Financial Accounting - HBSP Course Notes (Raghav)

Introduction
30 May 2021 05:32 PM
You will be keeping the accounts (or bookkeeping) for the Global Grocer store.
You have a limited amount of cash available to start up the business, but you hope to obtain bank loans
and also raise capital from outside investors.
• Financial accounting is a financial information system that tracks and records an organization's
business transactions and aggregates them into reports for decision makers both inside and
outside the business.
• A transaction is an event that has consequences for a business' financial condition.
• The event could be either external or internal to the business.
✓ Accounting practices in the United States are governed by a set of accounting rules referred to as
Generally Accepted Accounting Principles (GAAP).
✓ Accounting practices outside of the United States are usually governed by GAAP’s international
counterpart, the International Financial Reporting Standards (IFRS).
Financial Accounting Page 1

Terms and Concepts
30 May 2021 05:48 PM
Three main financial statements : Balance Sheet, Income Statement, Statement of Cash Flows
Five basic financial accounting concepts: Entity, Money measurement, going concern, consistency and materiality
Two important qualities of financial accounting information--Relevance and reliability
How the use of accrual accounting and generally accepted accounting principles aid accountants in their quest for
these qualities.
Balance Sheets (Statement of Financial Position)
➢ A report of the organizations financial situation at a particular point in time. It lists the entity's assets, liabilities and
owners' equity.
➢ It is called a balance sheet because it reports the balance or amount in each asset, liability and owners' equity account.
Income Statement
• The income statement details the entity's operating performance during a specific period
of time, known as the accounting period, displayed at the top of the statement.
• The income statement lists the revenues earned and expenses incurred during the period;
subtracting expenses from revenues results in the measurement of net income for the
period.
Statement of Cash Flows

• The statement of cash flows details the sources and uses of cash by the entity over an accounting
period.
• For the convenience of financial statement users, the statement of cash flows is organized by type
of business activity: operating, investing and financing.
Five basic financial accounting concepts
Concepts
Entity
• It states that accounts are kept for an entity as distinct from the people who own, run or do business with the entity.
• It allows the accountant to draw a virtual boundary around the entity and hence limit the activities that need to be tracked and
recorded.
Money measurement concept
Financial accounting deals only with things that can be represented in monetary terms.
Going Concern Concept
• It states that an Entity is expected to remain in operation for the indefinite future.
• The going concern concept directs the accountant to explicitly make this assumption in the absence of evidence to the contrary.
Consistency Concept
• It states that an entity should use the same accounting methods and procedures from period to period unless it has a sound reason to
change methods.
• Note that the consistency concept does not forbid a switch in accounting procedures.
Materiality Concept
• It states that an entity need only apply proper accounting to items that are material, i.e., significant to potential users of the financial
statements.
• This concept allows the accountant to be practical in choosing the appropriate degree of precision in the accounts.
Just what is material and not material is not made specific in accounting. The general rule is that, "An item is material if its disclosure would
impact the decisions of the users of the accounts."
The application of this rule requires accountants to judge what users of financial statements would consider significant to their decisions. As
in most matters requiring judgments, reasonable people can differ. Determining materiality is no exception.
Quality of the output depends on the relevance and reliability of the data presented
Relevance : Timeliness and usefulness of the information to its users.
Reliability : Objectivity and verifiability of the information.
There isn't a way to record a transaction that will maximize both these desirable properties. In such cases, reliability is
generally given precedence over relevance
Accrual accounting is a method of accounting which provides information about a company's assets, liabilities and ❖ Generally Accepted Accounting Principles (GAAP) are guidelines that accountants, managers and
auditors must follow while preparing and auditing accounting information for external reporting
owners' equity that cannot be obtained by accounting for only cash receipts and outlays. purposes.
Accrual accounting attempts to record the financial effects on a business of transactions that have economic ❖ GAAP requires the use of accrual accounting.
consequences for the business in the accounting period when the transaction occurs rather than only in the periods ❖ The Financial Accounting Standards Board (FASB) determines GAAP in the United States.
when cash is received or paid by the company.
❖ There also exists an International Accounting Standards Board (IASB), which, among other
• When applied consistently, accrual accounting is a means of enhancing the relevance of financial statements. activities, has undertaken a major effort to harmonize accounting standards around the world.
• Cash-basis accounting results in inadequate and misleading financial statements for all but the most simple of ❖ The International Accounting Standards Board (IASB) publishes International Financial Reporting
businesses. Standards (IFRS).
• As a result, accrual accounting is the accounting system of choice throughout the world today.
❖ FRS tends to be stated as in the form of broad principles. In contrast, much of GAAP tends to be stated
in the form of bright-line rules.

Balance Sheet
31 May 2021 04:01 PM
What we will be covering:

✓ How a balance sheet is organized
✓ Its main organizing principle, the accounting equation
✓ Two concepts that are important for the preparation of the balance sheet, dual aspect and historical cost
✓ Two financial ratios that can be computed from the balance sheet--current ratio and total debt to equity ratio.
Introduction
• The balance sheet, also known as a statement of financial position, is a snapshot at a specific point in time of the resources controlled by an entity (assets), the claims
against those resources (liabilities), and the owners' residual interest in the entity (owners' equity).
• In the side-by-side format shown, assets are listed on the left side of the balance sheet, liabilities and owners' equity are listed on the right.
• Statement of Affairs of the Company
TOTAL ASSETS = TOTAL LIABILITY + OWNER'S EQUITY

Assets, Liability and Equity
02 June 2021 05:40 PM
Assets
To be recorded as an asset, an economic resource must meet four requirements:

• Acquired at measurable cost
• Obtained or controlled by the entity
• Expected to produce future economic benefits
• Arises from a past transaction or event
Examples of Assets: Cash, Property, Merchandise, Prepaid Expenses etc.

Examples of Not an Asset: Reputation, Employee Contracts, Merchandise Past its sell date.
Tangible and Non Tangible Assets:

• Tangible Assets are Physical substances. Example: Computer, Merchandise, etc.
• Non Tangible Assets are assets that are not substance. Example: Licenses, Franchise Fee, etc.
Current and Non Current Assets:

• Current assets include cash and those assets that are expected to be converted into cash or
consumed within 12 months of the balance sheet date.
○ Example: Accounts receivable (money owed to entity by customers), merchandise inventory
(goods available for sale) and prepaid expenses (rent paid in advance for store).
• Non-current assets are assets that are expected to provide economic benefits for periods longer
than a year.
○ Examples: Land, Warehouse, store fixtures for display purposes, and franchise fee asset.
Some tangible, non-current assets with limited lives such as the warehouse building have an associated
contra-asset account called accumulated depreciation that reduces the recorded value of the asset.
Liability
A liability represents an obligation of the entity to other parties.
To be recorded as a liability, an obligation must meet three requirements:

• It involves a probable future sacrifice of economic resources by the entity
• The economic resource transfer is to another entity
• The future sacrifice is a present obligation, arising from a past transaction or event
Examples of Liabilities: Cash owed to Trade Creditors, Short term debt, Payable Mortgage
Examples of Not a Liability: Favours, personal parking tickets.
Current and Non-Current Liabilities:
• Current liabilities are obligations that are expected to become due within 12 months of the
balance sheet date.
○ Example: Accounts Payable(owed to suppliers), Taxes Payable, Short term debts.
• Non-current liabilities are obligations that are expected to become due more than 12 months past
the balance sheet date.
○ Example: Mortgage, Other Long term loans.
Owner's Equity
• It is the residual interest of the entity's owners in the company's assets, or the amount remaining after liabilities
are deducted from assets
• Also called as Net Assets, Stockholders' equity, shareholders' equity, or just Equity
Example:
Common stock - amount invested by shareholders. Also called as Paid in Capital.
Retained earnings - Cumulative earnings of the entity, less any distribution of earnings to owners of the entity.
Accounting Equation
TOTAL ASSETS = TOTAL LIABILITY + OWNER'S EQUITY

Concepts
02 June 2021 05:40 PM
Concepts
• Dual Aspect:
○ There are two sides to every accounting transaction. Recording both sides of each
transaction is known as double-entry bookkeeping.
○ After both sides of each accounting transaction are recorded on the entity's books, the basic
accounting equation should remain balanced
• Historical Cost:
○ This provide guidance on the amount at which a transaction should be reported initially in
the entity's accounts.
○ It requires that transactions be recorded in terms of their actual price or cost at the time
the transaction occurred.
○ Many monetary assets are recorded initially at their cost, and subsequently measured and
reported in the balance sheet at their market value. Monetary assets are items such as
marketable securities. Their market value can generally be estimated reasonably reliably.

