Galilee College Intermediate Accounting I Course No. ACC 211 Galilee Corporate Centre • Joe Farrington Road P.O. Box EE 16507 - Nassau, Bahamas Tel. (242)364-1776 Fax (242)364-1778 Email: galilee@coralwave.com www.gcollege.org Dr. Willis L. Johnson, Ph.D Certified Public Accountant Master Financial Professional (MFP) Certified Counselor Galilee College © 2007 Galilee College Course Outline COURSE NUMBER: Accounting I ACC 211 COURSE TITLE: Intermediate DEPARTMENT: Accounting CREDIT VALUE: 3.0 COURSE DURATION: 1 SEMESTER DATE PREPARED: July 2002 PREREQUISITES ACC 112, Accounting Principles II PROGRAM COORDINATOR _________________________________ REQUIRED TEXTS: INTERMEDIATE ACCOUNTING Notes I, Dr. Willis L. Johnson, Galilee College © 2006 SUPPLEMENTAL MATERIALS None COURSE DESCRIPTION Theories and problems involved in proper recording of transactions and preparation of financial statements. Review of the accounting cycle, discussion of financial statements, analysis of theory as applied to transactions relating to current assets, current liabilities, long-term investment and presentation on the Balance Sheet. COURSE OBJECTIVES Students will be expected to understand the environment of accounting; basic accounting theory; the recording process; the income statement and statement of retained earnings; the balance sheet; the time value of money; cash and short-term investments; current receivables and liabilities; inventory valuation, cost flow assumptions and estimating techniques; property plant and equipment acquisitions, subsequent expenditures, disposals, depreciation and depletion; intangible assets, and current liabilities. Program Context: This course is a second year course in the Accounting program. Course Learning Outcomes: Learning outcomes identify the knowledge, skills and attitudes that successful students will have developed and reliably demonstrated as a result of the learning experiences and evaluations during this course. Evaluation Strategies and Grading: Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 2 Class Attendance Full participation and attendance is expected for this course. Students who miss a class are responsible for any information discussed, assigned or distributed in that class period. Four exams are scheduled during the semester. The lowest exam score will be dropped. If an exam is missed for ANY REASON, that will be the exam dropped. If a second exam is missed for ANY REASON, a ZERO will be assigned to the second missed exam. There will be no make-up exams. Everyone is required to take the final exam. Calculators may be used on all exams, but you may NOT share calculators. FINAL EXAM QUIZ / TESTS ASSIGNMENTS 30% 60% 10% 100% Note that violation of academic honesty can affect the course grade. "Cheating" on an exam (i.e., the giving or receiving of aid) will result in a course grade of "F." Note that classroom behavior (for example, talking to other students during lecture) can negatively affect course grades by as much as three letter grades, e.g., an "A" can become a "D." GRADING SYSTEM: A 94% B 87% C 75% - 100% Excellent 4.00 93% Good 3.00 86% Average 2.00 D 68% - 74% Passed 1.00 F 0% - 67% Failed 0.00 COVERAGE Chapter 1: Concepts and Standards Chapter 2: Revenue Recognition Chapter 3: Financial Statements Chapter 4: Other Income Statement Items Chapter 5: Financial Statement Disclosure Chapter 6: Statement of Cash Flows Chapter 7: Cash and Investments Chapter 8: Receivables and Accruals Chapter 9: Inventories Appendix 1: Accounting Terms Appendix 2: Associate Degree Program (Accounting) Appendix 3: Bachelor’s Degree in Accounting Appendix 4: Accounting Courses Description Appendix 5: Accounting News Additional Information: 1. MISSED TESTS WILL RESULT IN A ZERO GRADE; SEE YOUR INSTRUCTOR TO DISCUSS THIS. 2. Texts, working papers and calculators are to be brought to every class. 3. Some details of your course schedule may vary by section/teacher or change as a result of unforeseen circumstances, such as weather, cancellations, College and student activities and class timetabling. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 3 Galilee College © 2007 Chapter 1 – Concepts and Standards A. Conceptual Framework 1. Statements of Financial Accounting Concepts (SFACs) describe objectives, qualitative characteristics, and other concepts that guide the FASB in developing sound accounting principles. SFACs do not establish accounting and reporting requirements. a. SFAC 1 = An objective is to provide information that is useful to potential investors, creditors, investment and credit decision makers b. SFAS 2 = Conservatism – Uncertainty and business risk are adequately considered. Record contingent loss but not contingent gain (if high, disclose in notes) 2. Gain contingencies are not recorded in the financial statements, but if high, they should be disclosed. This is GAAP conservatism. 3. Financial Reporting provides information about an enterprise’s performance during a period when it was under the direction of a particular management but does not directly provide information about that management'’ performance. There is no separation of performance from management action or related conditions. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 4 4. Asset – Transaction has occurred, entity has benefit & Control, and there is probable future benefit i. Asset Valuation Account (contra)= increase or decrease asset value (Note: This is not an asset or liability Account on its own) ii. E.g. Deferred Gross Profit collected for period beyond the B/S date is a contra account 5. Liabilities – Probable future sacrifices of economic benefits i. Liability Valuation Account = increase or decrease asset value (Note: This is not an asset or liability Account) Equity or Net Assets – Residual interest in assets of entity after deducting liabilities 6. 7. Elements describing transactions, events, and events circumstances during intervals of time a. Investments by owners b. Distribution to owners c. Comprehensive Income (change in equity due to nonowner sources) i. Does not include investment and distribution to owners ii. Encompasses changes Included in equity section of Balance Sheet - Holding gains and losses on available-for-sale securities and foreign currency translation adjustments. - Includes both Gross Margin and Operating Income iii. Return on Capital (including holding gains and losses due to price change) iv. Financial Capital Maintenance Concept (This is the traditional basis of F/S, including comprehensive income. - Increase in net asset (excluding owner transactions) - Return on investment (End. Net Assets – Beg. Net Assets – Owners Transactions) v. Physical Capital Concept vi. - Increase in physical resource capacity (excluding owner transactions) (excluding holding gains and losses due to price change) 8. Revenues - Inflows or other enhancements of assets of an entity or settlements of its liabilities due to service or product delivery of central/primary operations. (Revenues should be reported when earned.) i. Installment Method of Accounting Revenue is recognized only when cash is collected To record installment sale 9. Expenses – Outflows or using up of resources due to service or product delivery of central operations. (Expenses should be reported when incurred) 10. Gains (losses) – Increases/decreases in equity from peripheral or incidental transactions a. These may be operating or nonoperating Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 5 11. Accrual Accounting – An item that meets the criteria for recognition and measurement a. Accruals – Future Cash Flows b. Deferral – Past Cash Flows c. Allocation – Process of assigning or distributing an amount according to a 12. Recognition – Recording or incorporating an item in F/S of entity 13. Realization – Converting noncash resources and rights into money. E.g. Depreciated Asset exchange for notes payable. 14. Footnotes - = integral part of basic financial statements, they provide disclosures required by GAAP 15. Recognition Criteria – Determining whether items should be incorporated in F/S initially or as changes in existing items. I. FUNDAMENTAL CRITERIA (Subject to pervasive cost-benefit constraint and materiality. a. Must be F/S element b. Relevant attribute with reliability c. Information for decision making d. Information must be representationally faithful, verifiable neutrality (reliability) II. Recognition - item relevant quantified in monetary units with reasonable reliability. III. Different Measurable Attributes - Historical Cost – For plant assets and most inventories (initial acquisition cost) LCM is departure when utility is now less than cost - Historical Proceeds – Liability incurred to provide goods or services - Current (replacement Cost) – Cash or cash equivalent to replace asset * Recording Inventory at CRC is departure from H/C - Current Market Value (Exit Value) – Used to measure some marketable securities - Net Realizable Value – Used to measure short-term receivables and some inventories. Use if below historical cost. - Net Settlement Value – Used to measure trade payables and warranty obligations. - Present Value – Incorporates time value of money concepts (Used only for long-term receivables and payables) not to measure inventory Calculation of PV employs a set of estimated cash flows and interest rates Note: Expected Cash Flows encompasses all expectations about possible cash flows. 5 elements for PV measurement Includes i. Estimates of cash flow Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 6 ii. iii. iv. v. Expectations about their veriability The time value of money The price of uncertainty inherent in an asset or liability Other factors a. Estimation of Fair Value is the only objective initial recognition. B. Standards GAAP Hierarchy ESTABLISHED ACCOUNTING PRINCIPLES Level 1 Level 2 Level 3 FASB Statements & Interp. APB Opinions AICPA Acct. Research Bul. FASB Tech. Bulletins AICPA Industry Audit & Accounting Guides AICPA Statement of Position Consensus Position of the FASB Emerging Issues Task Force AICPA Practice Bulletins Level 4 AICPA Acct. Interpretation Qs & As Published by FASB Staff Recognized Industry Practice Other Accounting Literature * Comprehensive Basis of Accounting Other than GAAP 1. Basis of accounting to comply with regulatory agency 2. Basis of accounting for tax purposes a. recognize certain revenues and expenses in different reporting periods. 3. Cash Basis 4. Basis substantiated for all material items. E.g. price-level basis Note: When using other comprehensive basis of accounting other than GAAP, use terms that are appropriate for such basis. You do not want to confuse GAAP with Non GAAP. E.g. Statement of Assets and Liabilities arising form Cash Transactions (Not Balance Sheet) E.g. Statement of Revenue Collected and Expenses Paid (Not Income Statement) Note: Use titles to indicated that suggest non-GAAP Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 7 Chapter I – Class & Home Work 1. Match the concepts with the selected term Concepts and Standards 1. Probable Future Economic Benefits 2. Residual Interest In Assets 3. Enhancements Of Assets Or Settlements Of Liabilities From An Entity’s Major Or Central Operations 4. The Accounting Process Reducing An Amount By Periodic Payments Or Write-Downs 5. Formal recording of an item 6. The change in equity during a period from transactions and other events and circumstances from nonowner sources 7. Probable future sacrifices of economic benefits 8. Using assets or incurring liabilities by an entity’s major or central operations 9. An accounting process concerned with matching future expected cash receipts and payments 10. Assigning an amount according to a plan or formula 11. Increases in equity form incidental transactions of an entity, except form investments by owners. 12. An accounting process concerned with matching past cash receipts and payments 13. Conversion of noncash resources into money Answer 14. Decreases in equity resulting from transfers by the enterprise ot owners 15. Increases in Equity resulting from transfers to the enterprise for the purpose of increasing an ownership interest Selected Term A. Liabilities B. Revenues C. Gains D. Realization E. Assets F. Losses G. Accrual H. Financial Statement I. Recognition J. Deferrals K. Amortization L. Earnings M. Allocation N. Comprehensive Income O. Dividends P. Capital Contributions Q. Equity R.. Expenses 2. Match the Accounting Principles Source with the answer from the Category column. Accounting Principle Source 1. FASB Statement and Interpretations 2. AICPA Accounting Interpretations 3. FASB Q’s and A’s as published 4. AcSEC Practice Bulletins 5. FASB Emerging Issues Task Force Positions 6. APB Opinions 7. AICPA Accounting Research Bulletins 8. FASB Technical Bulletins 9. AICPA Statement of Position 10. AICPA Audit and Accounting Guide 11. Widely used accounting practices Answer Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson Category A) Category A B) Category B C) Category C D) Category D 8 3. Match the Concepts with the answer from the “Choices” Concept Answer 1. The relevant attribute for plant assets and most inventories. It is the cash or equivalent actually paid for an asset and is ordinarily adjusted subsequently for amortization (which includes depreciation) or other allocations. 2. The relevant attributes for liabilities incurred to provide goods or services to customers. It is a cash or equivalent actually received when the obligation was created and may be subsequently amortized. 3. Used to measure certain inventories and is the cash or the equivalent that would be paid for a current acquisition of the same or an equivalent asset. 4. Used to measure some marketable securities e.g., those held by investment companies, or assets expected to be sold at below their carrying amount. 5. Used to measure short-term receivables and some inventories. It is the cash or equivalent expected to be received for an asset in the due course of business, minus the costs of completion and sale. 6. Used to measure items such as trade payables and warranty obligations. It is the cash or equivalent equivalents that the entity expects to pay to satisfy the obligation in the due course of business. 7. In the theory, the most relevant method of measurement because it incorporates time value of the money concepts. In practice, it is currently used for only long-tern receivables and payables. Choices A) Current Market Value B) Net Realization Value C) Historical Cost D) Historical Proceeds E) Replacement Cost F) Present Value G) Net Settlement Value 4. Prepare a Memorandum to the bookkeeper explaining what a comprehensive basis of accounting other than GAAP may be and the required disclosures for OCBOA reports. REMINDER: Your response will be graded for both technical content and writing skills. You should demonstrate your ability to develop, organize, and express your ideas. Do not convey information in the form of a table, bullet point list, or other abbreviated presentation. TO: Staff Member FROM: New CPA REFERENCE: OCBOA Use and Disclosures Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 9 Galilee College © 2007 Chapter 2 – Revenue Recognition A. Recognition at the Point of Sale 1. Revenues recognized when realized or realizable and earned i. The revenue recognition criteria are ordinarily met at the point of sale. At this time, title and risk of loss usually pass to the buyer. ii. Exceptions exist to this principle. E.g. revenue may be recognized at the point of production if an established market exists for fungible goods, such as precious metals or agricultural products. - Evenly over benefiting periods - Revenue is not recognized prior to substantive delivery a. At point of sale – risk of loss pass to buyer i. FOB Shipping Point – When goods are shipped ii. FOB Destination – Tender delivery at destination b. At point of production for certain products: fungible goods; precious metals/agricultural products c. Or when collectibles is assured d. Deferred Revenues – cash received in advanced i. Reversal is made only when initial entry is to revenue account B. Recognition at Completion of Production 1. When products and other assets are readily realizable because they are salable, then a fixed price should be recognized as revenues upon completion of production. C. Cash vs Accrual Basis Revenues = cash collected a. Accruals – Future Cash Flows (Recognize Revenue and Expense when earned & occur) b. Deferral – Past Cash Flows (Postponing recognition of revenues and expenses) 1. Cash Basis – Records revenues when cash is received, and recognized expenses when cash paid. 2. Increases in inventory = more expenses (deduct from accrual basis) 3. Increase in payables = less expenses (add to accrual basis) D. Installment Method 1. Recognized income when receivable is collected a. Collection of Receivable is not reasonably assured (indeterminate) b. Gross Profit is recognized in income in proportion to cash collection c. Amount recognized each period = gross profit percentage (gp/sp) x cash collected d. Repossessed goods due to non-payment (Debit: deferred gp and loss) (Credit: Installment Receivable) e. N/I should included only realized GP Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 10 E. Cost-Recovery Method 1. Profit is recognized after collections exceed cost Subsequent amounts are treated entirely as revenues This method is more conservative than the installment method. a. Receivables are collected over extended period b. There is considerable doubt as to collectibility c. Recognizable estimate of loss cannot be made F. Long-Term Construction Contracts 1. Completed Contract (RECORD LOSS WHEN IT BECOMES APPARENT) a. Profit is recognized in year of completion b. Defer cost in construction-in-progress account until project is completed and revenue is recognized. c. Close CIP to sales 2. Percentage of Completion (RECORD LOSS WHEN IT BECOMES APPARENT) a. Recognize profit based on total profit, percentage completed and profit recognized to date b. CIP = (Cost & Recognized Income) (debit) c. Estimate total profit = total estimated cost – contract price. d. Total profit recognized to date = % completed x total expected profit e. Current period profit = Total profit to date – prior recognized profit f. Current Asset = (CIP – Progress Billing) g. Current Liability = (Progress Billing – CIP) Note: Progress Billing is an offset to CIP on Balance Sheet G. Consignment Accounting Cost of Goods Sold Beginning Inventory + Net Purchases = Goods Available for Sale - Ending Inventory = Cost of Good Sold Inventoriable cost include all costs of making the inventory ready for use Arrangement between owner of goods and sales agent. No Sale, but consigned pending sale. 1. Title remains with consignor (Owner) 2. Sales are recorded on books of consignor when goods are sold by consignee 3. Inventory shipped should be included in inventory of consignor (+ cost to transport goods) 4. Consignee records sales commissions when goods are sold h. debit consignment-in for the freight cost This is a receivable Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 11 H. 1. 2. 3. 4. 5. 6. 7. Interest Interest is the payment received by holders of money to forgo current consumption. PV of an amount = value today of some future payment (Future amount x PV Factor) FV of an amount = Investment today for availability tomorrow (Current Amount x FV factor) Annunities – Series of equal payments at equal intervals Ordinary Annuity (Annunity in arrears) = Series of payments made at the end of each period Annuity Due (Annunity in advance) = Payments are made or received at beginning of period Long-Term Receivalbes are reported at their PV The Interest Method of Amortizing Discount or Premium 1. Straight line Method = constant amortization each period 2. Interest Method = Constant rate of return on a receivable or payable (based on book value) 3. Discount or premium is difference between interest revenue or interest expense and actual amount of cash received or paid. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 12 Revenue Recognition: SPECIAL NOTES One of the most difficult issues facing accountants concerns the recognition of revenue by a business organization. Although general rules and guidelines exist, the significant variety of marketing methods for products and services make it difficult to apply the rules consistently in all situations. Chapter 19 is devoted to a discussion and illustration of revenue transactions that result from the sale of products and the rendering of services. Throughout the discussion, attention is focused on the theory behind the accounting methods used to recognize revenue I. The Revenue Recognition Principle The revenue recognition principle provides that revenue is recognized when (1) it is realized or realizable and (2) it is earned. Revenues are realized when goods and services are exchanged for cash or claims to cash (receivables). Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash. Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues, that is, when the earnings process is complete or virtually complete. The conceptual nature of revenue as well as the basis of accounting for revenue transactions are described in the following four statements. (a) Revenue from selling products is recognized at the date of sale, usually interpreted to mean the date of delivery to customers. (b) Revenue from services rendered is recognized when services have been performed and are billable. (c) Revenue from permitting others to use enterprise assets, such as interest, rent, and royalties, is recognized as time passes or as the assets are used. (d) Revenue from disposing of assets other than products is recognized at the date of sale. II. Point of Sale-the most common basis of revenue recognition Sales transactions result in the exchange of products or services of an enterprise for other valuable assets, normally cash or a promise of cash in the future. Although most sales transactions are fundamentally similar, differences in the method or terms of sale lead to real differences in the transactions themselves and thus to differences in the appropriate accounting for them. The discussion of sales transactions in the chapter is primarily focused on product sales transactions. The coverage of product sales transactions is further divided into the following topics: (a) revenue recognition at point of sale (delivery), (b) revenue recognition before delivery, (c) revenue recognition after delivery, and (d) revenue recognition for special sales transactions (covered in Appendix 19-A). The accounting principles and methods related to product sales transactions are fairly well developed in the accounting literature. Service sales transactions have recently received attention from AcSEC and the FASB. These efforts are an attempt to develop accounting theory and methodology related to service transactions as distinct from product transactions. According to the FASB, revenue is recognized when the product is delivered or the service is rendered. This time of recognition is normally at the time of sale when the product or service is delivered to Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 13 the customer. Some problems in implementing these basic principles arise when (a) sales have buyback agreements, (b) the right of return exists, and (c) trade loading or channel stuffing is present. In most business enterprises, a far greater proportion of total sales volume is handled on a credit basis than on an ordinary cash sale basis. In situations where the seller gives the buyer the right to return the product, the FASB concluded that the transactions should not be recognized currently as sales unless all of the following six conditions are met: a. b. c. d. e. f. The seller's price to the buyer is substantially fixed or determinable at the date of sale. The buyer has paid the seller, or the buyer is obligated to pay and the obligation is not contingent on resale of the product The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. The buyer has economic substance apart from that provided by the seller. The seller does not have significant future performance obligations to directly bring about the resale of the product by the buyer. The amount of future returns can be reasonably estimated. Even when revenues are recorded at date of delivery, with neither buyback or return provisions, some companies are recognizing revenues and earnings prematurely. This occurs in situations where trade loading or channel stuffing are present. Trade loading is an attempt to show sales, profits, and market share an entity does not have by inducing wholesale customers to buy more product then they can promptly sell. Channel stuffing is a similar tactic found mostly in the computer software industry. In channel stuffing, the software maker offers deep discounts to its distributors to overbuy and records revenue when the software leaves its loading dock. When this process takes place, the distributors' inventories become bloated and the marketing channel gets stuffed, but the software maker's financial statements are improved. III. Other Revenue Recognition Methods 1. Long-term Contracts In most circumstances, revenue is recognized at the point of sale because most of the uncertainties related to the earning process are removed and the exchange price is known. One of the exceptions to the general rule of recognition at point of sale is caused by long-term construction-type projects. The accounting measurements associated with long-term construction projects are difficult because events and amounts must be estimated for a period of years. Two basic methods of accounting for long-term construction contracts are recognized by the accounting profession: (a) the percentage-of completion method and (b) the completed-contract method. Please note that the percentage-ofcompletion method and the completed-contract method not be viewed as acceptable, interchangeable alternatives. a. Percentage-of-completion method The percentage-of-completion method should be used when estimates of progress toward completion, revenues, and costs are reasonably dependable and all the following conditions exist: Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 14 a. b. c. The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. The buyer can be expected to satisfy all obligations under the contract. The contractor can be expected to perform contractual obligations. Under the percentage-of-completion method, revenue on long-term construction contracts is recognized as construction progresses. Costs pertaining to the contract plus gross profit earned to date are accumulated in a Construction in Process account. The amount of revenue recognized in each accounting period is based on a percentage of the total revenue to be recognized on the contract. This percentage is the costs incurred on the contract to date divided by the most recent estimated total costs (cost-to-cost basis). Income recognized before completion is recorded by debiting Construction in Process and crediting Revenue from Long-term Contracts. Use of this method is dependent upon the seller's ability to provide a reliable estimate of both the cost to complete and the percentage of contract performance completed. When such estimates are considered reasonably dependable, the accounting profession has considered the percentage-of-completion method preferable. b. Completed-Contract Method The completed-contract method should be used only when (a) an entity has primarily short-term contracts, (b) the conditions for using the percentage-of-completion method cannot be met, or (c) there are inherent hazards in the contract beyond normal, recurring business risks. Under the completed-contract method, revenue and gross profit are recognized when the contract is completed. The principal advantage of the completed-contract method is that reported revenue is based on final results rather than on estimates of unperformed work. Its major disadvantage is the distortion of earnings that may occur. The accounting entries made under the completed-contract method are the same as those made under the percentage-ofcompletion method. with the notable exception of periodic income recognition. Contract Losses When the current estimates of total contract revenue and contract cost indicate a loss is expected, the entire expected contract loss must be recognized in the period in which it becomes evident under both the percentage-of-completion and the completed-contract-methods. In addition to normal financial statement disclosures, construction contractors should disclose (a) the method of recognizing revenue, (b) the basis used to classify assets and liabilities as current, (c) the basis for recording inventory, (d) the effects of any revisions of estimates, (e) the amount of backlog on incomplete contracts, and (f) the details about receivables. 2. Installment Method In some cases revenue is recognized after delivery of the product to the buyer. This is due to the fact that in certain sales situations the sales price is not reasonably assured and revenue recognition is Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 15 deferred. The methods generally used to account for the deferral of revenue recognition until cash is received are the installment method and the cost recovery method (discussed after the installment method). Use of the installment method is justified in situations where receivables are collectible over an extended period of time and there is no reasonable basis for estimating the degree of collectibility. The method is used extensively in tax accounting and has relevance because of the increased emphasis on cash flows. The term installment sale describes any type of sale for which payment is required in periodic installments over an extended period of time. The installment method places emphasis on collection, as installment sales lead to income realization in the period of collection rather than the period of sale. This does not mean that revenue is considered unrealized until the entire sale price has been collected but rather that income realization is proportionate to collection. This is due to the fact that the ultimate profit is more uncertain in installment sales than in ordinary sales because collection is more doubtful. Under the installment sales method of accounting, the gross profit (sales less cost of goods sold) on installment sales is deferred to those periods in which cash is collected. Operating expenses, such as selling and administrative expenses, are treated as expenses in the period incurred. For installment sales in any one year, the following procedures apply under the installment sales method: a. b. c. During the year, record both sales and cost of sales in the regular way using separate installment sales accounts and compute the rate of gross profit on installment sales transactions. At the end of the year, apply the rate of gross profit to the cash collections of the current year's installment sales to arrive at the realized gross profit. The gross profit not realized should be deferred to future years. In any year in which collections from prior years' installment sales are received, the gross profit rate of each year's sales must be applied against cash collections of accounts receivable resulting from that year's sales to arrive at the realized gross profit. To illustrate the installment sales method of accounting assume the following facts: Installment sales Cost of installment sales Gross profit Rate of Gross Profit Cash Receipts 1999 Sales 2000 Sales 2001 Sales 1999 $226,000 164,980 $ 61,020 27% 2000 $248,000 176,080 $ 71,920 29% 2001 $261,000 195,750 $ 65,250 25% $ 85,000 $ 96,000 123,000 $ 45,000 87,000 147,000 Only the 2000 journal entries will be shown. The entries for 1999 and 2001 are the same, but the entire set of entries for the installment method are demonstrated by the 2000 entries. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 16 To record 2000 installment sales Installment Accounts Receivable, 2000 Installment Sales 248,000 To record cash collected on installment receivables Cash219,000 Installment Accounts Receivables, 1999 Installment Accounts Receivables, 2000 To record 2000 cost of goods sold on installment Cost of Installment Sales Inventory (or Purchases) To close installment sales and cost of installment sales Installment Sales Cost of Installment Sales Deferred Gross Profit, 2000 To record realized gross profit Deferred Gross Profit, 1999 Deferred Gross Profit, 2000 Realized Gross Profit 248,000 96,000 123,000 176,080 176,080 248,000 176,080 71,920 25,920 (a) 35,670 (b) 61,590 (a) (b) When interest is involved in installment sales, it should be accounted for separately as interest income in the period received. Uncollectible installment accounts receivable should be accounted for in a manner similar to that used for such losses on other credit sales if repossessions do not normally compensate for uncollectible balances. Repossessions The accounting for repossessions recognizes that the related installment receivable account is not collectible and that it should be written off. Also, the applicable deferred gross profit must be removed from the ledger. Repossessed merchandise should be recorded in the Repossessed Merchandise Inventory account. The item repossessed should be recorded at its fair value. The objective should be to put any asset acquired on the books at its fair value or, when fair value is not ascertainable, at the best possible approximation of fair value. If installment sales transactions represent a significant part of total sales, full disclosure of installment sales, the cost of installment sales, and any expenses allocable to installment sales is desirable. Deferred gross profit on installment sales is generally treated as unearned revenue and classified as a current liability. 3. Cost Recovery Method Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 17 Under the cost recovery method, no profit is recognized until cash payments by the buyer exceed the seller's cost of the merchandise sold. After all the costs have been recovered, any additional cash collections are included in income. APB Opinion No. 10 allows a seller to use the cost recovery method to account for sales in which "there is no reasonable basis for estimating collectibility." The cost recovery method is required under FASB Statement No. 45 (franchises) and No. 66 (real estate) where a high degree of uncertainty exists related to the collection of receivables. The cost recovery method is more appropriate than the installment method when there is a greater degree of uncertainty. IV. Other Issues 1. Franchises Appendix 19A includes a presentation of franchise sales and consignment sales transactions. In franchise operations a franchiser grants business rights under a franchise agreement to a franchisee. Four types of franchise arrangements have evolved in practice: (a) manufacturer-retailer, (b) manufacturerwholesaler, (c) service sponsor-retailer (McDonald's, Pizza Hut, etc.), and (d) wholesaler -retailer. Franchise companies derive their revenue from one or both of two sources: (a) the sale of initial franchises and related assets or services and (b) continuing fees based on the operations of franchises. In 1981 the FASB issued Statement No. 45, "Accounting for Franchise Fee Revenue." This Statement was designed to curb abuses in revenue recognition and to standardize the accounting and reporting practices in the franchise industry. Initial franchise fees are to be recorded as revenue only when and as the franchiser makes substantial performance of the services it is obligated to perform and collection of the fee is reasonably assured. Continuing franchise fees should be reported as revenue when they are earned and receivable from the franchisee, unless a portion of them has been designated for a particular purpose, such as providing a specified amount for building maintenance or local advertising. When a franchisee is given an option to purchase equipment or supplies by a franchiser at a bargain purchase price (lower than the normal selling price), a portion of the initial franchise fee should be deferred and accounted for as an adjustment to the selling price of equipment or supplies. A franchiser should disclose all significant commitments and obligations resulting from franchise agreements, including a description of services that have not yet been substantially performed. 2. Consignments In a consignment sales arrangement, merchandise is shipped by the consignor to the consignee, who acts as an agent for the consignor in selling the merchandise. The merchandise shipped to the consignee remains the property of the consignor until a sale is made. When a sale is made, the consignee remits the proceeds, less any related expenses plus a sales commission, to the consignor. When the consignor receives word that a sale has been made, revenue is recognized and inventory is appropriately reduced. In accounting for consignment sales arrangements, the consignor periodically receives from the consignee an account sales that shows the merchandise received, merchandise sold, expenses chargeable to the consignment, and the cash remitted. Revenue is then recognized by the consignor. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 18 Chapter 2 – Revenue Recognition QUESTIONS A. Recognition at the Point of Sale CLASS: Tip Tippy sold $250,000 of merchandise to Win Winny on January 1, 2005, under each of the following situation record the transactions for Tip Tippy:1. The shipping terms were FOB Shipping point (The goods were still in Tip Tippy Warehouse) 2. The shipping terms were FOB Destination – Miami (The goods were still in Tip Tippy Warehouse) 3. The shipping terms were FOB Shipping point (The goods were already shipped) 4. The shipping terms were FOB Destination – Miami (The goods were already shipped, but did not reach Miami) 5. The shipping terms were FOB Destination – Miami (The goods had just arrived in Miami) HOME: Smith Smithy sold $100,000 of merchandise to Get Getty on January 1, 2006, under each of the following situation record the transactions for Smith Smithy on January 1st) Note: only record transactions on January 1st. 6. The shipping terms were FOB Shipping point (The goods were shipped the same day) 7. The shipping terms were FOB Destination – Nassau (The goods were shipped on January 13th) 8. The shipping terms were FOB Shipping point (The goods were shipped on January 2nd) 9. The shipping terms were FOB Destination – Nassau (The goods reached Nassau on January 1st) B. Recognition at Completion of Production CLASS: Cin Cinny Manufactured some fungible/perishable/special goods for In Inny at a sales value of $50,000. Record the following transactions for Cin Cinny:(1) The goods were manufactured on January 2, 2005, (2) The goods were paid for on February 10, 2005 HOME: Joe Joey Manufactured some chairs for Zed Zeddy at a sales value of $20,000. These chairs are used in the neighborhood schools. Record the following transactions: (2) The goods were manufactured on January 3, 2005, (2) The goods were paid for on January 9, 2005 C. Cash vs Accrual Basis CLASS: Record the following transactions for Min Minny:1. Received a telephone bill from Batelco for $4,000 on December 12, 2004 2. The telephone bill was paid for on the due date of January 19, 2005 3. Min Minny paid 2 years of insurance on December 1, 2004, $36,000 a. What is the entry on December 1, 2004? b. What is the entry at December 31, 2004? c. What is the balance in the prepaid insurance on May 31, 2006? HOME: 4. 5. 6. Record the following transactions for Milk Milky on December 31st 2004:Received a BEC from bill for $10,000 on December 31, 2004 60% The telephone bill was paid for on the due date of January 31, 2005 Milk Milky paid 2 years of insurance on September 1, 2004 $48,000 a. What is the entry on September 1, 2004? b. What is the entry at December 31, 2004 to record the insurance expense for the year? c. What is the balance in the prepaid insurance on at December 31, 2005? D. Installment Method CLASS: Gin Ginny had installment sales of $2,000,000 on January 1, 2004, The cost of sales were $1,500,000. The first payment of $900,000 was made on March 2, 2004, and the second payment was made on November 9, 2004 for $700,000. 1. Record the entry on January 1, 2004 2. Record the entry for the March payment? Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 19 a. How much of the gross profit is recognized? b. How much of the gross profit is deferred? c. What is the installment receivable balance after the payment? HOME: Pick Picky had installment sales of $3,500,000 on January 1, 2005, The cost of sales were $2,100,000. The first payment of $1,000,000 was made on September 1, 2005, 3. Record the entry on January 1, 2005 4. Record the entry on September 1, 2005t? a. How much of the gross profit is recognized at September 1, 2005? b. How much of the gross profit is deferred at September 1, 2005? c. What is the installment receivable balance as of September 1, 2005? E. Cost-Recovery Method CLASS: As the Financial Controller for Lil Lilly, you advised your accounting staff to use the cost-recovery method to recognized revenues. In a memo, explain why you suggest the used of the cost-recovery method. You should be explicit. Please referenced to applicable standard that would support your augment. HOME: Bet Betty used the Cost Recovery method and had sales of $1,000,000. Cost of sales were 75%. If Bet Betty collected $800,000, how much profit can be recognized? F. Long-Term Construction Contracts CLASS: As the Accounts manager for Good Goody, you received a 3 year long-term construction contract on July 1, 2003 from Pen Penny. The following were the details as of December 31, 2004: Contract price $3,000,000, cost incurred to date $900,000, Cost to complete $600,000, revenue recognized at December 31, 2003 $300.00. How much revenue should be recognized at December 31, 2004 under (1) the percentage of completion method? and (2) the completed contract method? HOME: As the Accounts manager for Hint Hinty, you received a long-term construction contract on January 1, 2005 from Sue Suey. The contract price was $6,000,000. At December 31, 2005, $100,000 profit was recognized, and at that time the cost to date was $600,000. In 2006, additional cost incurred was $2,500,000 and the estimated cost to complete was $1,200,000. Using the percentage of completion method, how much profit can be recorded in 2006? G. Consignment Accounting CLASS: 1. Did Diddy accounts showed the following information: Purchases $3,000,000, Freight-in $300,000, Freight-Out $200,000, Purchase Returns $500,000, Purchase Discount $100,000, Beginning Inventory $7,500,000, Cost of goods sold $3,500,000. What is Ending Inventory? HOME: Stub Stubb y consigned $3,000,000 worth of merchandise to Sell Selly on January 1, 2005. Stub Stubby paid the transportaion charges and agreed to pay commission to Sell Selly at a rate of 10%. If Sell Selly returned 20% of the inventory to Stub Stubby and sold the balance, how much should be remitted to Stub Stubby? CLASS: 2. Tin Tinny consigned $2,000,000 worth of merchandise to Nin Ninny on February 2, 2005. Nin Ninny paid the transportation cost of $200.00. At December 31, 2005 only 30% of the inventory remained in Nin Ninny’s warehouse. If Nin Ninny receives a consignment of $25%, what amount must be submitted to Tin Tinny at December 31, 2005? H. Interest CLASS: 1. On January 1, 2004, Mil Milly Co. exchanged equipment for a $200,000, noninterest-bearing note due on January 1, 2007. The prevailing rate of interest for the note of this type at January 1, 2004 was 10%. The present value of $1 at 10% for three periods is .75. What amount of interest revenue should be included in Mil Milly’s 2005 income statement? Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 20 CLASS: 2. On January 1, 2005, Ott Otty Company sold goods to Fox Foxy Co. Fox Foxy signed a noninterestbearing note requiring payment of $60,000 annually for 7 years. The first payment was made on January 1, 2005. The prevailing rate of interest for this type of note at date of issuance was 10% . If the present value factor was 4.36, what should Ott Otty record as revenues in January 2005? HOME: On January 1, 2005, Poke Pokey Company sold goods to Nod Noddy. If the present value of this note was 5.4 over a 8 year period, and 100,000 was paid by Nod Noddy on January 1st. What is the total revenue of this noninterest-bearing note can Poke Pokey recognized as of January 1, 2005. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 21 Galilee College © 2007 Chapter 3 – Financial Statements Basic Financial Statements a. Balance Sheet b. Income Statement c. Retained Earnings d. Cash Flows Note: Changes in SHE and number of shares of equity securities are necessary whenever financial position and results of operations are presented. A. Balance Sheet 2. Shows the financial position of business at a particular date (Assets, Liabilities and Equity) The BS is used in assessing an entity’s liquidity and financial flexibility. 3. Conceptual Elements and Classifications Assets Current: Cash, Cash Equivalents, Inventories, Receivables, Trading Securities, Certain Available-for-Sale & Held-to-maturity, and prepaid expenses Noncurrent: Investments and funds, Property, Plant & Equipment, Intangible Assets Liabilities Current: Obligations that will be due on demand within 1 year or operating cycle if longer, and obligations callable b creditor within 1 year due to debt violation. Noncurrent Long-term notes and bonds, liabilities under capital leases, pension obligations, Deferred tax liability arising from interperiod tax allocation, Obligations under product or service warranty agreements, Advances for long term commitments to provide goods or services, Advances form affiliated companies and Deferred revenue. B. Statement of Income and Retained Earnings 1. Shows the results of operations, also known as the statement of earnings 2. Revenues is a component for income from continuing operations 3. Income Statement Format: Pretax income from continuing operations Less Provision for Income tax = Income from Continuing Operations +/- Below the line (BELOW THE DEC) – Show Net of Taxes D – Discontinued Operations E - Extraordinary Items (unusual in nature and infrequent in occurrence) (if only one criteria is met = continuing operations. Separate Reporting) C – Cumulative effect of change in accounting principle Net Income EPS Note: Interest Expense is classified as a nonoperating item Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 22 4. Presentation of Income from Continuing Operations - Single-Step Income Statement = Provides one grouping for revenue items and one grouping for expense items (See page 95) Multi-Step Income Statement = Matches operating revenues and expenses in a section separate from nonoperating items. (See page 95) - Comprehensive Income – Display as part of full set of F/S if it has items of other comprehensive income. (NI must be shown as a component of comprehensive income in that statement) 5. Statement of Retained Earnings (Appropriated or Unappropriated) i. Prior-period adjustment – Corrections of errors in prior-period statements ii. Comparative Financial Statements - When presented, all prior periods affected by a prior-period adjustment are restated. iii. Quasi-reorganization – Eliminating deficit in retained earnings through deductions in other capital accounts. C. Cost of Sales (Beg. Inv. + Purchases – End Inv = GGS) Cost of Goods Manufactured BWIP + Material Used + Direct Labor + F/O = Manufacturing Cost - EWIP = Cost of Goods Manufactured (CGS + End. F/G – Beg. F/G) D. Other Expenses 1. General & Administrative (Incurred for the direction of the enterprise as a whole and are not related wholly to a specific function) 2. Selling 3. Interest (nonoperating item) * Imputed Interest on noninterest bearing note is treated as interest expense 4. Royalty * Contributions are recognized as expenses when made E. Personal Financial Statements Consist of Statement of Financial Condition & Statement of changes in net worth. Record Assets Estimated Current Values - Amount that asset could be exchanged between informed & willing buyer and seller - Current value may be based on discounted cash flow, market price, appraised value, etc. - Insurance should be reported at cash values – amount of any outstanding loans Record Liabilities at Estimated Current Amount Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 23 Lower of either amount of future cash to be paid discounted at the interest rate implicit in transaction in which the debt was incurred or amount at which debt could currently be discharged. Assets/Liabilities includes noncancelable rights/commitments to pay future amounts if: 1. Amounts are fixed or determinable 2. Not contingent 3. Do not require future performance or service Estimated Taxes (difference between BV of Assets & Liability x tax bases) a. Report between liabilities and net worth in Statement of Financial Conditions A business interest constituting a large part of an individual’s total assets should be presented in a personal financial statement as a single amount equal to the estimated current value of the business interest. F. Prospective Financial Information A financial forecast consists of prospective financial statements present an entity’s expected financial position, results of operations, and cash flow. This is based on assumptions reflecting conditions expected to exist and courses action expected to be taken. a. Client Management is usually responsible for these assumptions b. Outside parties can also be responsible c. Financial Projections include one or more hypothetical assumptions d. General Use – Financial Forecast used by non-negotiating party e. Prospective Financial Information is partial presented when it omits one or more of the following:- Sales or gross Revenues, Gross Profit or Cost of Sales, Unusual or infrequently occurring items, provision for income taxes, discontinued operations or extraordinary items, income from continuing operations, net income, primary and fully diluted earnings per share, or significant cash flows. - Prospective Financial Statements may take the form of complete basic statements or be limited to certain minimum items. Among these items are the summary of significant accounting policies and the summary of significant assumptions. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 24 Galilee College Intermediate Accounting I – Chapter 3 – Financial Statements Flip Flippy Additional Information Income Tax Rate 30% Discontinued Continued Operations Flip Flippy made a decision to discontinue it Bottling Division. This year, the Bottling Division had losses of $50,000 Extraordinary Items Flip Flippy benefited from a gain as a result of a hurricane damage. The amount of gain was $100,000. This was the first hurricane in Flip Flippy’s country. Instructions: Complete the Financial Statements using the additional information. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 25 Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 26 Charle Charley Additional Information Income Tax Rate 25% 1. During the year, Charle Charley discontinued its Packing Department and incurred additional income of $150,000 and additional expenses of $30,000. 2. A major Snow storm caused a severe damage to Charle Charley’s building. The damage of $90,000 was uninsured. Instructions: Complete the Financial Statements using the additional information. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 27 Galilee College © 2007 Chapter 4 – Other Income Statement Items (Below the DEC) A. Discontinued Operations (D) On October 3, 2001, The Financial Accounting Standards Board (FASB) issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, that replaces FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. The primary objectives of this project were to develop one accounting model, based on the framework established in Statement 121, for long-lived assets to be disposed of by sale and to address significant implementation issues. The accounting model for long-lived assets to be disposed of by sale applies to all longlived assets, including discontinued operations, and replaces the provisions of APB Opinion No. 30, Reporting Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, for the disposal of segments of a business. Statement 144 requires that those long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Therefore, discontinued operations will no longer be measured at net realizable value or include amounts for operating losses that have not yet occurred. Statement 144 also broadens the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. For the purpose of reporting discontinued operations, a component of an entity is a set of operations and cash flows clearly distinguishable from the rest of the entity for operational and financial reporting purposes. The results of operations of a component that has been disposed of or is classified as held for sale are reported in discontinued operations if: o Its operations and cash flows have been or will be eliminated form the ongoing operations of the entity as a result of the disposal o The entity will have no significant continuing post-disposal involvement in the component’s operations. Result of Operations Disposed of or classified as held for sale + loss on Write down to fair value - Cost to sell/+ gain form recoupment -/+ Applicable income taxes/benefits = Separate reporting as a component of income (discontinued operation) (Note: these should be reported in the period incurred) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 28 o If Gain/Loss is attributable to discontinued operations, and the prior year financial statements are presented, they should be reclassified for comparative purposes. o Amounts previously reported in discontinued operations in a prior period may require adjustment in the current period. - If such an adjustment is directly related to a prior period disposal of a component, it is reported currently in discontinued operations as a separate item, and its nature and amount are disclosed. - Note: A settlement of an employee benefit plan obligation is directly related to the disposal given a demononstrated direct cause-and-effect relationship. B. Extraordinary Items (E) Early extinguishment of debt = is ordinary and not extraordinary This does not include an investment transaction you have in another company Remember DEC 1. Extraordinary item = unusual and infrequent These items are not E/I (Write down of equipment, adjustments of accruals on long-term contracts, write-off of obsolete equipment, strikes, gain or loss on disposal Loss as a result of anti-trust action is extraordinary. There is no Extraordinary loss if debt has not been extinguished (a) However, if liability(debt) has been extinguished, i. this is extraordinary C. Accounting Changes and Error Corrections (C ) 1. Change in Accounting Estimate – Accounted for as component of income from continuing operations in period of change. a. Also in future periods if future periods are affected also. b. Accounted for prospectively only. c. Note: This treatment applies to change in accounting principle that is inseparable from the effect of a change in estimate. Summary of Statement No. 154 Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3 This Statement replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. Opinion 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 29 cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this Statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. This Statement defines retrospective application as the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity. This Statement also redefines restatement as the revising of previously issued financial statements to reflect the correction of an error. This Statement requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in nondiscretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. This Statement also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. This Statement carries forward without change the guidance contained in Opinion 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. This Statement also carries forward the guidance in Opinion 20 requiring justification of a change in accounting principle on the basis of preferability. Reasons for Issuing This Statement This Statement is the result of a broader effort by the FASB to improve the comparability of cross-border financial reporting by working with the International Accounting Standards Board (IASB) toward development of a single set of high-quality accounting standards. As part of that effort, the FASB and the IASB identified opportunities to improve financial reporting by eliminating certain narrow differences between their existing accounting standards. Reporting of accounting changes was identified as an area in which financial reporting in the United States could be improved by eliminating differences between Opinion 20 and IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. How the Changes in This Statement Improve Financial Reporting Under the provisions of Opinion 20, most accounting changes were recognized by including in net income of the period of the change the cumulative effect of changing to the newly adopted accounting principle. This Statement improves financial reporting because its requirement to report voluntary changes in accounting principles via retrospective application, unless impracticable, enhances the consistency of financial information between periods. That improved consistency enhances the usefulness of the financial information, especially by facilitating analysis and understanding of comparative accounting data. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 30 Also, in instances in which full retrospective application is impracticable, this Statement improves consistency of financial information between periods by requiring that a new accounting principle be applied as of the earliest date practicable. This Statement requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate that is effected by a change in accounting principle. The provisions of this Statement better reflect the fact that an entity should change its depreciation, amortization, or depletion method only in recognition of changes in estimated future benefits of an asset, in the pattern of consumption of those benefits, or in the information available to the entity about those benefits. A change in accounting principle required by the issuance of an accounting pronouncement was not within the scope of Opinion 20. Including all changes in accounting principle within the scope of this Statement establishes, unless impracticable, retrospective application as the transition method for new accounting standards, but only in the unusual instance that the new accounting pronouncement does not include explicit transition provisions. D. Earnings Per Share (EPS) To calculated shares used to calculate EPS prorate the time shares were outstanding i. Control Number: Income from continuing operations adjusted for preferred dividends A. This is the case whether potential common shares are dilutive or antidilutive B. If entity has loss from continuing operations available to common shareholders, no potential common shares are included to calculate DEPS amount C. For BEPS Numerator = Control Number – below the DEC items D. BEPS Denominator = Weighted Average number of shares E. DEPS Denominator = WA no. of shares + dilutive potential common shares (if control number is not a loss) Do not include antidilutive shares a. Market value is less than exercise price b. Potential common stock is included in the calculation of DEPS if it dilutive. F. Declaration and distribution of stock dividend must be treated as though it happened at the beginning of the year. G. OVERVIEW BASIC EARNINGS PER SHARE (BASIC EPS) measures the amount of profit earned by a company for each share of common stock it has outstanding. Earnings help to stimulate growth and pay for stockholders’ dividends. basic earnings per share = net income after taxes / shares common stock outstanding DILUTED EARNINGS PER SHARE (DILUTED EPS) measures the amount of profit earned by a company for each share of outstanding common stock, but Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 31 also takes into consideration stock options, warrants, preferred stock, and convertible debt securities which can be converted into common stock. H. Calculation of EPS Note: 1. Potential common stock is dilutive if its inclusion in the calculation of EPS results in a reduction of EPS, or an increase in loss per share. 2. In determining whether potential common stock is dilutive, each issue or series of issues is considered separately and in sequence from the most dilutive to the least dilutive. The issue with the lowest earnings per incremental share is included in DEPS before issues with higher earnings per incremental share. 3. If the issue with the lowest earnings per incremental share is found to be dilutive with respect to BEPS, it is included in a trial calculation of DEPS. 4. This process continues until all issues of potential common shares have been tested. Remember: 1. If Market Price is less than Exercise Price = Antidilutive Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 32 Dilutive Securities and Earnings: SPECIAL NOTES Per Share Chapter 17 examines the issues related to accounting for dilutive securities at date of issuance and at time of conversion. Also, the impact of the computation of earnings per share is presented. The significance attached to the earnings per share figure by stockholders and potential investors has caused the accounting profession to direct a great deal of attention to the calculation and presentation of earnings per share. I. Dilutive Securities Dilutive securities are defined as securities that are not common stock in form but that enable their holders to obtain common stock upon exercise or conversion. The most notable examples include convertible bonds, convertible preferred stocks, warrants, and contingent shares. 