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BBUS 361



Fall 2013 Professor Valerie Li


THE ROLE OF ACCOUNTING IN BUSINESS What is accounting? Financial information for decision makers to make decisions For investors, creditors, any external users Managers prepare the info for external users To know how the company is running A system to identify, measure, report the financial info to external parties for decision making Who are the primary users of financial accounting?  Others?

Creditors and investors

Why do they need this information? Returns Risk

Theoretical value of the firm: Based on market cap Stock price * shares outstanding =present value of future cash flows, determines stock price


STANDARD SETTING Why do we need standards? Conflict in interest Compare companies Consistent reporting system  Historical background:

Who sets the standards in the U.S.? FASB – private sector to set standards SEC authority of US to oversee standards Former big 4 accountants, creditors, government (SEC), investors, money managers, risk metrics, professor, CFO Accounting Standards Codification (ASC) Database of rules Example: Accounting for Research and Development Previously: R&D SFAS #2 Codification: 730-10-25 How are standards set? Political process Due process, very open Everyone can give their opinions as comments on proposals Example: Accounting for Employee Stock Options Cant record 0 for ESO because ESO has value so it is an expense for the company to give stock options Advantages: more insights from multiple parties

bias.Disadvantages: takes too long. go with not the best solution How do we know standards are followed? Auditors SEC enforcements Internal control/auditors CEO/CFO certifies financial statement after 2002 The board International Financial Reporting Standards (IFRS) Reasons for global accounting standards: Comparability of financial statements Difficulties/Drawbacks: Costly Hard to have one size fits all Current Status: Still debating 4 .

CONCEPTUAL FRAMEWORK Original Framework: Purpose: To set forth fundamentals on which financial reporting standards are based. Statement of financial accounting concepts  SFAC #8 Objectives of Financial Reporting  SFAC #8 Qualitative Characteristics of Accounting Information  SFAC #6 Elements of Financial Statements  SFAC #5 & #7 Recognition and Measurement in Financial Statements Current Conceptual Framework Project: Purpose: To develop an improved common conceptual framework that provides a sound foundation for developing future accounting standards (joint project with IASB) Eight phases:       Objectives and Qualitative Characteristics Elements and Recognition Measurement Reporting Entity Presentation and Disclosure … 5 .

Objectives of Financial Reporting (based on revised framework)  Provide useful information to capital providers -Helps assess amounts. timing and uncertainty about future cash flows .Clearly portrays the economic resources of an enterprise Qualitative Characteristics of Accounting Information (based on revised framework)  GRAPHIC 1-7 Hierarchy of Qualitative Characteristics of Financial Information Fundamental Characteristics:  Relevance: Capable of making a difference in a decision 6 .

tell everything  Neutrality (rejection of conservatism) Without bias  Free from material error Enhancing Characteristics:  Comparability Compare different firm’s financial statements Compare across time Consistency  Verifiability Credibility Can prove  Timeliness Have info ready in time and influence decisions  Understandability Easy to understand 7 . Predictive value Can predict future outcome  Confirmatory value Confirms prediction. change previous expectations depending on real outcome Provide feedback about previous evaluation  Materiality In specific context  Faithful Representation: Depicts the economic phenomena it purports to represent  Completeness Can’t hide any info.

= NI + Other Compr.Key Constraints  Cost Effectiveness Provide info if benefit of info is more than cost to prepare the info Elements of Financial Statements (based on SFAC #6)           Assets Liabilities Equity (or net assets = A – L) Investment by owners Distributions to owners (dividends) Comprehensive income Revenues Expenses Gains Losses  Assets – Probable future economic benefit obtained or controlled by a particular entity as a result of past transactions  Liabilities – Probable future sacrifice of economic benefit resulting from a present obligation of a particular entity as a result of past transactions. Income 8 .  Equity – Residual ownership interest (Assets less Liabilities)  Transactions with owners Two types: investment by owner’s like stock issuance Distribution to owners Like Dividends and stock buy back  Comprehensive Income Comp Inc.

Revenue – Expenses + Gains – Losses o Revenues: Inflow of assets or settlements of liabilities from on-going business o Gains: Inflow of assets or settlements of liabilities not from on-going business o Expenses: R&D should be assets but it is shown as an expense Outflow of assets for incurrence of liabilities from on-going business o Losses: Outflow of assets for incurrence of liabilities not from on-going business 9 .

Expense recognition: Matching Measurement: Five different attributes currently used in practice: 1.Recognition and Measurement (based on SFAC #5&7) Recognition: The process of recording an item in the financial statements  What are the alternatives to recognition? Disclose in the footnotes Criteria for recognition:  Definitions – The item meets the definition of an element of financial statements  Measurability – The item has an attribute you can measure  Relevance – The attribute is relevant  Reliability – The attribute is reliable Revenue recognition: Realization (after miderm will talk about this)  Realization principle: o The earnings process is complete or virtually complete. o There is reasonable certainty as to the collectability of the asset to be received. Historical Cost: 10 .

Present value of future cash flows: bonds 5.2. Net realizable value : net amount you collect and then end (A/R) 4. Current Cost: how much you have to spend to replace it 3. Fair value (market cost): you uwb much you can send it for? Which measurement is the most common for recognition? Why? 3 level floor value Level 1 : active fit Level 2: similion market Level 3: estimation Debate over Fair Value Accounting Evolving GAAP: (articulation of financial statements)  Balance sheet approach: revalue all assets I have at end and then at beginning and find the difference = net income  Income statement approach 11 .

THE ACCOUNTING PROCESS Review of Accounting Basics Four Main Financial Statements: • Balance Sheet • Income Statement • Statement of Cash Flows • Statement of Stockholders’ Equity Accounting Equation Relationship among Financial Statements Income statement and balance sheet: Change in RE = net income dividends Cash flows and 12 .

Accounting Equation -.Increase to the other side Accounting Cycle A complete description of the accounting cycle is given in figure 2-3 of your book (page 56) Recording Journal Entries Three components to a journal entry: 13 .Decrease to the same side or .Examples  An increase to one side of the equation must result in either: .

• If debits = credits  equation is always balanced • BUT…this does not mean that the journal entry is correct! • Also note: – Revenues increase S/E so an increase in revenues is a ___credit___ – Expenses decrease S/E so an increase in expense is a ___debit____ 14 .

…………….……………………………………28.000 Cash………….000 2) The company takes out a three-year loan from the bank in the amount of $10.10.. the first month of operations. She plans to call it “Top McQueen Espresso”. meaning the amount will be paid in 30 days.000 4) The company purchases 100 lbs of coffee beans for $1100. Espresso machine and cart………………….000.000. write out the appropriate journal entry. The purchase was made “on account”. Inventory…….100 15 . [Ignore interest payments for now] Cash………………………….20.. 1) McQueen contributes $20.000 Note payable……………………10. For each transaction described below.1..000 Owner’s equity……………………20.Top McQueen Espresso Practice Problem McQueen loves coffee and has decided to open an espresso stand.28.000 3) The company purchases an espresso machine and cart for $28. Cash…………………………. She enters into several transactions during June 2005..100 A/P……………………………1.000 to start-up the business..