Ratios
02 June 2021 05:41 PM
Ratios
Financial ratio analysis is used to assess the financial position and performance of an entity.
Financial ratios are ratios based on the amounts in the financial statements.
Current ratio : Current Assets / Current Liabilities

○ Current Ratio is a measure of an entity's ability to meet its maturing short-term obligations.
○ These short-term obligations are usually repaid in the normal course of business, as the entity's current assets are converted to cash.
○ Rule-of-thumb states that a healthy business will have a minimum current ratio of 2.
○ Because the appropriate current ratio varies by industries, financial statement users tend to focus on an entity's current ratio relative
to those of other, similar businesses.
▪ E.g. US Pharma has CR as 1.8, Software Industry has 2.9
▪ If financial statement users notice that an entity has a current ratio that is significantly higher than that of its peers, they may be
concerned that the entity holds more cash or inventory than a business needs. This may signal that it is locking up potentially
productive capital.
▪ If, on the other hand, an entity has current ratio that is significantly lower than that of its peers, financial statement users may
question its ability to satisfy its current obligations in a timely manner.
Total debt-to-equity ratio
• Total Debt to Equity Ratio : Total Debt / Total Equity

• Ratio of total debt (capital that accrues interest and has to be repaid to lenders) to equity capital (capital that does not demand interest and
does not have to be repaid).
• This ratio measures financial leverage or the degree of the entity's indebtedness relative to its equity funding.
○ When an entity assumes debt, i.e., accepts a loan, it has to pay interest and also repay the loan to the debt holder over an agreed-upon
period of time.
○ If the entity runs into hard times and fails to pay its maturing financial obligations to its debt holders, they can force the entity into
bankruptcy.
○ Equity capital, on the other hand, is a residual claim on the entity's assets. If a company becomes insolvent, equity holders get what remains
after debt-holders have been satisfied.
○ So, the larger the size of an entity's debt obligations relative to equity, i.e., the larger its total debt to equity ratio, the greater is the implied
strain on the entity to make regular payments to debt holders, and the higher is the risk of bankruptcy.
Interpretations:
1. If a company has a total debt to equity ratio that is significantly higher than that of its peers, financial statement users may be concerned
about its ability to make the required payments to its debt holders and the company's long-term solvency may be questioned.
2. If, on the other hand, a company has a total debt to equity ratio that is significantly lower than that of its peers, financial statement users
may question whether the company is being aggressive enough in pursuing profitable growth opportunities by raising debt when necessary
to finance those opportunities.

Income Statement
31 May 2021 07:40 PM
What we will be covering:

✓ Income statement and how it is organized.
✓ Three new accounting concepts - the realization, matching and conservatism concepts
✓ Two ratios that are important measures of operating performance: the gross margin and return on sales percentages.
Introduction
○ An income statement is a financial description of an entity's operating performance during an accounting period.
○ It reports the entity's sales, expenses and net income or loss for the period.
○ The income statement's basic equation is Sales minus Expenses equals Net Income.
Sales are increases in Assets or Decreases in Liabilities during a period resulting from delivering goods, rendering services or
other activities consulting the entity's Central Operations.
Expenses are decreases in assets or increase in liabilities during a period resulting from deliver of goods, rendering of services
or other activities consulting the entity's central operations.
Gross Margins :
○ Excess of Sales amount over the cost of goods sold amount.
➢ Gross Margin = Sales - Cost of Goods Sold (COGS)
Operating Expenses, Interest Expense and Income Tax Expense are populated below the gross margin.
Operating Expense:
○ Costs related to Operation of the business such as Marketing, Selling, Admin etc.
○ Generally given as a Single Account (Selling, General and Administrative Expenses, or SG&A Expenses).
➢ Operating Income = Gross Margin - SG&A Expenses
Interest Expenses:
○ Cost of Debt Financing for the accounting period.
○ Income before Income Taxes = Operating Income - Interest Expense
NET INCOME = Income before Income tax - Income Tax Expense
The Net income at the end of the Income Statement directly effects the Retained earnings in the Balance Sheet.

Retained Earnings and Dividends
02 June 2021 05:33 PM
Retained Earnings
▪ It is the sum of the company's net income to date, less dividends, if any, paid to the owners.
▪ The net income for the period is added to the retained earnings amount reported on the period's beginning balance sheet to de termine the period's
ending retained earnings, before any dividend payments.
Dividends
▪ Dividends are distributions of earnings to owners, usually in the form of cash.

▪ The payment of a dividend reduces the Retained Earnings account.
In summary, two events change the retained earnings account during an accounting period.
▪ First, the Net Income (loss) earned by the entity during the period increases (decreases) the retained earnings account.
▪ Second, any dividends paid during the period reduce the retained earnings account.
The payment of dividends is not an expense; it is a distribution of equity capital to investors. Hence, the payment of dividends is not recorded on the income
statement; instead, it directly reduces the retained earnings account.

Concepts
02 June 2021 05:34 PM
Concepts
1. Realization
a. Realization is the process of converting assets, such as merchandise for sale, into cash, cash equivalents, or good accounts receivable
b. It helps in determining when revenue is recognized. Two conditions must be satisfied.
i. First, the revenue must be earned, which typically means that the customer has received the good or service.
ii. Second, the revenue must have been realized or realizable, implying that the customer has paid or is expected to pay for the merchandise.
c. IFRS recognizes revenue when the "risks and rewards of ownership are transferred." In contrast, GAAP, among other requirements, recognizes revenue when it is
"earned."
2. Matching
a. The Matching concept indicates what expenses should be recognized when revenue is recorded
b. Timing of expense recognition is important since revenue less expenses equals net income
c. The Matching concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to this period's activities
but which are not directly related to products and services sold, are expensed this period.
3. Conservatism
a. The Conservatism Concept goes one step further by recommending that prudence be exercised in recording revenues and expenses. It says that revenues should be
recognized only when reasonably certain, but expenses should be recognized as soon as reasonably possible.
b. Conservatism in financial accounting means that an entity should recognize only those revenues for which there is a high degree of confidence that they will be earned
and realized.
c. Expenses, on the other hand, should be recorded as soon as they seem likely to be incurred. If the entity is uncertain whether to recognize an expense or about the
amount of an expense, the conservatism concept encourages it to pro-actively estimate the cost and record the expense.

Recording the Balance sheet
02 June 2021 05:34 PM
How to Record Sale on Balance Sheet
1. Cash Sale - When customer pays cash to the entity in return for goods
a. Sale increases the Retained earning account, and to balance out increases the Cash account.
b. Inventory account decreases by the COGS, and to balance out the Retained earnings records an expense by reducing COGS value.
c. Assets
i. Current Assets (Cash) increases
ii. Inventory Decreases by the amount of COGS
d. Equity Increase
i. Retained earnings increases by the amount of Cash - COGS.
2. Credit Sale - When customer buys on credit
a. Sale increases the Retained earning account, and to balance out increases the Accounts Receivable account.
b. Inventory account decreases by the COGS, and to balance out the Retained Earnings records an expense by reducing COGS value.
c. Assets
i. Accounts Receivable account increases
ii. Inventory Decreases by the cost value of the good sold
d. Equity Increase
i. Retained earnings increases by the amount of Cash - COGS.
Recording Expense
1. Operating Expenses
a. Salaries, Utilities are deducted from Cash account and recorded as expense in the income statement (hence in the Retained Earnings)
b. Rent Expenses - If paid in advance (as part of prepaid expenses), it is reduced from Prepaid expenses and recorded as an expense in income statement.
c. Depreciation - Expenses associated with the use of tangible non-current assets
i. If any non tangible asset is acquired, it is done so with the expectation that they would provide economic benefits for a num ber of years.
ii. The matching concept requires that the cost of each of these assets be spread over its useful life, and in each accounting period an expense be
recorded to reflect the reduction in the useful life of the asset. This expense is called Depreciation Expense.
iii. Accumulated depreciation account is created to record reduction in Balance Sheet value of Asset. It is a Contra Asset, or a negative Asset.
iv. An asset's historical cost minus its accumulated depreciation yields its net book value. The net book value of each long-lived asset is used to
compute total assets on the balance sheet.
v. NOTE: Land is never Depreciated
d. Amortization - For an intangible long-lived asset, we record a reduction in its remaining useful life by recording an amortization expense that directly
reduces the value of the asset on the balance sheet.
i. This is recorded differently from the Depreciation
ii. There is no associated Contra Asset account. Amortization is directly reduced from the relatable intangible asset account.
iii. Example - Franchise Fee.
2. Interest Expenses
a. Short Term Debt
i. Interest is recorded as Reduction in Cash account and Increase in Interest Expense (reduction in Retained earnings)
b. Long term debt - Mortgage
i. Interest is recorded as Reduction in Cash account and Increase in Interest Expense (reduction in Retained earnings)
ii. Principal amount is recorded as Reduction in Cash account and Reduction in Mortgage Payment on Liabilities side.
3. Tax Expense
a. Tax is calculated on the Income before Income Tax amount.
b. It is recorded as an increase in Taxes Payable Liability on the balance sheet, and a reduction in Retained Earnings.

