basics of indeterminate accounting.docx

7/29/2019 basics of indeterminate accounting.docx

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Intermediate Accounting

Institute of Business & Information Technology Page 1

ContentsCHAPTER2

Financial Accounting: ..........................................................................................................................2

Financial Statements:.........................................................................................................................2

Uses of Financial Statements.............................................................................................................. 2

Users of Financial Statements ............................................................................................................ 3

Components of Financial Statements ....................................................................................................... 2

Icome Statements ............................................................................................................................... 2

Statement of Retained earnings ......................................................................................................... 4

Balance Sheet....................................................................................................................................... 5

Statement of Cash Flow...................................................................................................................... 7

CHAPTER 2

Account Receivables ..........................................................................................................................9

Valuation of Account Receivables ..................................................................................................... 10

CHAPTER 3 ....................................................................................................................................... 12

Valuation of Account Receivables ..................................................................................................... 11

First-in-First-Out Method (FIFO) ..................................................................................................... 13

Last-in-First-Out Method (LIFO) ...................................................................................................... 14

Average Cost Method (AVCO) ......................................................................................................... 14

CHAPTER 4 ....................................................................................................................................... 15

Depreciations .................................................................................................................................. 14

Methods of Depreciation ................................................................................................................. 16

Straight-line Method of Depreciation ................................................................................................... 16

Activity Method of Depreciation / Variable Charge......................................................................... 17

Reducing Balance Method ...................................................................................................................... 17

Sum of Years Digit .................................................................................................................................. 17


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CHAPTER 1

Financial Accounting:

Financial accounting is the process that culminates in the preparation of financial reports on the

enterprise for use by both internal and external parties. Users of these reports are invertors,

creditors, managers, unions, and govt. agencies.

Financial Statements:

"The financial statements provide information about the financial position, performance and

changes in financial position of an enterprise that is useful to a wide range of users in making

economic decisions."

A financial statement is a formal record of the financial activities of a business, person, or other

entity. Financial statements should be understandable, relevant, reliable and comparable.

Reported assets, liabilities, equity, income and expenses are directly related to an organization's

financial position. If financial statements are issued strictly for internal use, there are no

guidelines, other than common usage, for how the statements are to be presented.

Uses of Financial Statements

. They are useful for the following reasons:

Used as an information providing tool for decision making about new decisions.

To determine the ability of a business to generate cash, and the sources and uses of that

cash.

To determine whether a business has the capability to pay back its debts.

To track financial results on a trend line to spot any looming profitability issues.

To derive financial ratios from the statements that can indicate the condition of the

business.

To investigate the details of certain business transactions, as outlined in the disclosures

that accompany the statements.


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Users of Financial Statements

Owners and managers require financial statements to make important business

decisions that affect its continued operations. Financial analysis is then performed on

these statements to provide management with a more detailed understanding of the

figures. These statements are also used as part of management's annual report to the

stockholders.

Employees also need these reports in making collective bargaining agreements (CBA)

with the management, in the case of labor unions or for individuals in discussing their

compensation, promotion and rankings.

Prospective investors make use of financial statements to assess the viability of

investing in a business. Financial analyses are often used by investors and are prepared

by professionals (financial analysts), thus providing them with the basis for making

investment decisions.

Financial institutions (banks and other lending companies) use them to decide whether

to grant a company with fresh working capital or extend debt securities (such as a long-

term bank loan or debentures) to finance expansion and other significant expenditures.

Components of Financial Statement

A. Income Statement

An income statement shows the results of operating for a period of time. The income statement

summarizes the revenues and expenses generated by the company over the entire reporting

period. The income statement is also known as aprofit and loss (P&L) statement, statement

ofearnings, statement of operations or statement of income.

Usefulness of Income Statement

Evaluate the past performance of the company

Provide a basis for predicting future performance

Help assess the risk or uncertainty of achieving future cash flows
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Types of Income Statement

1. Single Step Income Statement

A single step income statement uses just one subtraction. This is done by subtotaling all therevenues and gains together at the top of income statement and subtotaling all the expenses and

losses together below revenues. The sum of expenses and losses is then subtracted from the sum

of revenues and gains to arrive at net income.