1. Convertible Bonds In the case of convertible bonds, the conversion feature allows the corporation an opportunity to obtain equity capital without giving up more ownership control than necessary. Also, the conversion feature entices the investor to accept a lower interest rate than he or she would normally accept on a straight debt issue. Accounting for convertible bonds on the date of issuance follows the procedures used to account for straight debt issues. Issuance and interest payment of convertible bonds are recorded the same as that of any other bonds. If bonds are converted into common stock, the issue price of the stock may be based upon (a) the market price of the stock or bonds, or (b) the book value of the bonds. The market value method, while theoretically sound, is subject to criticism because the corporation recognizes a gain or loss as a result of an equity investment in that corporation. Under the book value method, no gain or loss is recorded, as the issue price of the stock is recorded at the book value of the bonds. The book value method has received the most widespread acceptance among practitioners. For example, assume that Irvine Corporation has convertible bonds with a book value of $3,200 ($3,000 plus $200 unamortized premium) convertible into 120 shares of common stock ($10 par value) with a current market value of $35 per share. The journal entries to be made under the market value approach and book value approach would be as follows: Market Value Approach (less-commen approach) Bonds Payable Premium on Bonds Loss on Redemption of Bonds Payable Common Stock Paid-in Capital in Excess of Par Book Value Approach Bonds Payable 3,000 200 1,000 1,200 3,000 3,000 Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 33 Premium on Bonds Payable Common Stock Paid-in Capital in Excess of Par 200 1,200 2,000 When an issuer wishes to induce prompt conversion of its convertible debt to equity securities, the issues may offer some form of additional consideration ("sweetener"). The sweetener should be reported as an expense of the current period at an amount equal to the fair value of the additional consideration given. Convertible debt that is retired without exercise of the conversion feature should be accounted for as though it were a straight debt issue. Any difference between the cash acquisition price of the debt and its carrying amount should be reflected currently in income as a gain or loss. 2. Convertible Preferred Stock Convertible preferred stock is accounted for in the same manner as nonconvertible preferred stock at date of issuance. When conversion takes place, the book value method is used. Preferred Stock, along with any related Additional Paid-in Capital, is debited; Common Stock and Additional Paid-in Capital (if an excess exists) are credited. If the par value of the common stock issued exceeds the book value of the preferred stock, Retained Earnings is debited for the difference. 3. Stock Warrants Stock warrants are certificates entitling the holder to acquire shares of stock at a certain price within a stated period. Warrants are potentially dilutive, as are convertible securities. However, when stock warrants are exercised, the holder must pay a certain amount of money to obtain the shares. Also, when stock warrants are attached to debt, the debt remains after the warrants are exercised. When detachable stock warrants are attached to debt, the proceeds from the sale should be allocated between the two securities. This treatment is in accordance with APB Opinion No. 14, and is based on the fact that the stock warrants can be traded separately from the debt. Allocation of the proceeds between the two securities is normally made on the basis of their fair market values at the date of issuance. The amount allocated to the warrants is credited to Paid-in Capital--Stock Warrants. The two methods of allocation available are (a) the proportional method and (b) the incremental method. To value the warrants under the proportional method, a value must be placed on the bonds without the warrants and then on the warrants. For example, assume that Pontell Corporation issued 1,000, $500 bonds with warrants attached for par ($500,000). Each bond has one warrant attached. It is estimated that the bonds would sell for 98 without the warrants and the value of the warrants in the market is $25,000. The allocation between the bonds and the warrants would be made as follows: Fair market value of bonds Fair market value of warrants Aggregate fair market value $490,000 25,000 $515,000 Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 34 $490,000 Allocated to bonds:$515,000 $475,728 $25,000 Allocated to warrants: $515,000 $ 24,272 The journal entry for the issuance of the bonds is: Cash Discount on Bonds Payable Bonds Payable Paid-in Capital-Stock Warrants 500,000 24,272 500,000 24,272 When detachable warrants are exercised, Cash is debited for the exercise price and Paid-in Capital-Stock Warrants is debited for the amount assigned to the warrants. The credit portion of the entry includes Common Stock and Additional Paid-in Capital. If detachable warrants are never exercised, Paidin Capital Stock Warrants is debited and Paid-in Capital from Expired Warrants is credited. If all the warrants described above are exercised under the following terms, for $15 cash and one warrant the holder will receive one share of $5 par value common stock, the journal entry to record the transaction would be the following: Cash Paid-in Capital--Stock Warrants Common Paid-in Capital in Excess of Par 15,000 24,272 5,000 34,272 Where the fair value of either the warrants or the bonds is not determinable, the incremental method may be used. That is, the security for which the market value is determinable is used and the remainder of the purchase price is allocated to the security for which the market value is not known. 4. Stock Rights Stock rights are issued to existing stockholders when a corporation's directors decide to issue new shares of stock. Each share owned normally entitles the stockholders to one stock right. This privilege allows each stockholder the right to maintain his or her percentage ownership in the corporation. No entry is required when rights are issued to existing stockholders. 5. Stock Compensation Plans (1) A stock option is another form of warrant that arises in stock compensation plans used to pay and motivate employees. This type of warrant gives selected employees the option to purchase common stock at a given price over an extended period of time. (2) According to Statement of Financial Accounting Standards No. 123, a company is given a choice in the method of recognizing the cost of compensation under a stock option plan. The two choices are: Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 35 a. the intrinsic value method, and b. the fair value method. The FASB encourages the use of the fair value method; however, if a company uses the intrinsic value method, it must provide in a note to the financial statements the pro forma net income and earnings per share, as if it had used the fair value method. a. The Intrinsic Value Method Under the intrinsic value method, compensation cost is measured by the excess of the market price of the stock over its exercise price at the date of grant. The date the employee receives the options is referred to as the grant date. The problem with this method is that when the market price and the exercise price are the same, no compensation cost results. Thus, the FASB still requires a company to disclose in the notes the pro forma net income and earnings per share amounts as if it had used the fair value method. b. The Fair Value Method Using the fair value method, total compensation expense is computed based on the fair value of the options expected to vest on the date the options are granted to the employees. Vesting occurs on the date the employee’s right to receive stock is no longer contingent on remaining in the company. Fair value for public companies is to be estimated use an option pricing model, with some adjustments for the unique factors of employee stock options. No adjustments are made after the grant date, in response to subsequent changes in the stock price æ either up or down. Nonpublic companies are permitted to use a "minimum value" method to estimate the value of the options. (3) Allocating Compensation Expense In general, under both the fair and intrinsic value methods, compensation expense is recognized in the periods in which the employee performs the serviceæthe service period. Unless otherwise specified, the service period is the vesting periodæthe time between the grant and the vesting date. To illustrate the accounting for a stock option plan, assume that on September 16, 1998, the stockholders of Jesilow Company approve a plan that grants the company's three executives options to purchase 4,000 shares each of the company's $1 par value common stock. The options are granted on January 1, 1998, and may be exercised at any time within the next five years. The option price per share is $30, and the market price of the stock at the date of grant is $40 per share. Using the intrinsic value method, the total compensation expense is computed below: Market value of 12,000 shares at the date of grant ($40) Option price of 12,000 shares at the date of grant ($30) Total compensation expense (intrinsic value) $480,000 360,000 $120,000 Using the fair value method, total compensation expense is computed by applying an acceptable fair value option pricing model. We will assume that the fair value option pricing model determines total compensation expense to be $180,000. Assuming the expected period of benefit is 3 years (starting with the grant date), the journal entries for each of the next three years under both methods are as follows: Intrinsic Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson Fair Value 36 Compensation Expense Paid-in Capital--Stock Options 40,000 60,000 40,000 60,000 If all of the options are exercised on July 1, 2002, the journal entries under both methods are as follows: Paid-in Capital—Stock Options Paid-in Capital in Excess of Par Intrinsic 360,000 120,000 12,000 468,000 Fair Value 360,000 180,000 12,000 528,000 If the option is expired, then debit paid in capital – stock options and credit paid in capital – expired stock options. If the option is forfeited (when the employee leaves the company before the vesting date), then debit paid in capital – stock options and credit compensation expense. (4) Noncompensatory Plans Compensation expense is not reported if: a. Substantially all full-time employees may participate on an equitable basis. b. The discount from market price is small; and c. The plan offers no substantive option feature. II. Earnings Per Share Earnings per share indicates the income earned by each share of common stock. Generally, earnings per share information is reported below net income in the income statement. When the income statement contains intermediate components of income (e.g., income from continuing operations), earnings per share should be disclosed for each component. 1. Simple Capital Structure A corporation's capital structure is simple if it consists only of common stock or includes no potentially dilutive convertible securities, options, warrants, or other rights that upon conversion or exercise could in the aggregate dilute earnings per common share. The formula for computing earnings per share is as follows: Net Income – Preferred Dividends Weighted Average Number of Shares Outstanding = Earnings per share If the preferred stock is cumulative and the dividend is not declared in the current year, an amount equal to the dividend that should have been declared for the current year only should be subtracted from net income or added to the net loss. Weighted Average Number of Shares Outstanding The weighted average number of shares outstanding during the period constitutes the basis for the per share amounts reported. Shares issued or purchased during the period affect the number of outstanding shares and must be weighted by the fraction of the period they are outstanding. When stock dividends or stock splits occur, computation of the weighted Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 37 average number of shares requires restatement of the shares outstanding before the stock dividend or split (they are assumed to have been outstanding since the beginning of the year). If a stock dividend or stock split occurs after the end of the year, but before the financial statements are issued, the weighted average number of shares outstanding for the year (and any other years presented in comparative form) must be restated. 2. Complex Capital Structure A capital structure is complex if it includes securities that could have a dilutive effect on earnings per common share. A complex capital structure requires a dual presentation of earnings per share, each with equal prominence on the face of the income statement. The dual presentation consists of basic EPS and diluted EPS. Companies with complex capital structures will not report diluted EPS if the securities in their capital structure are antidilutive (increase EPS). Net income – Preferred dividend Diluted EPS = Weighted ave. no. of shares outstanding – Impact of options, Impact of convertible other warrants, and – securities dilutive securities (1) Diluted EPS—Convertible Securities The if-converted method is used to measure the dilutive effects of potential conversion on EPS. The if-converted method for a convertible bond assumes (a) the conversion of convertible securities at the beginning of the period (or at the time of the issuance of the security, if issued during the period), and (2) the elimination of related interest, net of tax. Thus the denominator is increased by the additional shares assumed converted and the numerator is increased by the amount of interest expense, net of tax associated with those potential common shares. (2). Dilutive EPS--Stock Options and Warrants Stock options and warrants outstanding are included in diluted earnings per share unless they are antidilutive. If the exercise of the option or warrant is lower than the market price of the stock, dilution occurs. If the exercise price of the option or warrant is higher than the market price of the stock, common shares are reduced. In this case, the options or warrants are antidilutive because their assumed exercise leads to an increase in earnings per share. Treasury Stock Method The treasury stock method is used in determining the dilutive effect of options and warrants. This method assumes that the proceeds from the exercise of options and warrants are used to purchase common stock for the treasury. To illustrate the treasury stock method, assume 2,000 options are outstanding with an exercise price of $25 per common share. If the market price of the common stock is $60 per share, computation of the incremental shares using the treasury stock method would be: Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 38 Proceeds from exercise of 2,000 options $50,000 Shares issued upon exercise of options 2,000 Treasury shares purchasable with proceeds ($50,000/$60) (833) Incremental shares outstanding (potential common shares)1,167 For both options and warrants, exercise is not assumed unless the average market price of the stock is above the exercise price during the period being reported. As a practical matter, a simple average of the weekly or monthly prices is adequate, so long as the prices do not fluctuate significantly. III. Other Issues 1. Stock Options—Additional Complications Under APB Opinion No. 25, compensation expense is the difference between the market price of the stock and the option price on the measurement date. The measurement date is the first date on which both the number of shares involved and the option price are known. In many instances, the date on which the option is granted or the stock is awarded serves as the measurement date. Compensation expense is recognized in the period(s) in which the employee performs the services. If the service period cannot be clearly defined, the general rule followed is that any method that is systematic and rational is appropriate. Three basic types of plans used to compensate key executives and employees are: (1) incentive or nonqualified stock options plans, (2) stock appreciation rights, and (3) performancetype plans. The major distinction between an incentive and a nonqualified option plan relates to the tax treatment afforded the plan. The incentive stock option plan provides the greater tax advantage to the recipient, while the nonqualified option plan provides a greater tax advantage to the issuing company. In an incentive stock option plan the market price of the stock and the option price at the date of grant must be equal. Thus, no compensation expense is recorded in such plans because no excess of market price over option price exists at the date of grant. In a nonqualified stock option plan the difference between the market value and option price of the shares involved at the date of grant should be recorded as deferred compensation expense with an offsetting credit to paid-in capital-stock options. The deferred compensation expense is then allocated to a reduction of income over the period of service involved. Failure to exercise the options prior to their expiration date does not alter previous recognition of the compensation expense. To illustrate the accounting for a nonqualified stock option plan, assume Meeker Company announces a plan that grants certain executives options to purchase 15,000 shares of its $5 par value common stock at any time during the next 5 years at a price of $25 per share. If the options are granted on January 1, 1998, when the common stock is selling for $38 per share, total compensation expense on the measurement date (1/l/98) is: Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 39 Market value of 15,000 shares at date of grant ($38 x 15,000) $570,000 Option price of 15,000 shares at date of grant ($25 x 15,000) (375,000) Total Compensation Expense $195,000 The journal entry to record the total compensation expense at the date of grant is as follows: Deferred Compensation Expense Paid-in Capital--Stock Options 195,000 195,000 The Deferred Compensation Expense is amortized over the expected period of benefit as set by the company when the option is granted. 2. Stock Appreciation Rights Stock appreciation rights are a form of employee compensation that avoids some of the cash flow problems recipients of nonqualified stock option plans face. Under a stock appreciation rights plan, an employee is given the right to receive share appreciation, which is defined as the excess of the market price of the stock at the date of exercise over a preestablished price. This share appreciation may be received in cash, shares of stock, or a combination of both. Compensation cost for the plan at any interim period is the difference between the current market price of the stock and the option price multiplied by the number of stock appreciation rights. The measurement date is the date of exercise. Many executives believe their performance is not accurately reflected in the market price of the company's stock. As a result, some companies have performance-type incentive plans. These plans reward key executives for their performance when defined events such as growth in sales, growth in earnings per share, etc. take place. A performance-type plan's measurement date is the date of exercise because the benefits to be received (stock or cash) are not assured at the date of grant. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 40 Chapter 4 – Other Income Statement Items (questions) A. Discontinued Operations (D) Class: On December 31, 2005 Glen Glenny decided to discontinue its bleaching division. The income for the bleaching plant less the relevant expenditures for 2005 was $200,000. In 2004 the plant had income of $250,000. The income tax rate for both years was 30%. Show the comparative income statement for 2005. Home: 1. On December 31, 2004 Glen Glenny’s Board of Directors made a decision to cease its packing division which had income of $300,000 in 2003. With a consistent rate of 25%, the division had losses of $175,000 in 2004. Show the comparative income statement for 2004. 