Accounting synthesis

Chapter 1

All individuals, companies and businesses must keep track of their financial resources and their wealth, so they must keep accounts, which we call ACCOUNTING.

Accounting: The process of identifying, recording, summarizing & analyzing a company’s financial transactions, processing this into information and communicating this information to decision makers.

GOAL: to provide users with structured information; to collect + classify information concerning company activity.

Who uses accounting?

Internal Users

Management: To make day-to-day management decisions, they need to have all the information on the company's situation.

Employees: Attentive to results + signs of the company's good health.

External Users

Investors (owners): use accounting information to decide whether to buy, hold, or sell ownership shares of a company.

Shareholders: Find out about the company's financial health from the annual accounts.

Banks or financial institutions: analyze annual accounts to determine whether they can lend to the company.

Creditors (suppliers): Will check your solvency to see if they can give you credit.

Public authorities: interested in the financial aspect (VAT (tva)+ Tax declaration)

Central Balance Sheet Office: Gathers information from annual accounts and publishes it to the public.

Financial analysts: They try to estimate the figures to be announced by companies.

Accounting objectives

The French commercial code requires that the annual financial statements give a true and fair view of the company's assets and liabilities, financial position, results of operations and cash flows. Financial position and results of the company.

Fundamental Characteristics:

• Relevance: Information must influence decisions by predicting future outcomes or confirming past ones.
• Faithful Representation: Data should be complete, unbiased, and free from errors, accurately reflecting economic reality

Enhancing Characteristics:

• Comparability: Data should be consistent over time and with other entities to support effective comparisons.
• Verifiability: Independent parties should agree that information accurately represents an economic event.
• Timeliness: Information must be available early enough to help users make decisions when it matters most.

Assumptions

Assumptions provide a foundation for the accounting process.

Monetary unit assumption: means that we only record financial transactions that can be expressed in terms of money. This helps us measure economic events and is crucial when using the historical cost principle. `

Ex: You buy a computer for $500, and that's recorded in accounting because it's a money value. However, your computer's performance, though important, isn't recorded because it can't be measured in money terms.

Economic entity assumption: a fundamental accounting principle that requires a clear separation between the financial activities of a business entity and those of its owners and other entities. (Separation between their business expenses and private expenses)

Types of businesses

• Proprietorship: A business owned by one person.
• Partnership: A business owned by two or more persons associated as partners i
• Corporation: a business owned by shareholders

The accounting equation

A business has 2 main things: what it owns (assets) and what it owes (liabilities and equity). Assets are what it owns, like a company's money or property. Liabilities and equity are the rights to those assets, which can belong to people or organizations the company owes (like creditors) and the owners.

Basic eq 🡪 Assets = Liabilities + Equity

Assets should always equal the total of liabilities and equity. Liabilities come first in the equation because they get paid first if the business ends.

This equation works for all types of businesses, whether small like a corner store or huge like a big company. It's the foundation for keeping track of a business's financial transactions.

• Assets: What a company owns , it’s resources.

Ex: restaurant's delivery truck & cash

• Cash
• Accounts receivable / debtors/ receivable (creances): the amount of money owned to you
• Notes receivables (creance client): customers owe you $one specific date/period usually w/ an interest rate</li><li><strong><em>Inventory / stocks / Merchandise inventory:</em></strong> what u are selling.</li><li><strong><em>Prepaid expenses / prepayment:</em></strong> You paid in advance (EX: rent)</li><li><strong><em>Property, plant, equipment (PPE) (actifs immobilisés)</em></strong>: expected to be used for more than 1 period. <strong><em>EX:</em></strong><em> land, buildings, equipment, furniture, fixture</em></li><li><strong>Liabilities: </strong>Which are debts and obligations </li></ul><p><strong><em>EX:</em></strong><em> money owed to suppliers and banks. </em></p><ul><li><strong><em>Accounts payable / Creditors / payables:</em></strong><em> </em>the amount of$ you owe.
• Notes payable (prét/loan): amount of $$ the company must pay, usually w/ interest
• Accrued liabilities: a liability for an expense you have not yet incurred.

Ex : interest payable, salary payable

• Equity : What's left after subtracting liabilities from assets and represents the owners' claim on the company's assets.

🡪 It can include 2 main parts: share capital (money invested by shareholders when they buy shares) and retained earnings.

• Share capital: owners investment in the corporation
• Retained earnings : The money a company keeps from its profits after paying expenses and dividends. It's used for future growth or to cover unexpected costs.
• Dividends: Payments a company makes to its shareholders, typically from its profits. It's a way for owners to get a share of the company's earnings.
• Expenses: The costs a company incurs to run its business, like rent, wages, and supplies.

So, equity increases when shareholders invest or when the business makes money (revenues) and decreases when the company incurs expenses or pays dividends. This balance between assets, liabilities, and equity is crucial in accounting to keep track of a business's financial health.

Accounting transactions

Business transactions are economic events recorded by accountants. They can be external (involving interactions with outside entities) or internal (happening within the company).

EX: buying cooking equipment from a supplier or paying rent are external transactions, while using cleaning supplies internally is an internal transaction.

Not all company activities result in business transactions. Actions like hiring employees or chatting with customers may or may not lead to transactions. To decide, companies analyze each event to see if it affects the accounting equation's components. If it does, they record it.

Double entry system: Every transaction should have a dual effect on the accounting equation. For instance, if one asset increases, there must be a corresponding decrease in another asset, an increase in a specific liability, or an increase in equity. This process is part of the accounting cycle used by companies to record transactions and prepare financial statements.

Expanded equation : Assets = Liabilities + (Share Capital—Ordinary + Retained Earnings)

Each element has its role:

Share Capital—Ordinary: Represents the investment made by shareholders in exchange for ordinary shares.

Retained Earnings: Reflects changes due to revenues earned, expenses incurred, or dividends paid.

The expanded equation links the financial statements between each other.

Financial statements

• Income statement: shows a company’s financial performance. Its purpose is to show whether the company has made a profit. (Revenues + expenses)
• Statement of retained earnings: Summarizes the changes in retained earnings for a specific period of time. ( net income/loss , dividends )
• Balance sheet / statement of financial position : Shows a companies’ financial position , presented at the end of each accounting period. ( assets , liabilities , equity)
• Statement cashflow : Shows a companies’ cash receipts + payments
• A comprehensive income statement: used when a company, , has items of "other comprehensive income" that are important but not part of the net income. They add these items to the net income to calculate comprehensive income. This statement is usually presented after the traditional income statement.