400 Unearned revenue……………….5) The company purchases other miscellaneous supplies such as cups.. The rental fee is $200/month.800 Revenue………………………4. Rent expense……………………. cash sales totaled $4. Total supplies purchased during the month were $400. Cash…………………………………. milk.400 Cash………………….……400 6) The company pays a monthly rental fee for the space on which the cart is located. Cash…………………………. the company sold pre-paid “coffee cards”..800.200 Cash………………………………200 7) During the first month of operations. napkins..800 8) In addition. continuously throughout the month.……400 16 . Coffee card purchases totaled $400 during the month. Customers can purchase these cards in advance and redeem them at the time of purchase. Supplies……………………. All purchases were made for cash..4.. etc...

….T-account method Create T-accounts and post the above journal entries.. Wages paid to the part-time barista were $320. McQueen hired a parttime barista to help out. 17 .320 Posting -..320 Cash……………………. Salary expense……………….9) Since business was better than expected.

Adjustments can be classified as: Prepayments: cash before recognition. Cash is paid or received before expenses or revenue is recognized Example: prepaid expense. Cash has not been paid or received when revenue or expense has incurred Example: Prepayment Revenues Initially Debit Cash Credit Unearned revenue Adjusting entry Debit Liability Credit Revenue Initially Debit Prepaid expense Credit Cash Adjusting entry Debit Expense Credit Prepaid expense Accrual Initially Debit Receivable Credit Revenue Adjusting entry Debit Cash Credit Receivable Initially Debit Expense Credit Payable Adjusting entry Debit Payable Credit Cash Expenses 18 . These events require ‚adjusting entries‛ at the end of the reporting period.Adjusting Entries Some events that need to be recorded are not the result of transactions with external parties. unearned revenue Accruals: cash after recognition.

. Pre-collected revenue 1/10 Collect gift card $500 Cash………………………………………………….000 b.30.000 for 3 months rent Prepaid rent………….10.500 Unearned revenue……………………………500 1/31 $200 yet to redeem Unearned revenue…………………………300 Revenue………………………………………………300 19 .000 1/31 Adjustment Rent expense…………………. Prepaid expenses 1/18 Paid $30.30.000 Cash…………………………….000 Prepaid rent……………………….10.Example: Fiscal period is 1 month here 1) Prepayments a.

Alternative approach to record prepayments: to record initial cash directly into expense or revenue account. Pre-collected revenue 1/10 Collect gift card $500 1/31 $200 yet to redeem 20 . The adjusting entry then records the unexpired prepaid expense (asset) or unearned revenue (liabilities) as of the end of the period. Initially Prepaid Expense Debit Rent expense Credit Cash Debit Prepaid Rent Credit Rent expense Unearned Revenue Debit Cash 500 Credit Revenue 500 (instead of Unearned revenue) Debit Revenue 200 Credit Unearned revenue 200 Adjustment Previous Examples: 2) Prepayments c.000 for 3 months rent 1/31 Adjustment d. Prepaid expenses 1/18 Paid $30.

Accrued expenses 1/15 Wages accrued $400 Wages expense………………400 Wages payable…………….400 1/20 Paid wages $400 Wages payable……………….1000 21 ..3) Accruals a.1000 A/R……………….1000 Sales Revenue…………………1000 1/20 collect cash $1000 Cash………. Sales on account 1/15 credit sale of $1000 Account receivable…….400 Cash………………………………..400 b.

000*12%*1/12 = 100) 12) The espresso machine and cart are expected to last 5 years..Practice Problem (continued): Analyze the following items and determine if an adjusting entry is necessary.825 *$11x25lbs = $825 because bought 100 lbs for $1100 and 1100/100 = 11 *used up 75 lbs of coffee beans during the month Supplies expense……. Interest expense………. June 30 now 10) At month end. always straight line depreciation************ 22 .825 Inventory……………. She also counted her other supplies (cups.. Depreciation expense……………. etc.000/5 * 1/12= $466) or (28000/60) For this class. McQueen weighed the remaining coffee beans and found that she had 25 lbs remaining.300 *used up $300 worth of supplies 11) Interest on the bank loan is 12% payable annually. COGS……………….100 ($10... napkins.300 Supplies……………….467 Accumulated Depreciation………467 ($28.) and found that she had about $100 worth of supplies remaining.100 Interest payable…………..

$150 worth of cards were redeemed. In order to prepare the balance sheet. 150 was redeemed Financial Statement Preparation and Closing Entries The financial statements can now be prepared from the ending balances in each Taccount. Unearned revenue……………….150 Revenue…………………………. 2) Close income summary account to retained earnings.. Recall however that revenues and expenses DO NOT appear on the balance sheet but do affect the balance sheet through their effect on retained earnings.13) By the end of July. Closing process: 1) Close revenues and expenses to income summary account. What does it mean to ‚close‛ an account? To make it to zero balance Practice Problem (continued) Prepare the closing entry for ‚Top McQueen Espresso‛ for the month of June: 23 . we need to transfer the revenues and expenses to the retained earnings account. This method of transferring the revenues and expenses to retained earnings is known as the closing process.. 3) Close dividends to retained earnings.150 Because originally 400.

Prepare the income statement. balance sheet. 2001 Top McQueen Espresso Statement of Stockholders’ Equity For the month ended June 30. Top McQueen Espresso Income Statement For the month ended June 30. 2001 24 . and statement of stockholders’ equity for ‚Top McQueen Espresso‛ on the following pages.

investing.Top McQueen Espresso Balance Sheet June 30. First. classify each transaction as operating. we must return to the Cash T-account and examine the transactions that affected the account throughout the period. 25 . or financing and then prepare the statement of cash flows on the next page. 2001 To prepare the cash flow statement.

2001 Notice that Cash from Operation DOES NOT equal Net Income. 26 .Top McQueen Espresso Statement of Cash Flows For the month ended June 30.

benefits and efforts are measured in terms of cash inflows and cash outflows. 2. Accrual Accounting . Cash collection Debit Cash Credit Unearned Rev Later Debit Unearned Rev Credit Rev 27 . Revenues are inflows of assets (or decreases in liabilities) and Expenses are outflows of assets (or creation of liabilities).ACCRUAL VS.benefits and efforts are measured in terms of revenues and expenses. Cash is just one type of asset! Very generally: a) Revenues are recognized when earned. Cash Flow Accounting . b) Expenses are recognized when the ‚effort‛ (or resources) is expended to generate revenue (matching principle) Examples of differences in timing: Revenue Examples Revenue earned before cash received Sales on Account Debit AR Credit Sales Rev Later Cash collection Debit Cash Credit AR Cash received before revenue earned. CASH FLOWS CONCEPTS Cash flows from operations is a distinctly different concept from net income (accrual accounting): 1.

Expense Examples Interest expenses incurred Debit Interest expense Credit Interest payable Later payment Debit Interest payable Credit Cash Cash paid before expense occurs Prepaid rent Debit prepaid rent Credit Cash Later Debit Rent expense Credit Prepaid rent Note that in each case.Expense occurs before cash paid. Which measure is more important? NI is more important for investor The measure with more correlation to stock price is more important Don’t know for creditors 28 . an asset or liability ‚holds‛ the timing difference between net income and cash flows from operations.

‛ Journal of Accounting and Economics 18:3-42 29 . ‚Accounting Earnings and Cash Flows as Measures of Firm Performance: The Role of Accounting Accruals.. P.Dechow. 1994.

