PRINCIPLES OF FINANCIAL ACCOUNTING – REVIEW
Here is a brief review of notes I have written pertaining to your principles of financial accounting. This might help to jog your memory on specific topics dealing with assets, liabilities, equity, revenues, expenses and cash flows. The chapters indicate about what chapter in your textbook you would have covered that material in your introductory course.
Ch 1 & 2. PRINCIPLES, CONCEPTS & QUALITATIVE CHARACTERISTICS A. Measurement Principle – Historical Cost v. Fair Value
B. Revenue Recognition –
C. Matching Concept (also known as Expense Recognition) – D. Going Concern (Continuity Assumption)–
E. Economic Entity Assumption– F. Relevance
G. Representational Faithfulness (formerly known as Reliability) H. Consistency
I. Comparability
Qualitative Characteristics, Principles and Constraints
a. Relevance – Knowing the information will make a difference to the decision maker. Relevance now includes “Materiality” (the dollar magnitude of the transaction makes a difference in how it is recorded.)
b. Representational Faithfulness – – the true economic impact of the transaction is reported in a manner that is complete, accurate and neutral.
c. Comparability – “between” companies. They comply to the same set of rules (GAAP) d. Consistency – “within” the same company. Uses the same accounting method from one
year to the next. Allows for trend analysis.
e. Full Disclosure – footnotes are a required disclosure of the annual report and 10-K filing. f. Conservatism (i.e. when management has to choose between using alternative accounting
methods, always select the method that will not understate Liabilities or Expenses, and will not overstate Assets or Revenues) is no longer a qualitative characteristic as FASB feels it is in direct violation of
Representational Faithfulness (i.e. a company shouldn’t have to choose the most conservative approach but rather choose the accounting treatment that more clearly captures the true economic essence of the transaction). However, conservatism is still applicable to reporting financial information. g. Cost-Benefit – the benefit of knowing the information must exceed the cost of compiling
the information.
+/- Gains & Other Rev or (-) Losses & Other Expenses (Interest Exp) Income before taxes
- Income Tax Expense Net Income
B. Retained Earnings Statement: Beg. R.E (Jan. 1) +Net Income - Dividends End. R.E. (Dec. 31)
C. Statement of Stockholders Equity: (Includes Common Stock!)
Beg. SHE (Jan 1) $ xx + New Investment
by Owners xx (Common Stock)
+ Net Income xx
- Dividends (xx) (Retained Earnings) +/- AOCI xx
End SHE (Dec 31) $ xx
D. Balance Sheet: Assets = Liabilities + SHE (Common Stock + R.E.+/- AOCI)
Purpose: To show the financial position of a company at a point in time. Examines liquidity, solvency and risk as well as several key relationships that help to determine liquidity.
Limitations: Historical Cost and Omissions
Classifying Accounts: Current Assets – will convert into cash, be sold or consumed within 12 mos. or less
Current Assets include: Cash & Cash Equivalents, Short-Term Investments (Trading Securities), A/R, Inventory, Prepaids…listed in order of liquidity)
Long-Term Assets (useful life greater than 1 year) include: L-T Investments, PP&E, Intangibles, Other Assets
Current Liabilities (must be paid within 12 mos. or less), Long-Term Debt (maturities of more than 12 mos.),
Stockholder’s Equity (three parts: Common Stock, R.E., Accum. Other Comprehensive Inc.)
*Remember, Accum. Depreciation. reduces PP&E; ADA (allowance for doubtful accounts) reduces A/R to their Net Realizable Value, and a Discount on a Note Payable/Receivable reduces the face value of the Note to its Carrying Value. (Carrying Value and Present Value mean the same thing!!)
CH 3 Journal Entries and Debits & Credits Normal balances:
Assets, Expenses, Dividends & Losses: debit balance is their normal balance DEAD - Debits increase Expenses, Assets, Dividends
Liabilities, Equity, Revenues & Gains: credit balance is their normal balance
Ch 4 Adjusting & Closing Entries:
Adjusting Journal Entries (AJE’s) are necessary based on Accrual Accounting (i.e. Revenue Recognition and Matching)
Adjusting Entries - watch your dates!! AJE’s are necessary to update any unrecorded Revenue or Expense that has been earned/used up within the current accounting period.
then you’ll pay/receive the cash later (in the next accounting period.) Cash comes AFTER the Rev/Exp has been recorded.
