Revenue $7,000• At the end of the third year, all revenue has been taken and there is no remaining obligation (liability) to provide additional services.

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Liability Valuation #3:Off‐Balance Sheet Financing

• Financing arrangement where expenditures and/or obligations are not on the company's balance sheet. Common forms are:1. Operating leases. 2. Sale of receivables to a factor. 3. Special purpose entities (SPE’s).4. Joint ventures.

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Special Topics: Valuation of Liabilities Wrap Up (1 of 2)

You should be able to: • Identify classification issues related to short‐term debt that is expected to be refinanced to a long‐term basis.

• Demonstrate an understanding of the expense warranty and sales warranty approaches to accounting for warranties.

185


Special Topics: Valuation of Liabilities Wrap Up (2 of 2)

You should be able to (continued): • Define off‐balance sheet financing.

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Welcome to External Reporting Decisions

Income Taxes on the Balance Sheet

187

Reporting, Planning, Performance, and ControlIncome Taxes on the Balance Sheet

Income Taxes on the Balance SheetKey Learning Objectives

1. Demonstrate an understanding of interperiod tax allocation and deferred taxes.

2. Define and analyze temporary differences.3. Distinguish between deferred tax assets and deferred

tax liabilities. 4. Distinguish between temporary and permanent

differences. 5. Define operating loss carrybacks and carryforwards.

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Interperiod Tax Allocation• Arise from temporary differences between financial reporting and tax reporting.• Financial reporting – used for external reporting. •Mandated by an accounting framework such as US GAAP or IFRS.

• Tax reporting – used for tax return. • Based on existing tax laws.

189


Temporary DifferencesFour types of transactions can cause a temporary difference between financial and tax reporting: Taxable income:1. Delayed recognition2. Accelerated recognitionTaxable expenses:3. Delayed recognition.4. Accelerated recognition.

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Temporary Differences Are Timing Related • Timing between financial reporting and tax returns. • Over time, the financial reporting and tax returns will be in synch as the taxes are filed and tax audits completed.

• Examples of temporary differences include: • Different inventory costing methods – LIFO for tax return, other methods (e.g. FIFO) for financial statements.

• Different depreciation methods –accelerated method for tax returns; slower for financial reporting.

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Accelerated Recognition of Depreciation Expense• The IRS (US tax authority) may allow accelerated depreciation for new investments, while US GAAP does not.

• The resulting difference is temporary as the asset will eventually be fully depreciated for both tax and accounting purposes.

• During periods when there are temporary differences, there is interperiod tax allocation.

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Deferred TaxesDeferred taxes are the differences between income tax expense and income tax payable. • Income tax expense = financial reporting income * tax rate.

• Income tax payable = tax return income * tax rate.

• Deferred tax asset or liability = income tax expense ‐ income tax payable.

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Deferred Tax Assets• Deferred tax assets – Temporary differences resulting in future deductible amounts. For example:

1. Revenues or gains are included in taxable income before they are recognized in GAAP.• “Unearned revenue”, but cash was collected.

2. Expenses or losses recognized under GAAP before they are deductible for tax purposes.

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Deferred Tax Liabilities • Deferred tax liabilities – Temporary differences resulting in future taxable amounts. For example.

1. Revenues or gains recognized in GAAP before they are included in taxable income.

2. Expenses or losses deductible for tax purposes before financial reporting (GAAP).• Accelerated depreciation and LIFO for taxes.

195


Permanent Income Tax Differences• The event is recognized either in:

1. Pretax financial income (GAAP). Or

2. Taxable income.• But not both!

• Do not result in a deferred tax amount.

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Permanent Differences Examples • Permanent differences – have tax return or financial statement impact, but not both. For example: • Tax fines and penalties are financial reporting statement expenses but are not taxable deductions.

• Tax free municipal interest is income for financial reporting but is not taxed. Municipalities often have ability to issue “tax‐free” bonds.

• Business meals and entertainment – currently only 50% is deducible for tax purposes.