Types of accounting

Not all companies are subject to the same accounting system. This varies according to : Legal form (SA, SRL,..) , Business sector, Sales, Number of employees.

• Simplified accounting: for small businesses
• Double-entry bookkeeping: Double-entry bookkeeping means that each entry in an account must be matched by a "corresponding" entry. In one account must have a "symmetrical" counterpart in another account; Thus, any amount entered in the accounts will be transcribed twice: once on the debit side of an account, and a second time on the credit side. and a second time to the credit of another account.
• Compta (full diagram): For large companies
• Financial Accounting: Focuses on reporting a company's financial performance and financial position to external users, such as investors and creditors. (provides info for external users)
• Managerial Accounting: Provides internal management with information for planning, decision-making, and control within the organization. (provides info for internal users)
• Forensic Accounting: Investigates financial discrepancies and fraud, often used in legal proceedings.
• Governmental Accounting: Focuses on accounting and financial reporting within government entities
• Public accounting : offer expert service to the general public, in much the same way that doctors serve patients and lawyers serve clients.
• Private accounting : accounting within a specific organization or company

Standard charts of accounts (Plan comptable minimum normalisé) , a document containing all the company's account numbers. It is used to record the company's accounting entries.

Companies must file their annual accounts with the central balance sheet office of the central bank, and this information is made public.

Except for: tradesmen (individuals), small companies with limited liability (SNC, SCOMM, SC, SRL), hospitals, schools, etc.

The presentation and use of accounting are governed by the ACCOUNTING LAW

Chapter 2

Definition:

An account: it’s like a record or a place where you keep track of money or something valuable. In accounting an account is referred to as a T- account

Where the left side is called debit (Dr) and the right side is called credit (Cr). We use these terms in the recording process to describe where entries are made in accounts. When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.

Debit: represents every positive item in the tabular summary a receipt of cash. (Les debit represent une augmentation de Tresorie)

Credit: represent every negative amount represents a payment of cash.

Having increases on one side and decreases on the other reduces recording errors and helps in determining the totals of each side of the account as well as the account balance.

The balance is determined by subtracting one amount from the other. The account balance, a debit of €8,050, indicates that Softbyte had €8,050 more increases than decreases in cash.

Double entry: it’s the fact that every financial transaction has two equal and opposite effects. When you record a transaction, you write it down in two places: one as a debit and the other as a credit. These two entries balance each other, ensuring that the accounting equation (Assets = Liabilities + Equity) stays. This system helps track where the money comes from and where it goes, keeping your financial records accurate and organized as well as detection of errors.

An asset increases on the left side (debit side), and decreases on the right side (credit side).

We know that both sides of the basic equation (Assets = Liabilities + Equity) must be equal. So liabilities have to be recorded opposite from assets.

Liabilities increase on the right (credit side), and decrease on the left (debit side). Same for equity

The normal balance of an account is on the side where an increase in the account is recorded.

• Asset accounts normally show debit balances. (Debits to an asset account should exceed credits to that account).
• Liability accounts normally show credit balances. (Credits to a liability account should exceed debits to that account).

Since equity is composed of share Capital, Retained Earnings, Dividends, Revenues and Expenses.

Share Capital—Ordinary: Companies issue share capital—ordinary in exchange for the owners’ investment paid into the company. Credits increase the Share Capital—Ordinary account, and debits decrease. (Acts like liabilities (c’est un passif)

Retained Earnings: it’s the net income that is kept in the business. It represents the portion of equity that the company has accumulated through the profitable operation of the business. Credits (net income) increase the Retained Earnings account, and debits (dividends or net losses) decrease it. (Acts like liabilities (c’est un passif)

Dividends: it’s a company’s distribution to its shareholders. The most common form of distribution is a cash dividend. Dividends reduce the shareholders’ claims on retained earnings. Debits increase the Dividends account, and credits decrease it. (Acts like assest (c’est un actif)

Revenues and Expenses: The purpose of earning revenues is to benefit the shareholders of the business. When a company recognizes revenues, equity increases. So, the effect of debits and credits on revenue accounts is the same as their effect on Retained Earnings. That is, revenue increased by credits and decreased by debits. (Acts like liabilities (c’est un passif)

Expenses have the opposite effect. Expenses decrease equity. Since expenses decrease net income and revenues increase it, it is logical that the increase and decrease sides of expense accounts should be the opposite of revenue accounts. Thus, expense accounts are increased by debits and decreased by credits. (Expenses acts like asset (c’est un actfi)

Summary of Debit/Credit Rules

The 2^nd step in the accounting cycle: The Journal

Journalizing: is entering transaction data in the journal. A complete entry consists of :

• the date of the transaction (1)
• the accounts and amounts to be debited and credited (2,3)
• a brief explanation of the transaction. (4)
• The column titled Ref. (Reference) is left blank when the journal entry is made. It’s used later when the journal entries are transferred to the individual accounts

!!! In the journal you always have to enter the debit first and then the credit!!!

It is important to use correct and specific account titles in journalizing. Flexibility exists initially in selecting account titles. The main criterion is that each title must appropriately describe the content of the account. Once a company chooses the specific title to use, it should record under that account title all later transactions involving the account.

Simple and Compound Entries

The difference between simple entries and compound entries:

Simple entry is a transaction that only involves two accounts, one debit and one credit but compound entry it’s when transactions require more than two accounts (3, 4 ….or more accounts).

Step 3: The Ledger and Posting

The Ledger : a collection of T-accounts

In accounting, it’s like a detailed notebook where you keep a record of all your financial transactions. It's where you write down in and out of money in your business and you use it to see the complete history of your financial activities. The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances.

Companies normally use a general ledger. Which contains all the asset, liability, and equity accounts.

Standard Form of Account

This format is called the three-column form of account. It has three money columns—debit, credit, and balance. The balance in the account is determined after each transaction (the total of each account). Companies use the explanation space and reference columns to provide special information about the transaction. The reference column of a ledger account indicates the journal page from which the transaction was posted.

Difference between the Ledger and The Journal:

The general journal is where transactions are initially recorded in detail, while the ledger is a collection of individual accounts that provide a summary of the financial activity for specific accounts. The general journal is like a diary of transactions, while the ledger is like a set of categorized accounts that show the balances for each account. The information in the general journal is later posted to the ledger to keep track of the balances for each account.