What are the differences? COGS > cash paid for inventory by $825 Bought more inventory than you sold NI > CFO by 275 (on inventory T account) Look at Accounts Payable since didn’t pay for the inventory in cash yet AP goes up by 1100 Change in AP $1100 …. Why? Let’s compare the Net Income and Cash Flows from Operations of Top McQueen Espresso: Income Statement Revenue: 4950 Expenses: Cost of Goods Sold: (825) Supplies Expense: (300) Rent Expense: 200 Wage Expense: 320 Interest Expense: 100 Depreciation Exp: 467 NET INCOME: 2738 Statement of Cash Flows Cash collections from Sales: 5200 Cash paid for inventory: 0 Cash paid for supplies: (400) Cash paid for rent: (200) Cash paid for wages: (320) Cash paid for interest: 0 Cash paid for depreciation: 0 Cash flows from operations: 4280 Diff 250 825 100 0 0 100 467 1542 Notice: All else held constant 1) Revenues do not equal Cash Collections from Sales. Net Income for June did not equal Cash Flows from Operations. NI< CFO by $1100 because haven’t used cash to pay yet ---Change CA up and Inventory up which means CFO < NI If inventory is up then means you bought more than you sold.Recall that in our ‚Top McQueen Espresso‛ example. Why? 5200 is cash revenue collected Cash revenue is higher by 250 that means CFO will be higher than NI by $250 Cash revenue is greater than the accrued revenue by 250 because unearned revenue is 250 (goes up by 250) Change CL goes up (cause unearned) CFO > NI 2) Cost of Goods Sold (cost of coffee beans used) does not equal cash paid for inventory. and so cash expenses is higher 30 .

What are the differences CFO rev is 400 and CFO expense is 300 so = 100 So NI > CFO by 100 cause supplies expense went up and cash income goes down (bought more than you used) Supplies account goes up by 100 Change in CA goes up 100 4) Interest Expense does not equal Cash Paid for Interest. bad debt expense Dep bad del expense (adjust for change in CA and change in L) CF from operating activities NI +depreciation +unearned revenue +supplies 2738 467 250 (100) +AP +inventory +interest 1100 (275) 100 31 .Change in CL up………so CFO > NI 3) Supplies Expense does not equal Cash Paid for Supplies. we could reconcile Net Income to CFO as follows: Indirect method Statement of Cash Flows Start with NI Add back noncash items like dep. What are the differences? 100 because haven’t paid for the interest yet Accrued expense is higher than cash expense so NI < CFO What account is holding this difference? = Interest payable IP will go up by 100 So.

CFO 4280 32 .

Inferring Journal Entries Although many different events might affect any given account. Plant & Equip Accounts Payable Wages Payable Interest Payable Unearned Revenue Therefore. AND you know one reason for the change you can infer the other reason for the change. Practice Problem: Increase Decrease 33 . think about what will make the account increase and what will make the account decrease: Balance Sheet Account Accounts Receivable Interest Receivable Inventory Supplies Inventory Prepaid Insurance Prepaid Rent Property. if you know the change in a balance sheet account from the beginning of a period to the end of a period (the net increase or decrease in the account). there are generally ‚standard‛ transactions that affect each balance sheet account. Examples: For each account.

compute the following (NOTE: Assume that accounts payable relates entirely to merchandise inventory): a) Cash collected from customers $________________ b) Cash paid for rent expense $________________ c) Cost of goods sold $________________ 34 . the following information for the year ended 12/31/05 is provided to you: Accrual sales $24.500 10.700 Rent Expense 3. for the years ended December 31.400 8.100 2.600 2.900 12/31/05 9.000 7.000 In addition. Account Accounts Receivable Merchandise Inventory Prepaid Rent Accounts Payable Wages Payable 12/31/04 8.500 Cash paid to suppliers for inventory purchased on account 13.Following is selected balance sheet information from Koa’s Kitty Food. 2004 and 2005. Inc.900 2.000 9.400 Cash paid for wages 4.700 Using this information.900 1.

d) Wage expense $________________ This inference process is difficult but very useful. 35 . We will use it throughout the quarter and you will see again in BBUS 363 when you cover the Statement of Cash Flows.

INCOME STATEMENT PRESENTATION Typical Income Statement Format: Multi-step 36 .

623 1.0 919.08 1. net of $46.227 851 1.505 629 967 2. $116 and $152 tax Gain on disposal of discontinued operations.025 28.031 1.79 1.36 3.8 912.601 570 3. Economic events 37 . except per share data) 2004 2003 2002 Sales Net credit card revenues Total revenues Cost of sales Selling.498 7.410 25.51 903.2 $ $ $ $ $ $ $ $ 36.839 31.928 $ 1.78 908.21 — 1.657 722 1.78 0.27 — 1.159 556 2.99 1.603 984 1.54 2.3 $ $ $ $ $ $ $ $ $ $ $ $ Does it matter?  Valuation Implications: Types of irregular items: 1. general and administrative expense Credit card expense Depreciation and amortization Earnings from continuing operations before interest expense and income taxes Net interest expense Earnings from continuing operations before income taxes Provision for income taxes Earnings from continuing operations Earnings from discontinued operations.0 914.238 $ 3.097 42.52 0.619 $ 190 $ — $ 1.198 $ 2.885 $ 75 $ 1.811 584 2. Alternative: Single Step Format (millions.07 0.098 3.97 911.157 46.09 0.445 9.389 8.682 $ 1.797 737 1.519 891 37.76 0.146 1.376 247 — 1.809 $ 1.08 1.51 0.37 3. net of $761 tax Net earnings Basic earnings per share Continuing operations Discontinued operations Gain from discontinued operations Basic earnings per share Diluted earnings per share Continuing operations Discontinued operations Gain from discontinued operations Diluted earnings per share Weighted average common shares outstanding: Basic Diluted $ 45.27 — 1.259 3.21 — 1.1 $ $ $ $ $ $ $ $ 40.

Tax rate is 40% and income from continuing operations is $200.000. do NOT recognize the gain til actually sell the operations.When the component has been sold: 1) Income/Loss from operation of discontinued segment from the beginning of the reporting period to the disposal date. Example: Company disposes of a segment that had operating losses for the year of $40.a.000 and that resulted in loss of $10.When the component is considered held for sale:  If decision has been made in the current period to discontinue operation but not yet discontinued (eg by sale) need to  1. 38 . ASC 205-20): Component of a company 1) that has or will be eliminated from the operations of the company and 2) that the company will not have any significant continuing involvement in after disposal Proposed changes: (based on Exposure draft of a new ASU) : Component of a company 1) that has been disposed or 2) is classified as held for sale. recognize the expected loss on sale (an impairment loss)  But if FV > book value. and represents one of the following: 1) An operating segment 2) A business Why does it matter? Two components: . separately report the income/loss on this operation  2. 2) Gain or loss on disposal of discontinued segment . if FV of assets < book value. Discontinued operations (SFAS #144.000 on disposal.