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Tax Expenses and Benefits• Current tax expense/benefit – amount of taxes payable based on the existing tax laws and taxable income for the year.

• Deferred tax expense/benefit – net change in a year of the entity’s deferred tax amounts.

• Income tax expense/benefit – sum of: • Current tax expense/benefit.• Deferred tax expense/benefit.

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Operating Loss Carrybacks/Carryforwards (1 of 2)• Entities with net operating losses (NOL’s) have 2 mutually exclusive options:1. Carry loss forward 20 years or 2. Carry loss back 2 years and forward 20 years.

• Option 1: Carry loss forward ‐ results in a deferred tax asset that will reduce taxable income in future periods. • Reduces the amount of future income tax payable only, does not effect future income tax expense.

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Operating Loss Carrybacks/Carryforwards (2 of 2)• Option 2: Loss carry back and carry forward – entity files an amended return for up to the second prior year, offsetting prior tax expense. Entry required:

Debit: Tax refund receivable $10,000Credit: Income tax benefit from loss carryback

$10,000• Any amount not used in the two prior years can be carried forward for up to 20 years.

200


Income Taxes on theBalance SheetWrap up (1 of 2)

You should be able to: • Demonstrate an understanding of interperiod tax allocation and deferred taxes.

• Define and analyze temporary differences.• Distinguish between deferred tax assets and deferred tax liabilities, and temporary and permanent differences.

201


Income Taxes on theBalance SheetWrap up (2 of 2)

You should be able to (continued): • Define operating loss carrybacks and carryforwards.

202



Accounting for Leases

203

Reporting, Planning, Performance, and ControlAccounting for Leases

Accounting for Leases Key Learning Objectives

1. Identify the differences between capital and operating leases, and explain the accounting for each.

2. Explain why operating leases are a form of off‐balance sheet financing.

3. Understand lessee preference for capital leases versus operating leases.

4. Recognize the correct financial statement presentation for capital and operating leases.

204

Capital Leases vs. Operating Leases• Basic difference between these is what happens to the asset at the end of the lease.

• Two key questions that determine lease type: 1. Will the asset revert back to the owner

(lessor) at the end of the lease term? 2. Does the user of the asset (lessee) have an

identified path to acquire the asset? • There is different accounting for each lease type.

205

Reporting, Planning, Performance, and Control Accounting for Leases

Capital Leases• In essence are a long‐term purchase agreement. • On balance sheet as an asset and liability.

• Must have 1 of the following 4 items: 1. Lease life exceeds 75% of the asset life. 2. Transfer of ownership at the end of lease. 3. Bargain price purchase option. 4. Present value of lease payments exceeds 90%

of asset fair market value. 206


Accounting for Capital Leases (1 of 3)• At the inception of a lease, the lessee (user) recognizes a leased asset and a leased liability (obligation to paid).

• Values for both the asset and liability is the present value of the minimum lease payments.

Debit: Leased equipment $100,000Credit: Lease obligation $100,000

207


Accounting for Capital Leases (2 of 3)The leased asset is a fixed asset, and should be depreciated.

Debit: Depreciation expense – leased equipment $xxx

Credit: accumulated depreciation ‐leased equipment $xxx

208


Accounting for Capital Leases (3 of 3)• Each lease payment has 2 components:

1. Interest expense (calculated using the effective interest method).

2. Reduction of lease liability. • Entry to record lease payment

Debit: Interest expense $500Debit: Lease obligation $9,500

Credit: Cash/payable $10,000

209


Operating Leases• Long‐term rental agreement between the lessee (user) and the lessor (owner). • Lessee has the obligation to make payments. • Lessor has the benefits and risks of ownership.

• Obligation to make future payments is not on the lessee’s balance sheet.• Off‐balance sheet item.

210


Operating Leases• For example, a signed contract (legal obligation) for a 10 year lease is not on the books as a liability.

• Instead, rent expense is recorded as incurred every period.

Debit: Rent expense $xxxCredit: Cash/Accounts payable $xxx

211


Operating Lease Disclosures• Because the total obligation is not recorded on the balance sheet, operating leases are a form of “off‐balance sheet“ financing.