Posting

Posting is the procedure of transferring journal entries to the ledger accounts. This phase of the recording process accumulates the effects of journalized transactions into the individual accounts. Posting involves the following steps.

Posting should be performed in chronological order. That is, the company should post all the debits and credits of one journal entry before proceeding to the next journal entry. Postings should be made on a timely basis to ensure that the ledger is up-to-date. The reference column of a ledger account indicates the journal page from which the transaction was posted.

4th step in the cycle: The Trial Balance

A trial balance is a list of accounts and their balances at a given time ( c’est une photography a un points T dans l’entrprise). Companies usually prepare a trial balance at the end of an accounting period. Accounts are represented in the same order as in the ledger. Debit balances appear in the left column and credit balances in the right column. The totals of the two columns must be equal. The trial balance proves the mathematical equality of debits and credits after posting.

Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance may also uncover errors in journalizing and posting. It’s also useful in the preparation of financial statements.

The steps for preparing a trial balance are:

1. List the account titles and their balances in the appropriate debit or credit column.
2. Total the debit and credit columns.
3. Verify the equality of the two columns.

Chapter 3

Accrual-basis accounting and Adjusting Entries  

Creditors, investors, and consumers can not wait for the company to prepare their financial statements because they want to know how well the company performed for a period of time. Solution:  accountants divide the economic life of a business into artificial time periods.  

This concept is known as the time period assumption or perioding assumption it’s the division of the life of a business into specific time periods, usually one year. This allows us to measure and report the financial performance and financial position of the company at regular intervals, such as annually, quarterly, or monthly. 

Fiscal and Calendar Years 

Monthly and quarterly time periods are called interim periods.  

Fiscal year is an accounting time period that is one year in length. A fiscal year usually begins on the first day of a month and ends 12 months later on the last day of a month. Many businesses use the calendar year (January 1 to December 31) as their accounting period.  

Accrual- versus Cash-Basis Accounting 

Accrual-basis accounting: It means that you recognize revenue when you make a sale or provide a service, and you record expenses when you receive goods or services, even if the actual payment happens later. 

Cash-basis accounting: it’s a method of keeping financial records where you only record income and expenses when actual money changes hands. In other words, you recognize revenue when you receive cash and record expenses when you pay out cash.  

Accrual-basis accounting is therefore following International Financial Reporting Standards (IFRS).  

Recognizing Revenues and Expenses 

Revenue Recognition Principle  

Performance obligation: is a promise a company makes to provide a product or service to a customer. When the company meets this performance obligation, it recognizes revenue.  

The revenue recognition principle is when a company recognizes revenue in the accounting period in which the performance obligation is satisfied, they do so by performing a service or providing a good to a customer.  

Expense Recognition Principle  

Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition.  

The expense recognition principle. It requires that companies recognize expenses in the period in which they make efforts (consume assets or incur liabilities) to generate revenue.  

Summary of the revenue and expense recognition principles 

 The Need for Adjusting Entries 

In order for revenues to be recorded in the period in which services are performed and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. 

Adjusting entries ensure that the revenue recognition and expense recognition principles are followed. It is needed every time a company prepares its financial statements.  

Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several reasons:  

1. Some events are not recorded daily because it is not efficient to do so.  
2. Some costs are not recorded during the accounting period because the process is with time rather than as a result of recurring daily transactions. Examples: rent, and insurance.  

1. Some items may be unrecorded. Example is a bill that will not be received until the next accounting period.  

Adjusting entries are required every time a company prepares financial statements.  

The company analyzes each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account.  

Types of Adjusting Entries 

Adjusting entries are classified as either deferrals or accruals.  

 Adjusting Entries for Deferrals 

Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged.  

There are two types of deferrals : -Prepaid expenses , - unearned revenues

1. Prepaid Expenses 

Prepaid expenses or prepayments: are costs that you pay in advance for something you will receive or use in the future. It's like paying for a service or product before you actually get it. EX: if you pay your rent for the next month at the end of the current month, that's a prepaid expense. You've paid for the upcoming month's rent in advance.

Prepaid expenses are costs that expire either with the passage of time or through use 

Prepaid expenses are recorded as assets on your balance sheet because they represent something of value that you haven't used yet. As time passes and you benefit from what you've prepaid for you gradually recognize these costs as expenses on your income statement. (You increase (a debit) to an expense account and a decrease (a credit) to an asset account.)  

1. Unearned Revenues  

Unearned revenues: are payments you receive in advance for products or services you haven't delivered or provided yet. It's like getting paid for something you promise to do in the future. Now the company has a performance obligation to its customers. Items like rent, magazine subscriptions, and customer deposits are unearned revenues.  

Unearned revenues are the opposite of prepaid expenses since unearned revenue on the books of one company is likely to be a prepaid expense on the books of the company that has made the advance payment.  

Unearned revenues are recorded as liabilities on the balance sheet because they represent an obligation to deliver a product or service in the future.

As the company fulfills its promise and provides the service, it gradually recognizes the unearned revenue as earned revenue on the income statement, reflecting the revenue earned over time. (You decrease (a debit) a liability account and increase (a credit) a revenue account).  

Adjusting Entries for Accruals 

Accruals are expenses or revenues that are recognized ar an earlier date than the point when cash will be exchanged in the future. The adjusting entry for accruals will increase both the balance sheet account and an income statement account.  

1. Accrued Revenues  

Accrued revenues: It's when you've provided a product or service to a customer, and they owe you money, but they haven't paid you yet. Accrued revenues are recorded on the books to show that you've earned this money, even though it's not in your hands yet.

It helps keep track of what you're owed and reflects your company's financial performance accurately, matching income with the time when you earned it. 

An adjusting entry records the receivable that exists at the statement of financial position date and the revenue for the services performed during the period.

An adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.  

Summary

Accrued Expenses

Cost or expenditures that a company has incurred (collected) but has not yet paid or recorded in its financial statements. Ex: interest, taxes, and salaries.

They occur when a company consumes goods or services and is obligated to pay for them in the future, creating a liability.

To account for accrued expenses, companies need to make adjusting entries. These entries are necessary to reflect the financial obligations that exist at the statement of financial position (balance sheet) date and to recognize the expenses that belong to the current accounting period. Without these adjustments, both the liabilities and expenses on the financial statements would be understated.

Debiting an Expense Account: This increases the expense on the income statement, recognizing the cost incurred.