“Deferred” means any form of a “pre-payment” (Cash comes FIRST, but the company defers recognizing the Rev/Exp until time passes and it has been earned/used up.) Deferrals represent accounts like Prepaid Rent, Prepaid Advertising, and Unearned Revenue
(Deferred Revenue). All of these accounts represent cash being paid/received first but deferring the recognition of the expense or revenue until the end of the accounting period. At year end, these “Deferred” accounts are reviewed to measure how much Rev/Exp has been earned/used up. Always require AJE’s.
Closing Entries: close (bring to a zero balance) all temporary accounts (all revenues, expenses, and dividends), and transfer their balances into Retained Earnings.
(4) Journal Entries to Close:
Revenues xx Closing Entry #1: Closes “Revenues” Income Summary xx and brings the balance to zero.
Income Summary xx Closing Entry #2: Brings each “Exp” COGS xx account to a zero balance
Rent Expense xx By transferring all Rev & Exp into “Income Depr. Expense xx Summary”, you have now “summarized” Ins. Expense xx Net Income in ONE t-account.
Income Summary xx Closing Entry #3: Transfers Net Income Retained Earnings xx into Retained Earnings
(for the $ amount of net income)
Retained Earnings xx Closing Entry #4: Brings Dividends to a Dividend xx zero balances and reduces Retained Earnings
Chapter 6: Cash, Cash Equivalents, and Receivable I. Cash Controls
Cash = Cash on Hand (Petty Cash) + Cash in Banks + Undelivered Checks
Cash Equivalents – short-term investments in interest-bearing instruments (i.e. T-bills, commercial paper and money market funds), that are so near maturity (3 mos. or less), that changes in interest rates will not affect their maturity value.
As a method of internal control over Cash, a company would ALWAYS prepare a Bank Reconciliation at the end of every month. A bank reconciliation identifies and eliminates the timing differences between what the bank is showing for available cash balance and what the company has recorded. It also will find any errors.
Balance per Bank Balance per Books
1. Correct bank errors 1. Correct book errors
2. Add Deposits in Transit 2. Add collections of notes made by bank 3. Subtract Outstanding Checks 3. Subtract bank service charges (debit memos)
4. Subtract NSF checks (checks from customers that are no good)
This will give a true cash balance. Any additions/subtractions to the book side will require a journal entry. * debit memo means bank reduces cash, credit memo- bank increases cash.
II. Cash Equivalents: Short-term, Highly liquid, Less than 3 months to maturity. Never includes: Stock (regardless of how long management intends to hold the investment), IOU’s (these are receivables), Postage stamps (these are supplies) Always classify the following as cash equivalents if they mature in less than 3 mos.:
Treasury Bills
Commercial Paper
Money Market Funds
III. Short – Term Investments (Trading Securities)
Listed second in the order of liquidity as a current asset on balance sheet. Short-term
investments are made with the intent to hold them for a very short period of time (less than one year), and sold to achieve trading profits (i.e. price appreciation of stock) or earn interest revenue (if invested in interest-bearing bonds/CD’s, etc.), or dividend revenue. Be able to calculate the maturity value of a CD and accrued interest at year end or at maturity. IV. Accounts Receivable & Accounting for Bad Debts: The “Allowance” Method is preferred”
because it follows matching.
Using the “Allowance” Method means you will have the “Allowance for Doubtful Accounts” on the balance sheet as a “contra” asset that reduces you’re A/R to their Net Realizable Value (NRV…NRV represents what you expect to collect in cash from the amounts owed to the company from customers through credit sales) AND this method REQUIRES an AJE at year end to ESTIMATE bad debts.
(2) Allowance Methods for bad debts:
I. Income Statement Method II. Balance Sheet Method % of Credit Sales % of A/R or "Aging" Estimate = Bad Debt Expense Estimate = End. ADA
Theory: Matching Concept * Always PLUG Bad Debt Exp.
__Accounts Receivable Allowance for Doubtful Accounts
Beg. Bal | Beg. Bal.
+ Credit | - Cash Received - write offs + reinstate previous writeoff Sales | - write offs Balance B-4 Adjustment
| + Bad Debt Exp. (AJE)
| End. Bal | End. Bal.