198 $ 2.99 1.505 737 722 629 1.885 $ 75 $ 1.259 1.Example of discontinued operations from Target Corp 10-K CONSOLIDATED RESULTS OF OPERATIONS (millions.27 — 1.146 1.0 919.157 1.928 $ 36.682 $ 40.601 570 3.657 7.21 — 1.031 1. $116 and $152 tax Gain on disposal of discontinued operations.498 9.51 903.09 0.619 $ 190 $ — $ 1.797 8.389 25.025 37.097 891 46.098 967 3.410 31.08 1. net of $46.54 2.159 556 2.811 584 2.809 $ 1.78 908.07 0.603 984 1.445 28.51 0.839 42.376 247 — 1.76 0.27 — 1.2 $ $ $ $ $ $ $ $ 2. 39 . except per share data) Sales Net credit card revenues Total revenues Cost of sales Selling.37 3.97 911. general and administrative expense Credit card expense Depreciation and amortization Earnings from continuing operations before interest expense and income taxes Net interest expense Earnings from continuing operations before income taxes Provision for income taxes Earnings from continuing operations Earnings from discontinued operations.3 $ $ $ $ $ $ $ $ $ $ $ $ See Notes to Consolidated Financial Statements throughout pages 28-37.0 914.227 851 1.1 $ $ $ $ $ $ $ $ 3.519 1.8 912.623 1.21 — 1.08 1.78 0.79 1. net of $761 tax Net earnings Basic earnings per share Continuing operations Discontinued operations Gain from discontinued operations Basic earnings per share Diluted earnings per share Continuing operations Discontinued operations Gain from discontinued operations Diluted earnings per share Weighted average common shares outstanding: Basic Diluted $ 2004 2003 2002 45.238 $ 3.52 0.36 3.

Are estimates. Based on expected termination/severance payments to employees b. So could be too high or low Are they part of permanent earnings? 40 . Other unusual/irregular items: Income items that are unusual or infrequent (but not both) Restructuring charges .b.Fair value the liability a.Recognize when ‚incurred‛ not necessarily paid. Extraordinary items: Income items that are unusual and infrequent c. .

Street earnings: managers (and analysts) exclude items from earnings Some people refer to as excluding the ‚bad stuff‛: 41 .Pro forma earnings .

42 .

2. SOX Section 401.1. If firms report pro forma in a press release or elsewhere. Turns out pro forma earnings are more highly correlated with stock returns than reported earnings meaning (in an efficient capital market) …. they must reconcile to reported earnings What are managers’ incentives for reporting these items? 43 .

Combined with other revenue and/or expense line items 2.How should ‚irregular‛ or ‚unusual‛ economic events be reported? Options: 1. Include as a separate line item in the income statement  And include in calculation of income from continuing operations  And exclude from calculation of income from continuing operations 3. By-pass net income and record directly to retained earnings Why is this important? 44 .

Example: Coca-Cola Enterprises Examine the following Statement of Income and excerpts from the Notes to the Consolidated Financial Statements (next page). Did CCE have any unusual or irregular items during 2005? 45 .

46 .

000. The restructuring plan included layoffs of 2.  The company incurred damage to one of their production facilities in Arizona.000. General and Administrative Expenses of $180.  Excluding these items. resulting from a tornado.  The company’s income tax rate is 30%. the company had revenues of $1. equipment. Cost of Goods Sold of $600. Shepard Financing incurred a loss of $200. The sale of the subsidiary resulted in a gain of $50. that provided financing to customers to assist them in purchasing some of the more expensive items in the company’s product line.000 personnel and the disposal of non-productive assets and inventory from underperforming product lines.000. Prepare an income statement for Shepard Industries for the year ended December 31. 2004.000 shares of common stock outstanding and no preferred stock.  The company has (and always had) 100. The cost of the restructuring was $130. Shepard Financing.000  Due to poor performance.000. The company no longer offers financing directly but provides customers with referrals to financing companies that provide such services. several unusual events occurred at Shepard Industries:  The company sold a subsidiary.000. and Selling. 47 . the company announced a restructuring plan to reorganize its business units and streamline production.Practice Problem Shepard Industries is a manufacturer of medical devices. in good form (space available on next page). and inventory totaled $80. During 2004. Tornados are highly unusual occurrences in the area.000. The damage sustained to the buildings. Prior to the sale.000.

Shepard Industries Statement of Income For the Year Ended 12/31/2004 48 .

Changes in accounting principles: A change from one allowable method under GAAP to another (voluntary change) Ex: - or as a result of a rule change (mandatory change) c. firms must disclose: EPS for (a) income before any separately reported items. Accounting related (SFAS #154. recurring corrections/ adjustments to estimates in the financial statements Earnings Per Share is the amount of income earned expressed on a per share basis.2. misapplication of GAAP or misuse of facts b. 2006) a. (b) each separately reported item 49 . effective from January 1. Changes in accounting estimates: Normal. In the income statement. Corrections of errors: Error in financial statement resulting from mistake.

net of tax Extraordinary item.(3) net income  Basic EPS = (Net Income – Preferred Dividends) / # of common stocks outstanding. ($ in thousands.962) _ -$ (77.962) $ (.67) 50 . net of tax Net loss Basic earnings (loss) per share Loss from continuing operations before extraordinary item Loss from discontinued operations Extraordinary item Net loss 2010 $ (77. except per share data) Loss from continuing operations before extraordinary item Loss from discontinued operations.67) --$ (.

COMPREHENSIVE INCOME (SFAS #30) All changes in equity except those resulting from investments by or distributions to owners Comprehensive income = NI +Other Comprehensive Income (OCI) Common items in OCI: Impetus for this standard: Presentation: 1. Separate statement 2. Combined statement Accumulated Other Comprehensive Income (Accumulated OCI) .Reported in balance sheet 51 .

52 .

53 .

BALANCE SHEET AND DISCLOSURES Purpose: Typical Format: 54 .

What are assets? Assets Classified how: Operating cycle: define Limitations: Classifications:  Cash and Cash Equivalents Example: Dell (from the text) 55 .

 Shareholders’ Equity Residual ownership interest (assets less liabilities) 56 . The company has the intend and ability to sell within a year or operating cycle.Note 1—Description of Business and Summary of Significant Accounting Policies Cash and Cash Equivalents All highly liquid investments. AND EQUIPMENT. All other investments not considered to be cash equivalents are separately categorized as investments. with original maturities of three months or less at date of purchase are carried at cost and are considered to be cash equivalents. due from banks.  o  PROPERTY. including credit card receivables. PLANT. Short-term investments : temporary investment or short-term marketable securities.  What are liabilities? probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

The annual dividend will be paid in four quarterly installments on April 6.Other Important Disclosures/Elements of Financial Statements:   Notes to the financial statements Summary of Significant Accounting Polices pp 56-66 (11 pages!!)  Subsequent Events What are they? Walmart: 14. and December 11. June 1. we sold our Bombardier Global Express airplane for approximately $46.09 per share. September 8.787.000 in cash 57 . On March 27. and January 4. the Company issued and sold $1. Subsequent Events (in part) On March 5.  Related Party transactions What are they?  Why disclose?  Note M: Related Party Transactions (in part)On May 16.0 billion of 5. 2009. May 15. 2009. 2008. respectively. 2009. 2010. August 14.625% Notes Due 2034 at an issue price equal to 98. 2009. the Company's Board of Directors approved an increase in the annual dividends for fiscal 2010 to $1. 2009. to holders of record on March 13.981% of the notes' aggregate principal amount. 2009. we completed two transactions relating to our corporate aircraft. First.

000. Adverse 4.(a net after-tax cash benefit of approximately $29. Second. These transactions were approved by our Board of Directors.   Management Discussion and Analysis Auditors’ Report External auditor – attest to the fairness of the financial statements 1. for use of a Bombardier Global 5000 owned by the LLC.000) to an unrelated third party.000. Unqualified : 2. Howard Lester. our Chief Executive Officer and Chairman of the Board of Directors.000 in the second quarter of fiscal 2008.Disclaimer  Compensation of directors and top executives 58 . This resulted in a gain on sale of asset of approximately $16. we entered into an Aircraft Lease Agreement (the ‚Lease Agreement‛) with a limited liability company (the ‚LLC‛) owned by W. Qualified: 3.