Crediting a Liability Account: This increases the liability on the balance sheet, acknowledging the obligation to pay.

Accrued interest

The interest that accumulates on a debt but has not yet been paid. This interest accrues over time based on the principal amount, the interest rate, and the duration for which the debt is outstanding.

Example

• Yazici Advertising borrowed $5,000 on October 1, and they have to pay it back in three months. The annual interest rate is 12%.
• The interest for one month is $50 ($5,000 principal × 12% annual rate × 1/12).
• At the end of October, Yazici records this accrued interest. They increase "Interest Payable" (money they owe but haven't paid yet) by $50 and also record "Interest Expense" for $50 (the cost of the interest they've incurred during the month).

This way, the company keeps track of its financial obligations and expenses accurately for the current period without understating liabilities or overestimating net income and equity.

Accrued wages & salaries

They occur when a company has incurred salary and wage expenses but hasn't paid them yet. This is common when employees work for a certain period before receiving their paychecks. In accounting, these unpaid expenses are recognized as accrued liabilities until they are paid.

To account for accrued salaries and wages, companies need to make adjusting entries. :

1. Adjustment at the End of the Period: As the end of the accounting period approaches, the company assesses the unpaid salaries and wages for the work done in that period. In your example, you have accrued salaries of $1,200 at the end of October.
2. Adjusting Entry:
   • Debit Salaries and Wages Expense: This increases the expense on the income statement, recognizing the cost incurred. In this case, you debit it with $1,200.
   • Credit Salaries and Wages Payable: This recognizes the amount as a liability on the balance sheet, acknowledging the obligation to pay. You credit it with $1,200.

This makes sure that the company's financial statements correctly reflect the amount of salaries and wages incurred and owed during that specific accounting period.

When the company eventually pays the employees, usually in the next accounting period, they'll make another entry to debit Salaries and Wages Payable and credit Cash, effectively reducing the liability and recognizing the cash outflow.

Summary of basic relationships

Each adjusting entry affects one balance sheet and on income statement.

Step 6 & 7: Adjusted trial balance & financial statements

An Adjusted Trial Balance is an important step in the accounting process that helps ensure the accuracy of a company's financial records and forms the foundation for creating financial statements. Here's how it works:

Preparing Adjusted Trial balance

This adjusted trial balance reflects the updated account balances after making adjusting entries. It includes additional accounts like Prepaid Insurance, Notes Payable, Interest Payable, Unearned Service Revenue, and Salaries and Wages Payable, which were affected by the adjusting entries. The purpose of this trial balance is to ensure that the total debits (left side) equal the total credits (right side), which indicates the books are in balance. It is also the basis for preparing financial statements.

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Preparing Financial Statements

Income Statement: Companies create the income statement from the revenue and expense accounts. Revenues are listed at the top, followed by a list of expenses. The total expenses are subtracted from total revenues to calculate the net income or net loss for the period.

Retained Earnings Statement: Using the Retained Earnings account, the statement shows the beginning balance of retained earnings (from the previous period), adds the net income from the income statement, and subtracts any dividends. The result is the ending balance of retained earnings.

Statement of Financial Position (Balance Sheet): Companies prepare the statement of financial position from the asset and liability accounts in the adjusted trial balance. It includes assets such as cash, equipment, supplies, and accounts receivable, and liabilities like accounts payable, notes payable, and other obligations. The ending balance of retained earnings, as reported in the retained earnings statement, is also included.

The adjusted trial balance serves as the basis for creating these financial statements and ensures that all the accounting data are correctly presented.

Alternative treatment of deferrals

The company handles prepaid expenses and unearned revenues differently in its initial entries and adjusting entries.

1. Prepaid Expenses (Alternative Treatment):
   • When a company prepays an expense, it debits that amount to an expense account instead of debiting it to an asset account.
   • EX: if a company pays for rent in advance, it records the payment as an expense immediately.
2. Unearned Revenues (Alternative Treatment):
   • When a company receives payment for future services, it credits the amount to a revenue account rather than a liability account.
   • This means the company recognizes the revenue immediately, even though the services or products are not yet delivered.

The effect of this alternative approach is that it accelerates the recognition of expenses and revenues, making the financial statements reflect these changes earlier than traditional methods. It can only be used when specific circumstances allow it .

Prepaid expenses

When a company expects to use a prepaid expense (EX : supplies) before the end of the month, they debit (increase) an expense account (EX: Supplies Expense) rather than an asset account (EX: Supplies) at the time of purchase.

This eliminates the need for an adjusting entry at the end of the month. The expense account will show the cost of supplies used between the purchase date and the end of the month.

1. Adjusting Entry for Unused Supplies:
   • If the company doesn't use all of the supplies, they make an adjusting entry at the end of the month to account for the unused supplies.
   • For example, if 1,000 units of advertising supplies remain at the end of the month, an adjusting entry is made to decrease Supplies Expense and increase Supplies by 1,000.

This alternative approach simplifies the accounting process when a company is confident that they will consume prepaid expenses before the end of the period. However, if they end up not using all of the supplies, an adjusting entry is still necessary to ensure accurate financial reporting.

Unearned revenues

In the traditional approach, unearned revenues are initially recorded as liabilities. As services are performed, the liability decreases, and the corresponding revenue increases. However, some companies use a different approach

In an alternative treatment for unearned revenues, companies credit a revenue account when they receive cash for future services expected to be performed within the current period. If the services aren't provided by the period's end, an adjusting entry is made. Without this entry, the revenue is overstated, and the liability account is understated.

EX: if Yazici Advertising received 1,200 on October 2 for services expected to be performed by October 31, they would credit the Service Revenue account. If not all the services are performed, an adjusting entry on October 31 would be made:

Credit Service Revenue: 800 Debit Unearned Service Revenue: 800

This adjustment ensures accurate financial reporting by correctly reflecting revenue and liabilities.

Summary of Additional adjustment relationships

Alternative adjusting entries don’t apply to accrued revenues and accrued expenses because no entries happen before companies make these types of adjusting entries .

Financial reporting concepts

Assumptions

• Monetary unit assumption : means that we only record financial transactions that can be expressed in terms of money.
• Economic entity assumption: a fundamental accounting principle that requires a clear separation between the financial activities of a business entity and those of its owners and other entities. (Separation between their business expenses and private expenses)
• Time period assumption: The belief that financial information should be divided into specific time periods, like months or years, for easier analysis and reporting.
• Going concern assumption: based on the idea that a business will continue its operations indefinitely. It assumes that the company is not facing impending bankruptcy or planning to cease operations.