Net Realizable Value (NRV) = End. A/R (-) End. ADA
Direct Write Off Method – Waits until specific bad debt customer can be identified, then records bad debt expense & removes A/R. Potentially can violate the matching concept.
Notes Receivable: Watch your dates in calculating interest or maturity value on notes for less than one year. For short-term notes, always use simple interest!
Simple Interest:
Maturity Value = Principle + Interest
CH 7 Inventory (for Retailing and Manufacturing)
I. Cost of Goods Sold: Expense on Income Statement. COGS formula: Beg. Invt.
+ Cost of Purchases Goods Available for Sale - Ending Invt.
COGS
Cost of Purchases: Purchases
- Purch Returns & Allow. - Purch Discounts + Transportation In Cost of Purchases
Net Sales Calculation:
Sales
- Sales Returns & Allowances - Sales Discounts
- Credit Card Discounts Net Sales
Income Statement: Net Sales
- COGS
Gross Profit - Operating Expenses
Net Income
II. Inventoriable Costs: Add: Sales Tax
Freight In (FOB Shipping Point; i.e. freight-in) Insurance (during transit)
Deduct: Purchase Discounts
Purchase returns & Allowances
III. Accounting for Inventories: (2) Systems
A. Periodic: all items purchased for resale (inventory) are put into a temporary “Purchases” account. Uses the COGS formula to determine COGS at year end. This method cannot identify any “losses” due to theft, shrinkage, etc. It is used by companies that have a high volume turnover of inventory, low priced goods
B. Perpetual: Keeps a running total of inventory on hand and COGS is updated with each sale of an item. Only method that identifies “losses” in inventory.
Goods to include in Inventory
All goods in which the company has “legal title” to (location does not matter for goods in transit at year end.)
a. Goods In Transit
1. FOB Shipping Point – title transfers to buyer immediately when goods are accepted by common carrier.
2. FOB Destination - title transfers when goods arrive at final destination of buyer.
b. Consigned Goods - the owner (consignor) transfers physical goods to agent (consignee) for purposes of selling without ever giving up legal title. Goods held on consignment should never be included in ending inventory.
V. Reporting and Analyzing Inventory
(4) Inventory Cost Flow Methods (*results in different ending inventories & COGS values)
1. Specific Identification – specifically identifies each individual item in inventory, the original cost of the item and when it is sold, it is moved out of inventory for that specific cost and becomes COGS on income statement.
2. Weighted Average Method: $ Cost of Goods Available for Sale = Avg. cost/unit Total # units GAS
3. FIFO: First In, First Out
The First Item purchased (in) should be accounted for as the first item sold (out)
COGS = Start assigning the “cost” of the first units available (starting with beginning inventory) as your first layer and work down through the layers of inventory purchases until the number of units sold is accounted for as COGS. Sum the cost of these layers & report as COGS (expense on income statement)
End. Inventory = The $cost of the number of units that remain on hand at year end. Under FIFO this means the last units purchased and still here (the bottom layers…last purchases)
Advantages: assigns current cost to inventory. Good method with rapid turnover. Disadvantages: fails to match current costs with revenues.
If prices are rising, matches oldest costs with current revenue = higher net income (called Inventory Profits) & higher $ value of Inventory on Balance Sheet.
4. LIFO: Last In, First Out
The last item purchased (Last in) should be accounted for as the first item sold (First out) COGS = Last Units In (bottom layers representing the last purchases, are the first to be accounted for as “sold”)
Ending Inventory = First Units In (starts with the beginning inventory layers) Advantages: matches current costs with revenue.
Disadvantages: gives a non-current value to inventory as an asset on the balance sheet. LIFO, cont’d.
If rising prices, lower Net Inc and therefore less paid in income taxes. (LIFO Conformity Rule – if a company uses LIFO for tax purposes, they must also use LIFO for financial reporting purposes.)
VI. Gross Profit Method
Method used to estimate the amount of inventory on hand without having to take a physical count. Uses: 1. Preparing Quarterly financial statements
2. Determining Casualty Losses & Theft
Method: Based on a constant Gross Profit Rate (and therefore a constant COGS rate) determine the cost of the product sold for a period of time (i.e. the quarter or up until the date of the casualty loss… an estimate for COGS).