2. On December 31, 2005, Glen Glenny made a decision to place the packing division back in normal operations. i. How would this effect discontinued operations, and ii. What is the impact on depreciation for 2005? B. Extraordinary Items (E) Home: Write a one page memo to the board of directors explaining the following:i. What is an extraordinary item, ii. What is the treatment when an item is unusual and frequent iii. Why a strike generally is not extraordinary and iv. Why a strike by the Police Force is extraordinary. C. Accounting Changes and Error Corrections (C) Class Accounting Estimates) 1. Sal Sally purchased a new equipment on January 1, 2003 for $500,000. At that time there was no salvage value and the equipment had an estimated life of 6 years. Sal Sally used the Straight-line depreciation method. On December 31, 2005 Sal Sally’s accountant estimated that there is a salvage value of $50,000 and the equipment has a useful life of 5 years from time of purchase. In 2005, what is the depreciation expense, accumulated depreciation and Book Value respectively. Class (Errors): 2. On December 31, 2005 Flex Flexy realized that it failed to record certain depreciation expenses of $30,000 per year in 2003, 2004 and 2005. In 2004, the income was $200,000 and 2005 income was $220,000. Show comparative income statement in 2005 and 2004, as well a retained earnings section showing the effect of the above. Home (Accounting Estimates) 1. Slip Slippy purchased a building on January 1, 2000 for $4,000,000. At that time there was no salvage value and the building had an estimated life of 40 years. Sal Sally used the Straight-line depreciation method. On December 31, 2005 Slip Slippy’s Board of Directors estimated that there is a salvage value of $400,000 and the building has a useful life of 30 years from time of purchase. In 2005, what is the depreciation expense, accumulated depreciaiton and Book Value respectively. Home (Errors): 2. On December 31, 2005 Grip Grippy realized that it failed to record losses of $20,000 in 2002, $10,000 in 2003 and gains of $25,000 in 2005. In 2004, the income was $250,000 and 2005 income was $300,000. Show comparative income statement in 2005 and 2004, as well a retained earnings section showing the effect of the above. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 41 D. Earnings Per Share (EPS) Class: On December 31, 2005, Cool Cooly had net income of $1,500,000. During the year Common Stock were outstanding as follows: (Jan 1, Beginning 500,000, Issued on April 1st 300,000 and on October 1st issued 200,000). 10% $2,000,000 bonds were outstanding. The bonds had a denomination of $1,000 each convertible into 10 shares of common stock. No bonds were converted. Of the 130,000 share of Preferred Stock outstanding on Jan 1st, 50% were converted on April 1st. Preferred Stock received dividends of .10 each on Dec. 31st. Find the following for Cool Cooly:i. The weighted-average number of shares used to calculate BEPS ii. Earnings per share (BEPS) iii. The control number iv. The weighted-average number of shares used to calculate DEPS. v. The effects of the assumed conversions on the numerator of the DEPS vi. The Earns per share DEPS Home: On December 31, 2005, Cheap Cheapy had net income of $2,000,000. During the year Common Stock were outstanding as follows: (Jan 1, Beginning 600,000, Issued on July 1st, 400,000 and on November 1st issued 300,000). 8% $1,000,000 bonds were outstanding. The bonds had a denomination of $1,000 each convertible into 15 shares of common stock. No bonds were converted. Of the 200,000 shares so Preferred Stock outstanding on Jan 1st, 60% were converted on July 1st. Preferred Stock received dividends of .13 each on Dec. 31st. Find the following for Cheap Cheapy:i. The weighted-average number of shares used to calculate BEPS ii. Earnings per share (BEPS) iii. The control number iv. The weighted-average number of shares used to calculate DEPS. v. The effects of the assumed conversions on the numerator of the DEPS vi. The Earns per share DEPS Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 42 Galilee College © 2007 Chapter 5 – Financial Statement Disclosure A. Significant Accounting Policies An Accounting policy is a specific principle or a method of applying it. All Significant accounting policies must be disclosed as an integral part of the financial statements. 1. A disclosure of significant accounting policies is required when a selection has been made from existing acceptable alternatives; a. When the policy is unique to the industry (even if the policy is predominantly followed in that industry.) b. GAAP has been applied in an usual or innovative way e.g. A depreciation method is a selection from existing acceptable alternatives and should be included in the summary of significant accounting policies Note: F/S Disclosure should not duplicate details presented elsewhere in the F/S e.g Composition of plant assets, is already included in the depreciation schedule. Items to be disclose include:i. Basis of Consolidation ii. Depreciation Methods iii. Amortization of Intangibles iv. Inventory Pricing v. Recognized profit on long-term construction-type contracts vi. Recognition of Revenue from Franchising and leasing operations vii. Determining which investments are treated as cash equivalents B. Segment Reporting 1. Objective: To provide information about the different types of business activities of the entity and the economic environments in which it operates. 2. Report information about an operating segment if it satisfies one of three tests:i. Revenues = at lease 10% of combined revenues of reported operating segments Revenues: Sales to external customers, intersegment sales or transfers ii. Assets = at lease 10% of combined assets of operating segments iii. Absolute amount of reported P/L = 10% of greater, in absolute amount of a. Combined reported profit of operating segments that did not report a loss, or b. Combined reported loss of operating segments that did report a loss. Note: Revenues include both sales to external customers and intersegment sales or transfers. 1. Disclose measurement of segment profit or loss (including revenue) and segment assets. 2. The measure reported to the chief operating decision maker for purposes of making resource allocation and performance evaluation decisions regarding the segment. (same for assets) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 43 If items are not included in the measure, they need not be included in the reported amount of the operating segment. Assets are not defined as the quantitative threshold for separate reporting of information about an must be disclosed if sales to that customer are 10% or more of total revenue. Note: There is no percentage threshold if the sales are to foreign countries. operating segment.. Therefore, contra asset accounts are not included as well. 3. To determine operating segment profit or loss: Internal measure of segment profit or loss reported to the Chief Operating Decision Maker is used. Allocation of revenues, expenses, gains and losses are included in the determination of reported segment are included only if they were included in information reported to the Chief Operating Decision Maker. (Specific items are not included in the calculation) e.g. General Corporate Expense, Indirect Operating Expense. To determine segment profit = Sales – Traceable Cost – Allocated nontraceable cost - Interest expense is not included 3. The following information about geographic areas is disclosed if practicable:a. External revenues attributed to all foreign countries b. Material external revenues attributed to an individual foreign country c. Basis for attributing revenues from external customers d. Certain information about assets 4. Information about a major (single) customer If sales are 10% or more of total revenue C. Interim Financial Statements (Interim financial statements cover periods of less than one year) They emphasize timeliness over reliability Primarily, each interim period is viewed as an integral part of an annual period. (a) However – Use same principles as preparing annual statements 1. A market decline reasonably expected to be restored within the fiscal year may be deferred at interim reporting date because no loss is anticipated for the year. (favorable or unfavorable) Inventory losses from nontemporary market declines must be recognized at the interim reporting date, and increase if market price increase in later quarters. (Do not increase in excess of the previous decrease) Recognize lost in quarter of loss A loss recovery is treated as a change in estimate Never write inventory up above original cost. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 44 2. Extraordinary items should be included in the interim period occurred. (do not prorate) Below the DEC items are not deferred but included in interim period when occurred. 3. If a cost that would be fully expensed in an annual report benefits more than one interim period, it may be alllocated to those interim periods. E.g. Advertising cost deferred or accrued. 4. At end of each interim period, make best estimate of effective tax rate Should be based upon statutory rate adjusted for current year’s expected conditions: i. Anticipated investment tax credits ii. Foreign tax rates iii. Percentage depletion iv. Capital gains rates v. Other tax planning alternatives a. Include effect of any valuation allowance expected to be necessary 5. If cumulative effect accounting change occurs in other than the first quarter of the enterprise’s fiscal year, the proper treatment is to calculate the cumulative effect on retained earnings at the beginning of the year and include it in restated net income presented in the first quarter financial statements. All previously issued interim financial statements of the current year must be restated to reflect the new accounting method. D. Related Party Disclosures 1. A related party is any party that controls or can significantly influence the management or operating policies of the reporting entity. e.g. Two or more companies under common ownership or management control (a) Disclosure includes: i. Description of transaction for each period an income statement is presented ii. Dollar amounts of transactions for each period an income statement is presented and the effects of any change in method of establishing their terms iii. Amounts due from or to related parties as of the date of each balance sheet, including the terms of settlement iv. Certain tax information if the enterprise is part of a group that files a consolidated tax return. Transactions between companies must be disclosed 2. Financial statements should include disclosures of material related party transactions other than: a. Compensation arrangements b. Expense Allowances c. Other similar items in the ordinary course of business Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 45 Related parties are:- (Not per diem expenses) Directors, CEOs, COOs, Vice Presidents of major business functions, and persons performing similar policy-making functions. (These must all be disclosed) Note: Do not disclose information that will be eliminated in the consolidated financial statements. E. Financial Instruments Disclosures 1. Entities must disclose fair value of financial instruments for which it is practicable to estimate fair value. 2. Disclosure of information about significant concentrations of credit risk is required for most financial instrument. 3. Disclosure of information about significant concentrations of credit risk is required for most financial instruments (exempted: leases and insurance contracts and nonpublic entities) Financial Instruments – Cash, evidence of an ownership interest in an entity, or a contract that: i. Imposes on one entity a contractual obligation a. to deliver cash or another financial instrument to second entity, or b. to exchange financial instruments on potentially unfavourable terms with second entity, and ii. Conveys to the second entity a contractual right to a. receive cash or another financial instrument form the first entity, or b. to exchange other financial instruments on potentially favorable terms with the first entity. e.g. A note payable in U.S. Treasury bonds 4. Certain entities must disclose the fair value of financial instruments, whether or not they are recognized in the balance sheet, if estimation is practicable. 5. If it is not practicable for an entity to estimate the fair value of a financial instrument, the following should be disclose:i. Information pertinent to estimating the fair value of the financial instrument ii. Reasons that estimating fair value is not practicable. F. Derivatives and Hedging (Fair Values) = Assets or Liabilities in Financial Position Derivative = financial instrument or other contract that 1. has (a) one or more underlyings and (b) one or more notional amounts or provisions, or both 2. requires either no initial net investment or an immaterial net investment; and 3. requires or permits net settlement Example: The purchase of the forward contract as a hedge of a forecasted need to purchase wheat Derivative = Is a wager on whether the value of something will go up or down. Speculate (incur risk) or hedge (avoid risk). Derivative instruments:a. Call Option – Right to purchase something at an exercise (strike) price Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 46 b. Forward Contract – Negotiated agreement between two parties for stated among of commodity. c. Futures Contract - Agreement to make cash settlement during a specified time interval d. Interest Rate Swap – Exchange of interest payment fixed for interest payment floating e. Put Option – The right to sell something at an exercise (strike) price. IMPORTANT- Investment in derivatives will hedge against potential price increases. E.g. if forecasted need is 100 tons of oil over the next 6 months, a company can enter into a forward contract to purchase 100 tons of oil. (THIS IS A HEDGE) I. if Fair Value/or foreign fair value increase – include in earnings in period of change Only if – Its a foreign currency exposure of an available-for-sale security a. These are offset by losses or gains on hedged item attributable to risk being hedged Earnings = Net gain/loss attributable to the ineffective portion of the hedge 1. Ineffective portion = net decrease Effective portion = net increase 2. Notional Amount = number of currency units, shares, bushels, pounds, etc. Hedging – Purchase of sale of derivative or other instrument that neutralizes risk of a recognized asset of liability. These include: a. Firm commitment b. A forecasted transaction Fair Value Hedge – Exposure to changes in fair value of recognized asset or liability (i) Ineffective Portion = Report in Earnings (ii) Effective Portion = Report in OCI Cash Flow Hedge – Exposure to variability in C/F of a recognized asset or liability A. At Y/E include G/L in OCI B. Reclassify when transaction is completed as G/L. Remove from OCI e.g. Hedge of a foreign currency exposure of a forecasted foreign-currencydenominated transaction. Foreign Currency Fair Value Hedge – Hedges a foreign currency exposure of an unrecognized firm commitment. If increase Forward Contract Receivable Gain If decrease Loss Forward Contract Payable Loss Firm Commitment Liability Firm Commitment Asset Gain Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 47 A. At the Transaction Completion date, record Asset at Foreign Currency price x spot rate adjusted for any Firm commitment liability. Firm Commitment: Agreement with unrelated party, this firm commitment is i. Binding on both parties ii. Usually legally enforceable iii. Specifies all significant terms iv. Includes a disincentive for nonperformance Forecasted Transaction – Transaction that is expected to occur for which there is no firm commitment. G. Unconditional Purchase Obligations These are: Commitment to transfer funds in the future for fixed or minimum amounts of goods or services at fixed or minimum prices. Disclosure of Long-Term Obligations provides the standards of accounting for an unconditional purchase obligation that i. Negotiated as part of financing arrangement to provide contracted goods or services ii. Has remaining life of more than 1 year iii. Is noncancelable, but cancelable only under specific terms Include:a. Occurrence of a remote contingency b. With permission of other party c. Replacement agreement signed by same parties Not cancelable upon payment of a nominal penalty. Unconditional Purchase Obligations not recorded in Balance Sheet 1. Not a requirement, but an encouragement: To disclose amount of imputed interest necessary to reduce unconditional purchase obligation to its present value. i. If known by the purchaser (initial debt rate that provided the contracted goods or services. 2. Disclosures required are: Nature and terms of obligation Variable components of obligation Amounts of obligation purchase for each period an income statement is presented Fixed and determinable portion of obligations in of latest Balance Sheet for each of next 5 years:i. The aggregate amount of payments for unconditional purchase obligations ii. The aggregated amount of maturities and sinking-fund requirements for all long-term borrowings, and Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 48 iii. The amount at which all issues of stock are redeemable at fixed or determinable prices on fixed or determinable dates. H. Significant Risks and Uncertainties SOP 94-6, Disclosure of Certain Significant and Uncertainties is an important pronouncement on disclosures. Required disclosures include risks and uncertainties at the balance sheet date that could significantly affect reported amounts in the near term, that is, within 1 year of the balance sheet date. Current vulnerability due to concentrations must be disclosed if certain conditions are met. Disclosure is necessary if management knows prior to issuance of the statements that the concentration exists at the balance sheet date, It makes the entity vulnerable to a near-term severe impact Such impact is at least reasonably possible in the near term. A severe impact may result from: loss of all or a part of a business relationship, price or demand changes, loss of a patent, changes in available of a resource or right, or the disruption of operations in a market or geographic area. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 49 Chapter 5 Questions A. Significant Accounting Policies Home: You have been asked by Welt Welty Corporation to explain “Significant Accounting Policies”. What should be disclosed in the summary of significant accounting policies? 