The net income calculated using the single-step income statement is equal to that calculated

using a multi-step income statement.

Formula

Net Income = (Revenue + Gains) (Expenses + Losses)

Example

2. Multiple Step Income Statement

The multiple-step profit and loss statement segregates the operating revenues and operating

expenses from the non operating revenues, non operating expenses, gains, and losses. The

ABC CompanyIncome Statement

For The Year Ended December 31, 2012Revenues:

Sales $ 48,300Interest 1,340Rent 6,700

Total revenues $ 56,340

Expenses:Cost of goods sold $ 29,200Advertising 1,500Commissions 2,415Depreciationoffice building 2,900Interest 1,400Insurancesalespersons auto 2,250Salaries and wagesoffice 12,560Suppliesoffice 890Income taxes 1,540

Total expenses (54,655)Net income $ 1,685


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multiple-step income statement also shows the gross profit (net sales minus the cost of goods

sold).

Example

B.Statement of Retained Earnings

Statement of retained earnings is prepared after the income statement and before the balance

sheet. The statement of retained earnings explains the changes in retained earnings from net

income (or loss) and from any dividends over a period of time. This means that the statement of

retained earnings reports the change in retained earnings from the beginning to end of a time

period, usually a year.

Retained earnings of a company refer to income that is not distributed to the stockholders. You

can think of retained earnings as the amount of income that is left in the company. Retained

earnings is increased by net income or decreased by net loss, and decreased by dividends.

Remember that dividends are the distributions made to the stockholders.

ABC Company

Multiple step Income Statement

For The Year Ended December 31, 2012

Sales 2,400,000Cost of goods sold (1,250,000)Gross profit 1,150,000Operating expenses:Selling 280,000Administrative 212,000 (492,000)

Income from operations 658,000Other revenue and gains

Interest revenue 31,000Other expenses and losses

Interest expense (45,000) (14,000)Income before income tax 644,000Income tax@30% (193,200)Net income 450,800Earnings per share 6.44*

*450,800 70,000 shares.


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Formula

Beginning retained earnings + Net income - Dividends = Ending retained earnings

Example

C. Balance Sheet

The balance sheet presents a company's financial position at the end of a specified date. The

balance sheet is based on the following fundamental accounting model:

Assets = Liabilities + Owners Equity

Assets can be classed as either current assets or fixed assets.

Current assets are assets that quickly and easily can be converted into cash, sometimes at a

discount to the purchase price. Current assets include cash, accounts receivable, marketable

securities, notes receivable, inventory, and prepaid assets such as prepaid insurance.

Fixed assets, also known as a non-current asset or as property, plant, and equipment, is a term

used in accounting for assets and property which cannot easily be converted into cash. Such

assets are recorded at historical cost, which often is much lower than the market value.

Liabilities represent the portion of a firm's assets that are owed to creditors.

Short-term (current) liabilities include accounts payable, notes payable, interest payable, wages

payable, and taxes payable.

Long-term (non-current) liabilities include mortgages payable and bonds payable. The portion

of a mortgage long-term bond that is due within the next 12 months is classed as a current

liability, and usually is referred to as the current portion of long-term debt. The creditors of a

business are the primary claimants, getting paid before the owners should the business cease to

exist.

ABC CompanyRetained Earnings Statement

For The Year Ended December 31, 2012

Retained earnings at Dec 31, 2011 150,000Net income for the year ended 40,000Less Dividends (25,000)

Retained earnings at Dec 31, 2012 165,000
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Equity is referred to as owner's equity in a sole proprietorship or a partnership, and stockholders'

equity or shareholders' equity in a corporation.