Principles in Financial Reporting

1. Historical Cost Principle: Assets are recorded at their original cost and are not adjusted for changes in market value over time.
2. Fair Value Principle: Assets and liabilities are reported at their current market value, when that value is readily available and provides more relevant information.
3. Revenue Recognition Principle: Revenue is recognized when a company satisfies its performance obligations, typically when goods are transferred or services are performed.
4. Expense Recognition Principle: Expenses are recognized in the same period as the related revenues to accurately match costs with the revenue they help generate.
5. Full Disclosure Principle: Companies must disclose all important information that could impact financial statement users in accompanying notes when it cannot be reported directly on the financial statements.
6. Cost Constraint: This principle considers the cost of providing certain information against the benefits of having that information for financial statement users, helping to determine whether it should be disclosed.

Chapter 4 

The worksheet: 

It’s a multiple-column form used in the adjustment process and preparation of financial statements (to make one we need excel). A company CAN NOT publish it to external users. The completed worksheet is not a substitute for formal financial statements.  

• IT’S NOT A JOURNAL OR A GENERAL LEDGER but a working tool.  

• The use of it is optional but it offers the opportunity for the company to directly do their financial statement on this Excel document.  

 Step-by-step preparation of a worksheet:  

1.  Prepare your trail balance:  

Enter all the ledger accounts with their balances in the account titles column. Then enter debit and credit amounts from the ledger in the trial balance columns.  

1. Enter the Adjustments in the Adjustments Columns (keying):  

Enter all adjustments in the adjustment columns. 2 things can happen:  

• If an account that is already in the trail balance needs an adjustment, put the adjustment amount next to it.  
• If additional accounts need to be adjusted, insert them below “account titles”. 

1. Enter Adjusted Balances in the Adjusted Trial Balance Columns:  

Now, combine the trial balance and the adjustments account together for each account.  

Remember:   

• If the account is in debit in the trial balance and you have to credit it in the adjustment it means that in the adjusted trial balance you have to subtract both  

• If the account is in debit in the trial balance and you have to debit it in the adjustment it means that you have to add both  

• If the account is credited in the train balance and you have to debit it in the adjustment it means that you just need to subtract both  

• If the account is credited in the train balance and you have to credit it in the adjustment it means that you have to add both  

1. Extend Adjusted Trial Balance Amounts to Appropriate Financial Statement Columns 

Next, place the correct account in the income statement and the statement of financial position 

Rapple:  

• Income statement: ONLY revenues, expenses, and account receivable.  
• Balance sheet is ONLY assets, liability, and equity  

1. Total the Statement Columns, Compute the Net Income (or Net Loss), and Complete the Worksheet 

Finally, we have to total each column of the financial statements.  

Same rule as before:  To find the net income or loss, subtract the totals of the debit and credit in the income statement columns. 

• If the total credits exceed the total debits, the result is net income.  

Consequently: you must enter the amount in the debit of the income statement and in the statement of financial position in the credit column. (The credit in the statement of financial position indicates the increase in equity caused by net income.)  

What if instead of the net income we had a net loss?  

We would just put the result in the credit side of our income statement and debit our statement of financial position. Consequently, the debit in the statement of financial position indicates the decrease in equity caused by net loss.)  

Preparing Financial Statements from a Worksheet 

Now that the worksheet is complete, the company can now prepare its financial statement on individual sheets.  

Remember that the retained earnings statement is prepared from the statement of financial position columns because it just takes into account the retained earnings and dividends.  

Preparing Adjusting Entries from a Worksheet: (NO) 

• To adjust the accounts, the company must journalize the adjustments and post them to the ledger because a worksheet cannot be used for that. 
• (The reference letters in the adjustment columns and the explanations of the adjustments at the bottom of the worksheet help identify the adjusting entries)  

Closing the Books:  

When they say “Closing the books” it means that the company is preparing their accounts for the next period. They do this at end of the accounting period.   

Closing the book we can distinguish:  

• Temporary accounts: Accounts that will stay for only this accounting period meaning that at the end of the period they will be closed.  
• They include all income statement accounts and the dividends account.  
• Permanent accounts: Accounts that will stay for more than an accounting period, they will be carried from period to period in the company 
• They consist of all statements of financial position accounts.  

Preparing Closing Entries 

In preparing closing entries, companies transfer the revenue and expense accounts to the  “Income Summary”, after that they transfer the resulting net income or net loss from this account to Retained Earnings. And then they add dividends to the retained earnings. Companies usually record closing entries in the general journal.  

• Income Summary: is only used in closing entries.  

At this time:  

• All temporary accounts have a balance of zero, to accumulate data in the next accounting period.  
• Permanent accounts have the same value at the closing entry and the beginning of the entry. 

Closing Process :  

1. Debit each revenue account for its balance, and credit the Income Summary for total revenues. 
2. Debit Income Summary for total expenses, and credit each expense account for its balance. 
3. Debit Income Summary and credit Retained Earnings for the amount of net income. 
4. Debit Retained Earnings for the balance in the Dividends account, and credit Dividends for the same amount 

(They close net income in retained earnings and they add dividend to it) 

Rappel: Dividends are not an expense, and they are not a factor in determining net income.  

Posting Closing Entries: 

After posting the closing entries, all temporary accounts have a balance of zero.  

The balance in Retained Earnings represents the accumulated undistributed earnings of the company at the end of the accounting period. This balance is shown on the statement of financial position and is the ending amount reported on the retained earnings statement.  

In the closing process, a company will double-underline its temporary accounts and draw a single underline beneath the permanent accounts and they will be carried forward to the next period.  

Preparing a Post-Closing Trial Balance:  

After a company has journalized and posted all closing entries, they will prepare another trial balance, called a post-closing trial balance. It does not consider the temporary account because their balance is equal to 0 at the end of the fiscal year but it lists permanent accounts and their balances after the journalizing and posting of closing entries.  

The purpose: prove the equality of the permanent account balances carried forward into the next accounting period. 

Reversing Entries (Optional Step):  

A reversing entry is the exact opposite of the adjusting entry. Use of reversing entries is an optional bookkeeping procedure; it is not a required step in the accounting cycle.  

Correcting Entries (An Avoidable Step):  

Unfortunately, errors may occur in the recording process. Companies should correct errors, as soon as they discover them, by journalizing and posting correcting entries.  