FINANCIAL STATEMENT ANALYSIS General principles:  Scaling: Numbers need to be scaled to be economically meaningful o Common size financial statements I/S: Express all line items as a % of B/S: Express all line items as a % of o Ratios – Divide line items in economically meaningful way  Benchmarks: Need to compare to something to be useful Common ratios:  Liquidity: Ability to pay debts as they come due in the short-term Current ratio: CA/ CL Quick Ratio:  Solvency: Ability to pay debts when they come due in the long-term Debt to equity: Times interest earned: 59 .

Costco 60 . Activity: Effectiveness of asset use Receivables turnover Inventory turnover Asset turnover  Profitability: Ability to generate wealth in the long-term Profit margin Return on Assets (ROA) Return on Equity (ROE) ROE = Profit Margin  Asset turnover  (1+Leverage) Example: Nordstrom vs.

465.554.455.980 Were your intuitions correct? 61 .213.955 242.428 5.709.383 721.623 2.339.Nordstrom and Costco are both retailing giants but they have very different business models.538 12.090 3.673 4.634.235.000 556.545.491.841 594.711.552 37.688 1.549 1.802 6.383 4.900 901.049.528. would you expect to differ between the two companies? The following are selected data from Nordstrom and Costco for 2003: Sales COGS Net Income Receivables Inventory Current Assets Total Assets Current Liabilities Shareholders’ Equity Nordstrom 6.430 4.009 Costco 42. Which ratios discussed above.

REVENUE RECOGNITION Issue: What amount of revenue should a company report in a given period? General Principle: Revenue is recognized when it is both:  Earned  Realized or realizable How easy is this to apply? Start of Production Examples:  Merchandise sales at Nordstrom? End of Production Sale/ Start of delivery Cash of Asset Collection End of Cash Collection  Upfront ‚activation‛ fees associated with cellular service?  Sale of an iphone? Why is applying principle difficult? Why is it important? 62 .

T.Excerpt from Kravet.‛ Review of Accounting Studies 15:264-294 63 . 2010 ‚Accounting Restatements and Information Risk. and T. Shevlin.

or delays in customers' production schedules. At the end of its fiscal quarters. must request that the transaction be on a bill and hold basis. These include: 1.Facts: Company A receives purchase orders for products it manufactures. customers may not yet be ready to take delivery of the products for various reasons.Staff Accounting Bulletin (SAB) 104 (previously 101):  Reason behind the issuance of SAB 101  Is this GAAP? According to SAB 104.Question: o May Company A recognize revenue for the sale of its products once it has completed manufacturing if it segregates the inventory of the products in its own warehouse from its own products? o May Company A recognize revenue for the sale if it ships the products to a third-party warehouse but (1) Company A retains title to the product and (2) payment by the customer is dependent upon ultimate delivery to a customer-specified site? . but are not limited to. The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis. 3. The risks of ownership must have passed to the buyer. The customer must have made a fixed commitment to purchase the goods. not the seller. 64 . The buyer. 2. These reasons may include. a lack of available space for inventory. preferably in written documentation. having more than sufficient inventory in their distribution channel.The Commission has set forth criteria to be met in order to recognize revenue when delivery has not occurred. revenue is realized or realizable and earned when the following criteria are met:  Persuasive evidence of an arrangement exists  Delivery has occurred or services has been rendered 1) ‚Bill-and-hold‛ arrangements . .

" the customer is permitted to use the health club indefinitely.. (by whom).4. The seller must not have retained any specific performance obligations such that the earning process is not complete. the staff does not view the activities completed by the registrants (i. and 7. enrolling the customer. selling the membership. 6. The monthly usage fees collected from all customers are adequate to cover the operating costs of the health club. signing the contract. The equipment [product] must be complete and ready for shipment.e. 2) Customer acceptance provisions Installation. .In the situations described above. The ordered goods must have been segregated from the seller's inventory and not be subject to being used to fill other orders. The date for delivery must be reasonable and must be consistent with the buyer's business purpose (e. . working to specifications 3) Subsequent performance obligations Inconsequential? 4) License fee revenue  Delivery begins when license term begins 5) Nonrefundable upfront fees o A registrant sells a lifetime membership in a health club. The costs incurred to activate the telecommunications service are nominal.Unless the up-front fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process.g.. storage periods are customary in the industry). activating telecommunications services or providing initial set-up services) as discrete earnings events.  The seller’s price to the buyer is fixed or determinable  Collectibility is reasonably assured 65 . 5. so long as the customer also pays an additional usage fee each month. the deferral of revenue is appropriate.  A registrant requires a customer to pay a nonrefundable "activation fee" when entering into an arrangement to provide telecommunications services. The terms of the arrangement require the customer to pay a monthly usage fee that is adequate to recover the registrant's operating costs. There must be a fixed schedule for delivery of the goods. After paying a nonrefundable "initiation fee.

66 .

e. COGS) is recognized over the period in which cash is collected. the sale does not meet the ‚realized or realizable‛ criteria to recognize revenue. revenue (and the associated expense – i.. inventory reduction and deferred profit o Compute average gross margin on sales for the year o Recognize a portion of gross profit based on cash collected: gross profit %  $ collected  Cost recovery method o Same as above except recognize gross profit once cash received to date exceeds cost of sales 67 . during cash collection) If the collection of cash on a sale is not reasonably assured. Two methods:  Installment method o Record receivable.. In this case.e.Revenue Recognition after Delivery (i.

the company has no basis for estimating uncollectible accounts.000 100.000 150.000 2004 $260.000 Prepare the appropriate journal entries assuming the company uses the installment method: 2003 2004 What if the company uses the cost recovery method? Revenue Recognition before Delivery . The company began operations in 2003.Contract Accounting (ARB 45.000 (Sale B) 169. ASC 605-35) When would recognition before delivery be a concern? 68 .Practice Problem George Company sells washing machines and has a very lenient credit policy. In the first two years of operations the company had: Installment Sales Cost of Installment Sales Cash Collections: On Installment Sales A On Installments Sales B 2003 $250. As a result.000 75.000 (Sale A) 150.

and the construction is expected to last 2 years.000 in year 2.000. The contract price is $2.Two methods:  Percentage-of-completion method  Completed-Contract method Simple Example Seattle Grace Construction Company (SGCC) enters into a contract to build a new building for Addison Company. What percent of the project is completed at the end of year 1? How much of the revenue should be recorded in year 1 and year 2? Percentage Completion Year 1 Year 2 Revenues Expenses Net Income Which provides ‚better‛ information? Completed Contract Year 1 Year 2 Use percentage-of-completion when: 69 .000.000 in year 1 and $800. expected costs are $ Cost incurred on the project are $1.

The buyer can be expected to satisfy all obligations under the contract 4. Revenue ‚earned‛ in excess of amounts billed are kept in the Contracts in Progress (i. Accounting using Percentage-of-Completion Method JE to record costs incurred on the project: JE to record Revenue/COGS: Progress Billings: Contractually agreed-upon amounts that the contractor (seller) is allowed to bill the buyer at set intervals. revenues. and costs are reasonably dependable.. 2. Inventory) account. the consideration to be exchanged.e. The contractor (seller) can be expected to perform the contractual obligations. Estimates of progress toward completion.1. JE to record progress billings:  Why use a contra-account? Contracts in Progress Billings on CIP A/R 70 . and the manner and terms of settlement 3. Contract specifies enforceable rights regarding goods or services to be provided and received by the parties. Only the amounts ‚billed‛ can be recorded in Accounts Receivable.