1. List at least six items that should be disclosed and why? B. Segment Reporting CLASS: Trod Troddy Corp. and its divisions are engaged solely in manufacturing operations. The following data (consistent with prior years' data) pertain to the industries in which operations were conducted for the year ended December 31, 2005: Operating Segment --------A B C D E F Total Revenue ----------$10,000,000 8,000,000 6,000,000 3,000,000 4,250,000 1,500,000 ----------$32,750,000 =========== Profit ---------$1,750,000 1,400,000 1,200,000 550,000 675,000 225,000 ---------$5,800,000 ========== Assets at 12/31/05 ----------$20,000,000 17,500,000 12,500,000 7,500,000 7,000,000 3,000,000 ----------$67,500,000 =========== In its segment information for 2005, how many reportable segments does Trod Troddy have? HOME: Crod Croddy Corp. and its divisions are engaged solely in manufacturing operations. The following data (consistent with prior years' data) pertain to the industries in which operations were conducted for the year ended December 31, 2006: Operating Segment A B C D E F Total Revenue 8,350,000 3,100,000 2,555,000 7,940,000 1,230,000 9,350,000 $ 32,525,000 Profit 4,175,000 1,550,000 8,230,000 3,970,000 615,000 1,450,000 $ 19,990,000 Assets at 12/31/2006 6,262,500 2,325,000 5,392,500 5,955,000 1,590,000 5,400,000 $ 26,925,000 In its segment information for 2006, how many reportable segments does Crod Croddy have? C. Interim Financial Statements CLASS 1: Said Saidy Corp. experienced a $50,000 decline in the market value of its inventory in the first quarter of its fiscal year. Said Saidy had expected this decline to reverse in the third quarter, and in fact, the third quarter recovery exceeded the previous decline by $10,000. Said Saidy's inventory did not experience Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 50 any other declines in market value during the fiscal year. What amounts of loss or gain should Said Saidy report in its interim financial statements for the first and third quarters? HOME 1: Paid Paidy Corp. experienced a $90,000 decline in the market value of its inventory in the first quarter of its fiscal year. Paid Paidy had expected this decline to reverse in the second quarter, and in fact, the second quarter recovery was $110,000. Paid Paidy's inventory did not experience any other declines in market value during the fiscal year. What amounts of loss or gain should Paid Paidy report in its interim financial statements for the first and second quarters? CLASS 2: On June 30, 2006, Mill Milly Corp. incurred a $100,000 net loss from disposal of a component. Also, on June 30, 2006, Mill paid $40,000 for property taxes assessed for the calendar year 2006. What amount of the foregoing items should be included in the determination of Mill Milly's net income or loss for the 6-month interim period ended June 30, 2006? HOME 2: On September 30, 2005, Pill Pilly Corp. incurred a $300,000 net loss from disposal of it’s water making plant. Also, on September 30, 2005, Pill paid $100,000 for property taxes assessed for the calendar year 2005. What amount of the foregoing items should be included in the determination of Pill Pilly's net income or loss for the 9-month interim period ended September 30, 2005? D. Related Party Transactions HOME: SFAS 57 requires disclosure regarding “Related Party” transactions. Summarize SFAS 57 in a half page report to the Controller of Pleck Plecky Corporation. E. Derivatives and Hedging CLASS: On October 1, 2005, Hedge Hedgey, Inc., a calendar year-end firm, invested in a derivative designed to hedge the risk of changes in fair value of certain assets, currently valued at $1.5 million. The derivative is structured to result in an effective hedge. However, some ineffectiveness may result. On December 31, 2005, the fair value of the hedged assets has decreased by $350,000, and the fair value of the derivative has increased by $325,000. How Hedge Hedgey should recognize as the net effect on 2005 earnings? HOME: On September 30, 2006, Pledge Pledgey, Inc., invested in a derivative designed to Hedge the risk of changes in fair value of certain assets, currently valued at $2.1 million. The derivative is structured to result in an effective Hedge. However, some ineffectiveness may result. On December 31, 2006, the fair value of the Hedged assets has decreased by $500,000, and the fair value of the derivative has increased by $550,000. How Pledge Pledgey should recognize as the net effect on 2006 earnings? Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 51 Galilee College © 2007 Chapter 6 – Statement of Cash Flows A. General Changes in cash and cash equivalents during the period are to be explained in a statement of cash flows. Primary Purpose:i. Provide information about receipts and payments of a during a period. It also helps a. Investors, creditors, and other users to assess ability to generate cash inflows Cash Equivalents: Short-term, highly liquid investments, no risk of change in value because maturity date is so near. I. Ordinarily include only investments with original maturities to the holder of 3 months or less. II. Cash Equivalents has no effect on statement of cash flows. SFAS 95 states – Do not report cash flow per share (because it might imply that C/F is alternative to N/I as a measurement performance.) Disclose: i. Information about transactions that do not directly affect cash flow for the period ii. E.g. a. Converting debt to equity (disclose as supplemental info. In C/F Statement) b. Obtaining assets by assuming liabilities or capital lease c. Obtaining building or investment asset by receiving a gift d. Exchanging noncash asset or liability for another Income Statement Operating Operating Outflows Inflows Direct Method Direct Method Cash Cash Expenses Revenues Inventories Sales of goods/Serv. Wages Interest on loans Goods/Services Dividend Revenues Taxes Etc. = Income from Continuing Operations Balance Sheet Liabilities Financing + Issuance of Debt +/- Loans -Payment of Debt +Sale/Acqui. Assets +/- Investments SHE -Sale of Equipment Financing + Stock Issuance + Receipt from Donor - Distr. To owners - Payment of Dividends -Treasury Stock Trans. Assets Investing B. Operating, Investing, Financial Activities Cash inflows and Cash outflows ordinarily are not netted i. These should be reported separately at gross amounts Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 52 Operating activities may be reported in the statement of cash flows using the direct or indirect method. (SFAS 95 encourages the use of the direct method.) For direct method, an entity should at minimum, report the following classes of gross operating cash receipts and payments: a. Cash Collected from customers b. Interest and dividends received c. Other operating cash receipts, if any d. Cash paid to employees and other suppliers of goods or services e. Interest paid f. Income taxes paid g. Other operating cash payments, if any The indirect method reconciles net income of a business enterprise or the change in net assets of a non-for-profit organization to net operating cash flow. It removes from net income or the change in net assets the effects of: a. All past deferrals of operating cash receipts and payments b. All accruals of expected future operating cash receipts and payments c. Items whose cash effects are investing or financing cash flows Note: The same net operating cash flow will be reported under both methods. h. The reconciliation of net income to net operating cash flow must be disclosed regardless of the presentation chosen. C. Direct vs Indirect Presentation (Review) Statement of cash flows may be reported using:a. Direct Presentation (SFAS 95 Encourages) Following classes of gross operating cash receipts and payment (minimum) i. Cash collected form customers ii. Interest and dividends received iii. Other operating cash receipts iv. Cash paid wages, supplies and services v. Interest paid vi. Income taxes paid vii. Other operating cash payments b. Indirect Presentation c. (Reconciles net income or change in net assets of a non-for-profit organization to net operating cash flow. - Remove from net income or change in net assets, the effects of 1. All past deferrals of operating cash receipts and payments e.g. changes in: Inventory, deferred income, amortization of premium or discount on bonds, and prepaid expenses. 2. All accruals of expected future operating cash receipts and payments e.g. changes in receivables and payables 3. Items whose 4. cash effects are investing or financing cash flows. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 53 e.g. bad debt, depreciation, goodwill amortization, g/l on sale of PPE on Discontinued operations or debt extinquishment. Note: 1. Same net operating cash flow will be reported under both methods. 2. Reconciliation of N/I must be disclosed regardless of presentation. 3. Do not disclose: Reconciliation of Ending R/E to net cash flow from operations Quick Quicky (December 31, 2005) Cash at beginning of year 26,000 Cash from sale of common stock 48,000 Cash from sale of land 72,000 Cash paid for dividends 24,000 Cash paid for purchase of building 60,000 Cash paid to purchase land 15,000 Cash paid to retire bonds payable 50,000 Cash payment for income taxes 83,500 Cash payment for interest 8,000 Cash Payments for Merchandise 785,200 Cash payments for operating expenses 193,800 Cash received from customers 1,171,000 Increased in Accounts Payable 21,000 Increased in Accounts Receivables 11,000 Prepare a statement of cash flow (Direct Method) Pick Picky (December 31, 2005) Cash at beginning of year Cash from sale of common stock Cash from sale of land Cash paid for dividends Cash paid for mortgage loan Cash paid for purchase of land Cash paid for supplies Cash paid for treasury stock Cash paid to purchase land Cash paid to retire bonds payable Cash payment for income taxes Cash payment for interest Cash Payments for Merchandise Cash payments for operating expenses Cash received from customers Decreased in Accounts Payable Increased in Accounts Receivables Prepare a statement of cash flow (Direct Method) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 35,000 72,000 50,000 19,000 15,000 35,000 23,000 10,000 30,000 45,999 3,800 6,500 340,000 142,000 900,140 13,000 12,000 54 Galilee College © 2007 Chapter 7 – Cash and Investments A. Cash 1. Cash consist of: i. Coin & Currency on hand ii. Demand Deposits (checking accounts) iii. Time Deposits (Savings Accounts) iv. Near-Cash Assets (deposits or checks in transit) Current Assets – Assets available for current operations, which is one year or the normal operating cycle. These include cash and cash equivalents. Cash set aside to pay for noncurrent assets are not current, as well as legally restricted cash. i. Compensating balance – The amount the borrower may keep as an average or minimum amount on deposit with lender. a. When not legally restricted, these should be reported among the cash and cash equivalents in the current assets sections. b. When legally restricted, these should be classified as noncurrent. ii. An overdraft is a current liability. investments with original maturities of 3 months or less is cash equivalent Bank Reconciliation 1. Book Section: Include items in bank but not on books 2. Bank Section: Include items on book but not in bank B. Short-Term Investments SFAS 115 Investments in Debt Securities i. Classify as held-to-maturity ii. Measured at amortized cost in Balance sheet, if a. if there is positive intent & ability to hold to maturity MARKETABLE EQUITY SECURITY: (Trading or Available-for-Sale) 1. Trading securities (held principally for sale in the near term) i. Report at Fair Value ii. Recognize in earnings unrealized holding gains and losses 2. Available-for-Sale Securities – (Measured at FV on Balance Sheet) Not expected to be sold in the near term (Noncurrent Asset) i. FV Hedge – Recognize in earnings unrealized holding gains and losses (FV vs. Cost) ii. Non-FV Hedge - Recognize in OCI unrealized holding gains and losses (FV vs. Cost) - Dr. J’s Note: Unless it’s indicated that these are FV Hedge, assume NonFV and recognize in OCC. - OCI accumulates amounts, and it is a CONTRA SHE account. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 55 iii. iv. v. C. - Net Income is effected only if there is a realized Gain or Loss If transfer as Held-to-Maturity, continue to report unrealized gain/loss in OCI BUT, amortize similar to premium or discount * This amortization offsets or mitigate the effect on interest income of the amortization of premium or discount. Fair Value Accounting may result in a premium or discount whn a debt security is transferred to the held-to-maturity category. If transfer as Trading Security , recognize to earning any unrealized holding g/l If write down to FV because of permanent decline, do not reverse if increases occur - Increases will be reported as OCI Investments - Debt Securities If Market Rate increase over Yield Rate – Price of bond will decrease = discount If Market Rate Decrease over Yield Rate – Price of bond will increase = premium Discount means that the bonds have decline in Fair Value Premium means that the bonds have increased in Fair Value Note: 1. When bond is purchased at a premium its initial carrying value is greater than the maturity value 2. When bond is purchased at a discount its initial carrying value is less than the maturity value Cash Paid (Premium) Investor pays more than the face value of bonds Premium xx FV of Bonds xx Interest Expense 1since last interest) xx Cash xx Cash Paid (Discount) Investor pays less than the face value of bonds Interest Expense (since last interest) xx FV of Bonds xx Discount xx Cash xx Note: Carrying value is always higher when purchase at a premium, because the premium is extras that you pay, whereas, the discount is a reduced amount. Please Remember! Effective Interest Method Interest Revenue = (CV at Beg. Of period x yield (int. rate) Straight-line Method Interest Revenue is equal during the life of the bond, which reduces Carry value faster) D. Cost vs. Equity Method 1. Equity Method - Investor can exercise significant influence over investee Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 56 20% or greater <20% if significant influence is present If cost is at beg. Of year and additional share is not equity, treat at equity from beginning of year. >50% by one company = consolidated F/S, unless control is temporary Entries I. Earnings: Investment Earnings Dividends Cash Investment xx xx xx xx 2. Cumulative Preferred Dividend must be deducted whether or not paid 3. Change in fair value has no effect on investment 4. Cash Dividends received decreases investment carrying value = Equals Return of investment Goodwill = (Cost price – purchase price) Cost Method Investments less than 20% should be recorded at original cost Intercompany receivables should be recorded in full and separately - Eliminated only if ownership increase and entities consolidate. Dividends are not liabilities until declared. Liquidating Dividend reduces carrying value of investment (return of investment) Entries J. Earnings: No Entry Dividends Cash xx Dividend Income E. Sinking Funds Sinking fund – To segregate and accumulate assets to pay bond liability The fund is increased by revenue earned (interest and dividend) The fund is increased by additional deposits The fund is decreased by any administration cost xx 1. If amounts will be accumulated over a period of time, the calculation is (Desired amount divided by the future value of an annuity ordinary/advance) F. Cash Surrender Value Cash Surrender Value = Asset (noncurrent asset) 1. This is the loan value or surrender value of a whole-life policy 2. Calculation: Premium Paid – Insurance Expense Recognized 3. As CSV increases, insurance expense will decrease Entry to record life insurance proceeds Cash xx CSV xx Insurance Income xx Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 57 Investments: Special Notes The problems of accounting for investments involve measurement, recognition and disclosure. Companies usually invest in either debt securities or equity securities. Chapter 18 covers both investment in debt and equity securities. The first section presents accounting for investment in debt securities; the second section covers accounting for investment in equity securities. I. Investment in Debt Securities 1. What are debt securities? Debt Securities are instruments representing a creditor relationship with an enterprise. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, commercial paper, and all securitized debt instruments. 2. Accounting for debt securities depends on how long the company intends to hold the debt securities. Specifically, Debt securities are grouped into the following three separate categories: a. Held-to-maturity: Debt securities that the enterprise has the positive intent and ability to hold to maturity. Held-to-maturity debt securities are accounted for at amortized cost, not fair value. A Held-to-Maturity Securities account is used to indicate the type of debt security purchased. Discounts and premiums on long-term investments in bonds are amortized in a manner similar to discounts and premiums on bonds payable. The effective interest method is required unless some other method—such as straight-line— yields a similar result. b. Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences. Trading securities are reported at fair value, with unrealized holding gains and losses reported as part of net income. Any discount or premium is not amortized. A holding gain or loss is the net change in the fair value of a security from one period to another, exclusive of dividend or interest revenue recognized but not received. A valuation account called "Securities Fair Value Adjustment (Trading)" is used instead of debiting or crediting the Trading Securities account. c. Available-for-sale: Debt securities not classified as held-to-maturity or trading securities. Available-for-sale debt securities are reported at fair value. The unrealized gains and losses related to changes in the fair value of available-for-sale debt securities are recorded in an unrealized holding gain or loss account. This account is reported as other comprehensive income and as a separate component of stockholders' equity until realized. A valuation account called "Securities Fair Value Adjustment (Available-for-Sale)" is used instead of debiting or, crediting the Available-for-Sale Securities account to enable the company to maintain a record of its amortized cost. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 58 If bonds carried as investments in available-for-sale securities are sold before the maturity date, entries must be made to amortize the discount or premium to the date of sale and to remove form the Available-for-Sale Securities account the amortized cost of bonds sold. The realized gain or loss is reported in the Other Revenues and Gains section or the Other Expenses and Losses section of the income statement. Example #1 II. Investment in Equity Securities 1. What are equity securities? Equity securities are described as securities representing ownership interest such as common, preferred, or other capital stock. They also include rights to acquire or dispose of ownership interests at an agreed upon or determinable price such as warrants, rights, and call options or put options. 2. Accounting for investment in equity securities depends on the degree of investor’s influence over (or control of) the investee which usually is determined by the percentage of the voting stock of the investee held by the investor. Holding a. Less than 20% b. Between 20% and 50% c. More than 50% Method Fair Value Method (no significant influence) Equity Method (significant influence) Consolidated Statements (controlling interest) a. Fair Value Method When an investor has an interest of less than 20%, it is presumed that the investor has little or no influence over the investee. If market prices are available, the investment is valued and reported subsequent to acquisition using the fair value method. The fair value method requires that companies classify equity securities at acquisition as available-for-sale securities or trading securities. When acquired, available-for-sale equity securities are recorded at cost. Net income earned by the investee is not considered a proper basis for recognizing income from the investment by the investor. Therefore, net income is not considered earned by the investor until cash dividends are declared by the investee. The net unrealized gains and losses related to changes in the fair value are recorded in an Unrealized Holding Gain or Loss-Equity account that is reported as a part of other comprehensive income and as a separate component of stockholders' equity until realized. The accounting entries to record trading equity securities are the same as for available-for-sale equity securities except for recording the unrealized holding gain or loss. For trading equity securities, the unrealized holding gain or loss is reported as part of net income. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 59 b. Equity Method When an investor has a holding interest of between 20% and 50% in an investee corporation, the investor is generally deemed to exercise significant influence over operating and financial policies of the investee. The FASB has also listed other factors to consider in determining whether an investor can exercise "significant influence" over an investee. In instances of "significant influence," the investor is required to account for the investment using the equity method. Under the equity method the investment's carrying amount is periodically increased (decreased) by the investor's proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee. The investor must record as separate components the amount of ordinary and extraordinary income as reported by the investee. Under the equity method, if an investor's share of the investee's losses exceeds the carrying amount of the investment, the investor should discontinue applying the equity method and not recognize additional losses (unless the investor's loss is not limited). The following transactions illustrate the journal entries for an investment accounted for under the equity method. a. On 1/3/99 Workowski Corporation purchased 55,000 shares (26%) of Wendy Company at a cost of $8 per share. Investment in Wendy Company . . . . . . . . . . . . . . . . . . . . .440,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000 b. At the end of 1999 Wendy Company reported net income of $350,000 (all ordinary). Workowski's share is $91,000 ($350,000 .26). Investment in Wendy Company . . . . . . . . . . . . . . . . . . . . .91,000 Revenue from Investment . . . . . . . . . . . . . . . . . . . . . . 