Ratios
02 June 2021 05:48 PM
❖ Gross margin as a percentage of sales
○ It is the dollar gross margin divided by sales, expressed as a percentage.

○ Dollar gross margin is sales minus cost of goods sold. It represents the mark up on the cost of the products sold by a
company.
Insights:
○ We can compare the gross margin of a company at different points in time, or the gross margin percentages of
different companies in similar businesses.
○ This type of analysis provides financial statement users useful insights into a company's pricing strategy and
practices.
❖ Return on sales percentage
○ Net income per dollar of sales
○ We can compare the performance of a company at different points in time, or the performances of different
companies in similar businesses.
○ This type of analysis provides financial statement users useful insights into a company's pricing strategy and its
ability to control costs.
FUN FACT! - Over the past decade, return on sales percentages in the U.S. software industry have averaged about -4%, that is,
negative four percent! Despite their extremely high gross margin percentages, averaging about 70%, as a group, software
companies have had negative return on sales.

Accounting Records
02 June 2021 07:50 PM
Tracking and recording Transactions:

▪ We will be covering steps by which accounting systems track and record financial accounting transactions during an accounting period.
▪ We will be recording accounting transactions in a journal and ledger which will be used to prepare the balance sheet and income
statement for a period.
Steps to record the Financial activities during an accounting period Recording Transactions:
Asset Beginning Change Ending Owner's Beginning Change Ending

Balance Balance Equity Balance Balance

Journal Entries
02 June 2021 08:34 PM
Journal is a chronological record of the entity's transactions. Sample Journal:

Journal Debit Credit
- Each change to an account consists of a dollar amount and a direction (whether it is an increase or a decrease). Aug 31 Cash 80000
- We indicate the direction of the change by a specialized use of the words debit and credit. Common stock 80000
Aug 31 Cash 50000
Short term debt 50000
Note :
• Each permanent or balance sheet account has the August ending balance as its September beginning balance.
• Each temporary or income statement account starts this new accounting period with a zero balance.

Ledger
05 June 2021 01:06 AM
After a journal entry has been made, it is posted to the ledger, which
contains T-accounts, one for each account.
• Each T-Account is associated with a single account.

• At any given time, each account has a balance (the monetary
amount in that account). An account may have a debit (left-
side) or a credit (right-side) balance.
Journal - Balance Sheet Accounts Ledger
Journal - Income statement transactions Ledger

Adjusting entries
05 June 2021 02:44 PM
Once the accounting period completes, there are several adjusting entries to be made. We can identify the accounts that need to be adjusted.
They are prepaid expenses, warehouse building, store fixtures, franchise fee and taxes payable.
Take note that adjusting entries do not involve any economic exchange with a third party.
Example:
○ Expiration of the prepaid rent account is Decreased (credited since its an asset), and Operating expenses are Increased (Debited).
○ Accumulated Depriciation Account is Decreased (credited since its an Asset), and Operating Expenses account is Increased (Debited)
○ Amortization of Franchise Fee: It is decreasing the asset, hence Credited under the asset account and Debited on Operating Expenses.
○ Tax Expense: These are recorded as Debit on Tax Expense , and Credit on Tax Payable (Liability)
Once all adjusting entries are made, at closing all the income statement accounts are set to ZERO and the Retained account is debited as Offsetting entries.
After closing out the income statement (temporary) accounts, the balances in the ledger's balance sheet (permanent) accounts are
transferred to the balance sheet at the end of the period.

05 June 2021 03:53 PM
Statement of cash flows provides information about the entity's sources and uses of cash during an accounting
period.
The statement of cash flows can be presented in two different formats called the direct method and the indirect
method.
Direct Method
The direct method statement of cash flows summarizes transactions that have been posted to the cash ledger
account during the period.
Categories of cash statements:

Operating - Delivery of goods and services that generates revenues and expenses in income statement.
Example: Payment to Suppliers, Rent
Investing - Purchase and sale of long lived assets.
Example: Property Purchase, infrastructure purchase, Franchise Fee
Financing activities - Cash effects of Raising or Retiring debt, new issue or repurchase of equity, and
payment of any cash dividends.
Example: Stock Issued, Loans (short term and Long term)
Steps to prepare a Direct Method Statement:

Direct Method
• The direct method statement of cash flows is constructed
at the end of an accounting period using the cash account
in the ledger.
• Debit to cash is an increase in cash balance (a source of
cash) and credit is a decrease (a use of cash).
1. Classify each debit and credit in the cash account as

operating, investing, or financing item
2. Re-arrange them into these three categories to obtain the
direct method statement of cash flows.
Note: Interest Payments are categorized as Operating Trans and

not as Financing Trans, whereas a Principal Payment against a
loan is registered as a Financial Trans.
Indirect Method
Indirect Method
The two statements differ in only one area: the format and information included in the cash flows from
operating activities section.
The investing and financing cash flows sections are exactly the same in both types of statements of cash
flows.
The Operating Cash Flow entries in Indirect Method are made with following steps:
1. Start with Net Income as that is the result of the accrual accounting.
2. Record an Addition and Subtraction in separate sections. These are called De-accruals.
3. Each entry does not convey an actual cash flow, but states the adjustments made to each account.
Why use Indirect Method?
Because the operating section of the indirect method statement explains the difference between the
net income and the operating cash flows of the period, it provides readers with information about the
extent to which and the means by which the entity's net income of the period has resulted in operating
cash flows.
Net Income and Operational Cash Flows
• Accrual accounting focuses on capturing the economic meaning of a transaction, rather than its
cash effects.
• This usually results in a difference between a period's net income and the operating cash flow to
the entity, although both are the result of operations during the period.
De-Accrual:
1. A De-accrual is an adjustment made to the net income to arrive at the cash effect of operating
activities.
2. Add Increases in Liabilities and Decreases in Assets. Example: Depriciation, Amortization, change
in account and other payables.
3. Subtract Decreases in Liabilities and increases in Assets. Example: Account Receivables,
Inventories, Prepaid Expenses.
The difference between various expenses of the period (other than COGS) and cash paid to external
parties is termed as Net Cash Provided by operating activities.
COGS Transactions
When Inventory increases during a period

When Inventory increases during a period
Inventory purchases = COGS + Increase in inventory
COGS Inventory Purchases
When Inventory decreases during a period +Change in Inventory +Change in account payable
Inventory purchases = COGS - Decrease in Inventory ___________________ ___________________
Inventory Purchases Cash Paid to suppliers
Cash Paid to suppliers
COGS
When account payable increases during a period: + Change in Inventory
Cash Paid to supplier = Inventory purchases - Increase in accounts payable - Change in Accounts Payable
_________________________
When account payable Decreases during a period: Cash Paid to Supplier
Cash Paid to supplier = Inventory purchases + decrease in accounts payable
Summary of steps:
• We start with net income of the period
• Add depreciation and amortization expense
• Add decreases (or subtract increases) in accounts receivable
• Add decreases (or subtract increases) in inventory
• Add increases (or subtract decreases) in accounts payable
• Add decreases (or subtract increases) in pre-paid expenses
• Add increases (or subtract decreases) in other payables