71 .

250.Simple Example (con’t) Assume all construction costs are paid in cash.000 in years 1 and 2. and Addison pays that amount in each of the two years What journal entries would the company record if the company uses the percentage of completion method? Year 1 Year 2 Net impact on Financial Statements? Assets = Liabilities + S/E Changes in estimates: The total estimated costs of the project could change over time. This is treated as a ‚change in estimate‛ and is treated prospectively – that is. that the progress billings made by SGCC to Addison are $1. 72 . no changes are made to prior net income but changes are made going forward.

000 73 .000 700.050.000 1.000. Scranton Construction contracted to build an office building for Scott Industries for a total contract price of $1.000 2004 210. Revenue recorded in CY = Revenue earned to date – Revenue recorded in PY Expense recorded = Expense to date – Expense recorded in PY Practice Problem On July 1.900.000 900.000 0 900. The building was completed on December 31. 2005.000 2005 900.000 990.000 300. Additional data were: Contract costs incurred during the year Estimated costs to complete as of 12/31 Billings to Scott Industries Collections from Scott Industries 2003 $450. 2003.Thus.000 300.000 700. calculations of revenues and expenses should be based on cumulative amounts less amounts recorded in prior periods.

74 .Compute the amount of revenue and expenses that should be recorded in each year.

75 .Prepare the journal entries that would be recorded in each of the three years 2003 2004 2005 What amounts would be reflected on the company’s financial statements? 2003 Balance Sheet: 2004 2005 Income Statement: EXCEPTION: If a change in the estimate of total costs will result in the contact becoming unprofitable. the company must recognize in the current period the entire expected loss – which includes reversing any gross profit recorded in the prior period.

Revenue recorded = Expense recorded = 76 .

2003 2004 2005 77 .000 1.Practice Problem (con’t) Suppose that the estimated cost to complete as of December 31.340.000 Compute the amount of revenue and expenses that should be recorded in each year.000 700.000 1.000 1.050. 2004 were $1.000 2005 1.000 0 900.000 600.340.000.340.000 300.000 2004 210.000 and the estimated cost turns out to be correct: Contract costs incurred during the year Estimated costs to complete as of 12/31 Billings to Scott Industries Collections from Scott Industries 2003 $450.000 300.

Primary difference: Completed-contract vs.IFRS IAS 11 governs accounting for long-term construction contracts. Zero-Profit methods 78 .

delivery/performance of undelivered item considered probable and substantially under control of vendor Recent changes: Allocation of amounts (consideration) received should be based on relative selling prices. ASC 605-25) Examples: What are managers’ incentives with respect to accounting for multiple-deliverable items? Originally. The same monthly fee is charged by 79 . using:  Vendor-specific objective evidence  Third-party evidence  Best estimate of selling price BUT: Limited to amount that is NOT contingent upon delivery of additional item Example: CellularCo. delivered item could be considered separate ‚unit of accounting‛ only if all the following conditions were met: 1) Delivered item has value to customer on stand-alone basis 2) There is objective evidence of fair value of undelivered item 3) If general right of return exists.Multiple-deliverables (EITF 00-21. in arrangement with multiple ‚deliverables‛. There is a on-time ‚activation fee‛ of $50 and a monthly fee of $40 for the ongoing service. The contract requires the customer to pay a cancellation fee of $300 if the customer cancels the contract. (from EITF 00-21) CellularCo runs a promotion in which new customers who sign a two-year contract receive a ‚free‛ phone.

Further. The phone and activation are delivered first. 1) Are these separate units of accounting? Why or why not? 2) If yes. how should the total consideration be divided between the two units? 80 . CellularCo is sufficiently capitalized. CellularCo is not required to refund any portion of the fees paid for any reason.CellularCo regardless of whether a ‚free‛ phone is provided. CellularCo is considering whether 1) the phone and 2) the phone service (that is. the airtime) are separable deliverables in the arrangement. The activation fee is simply considered additional arrangement consideration to be allocated. The phone costs CelluarCo $100. assume that CellularCo frequently sells the phone separately for $120. followed by the phone service (which is provided over the two-year period of the arrangement). experienced and profitably business and has no reason to believe that the two-year service requirement will not be met.

access revenue is billed one month in advance and is recognized when earned. ‘‘Revenue Recognition in Financial Statements. 00-21.Example of disclosure on revenue recognition for multiple elements (from the 10-K of Cellco Partnership. 00-21. will continue to be amortized in the statement of operations. Equipment sales revenue associated with the sale of wireless handsets and accessories is recognized when the products are delivered to and accepted by the customer.‛ Prior to the adoption. Notes to Consolidated Financial Statements): Revenue Recognition The Partnership earns revenue by providing access to the network (access revenue) and for usage of the network (airtime/usage revenue).‛ SAB No. Effective July 1. d/b/a Verizon Wireless. ‚Revenue Arrangements with Multiple Deliverables. 104. as this is considered to be a separate earnings process from the sale of wireless services.‛ and EITF Issue No. ‚Revenue Recognition. The Partnership’s revenue recognition policies are in accordance with the Securities and Exchange Commission’s (‚SEC‛) Staff Accounting Bulletin (‚SAB‛) No. Subsequent to the adoption of EITF 00-21. Airtime/usage revenue. In general. the Partnership adopted the provisions under Emerging Issues Task Force (‚EITF‛) Issue No. roaming revenue and long distance revenue are recognized when service is rendered and included in unbilled revenue until billed. along with the related costs up to but not exceeding the activation fees. prior to the effective date. 2003. 101. The existing deferred balances. rules-based 81 . IFRS IAS 18 is the main standard related to revenue recognition and has similar requirements to SAB 104 BUT: more principles based vs. customer activation fees. which includes roaming and long distance revenue. the unearned portion is classified in advance billings. were deferred and amortized over the customer relationship period. customer activation fees are recognized as part of equipment revenue.

Revenue Recognition Exposure Draft (November 2011) Purpose: Core Principle: ‚Recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration received (or expected to be received)‛ Requirements:  Identify contracts with customers Consider substance over form Examples:  Identify separate performance obligations in the contract Bundled goods: Separate performance obligation if good/service is ‚distinct‛  Determine transaction price amount of consideration expected to be entitled  Allocate transaction price to separate performance obligations Based on relative standalone selling price basis What if not sold separately? .Expected market assessments approach  Recognize revenue when the entity satisfies each performance obligation When customer obtains control of good or service 82 .Expected cost + margin approach .