Example

ABC CompanyBalance SheetDecember 31, 2012

AssetsCurrent assets:

Cash $ 13,230Accounts receivable 23,450Inventory 45,730Prepaid rent 1,500Office supplies 2,340

Total current assets $ 86,250Fixed Assets:

Long-term investments 85,000Property, plant, and equipment:Land 250,000Automobiles $ 112,500

Less: Accumulated depreciation 22,500 90,000

Buildings 200,000Less: Accumulated depreciation 40,000 160,000

Total property, plant, and equipment 500,000Intangible assets:

Patents 40,000Total assets $ 711,250

Liabilities

Current liabilities:Accounts payable $ 18,255Income taxes payable 6,200Interest payable 1,500Notes payable, due June 30, 2013 10,000Salaries and wages payable 4,200

Total current liabilities $ 40,155Long-term debt:

Bonds payable, due December 31, 2016 160,000Total liabilities $ 200,155

Stockholders' EquityContributed capital:

Capital stock, $10 par value,15,000 shares issued and outstanding $ 150,000

Paid-in capital in excess of par value 50,000Total contributed capital 200,000Retained earnings 311,095

Total stockholders' equity 511,095

Total liabilities and stockholders' equity $ 711,250


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D.Statement of Cash Flow

A financial statement lists how a firm has obtained its funds and how it has spent them within a

period of time. It answers the questions Where the money came (will come) from? And where it

went (will go)?

The cash flow statement organizes and reports the cash generated and used in the following

categories:

Operating activities converts the items reported on the income statement from the accrual basis

of accounting to cash.

Investing activities reports the purchase and sale of long-term investments and property, plant

and equipment.

Financing activities reports the issuance and repurchase of the company's own bonds and stock

and the payment of dividends.

Example

ABC CompanyStatement of Cash Flow

December 31, 2012

Operating ActivitiesCash from customers 1,880,625Cash paid to employees (461,056)Cash paid to suppliers (1,145,179)Cash paid for interest (31,200)Cash paid for income taxes (71,790)

Cash provided by operating activities 171,400

Investing ActivitiesProceeds on the sale of land 50,000Purchase of equipment (107,000)

Cash provided (used) by investing activities (57,000)

Financing ActivitiesProceeds on the issuance of preferred shares 51,000

Dividends paid (49,000)Repurchase of common shares (10,000)Repayment of bonds payable (100,000)

Cash provided (used) by financing activities (108,000)Increase in cash and equivalents 6,400Cash and equivalents, end of year 13,325Cash and equivalents, beginning of year 6,925Increase in cash and equivalents 6,400
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CHAPTER 2

AccountReceivables

Accounts receivables (alternately receivables) are created when a customer purchases goods or

services from a company but do not pay for them at the time of purchase.

Current Receivables: expected to be collected within one year or one operating cycle,

whichever is longer.

Trade Receivable (A/R): oral promises of the purchasers to pay for goods sold and services

rendered. They are usually collected in 30-60 days. Thus, A/R is always reported as a current

asset with the net realizable value.

Notes Receivable (N/R): written promises to pay a certain sum of money on a specific future

date. N/R can be long-term or short-term and can be interest-bearing or noninterest bearing.

Transaction

Types of Discount

1. Trade Discount

The amount by which a manufacturer reduces the retail price of a product when it sells to a

reseller, rather than to the end customer. The reseller then charges the retail price to its customers

in order to earn a profit on the difference between the amount by which the manufacturer sold

the product to it and the price at which it then sells the product to the final customer.

2. Cash Discounts

Cash discounts are used to . . .

Increase sales

Encourage early payment by customers

Increase the likelihood of collections of accounts receivable

Sale of Inventory on creditAccount Receivables Dr

Sales Cr

Receive Cash from Customer

Cash DrAccounts Receivables Cr
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Transaction

Valuation of Account Receivables

Two method are used in accounting the uncollectable accounts

1. Direct write of method

Under the direct write-off method, no entries are made for bad debts until an account is

determined to be uncollectible at which time the loss is charged to Bad Debts Expense. The

expense is recognized when the account is written-off. This method is required for most tax

purposes

Transaction

2.Allowance method

Under the allowance method, an adjustment is made at the end of each accounting period to

estimate bad debts based on the business activity from that accounting period. Established

companies rely on past experience to estimate unrealized bad debts, but new companies must

rely on published industry averages until they have sufficient experience to make their own

estimates.