Step 1: $ Sales x (1-Gross Profit %) = $ estimate for COGS
Step 2: Use COGS formula:
Beg Invt. $xx + Net Purch. xx GAS xx - COGS (est) (xx)
Invt on hand $xx (estimate)
VII. Inventory Errors
Remember: If End. Invt. is overstated in the first year, Net Income will be overstated by the same amount for the same year (since COGS is understated).
In year 2 (the next accounting period), the error will ALWAYS reverse itself (i.e. have the opposite effect on net income) and wash out on the balance sheet (thru Retained Earnings), but Net Income will remain off. At the start of year 3, all financial statements will be okay.
Ch 8 Fixed Assets (PP&E) and Intangibles:
unusual to the installation process and should be expensed…not added to the cost of the asset.)
Do not include interest in the original cost of the asset UNLESS the asset is being constructed (ie. An office building is being constructed and it takes 2 years to complete. During the construction period the company financed the construction with a construction loan…the interest on the construction loan adds to the cost of building the building).
Depreciation: Straight-Line , Activity Method & DDB
Straight-Line Method: $Cost - $Salvage / # years life = Depr. Exp.
Activity Method:
Step 1: Cost / Unit = $ Cost - $ Salvage / # units or hours Step 2: Depr. Exp = # units produced this year x $Cost/unit
Double-Declining Balance:
2/#yrs life x [$cost - $Accum. Depr] = Depr. Exp. For year
Depr. Exp is what is recorded for the current year ONLY (on Inc. Stmt) Accum Depr is the accumulation of all of the depr. taken over the asset’s life (on Balance sheet as contra-asset account)
Book Value (BV) = $ Cost - Accum. Depr (on that date!) Costs incurred AFTER the asset has been placed into service:
Capital Expenditure – increases capacity, enhances productivity, extends useful life, increases salvage value, etc. Accounting treatment: Add cost to Book Value of asset and re-structure depreciation over REMAINING useful life.
Revenue Expenditure – for normal/routine maintenance and repairs. Does not improve productivity, extend useful life, etc.
Keeps the asset in working condition.
Sale of Fixed Asset: watch your dates for partial years on the sale! Cost xx
- A.D ( xx)
BV xx xx Cash (Fair Value)
|________________________| = Gain/Loss on sale
Intangibles: Amortize over the lesser of: Useful Life, Legal Life
If developed internally, Capitalize only legal fees to acquire + successful defense
Expense ALL R&D costs immediately
Ch 9 - Current Liabilities and TVM (Time Value of Money)
Know how to classify current liabilities and use Time Value of Money concepts as applied to Present Value.
Use simple interest on short-term notes (both interest bearing and non-interest bearing).
Make sure you can identify the type of cash flow (i.e. lump sum payment of principal & interest at maturity or periodic PMTs along the way. (i.e. one payment at the end [lump sum] requires the use of PV of $1; a series of equal payments [PMT] requires the use of PVOA)
Things to Remember:
1. If the question asks to find the payment (PMT), it must give you the PV. Therefore, the amount the company has borrowed (and needs TODAY) is the amount of the present value.
2. If it gives you the PMT, you must solve for PV using a PVOA compounding factor.
3. If you are not making payments along the way, then it is telling you the lump sum due at the end, and it must be discounted to PV using PV of $1 if it is a non-interest bearing note. The CV will ALWAYS grow because the company will now owe principal + unpaid interest.
4. Present Value is always less than Future Value because interest has been eliminated (discounted).
5. Short-term Notes Payable:
Interest Bearing v. Non-interest bearing Notes:
Interest Bearing: Maturity value = Principle + Interest (Princ. x % x #mos/12mos.) Non-Interest Bearing: (Notes issued at a discount): the interest was deducted in advance. Cash proceeds = Note Payable (-) [$Princ. x % Int. x # mos. for TERM of note]
Presentation on Balance Sheet: Note Payable $xx (at face value) Less: Discount (xx)
Carrying Value $xx
6. Classify Current Liabilities - any short-term debt to be paid in 12 mos. or less. Review Ch 9 notes for list of common Current Liabilities. Include current maturities of long-term debt. Include Contingent Liabilities IF both “Probable” and management can estimate the $ amount.