Differences between correcting entries and adjusting entries.  

1. Adjusting entries are an integral part of the accounting cycle.  

• Correcting entries are unnecessary if the records are error-free.  

1. Companies journalize and post adjustments only at the end of an accounting period, but they can make correcting entries whenever they discover an error.  
2. Adjusting entries always affect at least one statement of financial position account and one income statement account.  

• Correcting entries may involve any combination of accounts in need of correction.  

1. Correcting entries must be posted before closing entries. 

Classified Statement of Financial Position:  

The statement of financial position presents a snapshot of a company's financial position at a point in time.  

To improve users' understanding of a company's statement of financial position, companies group similar assets and liabilities because some items have similar economic characteristics.  

These help financial statement readers determine if the company has enough assets to pay 

• Its debts as they come due,  
• And short and long-term creditors.  

Intangible Assets:  

Intangible assets are long-lived assets that are not physical à they will stay for a long time in the company 

Ex: goodwill, patents, copyrights, trademarks, property, plant, and equipment  

Depreciation: is the practice of allocating the cost of assets to a number of years.  

Companies will systematically assign a portion of an asset's cost as an expense each year.  

The assets depreciated are reported on the statement of financial position in the account “less: accumulated depreciation”.  

Less: accumulated depreciation account: shows the total amount of depreciation that the company has expensed so far in the asset's life. 

Long-Term Investments:  

Long-term investments are generally:  

• Investments in shares and bonds of other companies that are normally held for many years 
• non-current assets such as land or buildings that a company is not currently using in its operating activities 
• long-term notes receivable  

Current Assets:  

Current assets are assets that a company expects to convert into cash or use within one year of its operating cycle.  

Ex: cash, investments, receivables (notes receivable, accounts receivable, and interest receivable), inventories, and prepaid expenses (supplies and insurance). 

The operating cycle of a company is the average time that it takes to purchase inventory, sell it on account, and then collect cash from customers.  

Equity:  

The content of the equity section varies with the form of business organization.  

• Proprietorship, there is one capital account.  
• Partnership, there is a capital account for each partner.  
• Corporations often divide equity into two accounts: Share Capital—Ordinary and Retained Earnings.  

Corporations record shareholders' investments in the company by debiting cash accounts and crediting the Share Capital—Ordinary account. And they combine the Share Capital—Ordinary and Retained Earnings accounts and report them in the statement of financial position as equity.  

Non-Current Liabilities:  

Non-current liabilities are obligations that a company expects to pay after one year.  

Ex: bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. 

Current Liabilities:  

Current liabilities are obligations that the company is to pay within the coming year of its operating cycle.  

Ex: accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable. We can add current maturities of long-term obligations 

Current maturities of long-term obligations are payments to be made within the next year on long-term obligations.  

The relationship between current assets and current liabilities:  

This relationship is important in evaluating a company's liquidity (its ability to pay obligations expected to be due within the next year.) 

• When current assets exceed current liabilities, the company has enough liquidity to pay the liabilities.  
• When current liabilities exceed current assets, the company doesn’t have enough liquidity to pay its creditors and they might end up in bankruptcy. 

Chapter 5 

Merchandising Operations and Inventory Systems:  

Merchandising: companies that buy and sell merchandise (inventory) as their primary source of revenue (also known as the sale of merchandise, sales revenue or sales.)  

There are 3 different types:  

1. Retailers à companies that purchase and sell directly to consumers  
2. Wholesalers à companies that sell to retailers  
3. Manufactures à they are the ones making the products for sale it to wholesalers  

A merchandising company has 2 categories of expenses:  

• Cost of goods sold: the total cost of merchandise sold during the period. 

This expense is directly related to the revenue recognized from the sale of goods.  

• Operating expenses: all expenses that a company will have to do in the purpose to sale inventory  

Operating Cycles:  

The operating cycle of a merchandising company is longer than the one of a service company because a merchandising company has to purchase and kept until it’s sold to customers  

Flow of Costs:  

The flow of costs for a merchandising company is:   

As goods are sold, they are assigned to the cost of goods sold.  

Ending inventory à are the good that are not sold at the end of the accounting period  

Perpetual inventory system and periodic inventory system:  

Companies use one of two systems to account for inventory:  

A perpetual inventory system:  

à Characteristic: companies keep detailed records of the cost of each inventory purchase and sale. These records show the inventory that should be on hand for every item. A company determines the cost of goods sold each time a sale occurs. 

A periodic inventory system:  

à Characteristic: companies do not keep detailed inventory records of the goods throughout the period. Instead, they determine the cost of goods sold only at the end of the accounting period.  

At that point, the company takes a physical inventory count to determine the cost of goods on hand. 

 Step to determine the cost of goods sold under a periodic inventory system:  

1. Determine the cost of goods on hand at the beginning of the accounting period. 
2. Add to it the cost of goods purchased. 
3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period. 

COGS = BB inventory + Purchases – EB Inventory

Advantages of the Perpetual System:  

A perpetual inventory system is named so because the accounting records continuously show the quantity and cost of the inventory that should be on hand at any time. 

This system is recommended by IFRS because it provides better control over inventories than a periodic system. (The inventory records show the quantities that should be on hand, so in case of robbery or shrinkage the company can investigate immediately.)  

Recording Purchases Under a Perpetual System:  

Purchase Invoice: is a document that supports each credit purchase.  

Here, the purchaser uses a purchase invoice and a copy of the sales invoice sent by the seller. It identifies:  

- Seller  

- Invoice date  

- Purchaser  

- Sales person  

- Credit terms  

- Freight terms  

- Goods sold: catalog number, description, quantity, price per unit  

- Total invoice amount  

Companies purchase inventory using cash or on account. à so they record an increase in Inventory and a decrease in Cash or account payable. 

Recording Sales Under a Perpetual System:  

In accordance with the revenue recognition principle, companies record sales revenue when the performance obligation is satisfied and this happens when the goods are transferred from the seller to the buyer.  

à Sales may be made on credit or for cash. 

• Business documents should support every sales transaction, to provide written evidence of the sale.  
• Cash Register Documents: provide evidence of cash sales  
• A sales receipt is a document that provides support for a credit sale. 

The original copy of the receipt goes to the customer, and the seller keeps a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price, and other information. 

The seller makes two entries for each sale.  