The specific customer accounts that will become uncollectible are not yet known when the

adjusting entry is made, a contra-asset account named allowance for bad debts, which is

sometimes called allowance for doubtful accounts, is subtracted from accounts receivable to

show the net realizable value of accounts receivable on the balance sheet

Sale of Inventory on creditAccount Receivables Dr

Sales Cr

Receive Cash from Customer within discounted period

Cash DrAccounts Receivables Cr

Receive Cash from Customer afterdiscounted period

Cash DrSales Cr

Bad Debt expense DrAccount Receivables Cr


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Recognition Entry

The first step in the allowance method is to pass an adjusting entry at the end of the period to

recognize bad. But unlike direct write-off method, we cannot credit accounts receivable because

it is actually a control account of many individual debtor accounts and we do yet not know which

particular debtor will make a default. We only know the estimated amount of receivable which

are likely to end up uncollected. Therefore a provision account called allowance for doubtful

accounts is credited in the adjusting entry.

Example

Bad Debts Expense 600

Allowance for Doubtful Accounts 600

In Balance sheet

The bad debts expense account, just like any other expense account, is closed to income

Statement account of the period. The allowance for doubtful debts is contra-asset account. It is

presented on balance sheet by subtracting it from accounts receivable as shown below:

Accounts Receivable $15,000

Less: Allowance for Doubtful Accounts 600

Accounts Receivable, net $14,400

Write-off Entry

When a debt is actually determined as uncollectible, the following journal entry is passed to

write it off.

Allowance for Doubtful Debts 70

Accounts Receivable 70

As more and more debts are written off, the balance in the allowance account keeps on

decreasing.
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CHAPTER 3

Valuation of Inventory

Inventory

Inventory is defined as assets that are intended for sale, are in process of being produced for sale

or are to be used in producing goods.

The following equation expresses how a company's inventory is determined:

Ending Inventory = Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS)

Recording Inventory TransactionsTwo methods of recording inventory transactions

3. Periodic inventory system

Merchandise purchases are recorded in the purchases account, and the inventory account balance

is updated only at the end of each accounting period

Transactions

4. Perpetual inventory system

Purchases, purchase returns and allowances, purchase discounts, sales, and sales returns are

immediately recognized in the inventory account, so the inventory account balance should

always remain accurate, assuming there is no theft, spoilage, or other losses.

Purchase of InventoryPurchases DrAccounts Payable Cr

Sale of InventoryAccounts Receivables Dr

Sales Cr

End of Period

Ending Inventory DrCost of Goods sold Cr

Purchases Dr

Beginning Inventory Cr
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Transactions

Inventory Valuation Methods

Inventory valuation methods are used to calculate the cost of goods sold and cost of ending

inventory. Following are the most widely used inventory valuation methods:

3. First-in-First-Out Method (FIFO)

According to FIFO, it is assumed that items from the inventory are sold in the order in which

they are purchased or produced. This means that cost of older inventory is charged to cost of

goods sold first and the ending inventory consists of those goods which are purchased or

produced later. FIFO method is closer to actual physical flow of goods because companies

normally sell goods in order in which they are purchased or produced.

Example

DatePurchases Sales Balance

Units Unit Cost Total Units Unit Cost Total Units Unit Cost Total

Mar1 60 15.00 900

5 140 15.50 2,170 60 15.00 900

140 15.50 2,170

14 60 15.00 900 10 15.50 155

130 15.50 2,015

27 70 16.00 1,190 10 15.50 155

70 16.00 1,120

29 10 15.50 155 50 16.00 800

20 16.00 320

31 50 16.00 800

Purchase of Inventory

Inventory Dr

Accounts Payable Cr

Sale of Inventory

Accounts Receivables DrSales Cr

Cost of Goods sold DrInventory Cr


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4. Last-in-First-Out Method (LIFO)

This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is

assumed that newer inventory is sold first and older remains in inventory. When prices of goods

increase, cost of goods sold in LIFO method is relatively higher and ending inventory balance is

relatively lower. This is because the cost goods sold mostly consists of newer higher priced

goods and ending inventory cost consists of older low priced items.

Example

Date Purchases Sales Balance


Mar 1 60 15 900

5 140 15.50 2,170 60 15 900140 15 2170

14 140 15.50 2,170 10 15 150

50 15.00 750

27 70 16.00 1,190 10 15 150

70 16 1,120

29 30 16.00 480 10 15 150

40 16 640

31 10 15 150

40 16 640

5. Average Cost Method (AVCO)

Under average cost method, weighted average cost per unit is calculated for the entire inventory

on hand which is used to record cost of goods sold. Weighted average cost per unit is calculated

as follows:

The weighted average cost as calculated above is multiplied by number of units sold to get costof goods sold and with number of units in ending inventory to obtain cost of ending inventory.