Revenue and Receivables
05 June 2021 06:46 PM
Revenue is recognized when it is earned and realized or realizable (SALE METHOD)
Earned: In most cases, revenue is earned when a sale has taken place, which is when:
• the customer has agreed to buy the goods and services;

• the goods or services have been delivered; and
• the seller has performed all of its obligation to the buyer
Realizable: The realized or realizable criterion is satisfied if the seller has received payment or reasonably expects to be paid.
Cases of Financial Concerns:
Deferred Revenue - Case of unredeemed Gift Certificates

• Case where the Sale meets the Realization Criteria (Customer Paid for the Gift Certificate) but the Revenue had not been earned since goods had not been delivered.
• Due to this, Gift certificate should not be included in the Sales Revenues for the accounting period.
❖ A new account is created called Deferred Revenue. It is the future revenue that has already been collected but has yet to be earned.
❖ Shown in the Liabilities section, reflecting the entity's obligation to provide merchandize to the holder of the gift certificate in the future.
❖ Other examples: Magazine subscriptions, Airline tickets, Theatre tickets, Coupons. Money is received prior to delivery of goods/services.
❖ We move the transaction from the general ledger to the monthly financial statements. Note that this sales transaction must remain on the balance sheet and cannot go into the income
statement as revenue until it is both earned and realized.
Bad Debts - When account receivables are not collected

❖ The entity creates an allowance for Bad Debts. The purpose of an allowance account is to record the accounts receivable at the amount you expect to receive in the future.
➢ Estimating a Bad Debt:

○ Companies assume that bad debts will be a constant percentage of accounts receivable and use it to calculate the allowance for bad debts.
○ Some companies also make an estimates based on the number of days that the Debt has gone bad for.
➢ Setting up an allowance:
○ 2 accounts need to be setup - Allowance for Bad Debt, and Bad Debt expense Account.
○ Allowance for bad debt is treated as a Liability (Placed on asset side as a Contra Account).
○ Bad Debt Expense account is an income statement account (Operating expense). To recognize a bad debt, the income statement account is debited.
➢ Write-off: When customer cannot pay
○ The deductions are taken as follows:
▪ Accounts receivable is credited with the $Bad Debt
▪ $Bad Debt is Debited under the account for bad debts (Contra Asset)
○ There will be no net change in the Accounts receivable account of the Balance sheet.
Refunds
❖ Same principle as Bad Debt.
➢ Liability account called "Allowance for sales returns": Amount that company expects to refund.
➢ "Estimated Sales Refund" account deducts the refund from gross sale.
○ On the Ledger, the Allowance for Sales Revenue Liability account is Debited $Refund.
○ Cash account is Credited (Declines) from the asset side by $Refund amount.
Prompt Payment Discounts

❖ These are incentive discounts to customers for paying the owed Cash back early.
❖ To plan for the payments, the entity sets up Allowance accounts in anticipation.
➢ Estimation -
○ Based on past data, one can estimate how many customers might avail the prompt payment discount.
○
○ Allowance for cash discounts is a liability account.
○ The corresponding account - Estimated cash discounts - is shown in the income statement as a deduction from gross sales
○ Allowance for cash discounts is a liability account

○ The corresponding "Estimated cash discounts" is shown in the income statement as a deduction from gross sales
➢ Collection -
○ Lets say customer payed back within the stipulated time.
○ Cash will be increased (Debited) with the $Account Payable - $Discount
○ Allowance for Cash discount (Liability) will decrease (Debit) by $discount amount.
○ Account Receivable will be decreased (Credited) with Account Payable.

Ratios
05 June 2021 10:02 PM
- Bad debt allowance to gross accounts receivable

- Turnover of accounts receivable or "days receivable" or "days sales outstanding" or simply "DSO's"
Bad Debt Ratio

▪
▪ Company with a low bad debt ratio is more likely to receive payment of its receivables outstanding.
▪ Financial statement users use the bad debt ratio against their knowledge of the issuers' business and
industry to assess the reliability of the company's net accounts receivable balance.
Companies in health and communications industries have a higher bad debt ratio than those in the energy or
defence industries.
Days Receivable Ratio
▪
▪ It is the average number of days necessary for the company to collect its outstanding accounts
receivable.

Inventory and Cost of Sales
05 June 2021 10:14 PM
What are we going to do?

▪ Review accounting for bought merchandise inventories
▪ Calculating cost of goods sold for a manufacturing operation
▪ Accounting for manufactured inventories (mix of raw materials, work-in-process and finished
goods)
▪ How to record inventory and cost of goods sold
○ Last In, First Out (LIFO)
○ First In, First Out (FIFO)
▪ "Lower of cost or market" rule - to determine the new value for inventory in case of damaged
goods
❖ Matching
○ The Matching concept indicates what expenses should be recognized when revenue is recorded
○ Timing of expense recognition is important since revenue less expenses equals net income
○ The Matching concept stipulates that expenses should be recognized in the same period as the relevant revenues are recognized. Costs related to
this period's activities but which are not directly related to products and services sold, are expensed this period
NOTE: Accounting
records keep track of the
○ Flow of Inventory Costs,
and not the flow of the
physical inventory items.
❖ Historical Cost
○ This provide guidance on the amount at which a transaction should be reported initially in the entity's accounts.
○ It requires that transactions be recorded in terms of their actual price or cost at the time the transaction occurred.
○ Many monetary assets are recorded initially at their cost, and subsequently measured and reported in the balance sheet at their market value.
Monetary assets are items such as marketable securities. Their market value can generally be estimated reasonably reliably.
❖ Cost of Goods Sold

Manufacturing Operations
06 June 2021 03:10 PM
✓ Manufacturing Operations:
○ Manufacturing Operations has 3 Inventory Accounts:

▪ Raw Materials - Cost for material and deliveries associated
▪ Work-in-Progress (unfinished products, Direct labour, Manufacturing overhead costs)
▪ Finished Goods
○ Inventories are recorded at Cost of Production
▪ Product Costs - Costs connected with Purchasing, Transporting and converting to finished product
▪ All costs remain in inventory until goods are sold
○ Main costs are
▪ Labour costs
▪ Material Cost
▪ Manufacturing Overhead - Manufacturing costs closely related to making the product but not exactly for the labour or materials.
Example: Depriciation.
○ Costs excluded:
▪ Advertising costs, Cost of running Purchasing dept, office cleaning, Selling expense, Administrative expense. These are considered to
be Operating Expenses
▪ Bought Inventory is not included in Manufactured Inventory Account. Instead, its assigned a separate account.
Tracking Inventories
There are two approaches to keeping track of inventories.

- Periodic - The periodic method, adjusts the inventory account periodically based on actual inventory counts. For example, at the end of
each accounting period, inventory on hand is counted and valued. This amount becomes the ending inventory.
- Perpetual - The inventory account is adjusted as each addition and withdrawal is made.

Change in price
❖ Complications arise when the prices of product inputs changes (materials and labour), or the prices of merchandise purchased for sale change.
❖ Any changes in input or purchase prices affect both the cost of the products sold and the cost of inventory on hand.
When inventory cost changes occur, managers must choose which products the change in input or purchase prices should affect - those that have been sold or those still
in inventory.
Inventory Valuation: Two of the most frequently used inventory costing approaches are "FIFO" and "LIFO."
- FIFO, or First In First Out, assumes that the earliest inventory would be the first removed and put into COGS.
- LIFO, or Last In First Out, assumes that the most recently added layer of inventory costs would be the first taken out.
▪ Note: These cost assumptions do not necessarily reflect the actual physical flow out of its physical inventory, which may be very different altogether.
▪ Firms choose LIFO or FIFO for a variety of reasons. But one important consideration is taxes.
▪ Under the US tax code, if a company uses LIFO for tax return purposes, it must also use LIFO for financial reporting purposes.
▪ As a result, in the US, many companies whose merchandise or production costs are rising with inflation tend to use LIFO since it enables them to report
lower taxable income and to pay lower taxes.
▪ In contrast, companies with falling per unit inventory costs, such as firms in the computer and electronics industries, tend to use FIFO because this
method leads to lower taxable income for their firms.
- The cost difference between FIFO and LIFO inventory is called the LIFO reserve.
- Specific Identification: Tracking each individual merchandize sold.
- Average Cost: Weighted average cost of the goods in the period's beginning inventory and all goods placed in inventory during the period is calculated. The new
weighted cost per unit is used to cost COGS and ending inventory.