7. Current Ratio – Improves when a company re-pays a current liability; decreases when a company takes on additional current liabilities.
Helpful Formulas (from ACC 242):
For Lump Sum payment of Princ & Interest at maturity:
PV = FV x PV of $1 (%, n)
For an Annuity (making installment payments):
PV = PMT x PVOA (%, n)
Semi-annual interest: double the # of periods and half the interest rate.Amortization Schedule for Notes Receibable/Payable:
1. Lump Sum (Principal + Interest) owed at maturity.
Date Cash Pmt. Interest Expense Principle Reduction Carrying Value
Issue $ PV of Note
1 -0- (CV x % Int.) -0- $PV + Unpaid Interest
2 -0- (New CV x % Int.) -0- $New CV + Unpaid Interest
3 -0-
4 -0- CV Increases until it reaches
2. Installment Payments (Princ & Interest) paid evenly throughout term of
Note
Date Cash Pmt. (-) Interest Expense = Principal Reduction Carrying Value
Issue $ PV of Note
1 $ xx (-) (CV x % Int.) = $ xx $PV (-) $Princ. Reduction 2 $ xx (-) (New CV x % Int.) = $ xx $New CV (-) Princ reduction
3 $ xx
4 $ xx CV decreases until it reaches
Zero after last PMT @ Maturity
Chapter 10
Long – Term Bonds PayableBonds – terminology
1. Stated Rate – fixed rate of interest paid on face value of the bond. (also called “Coupon Rate” or “Face Rate”. Locks in on date of sale.
2. Market rate – the going rate of interest that borrowers/lenders are willing to accept on the day the bond is sold (issued). The market rate locks in on the date of issuance. Market rate is also called the “effective rate” or “yield.”
3. term bond – all bonds mature on same date 4. serial bond – bonds retire in installments
5. callable bond – corp. reserves the right to buy them back early at stated “call” price
Bonds as a form of long–term liabilities appear on the balance sheet at their Carrying Value (CV). The CV represents the amount of debt actually owed on that balance sheet date (“current cash equivalent”). Therefore, it is equivalent to the present value of all remaining cash flows on that date.
Interest is an expense on the income statement. Interest Expense reduces Net Income, and therefore reduces Income Taxes. Because of this Income Tax Advantage, issuing debt rather than equity is oftentimes preferable.
Issuance of Bonds – 2 promises:
1. Promise to pay lump sum of face value at maturity. (Therefore an amortization table for a bond will always increase or decrease to reach the face value of the bond on the date of maturity.) 2. Promise to pay periodic interest payments during the life of the bond. (The only time you use
the stated rate of interest is to find the cash interest payment. You can then fill in this entire column on the amortization table as this is a fixed rate of interest and will not change over the life of the bonds)
Discounts & Premiums
1. If coupon rate = market rate sell at face value (Cash Interest Pmt = Interest Exp) 2. If coupon rate < market rate sell at a discount (selling price is less than face value). 3. If coupon rate > market rate sell at a premium (selling price is greater than face value).
Selling Price of a Bond:
Determine Selling Price using PV tables (always use MKT. % to discount to PV)
For bonds paying annual interest, don't adjust interest rate or # of pay periods.
For bonds paying semi-annual interest, cut in half the interest rate and double the # of pay periods.
PV of Face Value = FaceValue x PV of $1 (% mkt., n) Plus + PV of Cash Int. Pmts = PMT x PVOA (% mkt., n) ** = Selling Price of Bond
Interest Expense = C.V (Carrying Value) x Mkt. % Carrying Value reported on Balance Sheet:
1. If Premium: CV = face value + unamortized premium 2. If Discount: CV = face value - unamortized discount
Things to Know:
Know how to set up and use an amortization table to help with theory, journal entries, carrying value, interest expense for a year, etc.
Know the direction the amortization table will move:
a. If bond sold at a discount, the CV will increase over its life until it reaches face value at maturity.
b. If bond sold at a premium, the CV will decrease over its life until it reaches face value at maturity.
Effects of Discount:
1. A discount adds to the cost of borrowing (you actually have to match the market rate, which is more than the coupon). The corp. receives less cash today, but must pay back face value at maturity.