• Operating leases are required to be disclosed in financial statement footnotes, however limited disclosure prevents extensive evaluation by external users of the financial statements. • Total lease payments are aggregated by year.

212


Future Accounting for Operating Leases (1 of 3)• In February 2016 the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) "intended to improve financial reporting about leasing transactions".

• The ASU affects all leased assets, including real estate, airplanes, and manufacturing equipment.

213


Future Accounting for Operating Leases (2 of 3)• The ASU will require organizations that lease assets to recognize on the balance sheet the assets and liabilities for the rights andobligations created by those leases.

• Lessees will be required to recognize assets and liabilities for leases with lease terms of more than 12 months.

214


Future Accounting for Operating Leases (3 of 3)• The Accounting Standards Update (ASU) on leases will take effect for public companies beginning after December 15, 2018, and for all other organizations, beginning after December 15, 2019.

215


Impact of Change to Accounting for Leases• In 2014 the US Chamber of Commerce estimated all US public companies had $1.5 trillion of operating leases.

• Operating lease obligations at the end of 2014: • AT&T had $31 billion vs. $76 billion of long term debt. • CVS had $27.3 billion vs. $11.7 billion long term debt. • Delta Airlines had $12.7 billion vs. $8.6 billion long term debt.

• Source: “The New $2 Trillion Hit: Leases” by Michael Rapoport; Wall Street Journal, November 11, 2015.

216



Lessee Preferences: Capital vs. Operating• Ownership beyond lease period. • With a capital lease, the lessee has ownership after lease period.

• With an operating lease, ownership remains with the lessor.

• Limit liabilities on balance sheet. • Capital leases have an asset and a liability.• Operating leases are off‐balance sheet (changing in several years).

217

Reporting, Planning, Performance, and ControlAccounting for Leases

Accounting for Leases Wrap Up

You should be able to: • Identify the differences between operating leases and

capital leases, and explain the accounting for each. • Understand lessee preference for operating versus

capital leases. • Explain why operating leases are a form of off‐

balance sheet financing.• Recognize the correct financial statement

presentation for operating and capital leases. 218


Accounting for Equity Transactions

219

Reporting, Planning, Performance, and ControlAccounting for Equity Transactions

Accounting for Equity TransactionsKey Learning Objectives

1. Identify transactions that affect equity, including additional paid‐in capital (APIC) and retained earnings.

2. Identify reasons for the appropriation of retained earnings.

3. Determine the effect on shareholders equity of stock dividends and stock splits.

220

Equity Topic #1: Equity Accounts

Equity accounts include: • Common Stock.• Preferred Stock.• Additional Paid in Capital (APIC).• Other Comprehensive Income. • Retained Earnings.

221


Equity Accounts: Par Value Accounts

• Common stock: Common stock is valued at the par value, the legal value stated in the corporate charter. It has no relationship to the market value

• Preferred stock: Legal value. Used to determine the dividend (8% preferred with $20 par = $1.60 dividend).

• Note – Bond have a par value, but it refers to the bond’s face value. It is not a general ledger account.

222


Equity Accounts: Additional Paid in Capital (APIC)

• Stock issuances are the primary APIC transactions. • Initial Public Offerings (IPO) and secondary offerings.

• APIC is the amount received by the company issuing the stock that is in excess of par value.

223


Additional Paid in Capital (APIC) Entries IPO and Secondary Offerings

• A company issues 100,000 shares with a $1 par value for $10 a share. The entry is: Debit: Cash ‐ $1,000,000

Credit: Common stock (par) $100,0000Credit: Additional paid in capital $900,000

224


Equity Accounts: Other Comprehensive Income

Other comprehensive income includes: • Unrealized gains and losses from changes in the market value of “available for sale” marketable securities.

• Foreign currency translation adjustments when consolidating from the functional currency to the reporting currency.