Inventory Write-down
06 June 2021 03:18 PM
✓ If an event occurs, such as the rain storm, that reduces the value of the inventory below its original cost,
the inventory must be written down to its new selling price less the cost of disposal.
✓ This requirement is referred to as the "lower of cost or market" rule.
DEBIT: Cost of Goods Sold (to charge the write down to income)
CREDIT: Inventory (To write down the inventory to its new value)
In case of Abnormal Loss, the expenses are recorded in P/L account.

Inventory Ratios
06 June 2021 03:26 PM
The shorter the time period an item is in inventory, the lower the average investment in inventory.
Two ratios - inventory turnover and days inventory - are used to gauge the effectiveness of inventory
investment management.
✓ Inventory Turnover
- Average number of times inventory is sold during the year.
- Turnover is computed by dividing Cost of Goods Sold by the average inventory on hand
during the year.
✓ Days Inventory
○ "days inventory" calculation converts the turnover ratio to its days equivalent

Non-Current Assets
06 June 2021 03:38 PM
What will we be learning?

✓ You will learn about long-lived non-monetary assets and how to account for them.
✓ Key management challenges you will cover include:
✓ How to account for the acquisition, improvement and disposal of long-lived assets.
✓ How to estimate and account for the use of a long-lived asset over time, which accountants refer to as depreciation
✓ When to recognize "intangible assets", a special category of long-lived assets.
Recollection
Assets: To be recorded as an asset, an economic resource must meet four requirements:
• Acquired at measurable cost
• Obtained or controlled by the entity
• Expected to produce future economic benefits
• Arises from a past transaction or event
Long-lived assets are expected to provide economic benefits beyond one year
Current assets are generally consumed or converted into cash within a year
Long-lived assets (Non-Current Assets) can be classified into:

- Tangible assets: that can be seen or touched (Land, property, equipment)
- Intangible assets: that are without physical substance (Patents, Copyrights, Franchise license, trademark, Intellectual Property)
Depriciation: Long-lived assets are recorded initially at their cost, which is then allocated using a depreciation method to the periods
during which the asset is used in business.
Concerns:
Acquisition Cost: A machinery is acquired by the entity, and delivery & Installation charges paid
additionally. How can we record the Delivery & Installation Cost?
Asset Usage: How to account for the use of long term asset?
Repairs and Improvements: How should this be recorded?
Asset Sale: If an existing long term asset is sold, how should we record it?
Intangible Assets: Investment in R&D?

Acquisition Cost
07 June 2021 09:49 AM
➢ Capitalization:
▪ The acquisition of a fixed asset is often referred to as a capital investment.
▪ Costs associated with the acquisition of the asset that are incurred in bringing the asset to its intended location and to get it ready for
use are "capitalized", i.e. included as part of the total cost of the asset that appears on the balance sheet.
▪ For Land acquisition, realtor's fee and the cost of clearing or preparing the land for construction are capitalized and included in the
total cost.
▪ For Machinery, the cost of delivery, installation and trial runs are all capitalized.

Depriciation
07 June 2021 09:57 AM
• The loss ability to produce future benefits represents a cost to the company recognized over the useful life of
the asset.
• A depreciation expense, based on the asset's original cost, is recorded as an expense in the income
statement.
Methods of Calculating Depriciation
▪ Straight Line Method

○ Depriciation expense for a given Long-Lived asset is
same for each period of the useful life.
○ It assumes that the assets ability to produce future
economic benefits is used up at a constant rate.
▪ Accelerated Depriciation
○ Cases where the ability of asset to produce future
economic benefits is used up at a decreasing rate.
○ Its developed for Front Loaded usage pattern, where
periodic Depriciation expense declines steadily over
the asset's useful life.
Straight Line Method
After few years of using an asset, a company may revise its estimates of the asset's useful life and salvage value.
It can change these estimates and re-estimate the depreciation expense for the asset going forward, but it may not revise the depreciation
expense or accumulated depreciation recorded in prior years.
Accelerated Method
▪ Most commonly the double-declining balance (DDB) method is used.

Note that the Assets Beginning Book Value is the Asset's Cost less the accumulated Depriciation.
Because the Book Value of the Asset keeps declining, the Annual Depriciation under DBB also declines.
Accounting Depriciation
• Depriciation is accounted for in the balance sheet through the below accounts:
○ Work-in-Process Inventory (assets) is Debited
○ Accumulated Depriciation - Equipment (contra asset) is Credited

Improvement/Repairs
07 June 2021 01:56 PM
Cost of Improvements to existing Assets

• The cost of any improvements or "betterment" to an existing asset must be capitalized.
• A betterment makes the existing asset better than it was when it was purchased and/or
extends its life. It is recorded as an increase in the value of the existing long-lived asset.
• The depreciation is then calculated on the improved Asset's value.
• Please note, these DO NOT INCLUDE MAINTENANCE and REPAIRS .
All maintenance expenses are recorded as an Expense in the Balance sheet. Below is a sample:

Asset Sale
07 June 2021 02:03 PM
• When fixed assets are sold , they must be taken off the financial statements at their recorded
or "book" value.
• However, the book value of a fixed asset typically is not equal to its market value.
• At the time of sale, any difference between the sales price and the book value of the asset is
recorded as either a gain or a loss, depending on whether the sales price is greater or less
than the book value at sale date.
• Gains and Losses on sale are generally included in the line item "Other Income" shown below
"Operating Expenses" or "General & Administrative Expenses."
• NOTE: Material gains and losses must be disclosed in the notes to the financial statements.

Intangibles
07 June 2021 02:20 PM
Accounting for Intangible assets such as Patents, and for the cost that went into the Research & Development for that R&D Cost Expensed Due to Uncertainty
Patent (Raw material, labour etc.)
Legal Capitalized as Since the Product has been
• Research and development activities often result in the creation of new products which are expected to generate future Costs Assets discovered
revenues. However, these types of outlays are not capitalized.
• The outcome of research and development is considered too uncertain to meet the definition of an asset for financial
reporting purposes. Hence, the costs of these activities cannot be capitalized and must be expensed.
• In contrast, once a new product has been discovered (and the research uncertainty has been resolved), any legal costs of
filing a successful patent are viewed as being an intangible asset and are capitalized .
Amortization :
• The usage of Intangible assets over time is written off in each period under Amortized Expense.
• It is credited directly to the Intangible asset's account.
• It is decreasing the asset, hence Credited under the asset account and Debited on Operating Expenses.

Ratios
07 June 2021 06:39 PM
Return on Assets
• This ratio shows how quickly the firm is able to generate revenues from the use of long-
lived assets
• It helps the managers to see whether their investments in long lived assets are productive
○ Revenues - Firms operating Revenues

○ Avg. Log Lived Assets - Average of the beginning and the end of year Long Lived
Assets

Liabilities and Financing Costs
08 June 2021 10:03 AM
What will we be covering?

• Liabilities and how to account for them
• How to value and record future commitments under a zero coupon loan and a lease contract
• Time Value of Money and Present Value
Recap:
A liability represents an obligation of the entity to other parties.
To be recorded as a liability, an obligation must meet three requirements:

○ It involves a probable future sacrifice of economic resources by the entity
○ The economic resource transfer is to another entity
○ The future sacrifice is a present obligation, arising from a past transaction or event
• Current liabilities are obligations that are expected to become due within 12 months of the
balance sheet date.
• Non-current liabilities are obligations that are expected to become due more than 12 months
past the balance sheet date.
Going Concern Concept

Typically, liabilities are recorded at the amount that would be required to settle them at the
balance sheet date. In determining this amount, accounting assumes the liability will be settled in
the normal course of business, that is, the business is considered to be a going concern.
Conservatism
The conservation concept also plays a role in the recognition and measurement of liabilities. It
suggests it is prudent to recognize liabilities as soon as reasonably possible and to avoid
understating the amount of the obligation.
Executory Contracts
• These are contracts where each party has yet to perform their part of the contract.
• These contracts often appear to obligate the parties.
• However, accounting does not recognize obligations under an executory contract as liabilities

