Financial Accounting

WHAT IS ACCOUNTING?

“THE MEASUREMENT,PROCESSING AND COMMUNICATION OF FINANCIAL INFORMATION ABOUT ECONOMIC ENTITIES.”

Financial accounting deals with measurement and communication of information for external users.

Management accounting deals with measurement and communication of information for internal users.

Financial and management accounting measure and communicate the same economic reality in different forms.

 

Balance sheet

Financial position of a firm at a particular point in time

Summary of assets and financing of those assets (liabilities and shareholders’ equity)

Fundamental accounting equation: Assets = Liabilities + Shareholders’ Equity

  • Assets

Resources

  • Controlled by a firm
  • Probable economic benefits
  • Sufficient reliability to estimate these benefits
  • Examples: Cash, inventories, production machines
  • Current assets:Assets with relatively short life Examples: cash, inventories, accounts receivable
  • Long-term assets:Assets with relatively long life Examples: buildings, equipment

 

  • Liabilities

Obligations

  • To transfer economic benefits
  • Measurable
  • Benefit which creates the obligation received
  • Examples:Accounts payable, wage payable, debt
  • Current liabilities: Amounts due within a year (e.g., accounts payable,wage payable)
  • Long-term liabilities: Amounts due after one year (e.g., 15-year bank loan)
  • Provisions Amounts where there is at least reasonable certainty that an obligation will be incurred on some future date(e.g., settlement of environmental hazards)

 

  • Shareholders’ Equity

  • Investment of shareholders
  • The difference between total assets and total liabilities (Shareholders’ equity = Assets – Liabilities)
  • Common stock: Nominal (par) value of the shares*Number of shares issued
  • Additional paid-in capital: Excess cash received during share issuance
  • Retained earnings: Profits accumulated over the years and not distributed to shareholders

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Income statement

Financial performance over a period(generally a year or a quarter)

Summarizes firm’s revenues, expenses,gains, and losses over a period of time

COMPONENTS OF INCOME STATEMENT

  • Sales (or revenues, turnover)
  • Cost of sales (or cost of goods sold)
  • Operating expenses
  • Other income
  • Income taxes
  • Extraordinary gains/losses

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Cash flow statement

Cash inflows and outflows over a time period (generally a year or a quarter)

Summarizes how cash changes over a time period

It has three parts:

  • Operating
  • Investing
  • Financing

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Notes to financial statements

 

Fundamental Accounting Concepts

  • Going concern
    Going concern is a basic underlying assumption in accounting. The assumption is that a company or other entity will be able to continue operating for a period of time that is sufficient to carry out its commitments, obligations, objectives, and so on.
  • Conservatism
    The convention of conservatism, also known as the doctrine of prudence in accounting is a policy of anticipating possible future losses but not future gains. This policy tends to understate rather than overstate net assets and net income, and therefore lead companies to “play safe”.
  • Matching
    The matching principle is one of the basic underlying guidelines in accounting. The matching principle directs a company to report an expense on its income statement in the same period as the related revenues.
  • Consistency
    The consistency principle states that, once you adopt an accounting principle or method, continue to follow it consistently in future accounting periods. Only change an accounting principle or method if the new version in some way improves reported financial results.
  • Accruals
    An accrual allows an entity to record expenses and revenues for which it expects to expend cash or receive cash, respectively, in a future reporting period. It is nearly impossible to generate financial statements without using accruals, unless the cash basis of accounting is used.

    • Cash collection comes after revenues are earned.
    • Cash payment comes after expenses are incurred.

     

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Deferrals
Cash collection comes before revenues are earned.
Cash payment comes before expenses are incurred.

 

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Conservatism Concept

  • Revenues are recognized only when they are earned.
  • Losses are recognized even when there is uncertainty for the losses to happen.
  • Provisions
    – reduce the value of assets or create a liability
    – recognize an expense in the income statement
    – Examples: provisions for accounts receivables, inventories, warranties, and contingent losses

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Revenue Recognition Criteria:

1. Revenue is earned.
2. Revenue is measurable based on objective and verifiable evidence.
Examples:

  • Sales (Walmart): The company recognizes sales revenue, net of sales taxes, and estimated sales returns at the time it sells merchandise to the customer.
  • Membership Fee Revenue (Sam’s Club): The company recognizes membership fee revenue both in the U.S. and internationally over the term of the membership, which is typically 12 months.
  • (United Airlines) The company records passenger ticket sales and tickets sold by other airlines for use on United as passenger revenue when the transportation is provided.
  • (Apple) The company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped, and title and risk of loss and rewards of ownership have been transferred. For most of the company’s product sales, these criteria are met at the time the product is shipped.

3. Industry Variation to Revenue Recognition

  • Long-term contracts: Percentage of completion method
  • Natural resources and agricultural products: Completed contract method
    • (Apple) For sales of qualifying versions of iOS devices, Mac, Apple Watch, and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. Revenue allocated to the unspecified software upgrade rights and non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided.