91,000 c. In early 2000, Wendy Company paid a $75,000 dividend. Workowski's share is $19,500 ($75,000 .26). Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19,500 Investment in Wendy Company . . . . . . . . . . . . . . . . . 19,500 d. Wendy Company reported a $215,000 net loss (all ordinary) in 2000. Workowski's share is $55,900. Loss on Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55,900 Investment in Wendy Company . . . . . . . . . . . . . . . . . 55,900 Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 60 c. Consolidated Financial Statements When one corporation (the parent) acquires a voting interest of more than 50% in another corporation (the subsidiary), the investor corporation is deemed to have a controlling interest. When the parent treats the subsidiary as an investment, consolidated financial statements are generally prepared instead of separate financial statements for the parent and the subsidiary. The subject of when and how to prepare consolidated financial statements is discussed extensively in advanced accounting. If the parent and the subsidiary prepare separate financial statements, the investment in the common stock of the subsidiary is presented as a long-term investment on the financial statements of the parent under the equity method. III. Financial Statement Presentation of Investments As indicated, unrealized holding gains and losses related to available-for-sale securities are reported as part of other comprehensive income. The reporting of changes in unrealized gains or losses in comprehensive income is straightforward unless securities are sold during the year—then a reclassification adjustment is necessary. Held-to-maturity, available-for-sale and trading securities should be presented separately on the balance sheet or in the related notes. Trading securities should be reported at aggregate fair value as current assets. Individual held-to-maturity and available-for-sale securities are classified as current or noncurrent depending upon the circumstances. IV. Other Issues 1. Impaired Investments Each period every investment must be evaluated to determine if it has suffered a loss in value that is other than temporary (an impairment). If an investment is deemed impaired, the cost basis of the individual security is written down to a new cost basis. The amount of the writedown is accounted for as a realized loss and, therefore, included in net income. 2. Transfers Between Categories Transfers between any of the investment categories are accounted for at fair value. When transferring from trading investments to available-for-sale investments, stockholders' equity and net income are not affected. When transferring from available-for-sale investments to trading investments, unrealized gains or losses reported in stockholders' equity are reversed and the gain or loss is recognized in net income. Recording the Transfer of Securities When transferring from held-to-maturity debt securities to available-for-sale debt securities, a Securities Fair Value Adjustment account is used to record the difference between cost and dair value, other comprehensive income Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 61 and stockholder's equity is increased (decreased) due to the recognition of the unrealized holding gain (loss), but net income is not affected. When transferring from available-forsale debt securities to held-to-maturity debt securities, the amount in Securities Fair Value Adjustment (Held-to-Maturity) is transferred to Unrealized Holding Gain—Equity, and the Securities Fair Value Adjustment balance and the Unrealized Holding Gain (or Loss) are amortized over the remaining life of the investments. Change from the Equity Method If the investor level of influence or ownership falls below that necessary for continued use of the equity method, a change must be made to the fair value method. The earnings or losses that were previously recognized by the investor under the equity method should remain as part of the carrying amount of the investment with no retroactive restatement to the new method. Change to the Equity Method When converting to the equity method, a retroactive adjustment is necessary. Such a change involves adjusting retroactively the carrying amount of the investment, results of current and prior operations, and retained earnings of the investor as if the equity method had been in effect during all of the previous periods in which this investment was held. 3. Dividends Received in Stock Shares received as a result of a stock dividend or stock split do not constitute revenue to the recipients. The recipient of such additional shares would make no formal entry, but should make a memorandum entry and record a notation in the investments account to show that additional shares have been received. 4. Funds Assets set aside in special purpose funds are of two general types: (a) those in which cash is set aside for meeting specific current obligations and (b) those that are not directly related to current operations and are therefore in the nature of long-term investments. Examples of the first type include the following: Fund Petty Cash Fund Payroll Cash Account Dividends Cash Account Interest Fund Purpose Payment of small expenditures, in currency Payment of salaries and wages Payment of dividends Payment of interest on long-term debt Examples of funds not directly related to current operations and the purpose of each are: Fund Sinking Fund Purpose Payment of long-term indebtedness Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 62 Plant Expansion Fund Stock Redemption Fund Contingency Fund Purchase of construction of additional plant Retirement of capital stock (usually preferred stock) Payment of unforeseen obligations To keep track of the assets, revenues, and expenses of funds, it is desirable to maintain separate accounts. If the securities purchased for the fund are to held temporarily, they would be treated in the accounts in the same manner as temporary investments. Although funds and reserves (appropriations) are not similar, they are sometimes confused because they may be related and often have similar titles. A fund is always an asset and always has a debit balance; a reserve is an appropriation of retained earnings, always has a credit balance, and is never an asset. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 63 Chapter 7- Cash and Investment SECURITIES - Class Work On January 1, 2003 Saint Sainty purchased some Securities for $20,000. At December 31, 2003 and 2004, the securities were valued at $10,000 and $30,000 respectively. What are the entries to record purchase and values at the end of each year under each situation:A. Trading Securities C. Held to Maturity B. Available For Sale Securities SECURITIES -Home Work On January 1, 2002 Jake Jakey purchased some Securities for $50,000. At December 31, 2002 and 2003, the securities were valued at $60,000 and $55,000 respectively. What are the entries to record purchase and values at the end of each year under each situation:C. Trading Securities D. Available For Sale Securities E. Held to Maturity INVESTMENTS (EQUITY MEHTOD) Class Work On January 1, 2004 Smith Smithy purchased 20% of the shares of ABC Co for $500,000. At December 31, 2004 ABC Co. has earnings of $200,000 and paid dividends of $80,000. Instructions: On the Books of Smith Smithy, Record the following entries:a. January 1, 2004 b. December 31, 2004 c. Prepare a T Account to show the balance in the investment account at Dec. 31, 2004 INVESTMENTS (EQUITY MEHTOD) - Home Work On January 1, 2005 Yard Yardy purchase 25% of the shares of DEF Co for $300,000. At December 31, 2005 DEF Co. has earnings of $100,000 and paid dividends of $50,000. On the Books of Yard Yardy, Record the following entries:a. January 1, 2004 b. December 31, 2004 c. Prepare a T Account to show the balance in the investment account at Dec. 31, 04 INVESTMENTS (COST MEHTOD) Class Work On January 1, 2004 Benn Benny purchased 10% of the shares of ABC Co for $500,000. At December 31, 2004 ABC Co. has earnings of $200,000 and paid dividends of $80,000. Instructions: On the Books of Benn Benny, Record the following entries:b. January 1, 2004 b. December 31, 2004 c. Prepare a T Account to show the balance in the investment account at Dec. 31, 2004 INVESTMENTS (COST MEHTOD) - Home Work On January 1, 2004 Will Willy purchase 15% of the shares of DEF Co for $300,000. At December 31, 2004 DEF Co. has earnings of $100,000 and paid dividends of $50,000. On the Books of Will Willy, Record the following entries:b. January 1, 2004 b. December 31, 2004 c. Prepare a T Account to show the balance in the investment account at Dec. 31, 04 Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 64 Galilee College © 2007 Chapter 8 – Receivables and Accruals A. Fundamentals Noncurrent Receivable – will not be collected within 1 year or operating cycle i. Should be treated as an investment Current Receivable – Will be collected within 1 year or operating cycle. Accounting Loss: The loss that may have to be recognized due to credit and market risk that may have to be recognized due to credit and market risk as a direct result of the rights and obligations of a financial instrument. Off-Balance-Sheet risk arises because of the existence of conditional rights and obligations that may expose the entity to a risk of accounting loss exceeding the amount recognized in the balance sheet. E.g. recourse obligations on receivables sold. B. Uncollectible Accounts 1. Allowance Method – is GAAP (matches expense with revenues) (accrual accounting) Two ways to estimate uncollectible accounts:i. Aging of A/R (Asset Valuation) = adjustment to valuation ii. Bad Debt as % of sales (Income Statement) = credit sales x percentage Uncollectible Accounts Expense xx Allow for Uncollectible Accounts xx Collection of previously written off account 1. Reinstate account (increase receivables and allowance) 2. Decrease receivable by cash collected 2. Direct Method – Not GAAP, (no matching) expense only when uncollectibility is established. C. Other Measurement Issues 1. Trade Discounts – for a particular class of customer: Benefits, no need to reprint catalog for price changes. a. Buyer nor seller reflects trade discounts 2. FOB Shipping Point – Title passes when goods are delivered to shipper a. 2/10, n/30 = 2% discount if payment within 10 days, but net payment term is 30 days 3. Gross Method A/R – Record at Face Value i. Net Method A/R – Record net of Discount Gross Method A/R (gross) Sales (gross) To record sales xx xx Net Method A/R (net) Sales(net) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson xx xx 65 Sales Discount Allow for Sales Disc. No entry - Discount not taken xx xx No entry When discount is taken A/R (disc.) xx Interest Rev. xx 4. Right of Return – Sale may be recognized at time of sale when these conditions are met: 1. Substantial fixed Price 2. Buyer has paid or there is no contingency to pay 3. Buyer obligation is unchanged by damage, theft, destruction of product 4. Buyer economic substance is different from seller 5. No significant obligation by seller regarding resale of product by buyer 6. Amount of future returns can be reasonably estimated D. Accounts Receivable – Disposition 1. Generating Cash from Accounts Receivable: a. Assignment – Named accounts are pledged as collateral for a loan I. A/R remains property of assignor II. Cash is remitted to assignee b. Factoring – Sold outright at a discount to a third party i. This is on a nonrecourse, notification basis Transaction is treated as sale to buyer who accepts risk of collectibility Seller bears no responsibility for losses 2. Control over transferred financial assets is deemed surrendered when:i. Assets are beyond reach of transferor or its creditors (even in bankrupcy) ii. Transferee has right, free of constraining conditions to exercise, pledge, exchange rights. iii. Transferor had no control and is not party to agreement to repurchase or redeem prior to maturity. 3. Transfer of Financial Assets:1. Derecognize any all assets sold 2. Recognize all assets obtained and liabilities incurred (if practicable) 3. Initially measure at Fair Value any assets obtained and liabilities incurred (if practicable) 4. Recognized any gain or loss in earnings Assets obtained – liabilities occurred i. Cash + interest rate swap + call option = Assets obtained – Recourse obligation – Carrying amount) E. Notes Receivable – Measurement Note bearing interest at a reasonable rate (entry at issuance) PV is face amount (principal x rate x time) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 66 Interest Receivable XX Unearned Int. Rev. xx 1. Interest rate is presumed to be fair when note is exchange for services 2. If rate is not stated, or rate is unreasonable, i. Record note and services at fair value of service or market value of note (whatever is more clearly determinable) ii. If these values are not present, then record note and service using present value. PV = discounting future payments on note using imputed rate F. Notes Receivable - Discounting Calculation of proceeds: Interest: Principal x interest rate x time Maturity Value: Principal + Interest Discount: Maturity Value x Bank Rate x (time remaining) Proceeds: Maturity Value - Discount G. Affiliated Company Receivables Related Party – An enterprise and its equity-based investees 1. Receivable should be disclosed separately and fully 2. Separate treatment for nontrade receivables 3. In consolidated balance sheets, reciprocal balances should be eliminated e.g. payables and receivables Intercompany transactions should not be eliminated form the separate financial statements of the entities. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 67 Chapter 8 – Receivables and Accruals A. Fundamentals CLASS 1: In 2005 Blick Blicky had the following balances: Trade Accounts Receivable $93,000, Allow. For Uncollectible accounts $2,000, Claim against shipper for damaged goods $3,000. What is the value of net current accounts receivables? HOME 1: In 2005 Snick Snicky had the following: Accounts Receivable $60,000, Allow. For Uncollectible accounts 10% of A/R, Charges from shipper for shipping FOB Destination $4,000. What is the value of net current accounts receivables? HOME 2: Plick Plicky guarantied a loan for Drick Dricky in the amount of $100,000. Further, Drick Dricky had receivable of $90,000 and wrote of $20,000 in March 2005. a. What is the off balance sheet risk at December 31, 2005 for Plick Plicky? b. How much accounting loss can recognized by Plick Plicky at December 31, 2005? B. Uncollectible Accounts Class 1: At December 31, 2004 Sand Sandy had a balance of $3,000 in the allowance for doubtful accounts. At December 31, 2005 the balance of accounts receivable was $100,000. Credit Sales was $150,000. Sand Sandy estimated that 7% of its receivable will not be collected or 4.5% of its Credit Sales will not be collected. 1. What is the entry to record doubtful accounts expense at December 31, 2005 using the Asset Valuation Method 2. What is the entry to record doubtful accounts expense at December 31, 2005 using the Income Statement Method? 3. Explain the Direct Method approach. 4. $10,000 of receivables were written off on March 1, 2005, and customers paid $6,000 of the written-off account on September 30, 2005. What are the entries on March 1, 2005 and September 30, 2005? HOME: At December 31, 2005, Land Landy had accounts receivable valued at $150,000. Credit Sales was 20% higher than the Accounts receivable balance. Land Landy estimated that 6% of its receivable will not be collected or 4% of its Credit Sales will not be collected. The balance in the allowance account at the close of last year was $4,000. 5. What is the entry to record doubtful accounts expense at December 31, 2005 using the Asset Valuation Method 6. What is the entry to record doubtful accounts expense at December 31, 2005 using the Income Statement Method? 7. Explain the Direct Method approach. 8. $15,000 of receivables were written off on June 30, 2005, and customers paid 60% of the writtenoff account on November 30, 2005. What are the entries on June 30, 2005 and November 30, 2005? Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 68 C. Other Measurement Issues CLASS: Bled Bledy recorded sales on March 1, 2005 of $100,000 under the credit terms of 3/10, n/30 to Fit Fitty. Fit Fitty paid the invoice on March 9, 2005. 1. Record all transactions during march under both the gross method and the net method. 2. How much would Bled Bledy receive if the payment from Fit Fitty was made on March 12, 2005? HOME: Cled Cledy recorded sales on January 1, 2005 of $250,000 under the credit terms of 2/15, n/30 to Sit Sitty. Sit Sitty paid the invoice on Jauary 15, 2005. 1. Record all transactions during march under both the gross method and the net method. 2. How much would Bled Bledy receive if the payment from Sit Sitty was made on January 17, 2005? D. Accounts Receivable – Disposition CLASS: Spent Spenty was in serious financial trouble. He needed $300,000 pay to his suppliers. His A/R balance was $500,000. 1. What is the entry if Spent Spenty assigned $300,000 to Bank of Nova Scotia on December 31, 2005? 2. What is the entry if Spent Spenty factored $300,000 to Bank of Nova Scotia on December 31, 2005? (without recourse) HOME: Blent Blenty needed additional cash to finance a new factory building valued at $250,000. In using his A/R, 1. What are the entry if Blent Blenty assigned A/R valued at 50% and gave a promissory note for the balance to the Royal Bank of Canada at November 15, 2005? 2. What is the entry if Blent Blenty factored A/R valued at 50% and gave a promissory note for the balance to the Royal Bank of Canada at November 15, 2005? E. Notes Receivable - Discounting CLASS: Rot Rotty received from a customer a 1 year, $500,000 note bearing annual interest of 8%. After holding the note for 6 months, Rot Rotty discounted the note at Commonwealth Bank at an effective interest rate of 10%. What amount of cash did Rot Rotty receive from the bank? HOME: Mot Motty received from a customer a 1 year, $400,000 note bearing annual interest of 6%. After holding the note for 4 months, Mot Motty discounted the note at British American Bank at an effective interest rate of 8%. What amount of cash did Mot Motty receive from the bank? Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 69 Galilee College ©2007 Chapter 9 – Inventories A. Inventory Fundamentals Periodic Systems – Purchase account is used, and beginning inventory remains unchanged during the accounting period. During Year End of Year Purchase xx Cost of Goods Sold xx Accounts Payable xx Ending Inventory xx Purchases xx Beginning Inventory xx i. CGS = Beginning Inventory + Purchases = Available for Sale – Ending Inventory Perpetual Systems - Purchases are directly recorded in inventory account When Purchase When Goods are Sold Inventory xx Cost of Goods Sold xx Accounts Payable xx Inventory Inventory short/over at y/e Short/Inventory Inventory/Over xx xx xx 1. FOB – Shipping Point: Becomes property of buyer when shipped 2. FOB – Destination: Becomes property of buyer when tender of delivery is made Seller bears risk of delivering goods to designated point. REMEMBER: 1. Freight Cost paid by Consignee should be included in consignee’s A/R (Consignment-in) 2. SFAS 49: Accounting for Product Financing Arrangement, requires that a transaction in which a product is sold subject to repurchase at specified prices of the product, of a substantially identical product, or of processed goods of which the product is a component, be treated as a borrowing if the specified prices only fluctuate to cover changes in purchasing, financing, and holding costs. The money received is accounted for as a liability rather than as a sale. Note: When BI is understated, CGS will be understated When EI is overstated, CGS will be understated B. Cost Accounting for Inventory Cost – expenditure incurred in bringing an article to its existing location (freight, Insurance) - Interest cost is not capitalized for inventory, only constructed assets - Net method will include freight cost Purchases should be recorded net of trade discounts Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 70 C. Cost Flows – FIFO, Average Cost, and LIFO 1. Weighted-average inventory pricing : applicable to periodic inventory systems Unit Cost = (Total goods available divided by no. of units available) 2. Moving-average system – applicable only to perpetual inventories It requires that a new weighted average be computed after every purchase Based on inventory held and new inventory purchased. In period of rising prices = higher unit and total inventory cost because most recent purchases are given greater weight in the calculation. 