1. Records the sale: The seller increases (debits) Cash (or Accounts Receivable if a credit sale), and increases (credits) Sales Revenue.  
2. Records the cost of the merchandise sold: The seller increases (debits) Cost of Goods Sold, and decreases (credits) Inventory for the cost of those goods.  

As a result, the Inventory account will always show the amount of inventory that the company should have. 

For internal decision-making purposes, merchandising companies may use more than one sales account. On its income statement a merchandising company normally would provide only a single sales figure (so it will sum up all its individual sales accounts).  

Why doing that? 

1. It provides detail on all its individual sales accounts by adding considerable length to its income statement.  
2. Second, most companies do not want their competitors to know the details of their operating results.  

Chapter 6 

 How a company classifies its inventory depends on whether the firm is a merchandiser or a manufacturer.  

• In a merchandising company, only need 1 inventory account because they sell items that have common characteristics :  they are owned by the company and they are ready to be sale to customers.  

• In a manufacturing company, some inventory may not yet be ready for sale. So they divide there inventory into three categories:  

1. Raw materials : are the basic goods that will be used in production but have not yet been placed into production. 

1. Work in process : are good that have been placed  into the production process but is not yet complete.  

1. Finished goods : are good that are ready to be sold.  

Companies need to make inventory to know what products are left in the company after sales. It is usually done at the end of an accouting period  

When we observe the levels and changes in the levels of these three inventory types, financial statement users can gain information into management’s production plans.  

Ex : low levels of raw materials and high levels of finished goods mean that there’s enough inventory on hand and production will be slowing down.  High levels of raw materials and low levels of finished goods mean that the company is planning to step up production. 

Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods.  

With  just-in-time method, companies manufacture or purchase goods only when needed.  

Now we are going to focus on merchandise inventory. 

Determining Inventory Quantities :  

It doesn’t matter whether we are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period.  

If we are using a perpetual inventory system, companies take a physical inventory because they need : 

1. To check the accuracy of their perpetual inventory records. 

2. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft. 

If a companies is using a periodic inventory system  they will take a physical inventory for two different purposes: 

1. To determine the inventory on hand at the statement of financial position date 
2. To determine the cost of goods sold for the period. 

Determining inventory quantities involves two steps: 

1. Taking a physical inventory of goods on hand  
2. Determining the ownership of goods. 

Taking a Physical Inventory 

Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. An inventory count is generally more accurate when goods are not being sold or received during the counting. Consequently, companies often “take inventory” when the business is closed or when business is slow. This is why many retailers close early 1 day in January ( after the holiday sales and returns, because inventories are at their lowest level) to count.  

Determining Ownership of Goods 

One challenge in counting inventory quantities is determining what inventory a company owns.  

To determine ownership of goods, two questions must be answered:  

• Do all of the goods included in the count belong to the company?  
• Does the company own any goods that were not included in the count? 

Goods in Transit :  

A difficulty in determining ownership is goods in transit at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. 

To arrive at an accurate count, the company must determine ownership of these goods. 

Goods in transit should be included in the inventory of the company that has legal title to the goods.  

When the terms are FOB  (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. 

Ex : You purchase goods from a seller in Los Angeles with the agreement FOB Shipping Point terms for the transaction (you need to ship it to NewYork). The seller will prepares the goods for shipment in Los Angeles. Once the goods are handed over to the carrier in Los Angeles, ownership of the goods transfers from the seller to you, the buyer. From this moment as the buyer, you are responsible for the transportation costs, insurance, and any risks associated with the goods during transit from Los Angeles to New York. The goods are shipped to New York, and when it arrive as the buyer, you take possession of the goods. 

When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer. 

Ex : You and the seller agree to FOB Destination terms for the transaction ( to ship in NewYork) and he seller prepares the goods for shipment in Los Angeles. Unlike FOB Shipping Point, in FOB Destination, ownership of the goods remains with the seller until the goods reach the destination. The seller is responsible for the transportation costs, insurance, and risks associated with the goods during transit from Los Angeles to New York. The goods are shipped to New York, and ownership of the good is transferred to the buyer only when the good arrived to the destination. 

If goods in transit at the statement date are ignored, inventory quantities may be seriously miscounted.  

Consigned Goods.  

Consigned goods: is when someone will keep and sell the good of another business for them for a fee. The parti how does that don’t have an ownership on the good —> CCL the good must not be added in the inventory of the company who sell the good for the other company because they don’t own it. Normally when a company want another parti to sell a good for them is beause :  

. they when to keep their inventory cost low 

. they believe that they won’t be able to sell it themselves  

Ex: You and Sarah agree that she will provide her handmade jewelry to your boutique for display and sale. Despite the goods being physically in your boutique, Sarah, as the ownership of the jewelry.  Your boutique has Sarah's jewelry, and customers can purchase them directly from your store. When a customer buys a piece of jewelry, your boutique handles the sale, but you don't own the items. Instead, you and Sarah have agreed on a revenue-sharing arrangement or a fee for each item sold. If some jewelry items remain unsold after a certain period, you might return them to Sarah, or you could both agree on a plan for handling unsold items. 

Inventory Methods and Financial Effects:  

Inventory is accounted as a cost.  

When we say « Cost », it includes everything that is necessary to acquire a goods and place them in a condition ready for sale (every modification done to a good to put them in sell is considers as cost of inventory ).  

Ex: You purchase flour, sugar, eggs, and other ingredients to make the cupcakes. The cost of these raw materials is considered part of the inventory. The time and effort spent by the baker in mixing the ingredients, baking the cupcakes, and decorating them are considered as labor costs. These costs are also the inventory costs.  the electricity used by the ovens, the cost of packaging materials, and a portion of the rent for the bakery space, are costs associated with the production of the cupcakes. These costs are included in the inventory. If you need to transport the cupcakes to a retail location, any transportation costs incurred, such as fuel or shipping fees, are considered part of the inventory cost. The cost of storing the cupcakes in a refrigerated display or storage area, including rent for that space, contributes to the overall inventory cost.  

After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to find the total cost of the inventory and the cost of goods sold.  

But the problem is that in your inventory you ight have purchasesd the good at different prices and at different time cause your accounts to be miscounted  

(Cost of goods sold will differ depending on which two prices the company sold.)  

If a company can easily identify which particular units it sold and which are still in ending inventory, it can use the specific identification method of inventory costing. Using this method, companies can accurately determine ending inventory and cost of goods sold. 