225


Equity Accounts: Retained Earnings

• Retained earnings are the shareholders interest in the accumulated earnings of the company.• Retained earnings increase from net income. • Retained earnings primarily decrease from: • Net losses.• Dividends paid to shareholders.

226


Entries Affecting Retained Earnings (1 of 2)1. Entries to close revenue, expense, gain, and

loss accounts at year end.Debit: Revenue and gains $1,000,000

Credit: Expenses and losses $900,000Credit: Retained Earnings $100,000

227


Entries Affecting Retained Earnings (2 of 2)2. Entries related to dividends (contra‐equity) • Entry on the dividend declaration date.

Debit: Dividends $100,000Credit: Dividend payable $100,000

• Year end entry to close dividend account. Debit: Retained earnings $100,000

Credit: Dividends $100,000

228


Equity Topic #2: Appropriation of Retained Earnings (1 of 3)

• Retained earnings represent earnings attributable to shareholders, however they can be appropriated, (restrictions on use).

• Reasons for appropriation include: 1. Legal restrictions, part of a loan covenants.2. Explicitly required in a contract. • E.g. a bond indenture.

229


Appropriation of Retained Earnings (2 of 3) • Board of Directors votes on appropriation, it is a corporate action.

• Appropriation does not set aside cash or other assets,merely limits availability of dividends.• Appropriated retained earnings are not eligible for dividends.

• Primarily used so the company can communicate to investors and outside parties.

230


Appropriation of Retained Earnings (3 of 3) • The retained earnings appropriation must be recorded and disclosed.

• Journal entry to record appropriation: Debit: Retained earnings

Credit: Appropriated retained earnings• Appropriated retained earnings are still equity.

231


Equity Topic #3: Stock Dividends • All dividends are voted on “declared” by the board of directors.

• Stock dividends give shareholders additional shares of stock. • Since there is no distribution of cash or property; stock dividends are reclassifications of stockholders equity.

• 2 types of stock dividends: Small and large. 232


Small Stock Dividends Small stock dividend: The new shares being issued are less than 20%‐25% of the total number of shares outstanding prior to the stock dividend.• Journal entry: Transfer the market value of the shares being issued from retained earnings to additional paid‐in capital.

233


Large Stock Dividends Large stock dividend. The new shares being issued are more than 20% ‐25% of the total value of shares outstanding prior to the stock dividend.• Journal entry: Transfer the par value of the shares being issued from retained earnings to additional paid‐in capital.

234


Equity Topic #4: Stock Splits (1 of 2)• Stock splits are corporate actions (approved by board of directors) that occur when a company believes its market price is too high.

• Stock splits are usually done to increase the liquidity (trading potential) making more shares outstanding at lower prices. However, stock price does not matter to all companies• (Alphabet – NASDAQ: Google).

235


Equity Topic #4: Stock Splits (2 of 2)• Stock splits increase the number of shares outstanding and reduces the par value per share of the company's stock.

• Balances in the stockholders equity section of the balance sheet do not change.

• Increasing the number of shares outstanding decreases the market price per share, but has no impact on market capitalization.

236


2‐1 Stock Split Example (1 of 2)• Market value is $100 a share, the par value is $1.00 per share and there are 200,000 shares outstanding. • Market value is $20,000,000• Total par value is $200,000.

• After a 2‐for‐1 split, each shareholder has twice the number of shares. The par value is $.50 per share and there are 400,000 shares outstanding.

237


2‐1 Stock Split Example (2 of 2)• Total par value is still $200,000. • The market value is unchanged as well. • No journal entry is made.• However it is noted that there is a decrease in par value per share and increase in shares outstanding.

238


Equity TransactionsWrap Up

You should be able to: • Identify transactions that affect additional paid‐in capital (APIC) and retained earnings.

• Identify reasons for the appropriation of retained earnings.

• Determine the effect on shareholders equity of stock dividends and stock splits.