3. FIFO – Higher inventory than LIFO in period of rising prices FIFO sells old inventory/low cost first i. Y/E inventory is high & CGS is low LIFO sells new inventory/high cost first i. Y/E inventory is low & CGS is high 4. LIFO Reserve – Allowance account that adjusts an internal reporting method to LIFO This works similar to an allowance account. A balance is maintained to between a LIFO balance and another method. Cost of goods sold xx LIFO Reserve xx LIFO account is being decrease to bring in line with another method (could go the other way) D. Dollar-Value LIFO Dollar-Value LIFO – Accumulates inventoriable cost of similar items i. Similar and can be used interchangeably ii. Belonging to same product line iii. Constituting raw materials for a given product Determines changes in EI in terms of dollars of constant purchasing power (not in units of physical inventory) Calculation requires a specific price index for each year Double-extension approach – states inventory at current year cost and divide by baseyear cost = index for current year. Inv. at Current Year Cost INV at Base Year Cost Indexes are then multiplied by inventory layers at base-year cost E. Lower of Cost or Market (LCM) Market = Current cost subject to maximum and minimum values Maximum = Net Realizable Value Minimum = Net Realizable Value – Normal Profit Use Replacementt when it (Falls between NRV and NRV-NP) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 71 Replacement cost becomes the market value Market (Replacement Cost) < NRV – ceiling Market (Replacement Cost) > NRV – NP floor Note: 1. Replacement cost cannot be greater than Ceiling or less than Floor 2. RC must be lower than original cost Applying this rule separately to individual items will give a lower inventory F. Gross Profit Method Gross profit method – permitted for interim statements, but not year end - Adequate disclosure of reconciliation must be made with annual physical inventory at year-end. G. Retail Method 1. Retail Inventory Method: Records are kept of beg. Inv. and net. Purchases at both cost and retail. Other items affecting retail only: (and not cost) a. Sales Return b. Mark-ups and Mark-downs Freight-in is an element of cost only 2. Purchase returns are deducted for both cost and retail calculations 3. If FIFO is used, Beg. Inventory is subtracted from Net purchases Also, Cost to Retail percentage will be based on net purchases (cost/retail) 4. LCM Retail Method = normal calculation Cost/Retail percentage Is calculated based on goods available for sale 5. Dollar-Value LIFO Retail – convert inventory at retail year end prices to base year prices to determine liquidation (-) or layers (+). Multiply layers by price index Then multiply by cost-retail ratios H. Purchase Commitments An agreement, usually enforceable Disincentives for nonperformance. Losses arising from a purchase commitment not yet exercised. 1. If market price decline below commitment price – accrue a loss 2. Commitment is not recorded at time of agreement 3. Purchase commitment is noncanceable Loss is measured similar to inventory Disclose as losses on income statement of period during which the decline in price takes place. Loss on Purchase Commitment xx Purchase Commitment Liability xx Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 72 Chapter 9 – Inventory I. Inventory Fundamentals CLASS: Glen Glenny purchased $20,0000 inventory on February 1, 2005, Sold $15,000 at a mark up of 130% on March 1. All transactions were on account. The year end inventory showed a balance of $4,000, and Beginning inventory was $17,000. show all entries during the year, as well as the entry to balance the inventory account. Use both the perpetual and weighted average methods. HOME: Clen Clenny had beginning inventory of $30,000 and ending inventory of $50,000.00. He purchased $60,000 on July 2 and sold $45,000 at a mark up of 150% during the year. show all entries during the year, as well as the entry to balance the inventory account. Use both the perpetual and weighted average methods. J. Cost Flows – FIFO, Average Cost, and LIFO Comparably, for both CC and HH, calculate the following: Ending Inventory, Cost of Goods Sold, Gross Profit using the following methods: Weighted Average, Moving Average, First-In, First Out and Last-in, First Out. K. Dollar-Value LIFO On January 1, 2003, Life Lifey and Wife Wifey adopted the Dollar-Value Inventory method. Life Lifey and Wife Wifey entire inventory constitutes a single pool. Inventory Data for 2003 and 2004 are as follows:CLASS: Life Lifey Date Inv. At Current Inv. At Based Year Cost Year Cost 1/01/03 $150,000 $150,000 12/31/03 $220,000 $200,000 12/31/04 $276.000 $230,000 HOME: Wife Wifey Date Inv. At Current Inv. At Based Year Cost Year Cost 1/01/03` $200,000 $200,000 12/31/03 $287,000 $250,000 12/31/04 $357,500 $275,000 1. What is Price Index for each year, 2. What is the LFO inventory value at Dec. 31, 2004? L. Lower of Cost or Market (LCM) CLASS: On December 31, 2005, Chew Chewey determined its chocolate inventory was valued at $26,000 with a replacement cost of $20,000. Chew Chewey estimated that after further processing cost of $12,000, the chocolate can be sold for $40,000. Chew Chewey normal profit margin is 10% of sales. Under the lower of cost or market rule, what amount should Chew Chewey report as chocolate inventory in its December 31, 2005 Balance Sheet. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 73 HOME: On December 31, 2005, Taste Tastey determined its Now-and-Later inventory using the FIFO method valued at $30,000 with a replacement cost of $25,000. Taste Tastey estimated that after further processing cost of $15,000, the Now-and-Later can be sold for $50,000. Taste Tastey normal profit margin is 15% of sales. Under the lower of cost or market rule, what amount should Taste Tastey report as Nowand-Later inventory in its December 31, 2005 Balance Sheet. M. Gross Profit Method CLASS: The following information was obtained from Coke Cokey’s Sales $275,000, Beg. Inv. $30,000, End. Inv. $18,000. Coke Cokey’s gross margin is 20%. What amount represents Coke Cokey’s purchases? HOME: The following information was obtained from Pep Pepsi’s Sales $350,000, Beg. Inv. $40,000, purchases. $90,000. Pep Pepsi’s gross margin is 20%. What amount represents Pep Pepsi’s cost of goods sold? N. Retail Method Explain the advantages and disadvantages of using the Retail Method to cost inventory. O. Purchase Commitments CLASS: On January 1, 2003, Price Pricey signed a purchase commitment for three years supplies of floppy disk. The agreement was: 100,000 per year at the price of $10.00 each. During the second year, the floppy disks to Price Pricey became worthless and can be sold for only $2.00 each. What is the entry at December 31, 2004 to record the purchase commitment loss? HOME: On January 1, 2004, Best Besty signed a purchase commitment for two years supplies of ink pens. The agreement was: 1,000,000 per year at the price of 20 cents each. Immediately after signing, the ink pens became worthless and can be sold for only 2 cents. What is the entry at December 31, 2004 to record the purchase commitment loss? Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 74 Appendix 1 – Accounting Terms Accounts Payable: Accounts of money you owe. A liability that is usually created when you've made a purchase on credit. Accounts Receivable: Accounts of money owed to you for the sale of goods or services. Accrual basis: A method of accounting where transactions are recorded as they occur regardless of when payment for that transaction is made or received Accrued Assets: Assets from revenues earned but not yet received. Accrued Expenses: A liability incurred during the accounting period for which payment has not been made. Accrued Income: Income earned during an accounting period but not received/recorded by the end of the period. Aging: The grouping of like transactions by date. Example - sorting invoices by due date. Adjusting Entries: Special accounting entries that are made when you close the books at the end of an accounting period to bring the ledger up to date. Asset: Items that a business or individual owns or are owed. Audit: The scrutinizing of accounting records and supporting documents for accuracy and completeness. Audit trail: The information within the accounting system that reveals the effects of a transaction. Bad Debt: An account or receivable that has been deemed unrecoverable and written-off. Balance Sheet: A statement listing the total assets and liabilities; indicating the net worth of the company for the given time period. Capital: The right to assets of the owner of a business.. Cash basis: An accounting method where transactions are recorded when the actual change of payment occurs, regardless of when the goods or services are delivered. Certified Financial Statements: Financial statements that have been audited and certified by a CPA. Chart of accounts: A numerical listing of a business’s accounts. Closing Entries: Journal entries made at the end of the period to return the balance in all accounts to zero and ready the account for the next reporting period.. Credit: An entry on the right side of an account - decreases assets or increases liabilities. Debit: An entry on the left side of an account - increases assets or decreases liabilities. Depreciation: The allocation of the cost of a tangible, long-term asset over its useful life. Expenses: The daily costs incurred in running a business. Fiscal: A 12 month accounting period. Not necessarily a calendar year. General Ledger: The master record of all the balance sheet and income statement account balances. Gross profit: The amount of net sales minus the amount of cost of sales Income statement: A statement that summarizes revenues and expenses. Invoice: A form, sent from the seller to the buyer, listing the items bought, price, terms etc.. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 75 Journal: A chronological record of transactions, also known as the book of original entry. Ledger: A book containing accounts to which debits and credits are posted from books of original entry. Liability: A debt or obligation. Net sales: The amount left when returns, discounts, and allowances are deducted from sales revenue. Operating Expenses: The expenses that are incurred from the daily operation of the business. Owners' equity: The owners' right to the assets of an entity. Prepaid Expenses: Amounts that are paid in advance for product is not used up during the accounting period. Post: The process of transferring amounts from a journal to the appropriate ledger accounts. Purchase order: Written instructions to a vendor to ship and bill for the listed items. Reversing Entry: An entry made to reverse a prior entry.. Trial Balance: A work sheet showing the balances in each account; used to prove the equality of debits and credits. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 76 Appendix 2 Associate Degree Program (Accounting) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 77 Appendix 3 Bachelor’s Program (Accounting) Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 78 Appendix 4 Accounting Courses Description COURSE DESCRIPTION ACCOUNTING ACC 111 ACCOUNTING PRINCIPLES I Introduction to the fundamental Principles of Accounting and its relationship to business. Includes the basic accounting procedures from the business transaction through the journals and ledgers to the financial statements. Emphasis is placed on principles and procedures in accounting for receivables, payables, inventories, plant assets and payroll. 3 Semester Hours ACC 112 ACCOUNTING PRINCIPLES II Major emphasis is placed on the procedures involved in accounting for capital structure of corporations. Includes accounting principles for partnerships, departmental operations, home and branch activities and bond issues. Also introduced is basic Accounting procedures, fundamentals of Financial Statement Analysis and Tax Accounting. Prerequisite: ACC 111 3 Semester Hours ACC 211 INTERMEDIATE ACCOUNTING I Theories and problems involved in proper recording of transactions and preparation of financial statements. Review of the accounting cycle, discussion of financial statements, analysis of theory as applied to transactions relating to current assets, current liabilities, long-term investment and presentation on the Balance Sheet. Prerequisite: ACC 112 3 Semester Hours ACC 212 INTERMEDIATE ACCOUNTING II Detailed presentation of theory applied to plant and equipment, intangible assets, long-term debt, capital stock and surplus; correction of errors of prior periods; analysis of financial statements and statement of application of funds. Prerequisite: ACC 211 3 Semester Hours ACC 214 COST ACCOUNTING I A Comprehensive study of the Manufacturing Business using a job order Cost Accounting system. Prerequisite: ACC 112 3 Semester Hours ACC 215 COST ACCOUNTING II A Comprehensive study of the Manufacturing Business using a process Cost Accounting system and a standard Cost Accounting system. Also studied is cost data for planning, control and decision making. Prerequisite: ACC 214 3 Semester Hours ACC 221 QUICKBOOKS ACCOUNTING This course will familiarize students with the basic concepts from in QuickBooks. First time users of QuickBooks will be introduced to the various features this accounting software has to offer. Using a Windows environment, students will receive hands-on instruction as they work through scenarios of entering data and setting up accounts. 3 Semester Hours ACC 311 MANAGERIAL ACCOUNTING Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 79 This course stresses the use of accounting for Managerial planning and control. Emphasis is placed on the role of accounting in decision making. It covers retailing, wholesaling, manufacturing and administrative operations. Prerequisite: ACC 112 3 Semester Hours ACC 312 ADVANCED ACCOUNTING I Property Acquisition, Revaluation and Retirement, Depreciation Principles and practices are studied in greater depth. Intangible Assets, Current and long-term Debt, Pension Plans, Corporation formation and Capital Stock transactions are covered. Financial Statement analysis, Funds flow and related statements are given thorough treatment. Frequent reference is made to pronouncements by the Securities and Exchange Commission and the American Institute of Certified Public Accountants (AICPA). Prerequisite: ACC 212 3 Semester Hours ACC 313 ADVANCED ACCOUNTING II Accounting theory and current practices are studied in depth with emphasis on the concepts and standards prevailing in the accounting profession. Coverage is afforded such topics as Partnerships formation, Dissolution and Liquidation, Installment and Consignment Sales, Home Office and Branch Accounting Consolidations. Prerequisite: ACC 312 3 Semester Hours ACC 314 GOVERNMENTAL ACCOUNTING Study of accounting for governmental entities including: budgets, general funds, capital project funds, debt service funds, trust and agency funds, fixed assets, capital expenditures, property tax accounting, and interfund relationships. Also includes accounting standards for voluntary health and welfare organizations, colleges, hospitals, and other types of not-for-profit organizations. Prerequisite: ACC 212 3 Semester Hours ACC 315 PRINCIPLES OF AUDITING A practical presentation of modern audit practices, emphasizing the principles and objectives of an audit. Analysis of the audit basis, the best standards, objective reporting, the adoption of improved accounting standards, business controls, professional ethics, and legal liability. Prerequisite: ACC 212 3 Semester Hours ACC 321 INDIVIDUAL INCOME TAXES The Internal Revenue Code, the various income tax acts, and problems of the preparation of U.S. tax returns are studied as they relate to the individual. Emphasis is placed on the determination of income and statutory deductions in order to arrive at the net taxable income. Prerequisite: ACC 212 3 Semester Hours ACC 322 CORPORATE INCOME TAXES The U.S. Internal Revenue Code and the various income tax acts are studied as they relate to partnerships, estates, trusts, and corporations. Federal estate tax return problems are considered. Methods of tax research are integrated into each of the areas studied. Prerequisite: ACC 321 3 Semester Hours Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 80 Appendix 5 Accounting News On December 6, 2004, the American Institute of Certified Public Accountants held a significant joint meeting at the Harbor Side Financial Centre in Jersey City, New Jersey. At this joint session which included the National Association of State Boards of Accountancy and the Prometric Testing Center, certain CPA Review Providers were invited, which included, Dr. Irvin Gleim of Gliem Publication, Dr. Willis L. Johnson, of the Galilee CPA Review, and other leaders in the provisioning of CPA education. Both Dr. Gleim and Dr. Johnson attended the original meeting for the new Computer Based Examination on December 15, 2003 a the AICPA headquarters in New York. Dr. Johnson called for local CPA testing in the Bahamas and other countries outside the U.S. Supported by Dr. Gleim and other review providers, Dr. Johnson substantiated his plea by referring to charges for hotel, airline, meals, transportation and excessive time in the U.S. He indicated that although the exams can now be taken in Miami, CPA candidates have experienced numerous difficulties that are financially and emotionally burdensome. Dr. Johnson presented cases where the Prometric system either crashed, malfunctioned or encountered other administrative difficulties. Further he said, that the state boards take an unusual long time before a candidate can receive his or her Notice to Schedule. Some time at least four month. While he said that these problems might exist if testing is locally done, at least, candidates will be at home and the cost of rescheduling will not be difficult to bear. During the session it was reported that some 308 Bahamian candidates sat the CPA exam in 2003. While the 2004 statistics were not completed, Dr. Johnson indicated that there will be an increase in numbers due to the increase in his volume of candidates engaged in the Galilee CPA Review Program. As a result of the widespread support for local testing outside the U.S. , a task force was appointed to present a white paper to the AICPA by mid January 2005. This white paper will address the following issues: International volume Disadvantages if the Exam is not administered outside the U.S. Additional testing administrative fee Internationally security issues Examination Frequency David Ginsburg, President and CEO of Prometric, who supports local testing in the Bahamas and other countries outside the U.S will address security issues. Gleim CPA Publications Irvin N. Gleim, Ph.D., CIA, CMA, CFM, CPA, CFII, is Professor Emeritus, at the Fisher School of Accounting, University of Florida. He has been active in both pilot and accountant training for over 30 years. His knowledge transfer systems make learning and understanding an intuitively appealing process. Dr. Gleim is helping individuals attain higher levels of knowledge (analysis, synthesis, and evaluation) while they learn concepts and problem solving techniques. Dr. Gleim’s mission is to maximize knowledge transfer while minimizing time, frustration, and cost. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 81 Galilee CPA Review Willis L. Johnson, Ph.D., CPA, MFP, Certified Marriage and Family Counselor serves as president of Galilee College and Galilee Professional Institute. Dr. Johnson is a veteran lecturer. For the past five years he has been engaged in directing the Galilee CPA Review program. He is known for his profound academic theatrics as he delivers the CPA curriculum. His success rate is phenomenal and measures alongside other giants in the region. The Galilee CPA Review is newly fueled and well prepared to provide quality instruction by way of a sophisticated approach that will catapult candidates to the levels of success that they aspire to. Galilee College – Intermediate Accounting I © Dr. Willis L. Johnson 82