2. Carrying value increases over the life of the bond until it reaches face value at maturity.
3. Amortization of discount increases interest expense because interest exp is based on CV, and CV is growing with every interest period.
Effects of Premium:
1. Premium reduces the cost of borrowing (you are again matching the market rate of interest…which represents your true cost to borrow…and market is less than coupon.)
2. Carrying value decreases over its life until it reaches face value at maturity.
3. Amortization of premium reduces interest expense each pay period because CV is decreasing over the life.
To Determine Total Cost of Borrowing: (2) ways to calculate:
1. Compare cash inflows and outflows, the difference = cost to borrow over life of bond
2. Total cash paid out in interest over life of bond + Discount (on date of issuance) = total cost to borrow
Or
Total cash paid out in interest over life of bond (–) Premium (on date of issuance) = total cost to borrow.
Helpful formulas to find:
a. Unamortized Premium/Discount: b. Gain/Loss on Retirement:
Face Value Carrying Value Cash to Repurchase
|___________________________________| |___________________________________| = Unamortized Prem/Discount = Gain/Loss on Retirement
Chapter 11 - SHE
I. Stockholder's Equity--know the difference between earned and contributed capital and what affects Retained Earnings.
II. Retained Earnings (earned capital) is affected by:
+/(-) Prior Period Adjustments (to correct an error that affected NI from a prior year) + NI,
(-) dividends (both cash and stock),
III. Capital Stock--know these terms:
A. Authorized shares--total # of shares that can ever be sold by corp. (in charter) B. Issued shares--total # of shares sold by corp. since it originated
C. Outstanding shares--# of shares held by outside sources (# shares issued- # treasury shares = # outstanding) D. Treasury stock--stock the company has reacquired E. Par vs. Non-par value shares
IV. Rights of common and preferred stockholders
Preferred Shareholders – right to receive their dividends first before common get anything. Common Shareholders – (1) Voting Rights (2) Right to receive a Dividend (not guaranteed… unlike Preferred stock), (3) Pre-emptive Right (right to maintain their percentage share of ownership IF new shares are issued) and (4) Liquidation Right
V. Issuance of Stock
If selling price > par value
Cash (# of shares * selling price) xx
Common Stock (# of shares * par value) xx
APIC (plug) xx
APIC is excess of $ selling price over $ par.
Stock issued for non-cash asset: record at Fair Value of stock (if traded daily) or asset rec'd
Dividends
--always decreases RE
--preferred stockholders receive their dividends first
--Common Dividend calculation = # of shares outstanding x $0.xx div per share (remember, shares held in treasury lose all of their rights while being held by the company)
--know the three important dates for dividends (date of declaration, date of record, and date of payment)
Dividend Distributions between Preferred (Cumulative) and Common shareholders Pref Dividend = # issued x $Par x % return
Preferred shareholders get their dividends first, and if cumulative, must be paid all of the unpaid dividends from prior years (dividends in arrears) + current year’s dividend before common shareholders get anything.
VI. Treasury Stock--using the cost method To reacquire:
Treasury Stock (cost)(shares) xx
Cash (cost)(shares) xx
To sell reacquired treasury stock:
When re-issued for more than cost: Cash (shares issued)(market price) xx
Treasury Stock (shares issued)(cost) xx
APIC- T.S xx (PLUG)
Treasury stock carries a debit balance and reduces SHE.
Total Contributed Capital = Pref. Stock + Common Stock + APIC # shares issued x $Par = contributed capital
# shares issued - # treasury = # outstanding (only pay a dividend on shares outstanding)
Treasury Stock (# shares x $Cost) = (xx) reduces total SHE
VII.
EPS
-
Net Income – Pref. Dividends
Weighted Avg.
# C.S. OutstandingCh. 13 –
Cash Flows:Direct Method: Cash Received from Customers: Revenues
+ change in A/R cash received
Cash Paid to Suppliers: Cash Paid Other:
(COGS) (Expense)
+ change in Inventory + change in + change in A/P CA or CL (Cash Paid) (Cash Pd)
Indirect Method: Net Income
+ Depr. Exp. + Gains/Losses
+ all changes in current assets and current liabilities Cash Flow from Operations
Non-Cash Transactions: Exchange land for Common Stock (or any asset other than cash)
Exchange L-T Debt for fixed asset Depr./Amort. Expense