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Example

DatePurchases Sales Balance


Mar 1 60 15 900

5 140 15.50 2,170 60 15 900

140 15.50 2,170

200 15.35 3,070

14 190 15.35 2,916 10 15.35 154

27 70 16 1,190 10 15.35 154

70 16 1,120

80 15.92 1,274

29 30 15.92 478 50 15.92 796

31 50 15.92 796

CHAPTER 4

Depreciation

Depreciation is a means of cost allocation. It is a non cash expense. Depreciation is the

accounting process allocating the cost of tangible assets to expense in a systematic and rational

manner to those periods expected to benefit from the use of asset

For example, if a PC cost 60,000 and was expected to be used for three years, it might beestimated at the end of the first year that a third of its overall usefulness had been consumed.

Depreciation would then be charged at an amount equal to one third of the cost of the PC, i.e.

20,000. Profit would be reduced by 20,000 and the value of the PC in the balance sheet would be

reduced from 60,000 to 40,000.

Factors to Consider in Asset Depreciation

Depreciable life (how long?)

Salvage value (disposal value)

Cost basis (depreciation basis)

Method of depreciation (how?)


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Methods of Depreciation

There are several methods of depreciation.

1.

Straight-line method.2. Activity based method.

3. Decreasing charge methods (accelerated):

a) Sum-of-the-year-digit.

b) Declining-balance method\ Reducing balance method.

Straight-line Method of Depreciation

In straight line depreciation method, depreciation is charged uniformly over the life of an asset.

In this method, salvage value of the asset is subtracted from its cost to get the depreciable

amount. The depreciable amount is then divided by the useful life of the asset in number of

periods to get the depreciation expense per period. Due to the simplicity of the straight line

method of depreciation, it is the most commonly used depreciation method.

Formula

The formula to calculate the straight-line depreciation of an asset for a period is:

Example

On Jan 1, 2011 Company A purchased a vehicle costing 20,000. It is expected to have a value of 5,000 at

the end of 4 years. Calculate depreciation expense on the vehicle for the year ended Dec 31, 2011.

Solution


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Activity Method of Depreciation / Variable Charge

Theactivity method of depreciation (also called thevariable charge approach or unit of

production approach) assumes that depreciation is a function of use or productivity instead of

the passage of time. The life of the asset is considered in terms of either the output it provides

(units of produces), or an input measure such as the number of hours it works. Conceptually, the

proper cost association is established in terms of output instead of hours used, but often the

output is not easily measurable. In such cases, an output measure such as machine hours is a

more appropriate method of measuring the dollar amount of depreciation charges for a given

accounting period.

Formula

The following formula is used for the calculation of depreciation charge under activity method:

( )

Example

Plastic LTD purchases a steel mould costing 1,000,000 to be used in the production of plastic

glasses. The mould could be used in 8 production batches after which it will have a scrap value

of 20,000. During the first year, the company manufactures 2 batches of glasses.

Solution

( )

Reducing Balance Method

The reducing balance method allows you to consider a certain depreciation percentage to

depreciate the alignment machine rate annually. This method takes into consideration anaccelerated rate of depreciation. This is useful for those assets in which a higher value is lost

during the beginning years of usage. The only flaw of this method is it does not take into account

the scrap or residual value of the asset.


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( )

Year Opening

Book value

Depreciation

Base

Remaining

Life in years

Depreciation

Fraction

Depreciation

Expense

Book value

at the end

of year

1 750,000 720,000 8 8/36 160,000 590,000

2 590,000 720,000 7 7/36 140,000 450,000

3 450,000 720,000 6 6/36 120,000 330,000

4 330,000 720,000 5 5/36 100,000 230,000

5 230,000 720,000 4 4/36 80,000 150,000

6 150,000 720,000 3 3/36 60,000 90,000

7 90,000 720,000 2 2/36 40,000 50,000

8 50,000 720,000 1 1/36 20,000 30,000

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basics of indeterminate accounting.docx