Cash and Cash equivalents usually combined and reported as the most liquid ‚current asset‛. • close to maturity. Restricted cash cash that has been set aside for a particular use and is not available for paying current liabilities. highly liquid investments that are: • easily converted into a known amount of cash. RECEIVABLES Two main types of receivables:  Accounts receivable – short-term.CASH AND EQUIVALENTS Cash Cash equivalents short-term. – no longer than three months from date of purchase • not sensitive to interest rate changes. Compensating Balance is some specified minimum amount that must be maintained on deposit with a bank that has made a loan to the company. written promises to pay a certain sum of money on specified future date(s) Accounts Receivable Two main accounting issues: 83 . oral promises to pay for goods or services sold  Notes receivable – short or long-term.

n/ 30 Discount percent # of days discount is available Otherwise. Sales Discounts Offered to encourage prompt payment. using an allowance for returns and/or an allowance for uncollectibles as necessary. Example of terminology: 2/10. net (or all) is due Credit period Gross method (most common): Sales recorded at gross amount. discounts taken are recorded in a contra-revenue account called ‚Sales discounts‛ 84 .1) Recognition (initial valuation)– record account receivable at face vaue less any trade discount and possibly and cash discount 2) Subsequent valuation – record account receivable (net) at net realizable value. n/30 2 /10.

n/30.Simple Example: ABC Company sells a widget to XYZ company for $5. At time of sale: When discount period expires: What is the cost of offering cash discounts? In our simple example.000 on terms 2/10. what does the company earn if it doesn’t offer a discount? What does it earn if it does offer the discount (suppose annual interest is 10%)? 85 . discounts NOT taken. At time of sale: If paid in 10 days: Net method: Sales recorded at net amount. recorded as additional income (perhaps as Interest Income).

Valuation Accounts receivable should be recorded at ‚net realizable value‛ – the net amount the company expects to receive in cash. Accounting under Allowance Method: JE to record estimate of uncollectible accounts each period as bad debt expense: JE to record specific accounts determined to be uncollectible: Two basic methods for estimating bad debt expense: 1) Percentage of sales method: 86 . Requires determination of whether accounts will be collected.Wait until specific accounts are known to be uncollectible (direct writeoff method). -.Estimate amount of accounts receivables that will ultimately not be collected and record amount in the period in which revenue is generated (allowance method). How do we know which accounts won’t be collected? -.

000 of specific accounts which are deemed uncollectible 4) Estimated bad debt expense a.000 The following events occurred during 2005.000 on A/R 3) Identified $20.000 on account 2) Collected $800. for doubtful accts of $10.5%) Compute the balances in each account at year end: 87 . using the percentage of sales method (2.000.2) Percentage of receivables method Practice Problem The following information is taken from the balance sheet of Mickey Company at 12/31/2004: Accounts Receivable (net of allow.000) $90. Prepare the journal entries for each event: 1) Sold $1.


Allow. for DA

Bad Debt Exp.

b. Now assume the company estimates bad debt expense using the percentage of receivable method. An aging schedule of Accounts Receivable at 12/31/2005 is as follows (with estimated % of uncollectible for each group): Current 1-30 days 31-75 days 75+days $130,000 70,000 30,000 50,000 280,000 2% 5% 10% 30%

Under the two methods: %age of Sales Accounts Receivable Balance Allowance for Doubtful Accts Net Receivable Bad Debt Expense Why is bad debt expense and allowance balances different under these two methods? Aging


Advantages/Disadvantages:  % of Sales

 % of Receivables

Recoveries – Accounts that have been written off the books that are subsequently collected. Recoveries are accounted for by 1) reversing the write-off entry, 2) recording the collected cash.


Notes Receivable Notes receivable should be recorded at the present value of the cash expected to be collected. Cash Flows:  Principles: amount to be received at the maturity  Interest : periodic interest payment Definition: written promises that will receive certain sum(s) of money at specified future date(s). Short –term : Long – term : Interest – Bearing Notes Recognition: Record the face amount and recognize interest revenue when it is earned; EX: On October 1, 2012, McQueen Company sold car parts and accepted a $5,000, 90-day, 12% note from Mater Corp. Interest is payable at maturity. Mater paid all amounts due on December 31, 2012. Record the necessary journal entries. 1) First Scenario: McQueen’s FYE is 12/31 10/1/12


2) Second Scenario: McQueen’s FYE is 10/31 10/1/12


2012. 90day.10/31/12 12/31/12 Non-Interest Bearing Notes Recognition: using a discount account (essentially the same method as long-term notes) EX: On October 1. 1) First Scenario: McQueen’s FYE is 12/31 10/1/12 12/31/12 91 . non-interest-bearing note from Mater Corp. Record the necessary journal entries. Mater paid all amounts due on December 31.000. McQueen Company sold car parts and accepted a $5. 2012.

2) Second Scenario: McQueen’s FYE is 10/31 10/1/12 10/31/12 12/31/12 What is the effective rate? Subsequent Valuation of Notes Receivable Using an allowance account for uncollectibles : provisions for loan loss More important for long-term notes receivable 92 .

2009.000 of its accounts receivable to a finance company and signs a promissory note. ABC Company assigns $100. Interest on the note at 12% is payable monthly. 93 .Financing with Accounts Receivables Companies will sometimes transfer their receivables to another party.  Secured Borrowing – Borrowing money and using receivables as collateral o Pledging – o Assigning – Practice Problem: On December 31. The finance company advances 80% of the accounts receivable assigned less a finance fee of 1.6% of the accounts receivable assigned.

2010 94 .000 and sales discounts (ABC uses the gross method) of $2. At the end of January.000 related to the assigned accounts receivable. ABC recorded cash collections of $58. 2009 During January 2010. January 2010 January 31. ABC remitted the cash for the assigned accounts receivable collected plus accrued interest to the finance company.December 31.

 Selling Receivable – Transferring rights to collect receivables to a third party in exchange for cash o Without recourse – purchaser bears risk of uncollectibility o With recourse – seller bears the risk of uncollectibility Why do firms do this? Which would managers prefer? Criteria for classification as ‚sale‛ (SFAS #140. Transferees can pledge or exchange the transferred asset 3. Transferred asset is isolated from transferor (beyond reach of transferor’s creditors) 2. Transferor does not have effective control of asset through repurchase agreement 95 . ASC 860-10-40): 1.

000 of accounts receivable to a factor. B Company sells $100.000 of the factored accounts receivable will be uncollectible. 2009. The factor retains the remaining 10% to cover its factoring fee (5% of the factored accounts receivable) and to provide a cushion against potential sales returns.000 and that $3.Practice Problem On December 31. Without Recourse With Recourse 96 . B receives cash equal to 90% of the factored accounts receivable. B estimates that the fair value of the last 10% of receivables to be collected is $9.

INVENTORY Items held for sale in the ordinary course of business. 2) acquisition/Production. up-to-date records of inventory important? -  Perpetual inventory system – tracks purchases and sales as they occur  Periodic inventory system – inventory physically counted periodically What effect do errors in inventory counts have on the financial statements? Recall: Beginning Inventory + Purchases – COGS = Ending Inventory Balance Sheet This Period Overstated Inventory Understated Inventory Income Statement This period Next period 97 . Three issues related to inventory: 1) Control. 3) Cost Flow Assumption Control Why are accurate.

FOB destination  Buyback arrangements 2) Cost to attach General rule: All costs associated with manufacture. storage or preparation. reduce inventory if discounts taken  Net method: Record in inventory at net amount. acquisition.Acquisition/Production of Inventory 1) Items to include  Consigned goods  Goods in Transit FOB Shipping point vs. record Discounts Lost as other expense 98 .  Merchandising Company:  Manufacturing Company: Cash Discounts  Gross method: Record in inventory at gross amount.

99 .