239



Special Topics: Revenue Recognition

240

Reporting, Planning, Performance, and ControlSpecial Topics: Revenue Recognition

Special Topics: Revenue RecognitionKey Learning Objectives

1. Apply revenue recognition to various types of transactions.

2. Identify instances where revenue is recognized before and after delivery of goods or provision of service.

3. Compare and contrast the percent of completion and completed contact methods for the following: Recognition of costs of construction, progress billings, collections, and gross profit.

241

Standard Revenue Recognition (1 of 3) • Cash basis – revenue recognized when cash is

received. • Accrual basis – revenue recognized when it is

realized or realizable, and earned. • Typically when goods are transferred or

services rendered and the customer pays or is invoiced.

242


Standard Revenue Recognition (2 of 3) With accrual basis, 2 elements need to be present: 1. First element: Revenue is realized or realizable.

Refers to consideration received. • Realized: Goods or services have been exchanged for cash or claims to cash.

• Realizable: Goods or services have been exchanged for assets that are readily convertible to cash or claims to cash.

243


Standard Revenue Recognition (3 of 3) 1. Second element: Revenue is earned. • Typically the goods are transferred or services

provided. • The earnings process needs to be

“substantially completed.”

244


Special Revenue Recognition Situations • There are 3 special revenue recognition situations on the CMA exam where revenue recognition differs from the standard “realized, realizable and earned” principles. 1. Receivables will be collected over time. 2. Customer pays in advance. 3. Long‐term project delivered at completion.

245


Special Revenue Recognition #1: Receivables Collected Over Time

• Even though a receivable exists (revenue is realized) and the product or services has been provided (revenue is earned), revenue recognition is delayed if: • The receivable will be collected over time

AND • There is no way to estimate collectability.

246


Special Revenue Recognition #1: Receivables Collected Over Time

In these cases, the recognition of revenue depends of the estimate of collectability when the good or services are provided.

Two methods, depends on the situation: 1. Installment sales method – no basis to

estimate collection. 2. Cost recovery method – considerable doubt

regarding collection. 247


Receivable Collection Over Time and No Basis to Estimate of Collection:

Installment Method• Used when receivables will be collected over an extended period of time and there is no reasonable basis to estimate the collectability.

• Recognizes revenue and cost of goods sold as each installment is collected, based on the total installment sales and associated cost of goods in the year the sale was made.

248


Receivable Collection Over Time and Doubtful: Cost Recovery Method

• Used when receivable will be collected over time and there is considerable uncertainty regarding the collection of a receivable.

• No recognition of any revenue until all of the costs related to the sale have been collected.

• Once the payments have recovered the seller's costs, revenue and profit can be recorded.

249


Special Revenue Recognition #2: Customer Pays in Advance (1 of 2)

• Used when a company receives cash before the goods have been transferred or services provided to the customer.• Revenue can not be recorded since it not earned.

• Revenue is recognized over time as the goods or service are provided to the buyer.

250


Special Revenue Recognition #2: Customer Pays in Advance (2 of 2)

• Examples of customers paying in advance of receiving goods or services: • Subscriptions or memberships.• Season tickets. • Extended warranty.

251


Customer Pays in Advance Example (1 of 2)Scenario: Customer pays $120 for an annual membership. The money paid is in essence a deposit for monthly access. • Entry to record the initial receipt of cash

Debit: Cash $120Credit: Deferred Revenue $120

• Deferred revenue is a liability.

252


Customer Pays in Advance Example (2 of 2)• Entry each month of the subscription period to record revenue.

Debit: Deferred revenue $10 Credit: Revenue $10

253


Special Revenue Recognition #3: Long‐Term Contracts (1 of 2)

Long‐term projects: • Span multiple fiscal periods• Incur costs over the project life• Have delivery at completion. • E.g. ships, airplanes, buildings, etc.

254


Special Revenue Recognition #3: Long‐Term Contracts (2 of 2)

• Two accounting methods: 1. Percent of completion (POC).2. Completed contract.

• With both methods, revenue recognition is disconnected from customer billings and cash collections.

255


Long‐Term Contracts: Timing of Revenue and Billings

• Unbilled revenue is an asset recognized whenever revenue is booked but no invoiced.