Zero Coupon Debt
08 June 2021 10:19 AM
It is a type of loan:
• The borrower agrees to pay the lender a fixed amount in the future in return for receiving an amount today Present Value - Assume you receive $1000 at the
that is less than the future payment. Future Value end of the time period
• The borrower is also relieved from having to make periodic interest payments to the lender.
Example: The Borrower agrees to pay $100,000 in 2 years time in return for receiving a loan of $90,000 today.
Periodic interest payments will not be required.
Future value, present value and compound interest are the keys to understanding the economics and the accounting
for the proposed zero coupon loan.
Future Value Definition:
• The future value of any amount of money today is the amount that it would be worth if it were invested and
grew at the specified compound interest rate over a given time period.
Present Value
• Same concepts to compute how much an amount to be received in the future is worth today . You can also use Present Value Table for calculating the Present Value
• The basic idea underlying the present value concept is that an amount of money available today is more
valuable than the same amount received in the future . Because the money available today can grow by
investing it to earn more money as time passes.
• The present value of an amount to be received at a specified future date is the investment that we would need
to make today that, with the benefit of compound interest, would grow to the same amount as the future
amount to be received at the future date.
For cases where interest needs to be compounded semi-annually

• Divide the Rate of Interest by 2, and multiply the time period by 2.
• The Present value will always come as Lower that when calculated annually.
Accounting a Zero Coupon Debt
• Initially, Zero coupon loans are recorded as a liability at the amount received. Then, in each subsequent accounting period,
interest is accrued at the rate implied by the arrangement.
• The accrued interest is recorded as an expense and an addition to the loan liability balance.
The interest accrual reflects the fact you have had the use of the creditor's money, which in turn creates a future obligatio n. The
recording of the interest ensures that the cost of the loan is reflected in the period that the loan was used.

Leases
08 June 2021 04:21 PM
A lease grants the lessee the use of property for a specified time in exchange for a series of periodic rental payments to the owner of the
leased property. The owner of the leased property is called the lessor.
• For legal purposes, leases are executory contracts.

• Normally, accounting does not recognize executory contract obligations as liabilities. But some
leases are an exception.
• Depending on the terms of the lease, the lease obligation may be recorded by the lessee as a
liability and the leased asset as an asset. These are referred to as Capital Leases (mimicking a
substance purchase)
• All other leases are referred to as Operating Leases.
Capital Lease
• Because of the ownership-like nature of the lessee's rights to use the leased asset, capital lease
accounting assumes the lessee has in substance financed the acquisition of the right to use the
leased asset with an instalment loan.
• Consequently, the lessee records initially the present value of the lease payments as a liability
along with an asset in the same amount.
• Subsequently, the leased asset is depreciated like any similar owned asset and the liability is
accounted for as an instalment loan.
Under GAAP, a lease arrangement is classified as a capital lease if one of the following criteria are met:
✓ Ownership of the leased asset is transferred to the lessee at the end of the lease term. Asset is depreciated over useful life
✓ The lessee has an option to purchase the leased asset at a bargain purchase price. }
and Salvage value is considered
}
✓ The term of the lease is 75 percent or more of the leased asset's economic life (i.e., its
productive life). Asset is depreciated over
✓ The present value of the lease payments discounted by the lessee's borrowing cost is 90 percent Lease term and Salvage
or more of the fair value of the property. value is not considered
Present Value of a lease
• The present value of an amount to be received at a specified future date is the investment that we
would need to make today that, with the benefit of compound interest, would grow to the same
amount as the future amount to be received at the future date.
• The lease payments that the lessee promises in the future can be valued today by taking their present
values and summing them up.
Annuity
• A lease agreement typically involves making identical payments each year for a specified period.
• These are termed as Annuity.
Annuity can be calculated using an Annuity Table.
The present value of the $1 per time period at a set Rate of Interest is given in the Annuity table.
Steps to evaluate a Lease:
1. Calculate the Present Value

a. Calculate using the lease payments to be made.
b. This will be the Initial Amount recorded for the Capital Lease related Liability and Asset
c. Example:
i. Annual Lease Payment is $3,000 for 3 years @ 10%
ii. Present Value = Annual Lease Payment * Present Value of Annuity of $1
iii. $3,000 * 2.487 = $7,461
d. Record Capital Lease Liability
i. Debit - Lease Machinery (since Asset Increases)
ii. Credit - Capital Lease Obligation (since Liability increases)
2. Generate the capital lease obligation amortization schedule and related journal entries
a. Accounting views this obligation as being similar to an instalment loan.
b. When the obligation is displayed in the balance sheet it must be presented in two parts.
i. The next year's principal reduction portion in the next annual lease payment is shown as a current liability in the current
period's balance sheet.
ii. The obligation remaining after the current portion is deducted from the total end-of-period obligation and is reported as
a non-current liability.
c. Therefore, each rental payment will consist of two components.
i. A 10% interest payment on the outstanding balance of the loan
ii. Repayment of part of the loan's outstanding balance
3. Generate the depreciation schedule and related journal entries for the leased asset
a. The annual depreciation is calculated using the three year lease term.
b. Since the leased asset must be returned to the lessor at the end of the lease, it does not have any residual value to the lessee.
Operating Lease
• If a lease is not a capital lease, it is classified as an operating lease.

• If a lease is not a capital lease, it is classified as an operating lease.
• The accounting for an operating lease is straightforward. The periodic lease payments are simply recorded as a
lease expense each year. Neither a liability nor an asset is recognized.

Contingency Liabilities
08 June 2021 06:54 PM
The obligation involves uncertainty as to the possible cost which will only be resolved by some future event that may or may not happen.
A loss contingency is recognized as a liability when both of the following conditions are met:
• Information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired
or a liability has been incurred (That is, the three liability criteria have been met).
• The amount of the loss can be reasonably estimated.
To make the judgement on the probability of incurring a loss in future, accountants recognize the likelihood of the future event that will
confirm the loss has occurred can range from probable to remote.
IFRS refers to those contingent liabilities that GAAP recognizes on the balance sheet as "provisions," not
"contingent liabilities." The term "contingent liability" is reserved to describe those unrecognized
contingent liabilities that under GAAP and IFRS may or may not have to be disclosed.

Debt Ratings
08 June 2021 08:19 PM
The investment quality of the debt of companies may be rated by debt-rating services.
▪ For example, Moody's, a leading debt rating service, issues ratings that are expressed in terms such as AAA (the highest rating) all the way down to C (the lowest rating).
▪ The rating represents the likelihood the debtor will pay the debt's principal and interest on time.
▪ For the most part, the higher the debt rating, the lower is the required rate of return of investors.
▪ Debt rated triple B or better is considered to be of "investment grade." It is considered to be a relatively safe investment.
Interest Coverage Ratio
• These ratios are designed to measure how adequately creditors are protected by funds
generated by the debtor's operations.
• Higher the EBIDTA Ration, higher the company's Debt rating.

Investments & Investment Income
08 June 2021 10:32 PM
What will we be covering:
✓ How to record the acquisition of short-term investments in stocks and bonds.

✓ How to record gains and losses on different types of short-term investments.
✓ How to record a long-term investment that results in the acquirer gaining control over the other company and integrating the two businesses.
Motivation:
• Park excess cash needed to fund working capital or long-term assets in the near future.
• Strategic acquisitions of other company that enable integration into its own operations, or to take other actions that improv e the performance of
the newly-created combined firm.
Acquisition:
○ One firm controls another if it owns a majority (i.e. more than 50%) of its common equity.
○ Managers view controlling investments as long-term and strategic.
○ These types of investments are called business acquisitions or combinations and are accounted for using the purchase method.
Securities:
○ Investments in corporate debt or equity stakes of less than 20% are usually viewed as not involving control.
○ These types of investments arise when a firm is using the investment as a convenient temporary place to park excess cash.
○ These investments are called marketable securities and are accounted for using either the cost or market method.
Equity Investments:
○ Investments in the equity of another company that are 20% or more, but less than majority ownership are likely to provide the acquiring firm
with some in-between level of control.
○ These types of investments are called equity investments or investments in associated companies, and accounted for using the equity method.

Marketable Securities
09 June 2021 02:38 AM
• Shown as ASSETS on balance sheet.