Inv. COGS: First items purchased (oldest items) are the first items sold (FIFO) End. The difference between. for example. of units available for sale IMPORTANT POINT: The method chosen need not represent the actual movement of inventory!! It is simply a method of assigning $ values to inventory items. LIFO periodic and LIFO perpetual. is in what you consider "available for sale" at the time of each sale. (LISH) 3) LIFO – Assume most recent items purchased are sold first. Practice Problem: 100 .: Last items purchased (newest items) stay in ending inv. COGS: End Inv: Last items purchased are the first items sold (LIFO) First items purchased stay in ending inv. For this class. 2) FIFO – Assume items are sold in the order they are purchased.Cost Flow Assumption Question: How do we allocate the total cost of goods available for sale (beginning inventory + purchases) between COGS and ending inventory? Beginning Inventory + Purchases = COGS + Ending Inventory Four possibilities: 1) Specific ID: Specifically identify which items were sold and which are remaining. (FISH) 4) Weighted Average: Items sold are valued at the weighted average cost of the goods available for sale  COGAS/total no. A company may use any of the above methods under either a periodic or a perpetual inventory system. we will assume a periodic inventory method for all computations of COGS.

LIFO WA 101 .The following information relates to the Sunny Valley Corporation for the month of October: Date Beginning October 5 October 12 October 22 October 25 TOTAL Description Purchase Sale Purchase Sale Units 300 220 260 150 80 Cost 10 11 12 Total Compute COGS and ending inventory assuming the company uses the FIFO cost flow assumption: Compute COGS and ending inventory assuming the company uses the LIFO cost flow assumption: Compute COGS and ending inventory assuming the company uses the Weighted Average cost flow assumption: Notice that under each method COGS + EI = COGAS. Why? FIFO COGS Ending Inv.

This is called ‚liquidating LIFO layers‛. LIFO Liquidations If the number of units sold exceeds the number of units purchased.COGAS Which method provides the most current cost in Ending Inventory? Which method provides the most current cost in COGS? If prices rising: COGSLIFO NILIFO EILIFO COGSLIFO NILIFO EILIFO COGSFIFO NIFIFO EIFIFO COGSFIFO NIFIFO EIFIFO If prices falling These relations are true as long as the number of units purchased exceeds the number of units sold. the company has the following purchases and sales: Purchases Sales Units 200 400 Cost 13 Total 2. the company has essentially ‚sold‛ some of the beginning inventory units (which may have very old costs attached to them). Suppose in the following year. Practice Problem (con’t) Continue the Sunny Valley Corporation example.600 What is COGS under LIFO? 102 .

What is COGS under FIFO? 103 .

000) 125. At 12/31/2004.000. Companies often maintain records on a FIFO basis and at the end of each period compute EI on a LIFO basis and adjust the reserve accordingly. the company purchased $825. The company values its inventories under the LIFO method. At 12/31/2005. Primary Difference: NO LIFO! 104 . the company reported the following: Inventories (net of LIFO reserve of 25.000 During 2005. Record the journal entry to adjust the LIFO reserve FIFO or LIFO? Arguments in favor of LIFO Arguments in favor of FIFO IFRS IAS 2 governs accounting for inventory. The LIFO reserve is a contra-account to Inventory.LIFO reserve The difference between EI valued on a LIFO basis and EI valued on a FIFO basis is often referred to as the ‚LIFO reserve‛.000.000 of inventory and determined COGS using FIFO to be $800. inventories using LIFO would be valued at $140. Practice Problem McCoy Industries is a manufacturer of small office equipment.

If units purchased > units sold (or units EI > units BI) If units purchased < units sold (or units EI < units BI) If $ purchased > $ sold (or $ EI >$ BI) If $ purchased < $ sold (or $ EI < $ BI) But.  LIFO layer added  LIFO layer liquidated 105 . Compute price change from ‚base year‛ prices (price index) for the pool of inventory  LIFO layer added  LIFO layer liquidated Under DVL. ‚price level‛ changes). to determine if LIFO layers are added or liquidated. Ending inventory is compared to beginning inventory. Recall: Under unit LIFO.Dollar Value LIFO Using the LIFO method discussed previously can be problematic because of 1) record-keeping and 2) LIFO liquidations. which applies LIFO procedures to pools of similar goods based on dollars rather than units.e. How do we do that? 1. if tracking inventory in $’s and not units: Inventory in $ = inventory in units x cost/unit  Inventory in $ could be due to  in units or  in cost/unit  Inventory in $ could be due to  in units or  in cost/unit Therefore.. we need to adjust the inventory in $’s to ‚take away‛ the effect of changes in cost/unit (i. both measured in dollars adjusted for inflation. An alternative is Dollar-value LIFO (DVL).

Divide the inventory value for the pool (based on current prices) by price index The difference between the beginning inventory at base year prices and the ending inventory at base year prices indicates whether a layer has been added or taken away: If EIBASE$ > BIBASE$  LIFO layer added  add LIFO layer at current year cost (multiply layer at base year prices and multiply by price index) If EIBASE$ < BIBASE$  LIFO layer liquidated  remove most recent layers added 106 .Price index – a measure of the change in prices from a base year (the first year dollar value LIFO is adopted in this case) to the current year. Price index = Ending inventory quantities x current end-of-year costs Ending inventory quantities x base end-of-year costs (Mostly is given) 2.

2 1.Practice Problem On January 1.500 144. changed from FIFO to dollar value LIFO.5 1. its beginning FIFO inventory was $100. At that date.3 Compute ending inventory on a dollar value LIFO basis for each year: 107 .400 Year-end price index 1. The following information relates to the company’s inventory for the years ended 12/31/2000 through 12/31/2003: Year-ended 12/31/2000 12/31/2001 12/31/2002 12/31/2003 Ending inventory at current costs (or FIFO) $124. Deoxys Inc.200 140.000.4 1.800 169. 2000.

If the company purchased $500.000 of goods during 2000. what would COGS be under FIFO and under LIFO? 108 .

use NRV  If RC < NRV less normal profit margin. for the five different items it sells to its customers. Product Product Product Product Product 109 . except:  If RC > Net Realizable Value (NRV). ‚market‛ is defined as replacement cost (RC). Determine the appropriate “market” value for each of the five products. The LCM rule can be applied to products individually or to groups of products. use NRV less normal profit margin Note that the rule is ‚asymmetric‛ – inventory is reduced if market falls below cost but is NOT written up if market rises above cost.INVENTORY – ADDITIONAL ISSUES Lower of Cost or Market (LCM) rule GAAP requires that inventories be reported at the lower of ‚cost‛ or ‚market‛  What is ‚Cost‛?  What is ‚Market‛? Under GAAP. What is the advantage of grouping products? Journal entry to record write-down: What impact does the company’s choice of cost flow assumption have on the probability of an inventory write-down? Practice Problem The following data relate to Zubat Inc.

000 1.400 240 140 What value should be reported for ending inventory if the company applies the LCM.125 1. to individual products? Prepare any necessary journal entries to adjust inventory to LCM.300 1800 600 180 C $1.875 375 200 E $800 900 1.500 675 1. 110 .200 300 120 D $1.000 550 850 250 90 B $2. What is the value of ending inventory if the company applies LCM to the entire inventory? Prepare any necessary adjusting journal entries.000 1.Historical Cost Replacement Cost Estimated selling price Estimated costs of disposal Normal Profit Margin “Market” A $1.

How would that change our previous analysis? Also.IFRS Another difference between US GAAP and IAS 2 relates to LCM. write-downs can be subsequently reversed if market value increases BUT only up to the amount of the original write-down. Under IAS 2 market is always defined as NRV. o 111 .