• Progress billings are a liability recognized when the client is billed, usually based on milestones.

• Timing differences on the balance sheet: • Unbilled revenue > progress billings.• Progress billings > unbilled revenue.

256


Percent of Completion (POC) Accounting• Used for long‐term projects (multiple periods,

costs are incurred throughout project, customer delivery at the end of the project).

• Revenue recognized as costs are incurred based on the % of total costs incurred.• Costs incurred/total expected costs. • If 60% of the total costs have been incurred,

60% of the revenues are recognized. 257


Percent of Completion (POC) Entries (1 of 2) 1. Contract costs are recorded as incurred:

Debit: Construction in progress (IS)Credit: Accounts payable/payroll (BS)

2. Revenue is recorded proportionally as costs are incurred:

Debit: Unbilled revenue (BS)Credit: Revenue (IS)

258


Percent of Completion (POC) Entries (2 of 2) 3. Billings are recorded as outlined in the contract

and are independent of revenue recognition: Debit: Accounts receivable (BS)

Credit: Progress billings (BS)• Progress billings is a contra‐asset account, have a credit balance.

• Typically customer billings are based on meeting project milestones.

259


Percent of Completion Example (1 of 2)• Scenario: Budgeted revenue of $200k, budgeted costs of $120k, budgeted margin of $80K.

• Revenue booked based on the percentage of total costs incurred to total costs. • Once costs of $30k (25% of all costs) are incurred, the company can book 25% of total revenue‐ $50k (25% of $200k).

260


Percent of Completion Example (2 of 2)• Once $60k of costs are incurred (50% of total $120 costs), the company can book 50% of total revenue ‐ $100k (50% of $200k).

• Need to be careful if total estimated costs changes, especially if the costs increase without a commensurate increase change in revenue. In this case, too much revenue may have been recorded, and may need to be decreased.

261


Completed Contract Method (1 of 2)• All revenue is recognized at completion. • Should be used if total costs will be difficult to estimate.

• Defers all contract costs in an inventory account until the project is completed.

• Records billings in a progress billings.

262


Completed Contract Method (2 of 2)• Potential benefit: Defers tax liability until after project is completed.

• Allowed with US GAAP; not allowed with IFRS.

263


POC vs. Completed Contract Method

264

Percent of Completion Completed Contract

Billings Based on milestones; not tied to revenue.

Collections Based on billings, not tied to revenue.

Costs Cost of sales as incurred.

An asset until end of project.

Revenue As costs are incurred. At end of project.

Gross profit

As costs are incurred. At end of project.


Revenue RecognitionWrap Up

You should be able to: 1. Apply revenue recognition to various types of

transactions.2. Identify instances where revenue is recognized before

and after delivery of goods or provision of service.3. Compare and contrast the percent of completion and

completed contact methods for the following: Recognition of costs of construction, progress billings, collections, and gross profit.

265



Special Topics: Income Measurement

266

Reporting, Planning, Performance, and ControlSpecial Topics: Income Measurement

Special Topics: Income MeasurementKey Learning Objectives

1. Demonstrate an understanding of the treatment of gain or loss on the disposal of fixed assets.

2. Define and calculate comprehensive income.3. Identify correct accounting treatment of

discontinued operations. 267


Topic #1: Disposal of Long‐Term Assets• Gains and losses are recognized when fixed

assets are disposed of. • Gain or loss is the difference between

consideration received (if any) versus the carrying value of the asset• Consideration: Value received (usually cash). • Carrying value: Historical cost lessaccumulated depreciation.

268


Topic #1: Disposal of Long‐Term Assets• 4 steps to determine gain/loss:

1. Deprecation is recognized to the disposal date.

2. Historical cost and accumulated depreciation are removed.

3. Consideration received (if any) is recorded.4. Gain or loss: Difference between the

consideration and the carrying amount. 269


Topic #1: Disposal of Long‐Term AssetExample (1 of 4)

A company sold a fixed asset for $30,000. The initial valuation of the asset was $200,000, and there was accumulated depreciation of $150,000.