• They are investments that are:
○ Readily Marketable
○ Expected to be converted to cash within 12 months
○ Have no control implications for the company whose securities are acquired.
• Example:
○ Commercial Paper - short-term interest bearing note issued by corporations
○ Treasury Bills - interest paying short-term obligations sold by the U.S. Treasury
○ Common stocks, corporate promissory notes, corporate bonds.
• Any investment longer than 12 months is recorded as Long-term asset in balance sheet.
➢ The first step in the marketable security accounting decision is to determine the investor's intent.
Trading
- Hold-to-maturity
▪ Debt securities that the investor intends to hold to maturity.
▪ Accounted for on the balance sheet at their cost.
▪ Holder does not record any change in the market value of the Note.
- Trading
▪ Debt and equity securities that the holder intends to sell in the near term to earn profits from short-
term movements in the security's price
▪ Accounted on balance sheet at their current market value. Any unrealized gain or loss since the last
balance sheet date or at time of sale is included in the income statement as investment income
- Available-for-sale
▪ Debt and equity securities that do not fall into either the hold-to-maturity or trading security categories. Available for sale
▪ Reported on the balance sheet at their market value.
▪ Unrealized gains and losses on available-for-sale securities are not shown as Investment Income. They
are directly credited/debited to a special shareholders' equity account called Unrealized gains and
losses on Available-for-Sale Securities.
▪ Any related unrealized gain or loss recognized to date is eliminated from owners' equity and the actual
gain or loss is recorded in the income statement

Business Acquisitions
09 June 2021 02:39 AM
A business acquisition is a transaction where one entity gains control over the assets and operations of another.
The acquisition method of accounting:
• The acquiring company records on its balance sheet the fair value of the net assets (that is the assets net of any liabilities) that it acquires.
• Fair value is the amount a willing buyer and seller would exchange for an asset or liability in a current transaction, other than a forc ed or
liquidation sale.
• If the purchase price is greater than the fair value of the net assets acquired, the excess purchase price is recorded as an asset called
goodwill, and is reported as an intangible asset on the balance sheet.
• Net assets acquired is the difference between the value of the acquired assets excluding any goodwill and the value of the acquired
liabilities.
Question: Is the sign in

the formula correct?
Goodwill (intangible asset):

• It reflects the value of a company's intellectual capital, product strength, good reputation and
other valuable intangible attributes of the acquired company.
• Goodwill only appears on the balance sheet when a company purchases another company for
more than the fair value of its net assets.
• Goodwill is not Amortized
• It is tested annually for impairment. If the Goodwill is impaired, the value of the asset declines
and an Impairment Expense is written-down.

Deferred Taxes and Tax Expenses
09 June 2021 10:55 AM
What will we be covering?

✓ Accounting for income taxes
✓ Methods used to prepare a firm's taxable income and estimate the taxes that it owes the government
✓ Differences in a firm's pre-tax earnings for tax and financial reporting purposes can give rise to a deferred tax liability or asset, an accrual
on the balance sheet
✓ How to record the tax expense in the income statement and in any deferred tax asset or liability balance sheet accounts
❖ The taxable earnings on your tax return will be different than the earnings before tax amount shown in the financial
statements.
❖ This difference arises because the accounting methods for recording transactions used for tax reporting are not always the
same as those used for financial reporting.
Tax vs Financial Reporting
❖ Governments have different objectives and information needs than a firm's investors.
○ Example, the government often permits firms to use shorter economic lives and more accelerated depreciation of
new equipment for tax purposes to meet its economic goals of encouraging investment in new capital and creating
additional employment.
○ Governments often disallow tax deductions for expenses that are estimates of future losses, such as estimated bad
debt expenses. Instead, these losses are reported for tax purposes when a loss has actually occurred.
In layman terms (as explained by my father):
• Deferred means postponing something. Deferred tax mean postponing a Tax for future.
• In your expenses, if you increase depriciation:
○ Your expenses increase
○ Profits decreases
○ Tax payable on the profits decreases
○ This means you have deferred the obligation to pay tax.
○ Hence, you are liable to pay the tax in future (Deferred Tax Liability)
• Conversely, if you decrease depriciation:
○ Your expenses decrease
○ Profits increases
○ Tax payable on the profits increases
○ This means you have payed tax in advance, hence creating an asset (Deferred Tax Asset)
○ This means that the government is liable to pay you in future, and so the future taxes will decrease.

DT Accruals
09 June 2021 01:01 PM
Deferred Tax Accruals
Question is, what should we do to reflect the effect of differences in accounting methods used in the firm's financial reporting
and tax books?
➢ Standard setters have dealt with these accounting differences by requiring that the tax expense be based on Income Before
Taxes in the financial reporting books rather than Taxable Income in the tax books.
➢ This leads to the creation of a deferred tax accrual to reflect the tax effect of any accounting method differences that exist
between the two sets of books.
➢ The tax accrual can appear as a liability or an asset on the firm's balance sheet.
Deferred tax accounting is used when the following three conditions hold:
• A transaction or event is accounted for differently in an entity's financial reports and income tax returns.
• The accounting effect of the difference in accounting policies is temporary in that the early period effects of the difference are reversed
in later periods.
• The accounting difference has tax consequences.
○ Permanent differences occur when either revenue or expenses are recognized for tax return purposes but never for financial
reporting purposes or expenses or revenues are recognized for financial reporting purposes but never for tax return purposes.
○ These differences in financial and tax return accounting does not result in the recognition of a deferred tax accrual
Example: Interest paid on tax exempt securities such as Bonds. This is recorded as income in the Balance sheet, but not recorded in the
Tax books.

DT Liabilities When the Taxes due (Tax Book) are < Tax Expense (Financial Book)
09 June 2021 01:02 PM
Deferred Tax Liability
Deferred Tax Liabilities appear as Current/Long term liability depending on the when the difference in
the depriciation expense are reversed.
➢ Deferred tax liability, unlike most liabilities, is not a present obligation to transfer resources to
another entity.
➢ Instead, it is little more than a balancing credit entry to the liability section of the balance sheet
to offset a debit entry made to the income statement. This debit entry is made so that the income
statement is not misleading.
❖ A deferred tax liability is the future tax consequences attributable to temporary accounting
differences between financial and tax accounting policies where the future tax consequences
result in higher future taxes.

DT Assets When the Taxes due (Tax Book) are > Tax Expense (Financial Book)
09 June 2021 02:09 PM
A tax Benefit that arises since the Taxes Paid are greater that the Tax Expensed in the Financial books.
Deferred Tax Assets appear as Current/Long term Asset depending on the when the difference in the depriciation expense are reversed.
❖ Deferred tax assets arise when temporary differences between a company's financial and tax
accounting result in future lower taxes.
❖ Deferred tax assets and their related deferred tax benefits are only recognized in the balance
sheet and income statement if management believes it is "more likely than not" (a better than
50-50 chance) that the future tax benefit will be used to lower the tax payments in subsequent
years. This last condition conforms to the conservative concept.
Loss Carry Forwards
➢ Deferred tax assets can also arise if there are no temporary differences in reporting methods used for tax and financial reporting books, but the
firm reports losses for tax purposes.
➢ In US, companies that report losses on their tax returns can carry forward these losses for tax return purposes for 20 years and apply them as an
offset to any future taxable income.
➢ Tax in current loss that results in lower future tax payments is recorded as deferred tax asset.
➢ The amount of the past losses carried forward to offset future taxable income is called a "tax loss carry forward"

Tax Expense
09 June 2021 02:29 PM
Current Tax Expense: Tax due to the tax authority that period
Deferred Tax Expense: Tax accrual required to reflect any temporary accounting differences between financial
and tax accounting policies