 

Fraud in Revenue Recognition (Sunbeam)

  • A small appliance maker filed for bankruptcy in 2001.
  • Engaged in massive revenue recognition frauds between 1996 and 1998:
    – Ship more goods than ordered by customers
    – Ship goods when the order is cancelled
    – Bill and hold: Sell goods under a nearly buy program where retailers can pay six months later and store the goods in Sunbeam’s warehouses
    – Book a sale and ship the goods to a warehouse rented by Sunbeam

 

Short-term Assets

  1. Accounts Receivable
  2. Inventories

They are generally converted into cash within a year.

Accounts receivables are not valued at face value on the balance sheet, but are valued at net realizable value (NRV). NRV=Face value less cash discounts, sales returns, and bad debts.

  • Discounts given over sale price if the customer pays in a certain time period to encourage early payment:

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  • Some firms allow customers to return goods up to a certain time period. Firms need to estimate sales returns and record a provision for sales returns when the sales are made. This provision is called sales return allowance.
    – A contra asset
    – Netted against accounts receivable in the balance sheet

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  • Bad debts occur when debtors do not pay
    – reduce the amount of accounts receivable on the balance sheet
    – create a loss in the income statement
    Just like sales returns, a provision for bad debts is created when sales are made. Bad debt provisions are calculated according to one of the following methods:
    – Percentage-of-sales method (most common)

    • Provision for bad debts is equal to a certain percentage of the credit sales.
    • The percentage comes from either past experience or the bad debt rate of other firms in the same industry.

    – Ageing schedule
    – Specific account analysis

Illini Supermarket made total credit sales of $700,000 in year 2015. Illini Supermarket collected $500,000 by December 31, 2015. Expected bad debt rate is 5%of credit sales.

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Illini Supermarket collects $100,000 from debtors in year 2016. In addition, debtors who owe $20,000 go into bankruptcy. Illini Supermarket is able to get $5,000 from these bankrupt debtors.

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1. Suppose that total provisions for sales returns is $100 and doubtful accounts is $400. Net Receivables = $6,778. What is the percentage of total accounts receivable Walmart does not expect to collect in year 2015?

6,778 + 500 = $7,278
Provisions / Total AR = 500 / (6,778 + 500) = 7%

2. Suppose that provision for doubtful accounts was $510 at the end of year 2014 and the amount of bad debt expense was $20 in year 2015. What is the amount of accounts receivable written off?

Provision for doubtful accounts

Beginning balance

(510)

Bad debt expense

(20)

Write offs

130

Ending balance

(400)

 

Inventories

Types:

  • Manufacturing companies:
    – Rawmaterials
    – Work-in-progress
    – Finished goods
  • Trading companies:
    – Goods available for sale

Inventories are valued on the balance sheet as the lower of
– cost or
– net realizable value (NRV): sale price – selling costs
Inventory values cannot be marked up over the cost.

Inventory write-down is needed when NRV is less than the cost.
Inventory write-down
– decreases the value of inventory account on the balance sheet
– creates a corresponding expense on the income statement
– is not reversible

 

Cost of Goods Sold (COGS)

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Cost Flow Assumptions

  • Firms cannot always keep track of goods purchased or sold.
  • Cost flow assumptions are needed
    – Last-in-first-out method (LIFO)
    – First-in-first-out method (FIFO)
    – Average cost method

Calculate the cost of goods sold and ending inventory using LIFO, FIFO and weighted average methods

Units

Unit cost

Unit price

Beginning inventory

100

$5

January sale

(80)

$8

February purchase

30

$6

March purchase

40

$7

Ending inventory

90

FIFO
• Cost of goods sold: 80*$5 = $400 [It all comes from beginning inventory]
• Ending inventory:
20*$5 [Remaining beginning inventory]
+ 30*$6 [February purchase]
+ 40*$7 [March purchase]
= $560

LIFO

• Cost of goods sold:
40*$7 [March purchase]
+  30*$6 [February purchase]
+  10*$5 [Beginning inventory] = $510

• Ending inventory: 90*$5 = $450 [Remaining beginning inventory]

Weighted average
• Average unit cost:
– Total purchase cost / Total number of units purchased = $5.65
– Total purchase cost:
100*$5 [Beginning inventory]
+ 30*$6 [February purchase]
+ 40*$7 [March purchase]
– Total number of units purchased: 100 + 30 + 40
• Cost of goods sold = 80*$5.65 = $452
• Ending inventory = 90*$5.65 = $508

Under increasing prices

FIFO

LIFO

Ending inventory balance

Higher

Lower

Cash flows

Lower

Higher

Cost of goods sold

Lower

Higher

Income before taxes

Higher

Lower

Income taxes

Higher

Lower

Net income

Higher

Lower