Required: (1) What is the carrying value of the asset? (2) What is the gain or loss? (3) What is the accounting treatment for the disposal?

270



• Requirement 1 ‐ Asset carrying value.$200,000 Initial valuation ($150,000) Accumulated depreciation$50,000 Carrying value

271



• Requirement #2 – Gain or loss$30,000 consideration (cash) received($50,000) carrying value$20,000 loss on disposal

272



• Requirement 3 ‐ Accounting entry: Debit: Cash $30,000Debit: Accumulated depreciation $150,000Debit: Loss on disposal ‐ $20,000

Credit: Fixed asset ‐ $200,000• The loss on disposal is closed to retained

earnings at the end of the year. 273


Topic #2: Comprehensive Income (1 of 3)Comprehensive Income is the sum of: 1. Net Income/Net Loss • Income Statement

Plus2. Change in “Other Comprehensive Income”• Account in the stockholders equity section of balance sheet.

274


Topic #2: Comprehensive Income (2 of 3)• Other Comprehensive Income – Stockholders equity account that tracks valuation adjustments: • Unrealized holding gains or losses from available for sale securities.

• Foreign currency translation gains or losses.

275


Topic #2: Comprehensive Income (3 of 3)• The rationale for comprehensive income is that the combination of income statement results and unrealized valuation adjustments provides the user of the financial statements a larger and more meaningful picture of the organization as a whole.• Remember to keep the users of the financial statements in mind.

276

Topic #3: Discontinued Operations • A discontinued operation is a business segment that an organization is in the process of exiting, or has plans to exit and dispose.• Materiality is important!

• Only disposals of businesses that represent strategic shifts that have a major effect on an organization’s operations and financial results can be reported in discontinued operations.

277


Discontinued Operation Criteria• Examples include a withdrawal from a geographic area, exiting a line of business, or a equity method investment.

• Needs to meet 1 of 2 criteria: 1. Ongoing operation that will be be disposed

as part of a single, coordinated plan. 2. Newly acquired operation that the business

intends to resell. 278



Financial Reporting of Discontinued Operations (1 of 2)

• Show separately below continuing operations.• 2 components for income statement presentation: 1. Operating income/loss from the discontinued

operation. • Separate measurement starts on the date the

company announced intention to exit the business.

279


Financial Reporting of Discontinued Operations (2 of 2)

2 components for income statement (continued):

• The operating income/loss is presented each year until the business is fully exited.

2. Gain/loss on disposal of discontinued operation.• Book value of net assets less “consideration” received (if any).

280

281

Discontinued Operations PresentationContinuing Operations: Revenue $10,000Cost of goods sold $4,000Gross margin $6,000Selling, general, and admin expense $2,000Income before taxes $4,000Income tax expense $1,000

Income from continuing operations $3,000Discontinued Operations: Loss from operations, net of tax $(500)Loss on disposal, net of tax $(200)

Loss from discontinued operations $(700)Net income $2,300


Special Topics: Income Measurement Wrap Up

You should be able to: 1. Demonstrate an understanding of the

treatment of gain or loss on the disposal of fixed assets.

• Define and calculate comprehensive income.• Identify correct treatment of discontinued

operations. 282



US GAAP and IFRS Differences

283

Reporting, Planning, Performance, and Control US GAAP and IFRS Differences

US GAAP and IFRS Differences Key Learning Objectives

Identify and describe the differences between US GAAP and IFRS for the following: 1. Revenue recognition.2. Expense classification.3. Consolidations.4. Financial statement presentation.5. Asset valuation, including goodwill.

284

Where does US GAAP Come From? (1 of 2)

• Generally Accepted Accounting Principles• Set by the Financial Accounting Standards

Board (FASB)• Sources of US GAAP:

1. Statements of Financial Accounting Standards• Most authoritative GAAP; Over 150 FASB’s

issued to date.