Owner's Equity
09 June 2021 04:02 PM
You will learn about owners' equity and a number of equity transactions:
- Paid-in capital
- Par value
- Issues of preferred stock
- Stock repurchases
- Dividend distributions
- Stock splits
- Stock options
- Comprehensive income
Common Stock
• At the time of issuing the stock, nominal value of the stock is set as its par value. However, Par Value does not indicate the stock's worth.
• The balance sheet shows the value of the stock at its par value.
• Difference between the Issue Amount and the Par Value is called Additional Paid-in Capital. This also appears in the Owners Equity section
of the Balance Sheet.
The sum of the par value and additional paid-in capital

for common stock is called Paid-in Capital.
Preferred Stock
Differences between preferred stock and common stock:
• Preferred stock is less risky than common stock since it has higher priority in receiving dividend payments and return of capital in
the event of a liquidation of the company.
• Preferred stock does not have voting rights.
• Preferred stock is typically entitled to a fixed dividend rate, comparable to fixed interest debt. In contrast, common stock is not
entitled to any specified dividend payment.
Cumulative Preferred Stock: specifies that if the company is unable to pay the preferred dividends in a given year, it cannot pay any
common stock dividends until the preferred dividends in arrears are fully paid.
Convertible Preferred Stock: specifies that the preferred stock can be converted into common stock at a defined exchange rate at the
option of the preferred stock owner.
Redeemable Preferred Shares: specify that the issuing company must buy back the preferred shares at a defined price within a defined
time period.
Treasury stock (Stock Repurchases)
• Sometimes companies buy back their own common stock. This purchased stock is called treasury stock.
• While dividends are taxed at ordinary income rates, stock repurchases enable some investors to receive cash in a form that leads to
a capital gain, which is typically taxed at capital gains rate that is lower than the rate used to tax ordinary income.
• This tax difference has led many companies to make distributions to shareholders in the form of a stock repurchase rather than a
dividend.
Stock repurchases are reported as a negative owners' equity account in the balance sheet.
Dividends
• Companies pay out cash to shareholders in the form of a dividend

• The stocks of firms that pay dividends are called income stocks, and tend to attract a different class of investor than those that
avoid dividends to focus on growth. Investors attracted to income stocks include:
○ Retired investors who want a steady stream of income, and
○ Institutions that do not pay taxes on dividends.
➢ Dividends can only be paid by firms that have positive retained earnings.
➢ This form of restriction is intended to preclude a firm from liquidating its assets, paying stockholders a liquidating dividend and
leaving creditors with the company shell.
On the balance sheet, the commitment to pay a dividend is shown as a current liability, usually called Dividends Payable. It is offset by
reducing Retained Earnings.
Stock Split
• A split changes the number of shares owned by its current shareholders, but does not change the book values of the
firm's assets, liabilities, or its owners' equity.
• To record this change, stock with the old par value need to be removed from the books and stock with the new par value
recorded along with an adjustment to the stock's par value.
❖ Stock splits that result in an issuance of new shares that in total are less than 20 - 25 percent of the outstanding shares
are called a stock dividend.
○ A debit entry equal to the market value of the shares issued is made to retained earnings.
○ A compound credit entry is made to common stock for the par value of the issued stock along with an entry to
additional paid-in-capital for the difference between the stock's market value and its par value.
Stock Options
❖ If a company grants a stock option to a manager, the manager has the right to buy the stock from the company at a
specified price, called the exercise or strike price, within a specified period, called the exercise period.
Comprehensive Income
• There are some gains or losses that are not recorded as part of Net Income. For example, in
available-for-sale securities are revalued to their fair value each accounting period.

available-for-sale securities are revalued to their fair value each accounting period.
• However, these gains were not reported as part of Net Income. Instead, they were shown as a
separate owners' equity account called Unrealized Gain on Available-for-Sale Marketable
Securities.
The Comprehensive Income Statement shows changes in shareholders equity arising from all changes
other than new investments by or distributions to owners, and in the case of Global Grocer includes:
• Net Income, and

• Unrealized gains and losses on available-for-sale securities

Return on Equity
09 June 2021 05:00 PM
Return on Equity ratio (ROE) : This ratio is simply Net Income divided by Owners' Equity.
This ration shows how much return the company was able to generate from the investment that shareholders made in the company (both
their investment of capital and the reinvestment of earnings)
Owner's equity could be Beginning Equity, Ending Equity or Average Equity.
A firm's Return on Equity can be decomposed into three key components or drivers:
Firm can improve its ROE by :

(a) Increasing net income margins though improved pricing or cost controls,
(b) Increasing asset turnover, by reducing its working capital needs or making long-term assets work more productively, or
(c) by increasing the firm's financial leverage by taking on additional debt financing.

Summary
09 June 2021 05:09 PM
• Owners' equity may include more accounts than just common stock and retained earnings
• The common stock account consists of two accounts - common stock at par and additional paid in capital
• In addition to issuing common stock, firms can issue Preferred Stock, which has higher priority in bankruptcy and usually
has a specified dividend rate.
• A form of cash distribution to shareholders is a stock repurchase, which leads to the creation of Treasury Stock, a negative
line-item in Owners' Equity.
• Dividend distributions result in the payout of cash to shareholders, and reduce reinvested profits.
• Stock splits change the number of shares outstanding and the par value of the shares, but they do not affect the book
values of total assets, liabilities and equity.
• Stock options are designed to help link managers' incentives with those of shareholders. Their estimated value at date of
grant is typically recorded as a compensation expense over the period during which the options vest.
• Some gains and losses, such as unrealized gains and losses on available-for-sale securities are deliberately excluded from
Net Income, but are included in a Comprehensive Income Statement and separately reported in Owners' Equity.
• Return on Equity (ROE) is a useful measure of the return that a firm generates during the period on owners' equity. It is
driven by three factors: operating performance represented by net profit margins, asset management represented by
asset turnover, and the firm's capital structure represented by its financial leverage.

EXAM
08 June 2021 02:59 PM
FA-
Test 1:
Ans 1: https://www.scribd.com/document/442516516/Financial-Accounting-Online-Course-Final-
Exam-1-Answer-Key-docx
https://www.scribd.com/document/423574400/Financial-Accounting-Solutions-1-Comments-pdf
Test 2: https://www.askassignmenthelp.com/harvard-financial-accounting-final-exam-2.html
Test 3: https://www.askassignmenthelp.com/harvard-financial-accounting-final-exam-3.html

Financial Accounting - HBSP Course Notes (Raghav)

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Financial Accounting - HBSP Course Notes (Raghav)

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Introduction

30 May 2021 05:32 PM

Financial Accounting Page 1

Two important qualities of financial accounting information--Relevance and reliability

Balance Sheets (Statement of Financial Position)

Statement of Cash Flows

Financial Accounting Page 2

Five basic financial accounting concepts

Money measurement concept

Going Concern Concept

Relevance : Timeliness and usefulness of the information to its users.

Reliability : Objectivity and verifiability of the information.

Financial Accounting Page 3

What we will be covering:

TOTAL ASSETS = TOTAL LIABILITY + OWNER'S EQUITY

Financial Accounting Page 4

To be recorded as an asset, an economic resource must meet four requirements:

Examples of Assets: Cash, Property, Merchandise, Prepaid Expenses etc.

Tangible and Non Tangible Assets:

Current and Non Current Assets:

A liability represents an obligation of the entity to other parties.

To be recorded as a liability, an obligation must meet three requirements:

Current and Non-Current Liabilities:

TOTAL ASSETS = TOTAL LIABILITY + OWNER'S EQUITY

Financial Accounting Page 5

Financial Accounting Page 6

Current ratio : Current Assets / Current Liabilities

Total debt-to-equity ratio

• Total Debt to Equity Ratio : Total Debt / Total Equity

Financial Accounting Page 7

What we will be covering:

NET INCOME = Income before Income tax - Income Tax Expense

Financial Accounting Page 8

▪ Dividends are distributions of earnings to owners, usually in the form of cash.

Financial Accounting Page 9

Financial Accounting Page 10

How to Record Sale on Balance Sheet

Financial Accounting Page 11

❖ Gross margin as a percentage of sales

○ It is the dollar gross margin divided by sales, expressed as a percentage.

❖ Return on sales percentage

○ Net income per dollar of sales

Financial Accounting Page 12

Tracking and recording Transactions:

Asset Beginning Change Ending Owner's Beginning Change Ending

Financial Accounting Page 13

Journal is a chronological record of the entity's transactions. Sample Journal:

Financial Accounting Page 14

• Each T-Account is associated with a single account.

Journal - Balance Sheet Accounts Ledger

Journal - Income statement transactions Ledger

Financial Accounting Page 15

Financial Accounting Page 16

Categories of cash statements:

Steps to prepare a Direct Method Statement:

1. Classify each debit and credit in the cash account as

Note: Interest Payments are categorized as Operating Trans and

Why use Indirect Method?

Net Income and Operational Cash Flows

When Inventory increases during a period

Financial Accounting Page 17

Financial Accounting Page 18

Revenue is recognized when it is earned and realized or realizable (SALE METHOD)

• the customer has agreed to buy the goods and services;