285


Where does US GAAP Come From? (2 of 2)• Sources of US GAAP (continued):

2. Interpretations ‐ modify or extend existing standards. Approximately 50 issued to date.

3. Technical Bulletins ‐ guidelines on applying standards, interpretations, and opinions.

• Future Source: • Statements of Financial Accounting Concepts• FASB “framework” for future standards

286


Groups Interested in US GAAP • Securities and Exchange Commission (SEC)• Regulates use of GAAP. SEC filings (10‐K’s

and 10‐Q’s) must conform to GAAP.• Public Company Accounting Oversight Board (PCAOB). • Oversees firms that audit public companies.

• American Institute of Certified Public Accountants.

287


International Financial Reporting Standards (IFRS)

• IFRS are designed as a common global language to allow comparability across international boundaries.

• Common global language is particularly relevant for users with dealings in several countries.

• Progressively replacing national accounting standards, used in over 120 countries, fully implemented in over 90 countries.

• Not yet adopted by United States, Japan, India, Russia.

288


IFRS Use in the United States• Internal direct users:

1. Accountants in US companies that are subsidiaries of foreign companies.

2. Accountants in US companies that own foreign subsidiaries.

• External indirect users: 1. US financial analysts who compare US (US

GAAP) and non‐US (IFRS) companies. 289


US GAAP vs. IFRS Differences• A major cause of differences is that US GAAP is rule‐based, and IFRS is principle‐based. • Rules based: Emphasis on the form of the transaction.

• Principle based: Emphasis on the substance of the transaction.

• Principle basis provides greater potential for different interpretations of similar transactions.

290


Revenue Recognition Differences

Item US GAAP IFRS

Completed contract method for longterm contracts

Allowed. Not allowed. Must use percentage of completion or cost recovery methods.

291


Expense Classification Differences

Item US GAAP IFRSIncome Statement Expenseclassification

Must presentexpenses based by function.

May present expenses by function or nature. Disclosures of expenses by nature are required if function is used.

• Function: Selling, general, research, development, etc. • Nature: Salaries, depreciation, rent, etc.

292


Consolidation of Subsidiaries Differences Item US GAAP IFRS

Consolidationof subsidiaries

Focus is on controllingfinancial interests. Control is defined as greater than 50% ownership.

Focus is on the power to control. Control is defined as the ability to govern the financial and operating policies of the entity, regardless of % ownership.

293


Financial Statement Presentation Differences

Item US GAAP IFRS

Classification of deferred tax assets and liabilities.

May be classified as current or non‐current,depending on nature of asset or liability.

All deferred tax accounts must be classified as non‐current.

294


Asset Valuation Differences (1 of 2)

Item US GAAP IFRS Use of fair value Most assets must

be valued (stated) at historical cost or lower of cost or market*.

Assets can be valued (stated) at fair value.

* Remember that marketable securities classified as “trading securities” or “available for sale” are re‐valued to the market price every period.

295


Asset Valuation Differences (2 of 2)

Item US GAAP IFRS

Fixed assetrevaluation

Not permitted Permitted for an entire class of assets

Use of LIFO to value inventory

Permitted. Not permitted.

Development costs (R & D)

Expensed as incurred.

Can be capitalized as an intangible asset.

296


IFRS Goodwill Impairment Test• IFRS uses a single‐step method• Determine fair value of business less the cost to sell and compare to the business value of the asset.

• If fair value is lower than the business value, goodwill is written down.

• If fair value is greater than business value, no action is needed.

297


Changes to US GAAP Goodwill Impairment • Effective for years ending after Dec 2019, the 2‐ step method is changed to 1‐step.

• The goodwill impairment test will compare the fair value of a reporting unit with its carrying amount.

• Impairment will be the amount the carrying amount exceeds the reporting unit’s fair value.

298


US GAAP and IFRS Differences Wrap Up

You should be able to: • Identify and describe the differences between US GAAP and IFRS for: • Revenue recognition and expense classification.• Consolidations.• Financial statement presentation.• Asset valuation, including goodwill.

299


external financial reporting decisionfinancial statement overview statement of cash flows (1 of 2)...

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