If a company uses specific identification it requires  

- that companies keep records of the original cost of each individual inventory item.  

Ex: Imagine you run a small antique shop, and you have three unique items for sale:  

• Typewriter: Purchased for $200 
• Record Player: Purchased for $150 
• Rare Book: Purchased for $300 
• A customer comes in and buys the typewriter. In a specific identification system, you would record the sale using the actual cost of the typewriter, which is $200. 
• Another customer purchases the vintage record player. You would record this sale using the cost of the record player, which is $150. 
• The rare book is still in your inventory. 

Historically, this method was possible only when a company sold a limited variety of high-unit-cost items that could be identified clearly from the time of purchase through the time of sale. Ex of  products which  we can still use the method: cars, pianos, or expensive antiques. 

Today, this practice is still relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost flow assumptions.  

Cost Flow Assumptions :  

This technique can be used when we sell a large amount of identical unis to track the cost of good flow  

There are three assumed cost flow methods but we will only use two because they are permitted be IFRS : 

1. First-in, first-out (FIFO)  

2. Average-cost 

3. Last in first out (LIFO)—> used by GAAP 

To demonstrate the two cost flow methods, we will use a periodic inventory system. We assume a periodic system because very few companies use perpetual FIFO or average-cost to cost their inventory and related cost of goods sold.  

Companies that use perpetual systems often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they will have to recalculate cost of goods sold using periodic FIFO or average-cost 

First-In, First-Out (FIFO) : 

The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. Here, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. It does not necessarily mean that the oldest units are sold first, but that the costs of the oldest units are recognized first.  

Under FIFO, since it is assumed that the first goods purchased were the first goods sold, ending inventory is based on the prices of the most recent units purchased. That is, under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.  

FIFO (First-In, First-Out): FIFO assumes that the oldest inventory items (first to be purchased or produced) are the first to be used or sold.  

Ex: Most of the books Bookmarker sells are bought from publishers. The price of these books is set by the publisher and this price can change based on the popularity of the book, printing costs, number of books bought, etcetera. During 2020, the following transactions have occurred for a book. Assume that Bookmarker uses a perpetual inventory system. The owner can easily calculate total sales revenue for this title, because he knows that 45 books were  

sold during 2020 at a price of €20 per copy, but he is not sure what number he has to use for the cost of goods sold. He knows this number depends on the assumed cost flow method FIFO, Average-cost, and LIFO. Let’s follow the FIFO method  

Total inventory before sales : 30+ 10+10+10= 60  

Unite of inventory sold : 45 

Inventory left : 15 (ending inventory)  

Average-Cost 

When we use the average-cost method we have to take the average of what we have brought during the accouting period and use it to identitfy the cost of good sold and the value of the inventory.  

Average Cost: The average cost method assigns a cost based on the average price of all units in inventory. This method evens out the cost of goods sold and provides a middle-ground approach between FIFO and LIFO during fluctuating prices.  

EX: At the beginning of the month, the store has 200 packs of pens from the previous month, which were purchased at $1.50 each. 

•  Throughout the month, the store makes two additional purchases: 
• Purchase 1: 100 packs of pens at $1.60 each 
• Purchase 2: 150 packs of pens at $1.70 each 
• The store makes various sales throughout the month but doesn't immediately reduce the inventory. Instead, it keeps a record of the sales. At the end of the month, the store physically counts its remaining inventory and determines the cost of goods sold (COGS) using the average cost method. 
• Calculation of Average Cost: 
• The average cost per unit is calculated by taking the weighted average of the costs for the available inventory. 

 If the store sells 300 packs of pens during the month, it uses the average cost of $1.59 to calculate the cost of goods sold. 
COGS = 300 × $1.59 
COGS ≈ $ 477 

The ending inventory is the remaining unsold packs of pens, valued at the average cost. 

Ending Inventory=(200+100+150)−300 
Ending Inventory = 450 − 300 

Ending Inventory = 150 packs 

LIFO Inventory Method:  

LIFO (Last-In, First-Out): LIFO assumes that the newest inventory items (last to be purchased or produced) are the first to be used or sold. This method often results in higher costs of goods sold and lower ending inventory when prices are rising.  Under IFRS, LIFO is not permitted for financial reporting purposes. LIFO is used for financial reporting in the United States, and it is permitted for tax purposes in some countries. Its use can result in significant tax savings in a period of rising prices. Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining cost of goods sold.  

Financial Statement and Tax Effects of Cost Flow Methods 

A recent survey of IFRS companies indicated that approximately 60% of these companies use the average-cost method, with 40% using FIFO. In fact, approximately 23% use both average-cost and FIFO for different parts of their inventory. 

The reasons companies adopt different inventory cost flow methods are varied, but we can count 3 main ones  

1. income statement effects 

2. statement of financial position effects  

3. tax effects. 

Income Statement Effects: 

To understand why companies choose either FIFO or average-cost, let’s examine the effects of these two cost flow assumptions on the income statements 

Note the cost of goods available for sale (HK$12,000) is the same under both FIFO and average-cost. However, the ending inventories and the costs of goods sold are different. This difference is due to the unit costs that the company allocated to cost of goods sold and to end- ing inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes.  

In periods of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income, such as the following. 

1. If prices rises , FIFO will reports a higher net income than average-cost because using  Fifo we are taking the first purchases (= less expensive purchase) the cost of good sold will be lower and since I leave my ending inventory with my last purchase (= most expensive purchase) it will be higher. if my cost of good sold is low my net income is high   

2. If prices are falling, FIFO will report the lower net income and average-cost the higher because using  Fifo we are taking the high purchases (= most expensive purchase) the cost of good sold will be higher and since I leave my ending inventory with my last purchase (= less expensive purchase) it will be lower. if my cost of good sold is high my net income is low 

CCL: companies tend to prefer FIFO because it results in higher net income because external users  view the company more favorably and , managers will receive bonuses if the net income is higher.  

Statement of Financial Position Effects : 

A major advantage of the FIFO method is that in a period of rising prises, the costs allocated to ending inventory will close to their current cost.  

Ex: Imagine you have a stack of boxes, and you keep adding new boxes on top. When you sell something, you take from the top (the oldest boxes). In a period of rising price, using FIFO is like selling the older items first. This means the cost you assign to your ending inventory (what's left unsold) is closer to the current, higher prices. 

The average-cost method is that in a period of rising prices, the costs allocated to ending inventory may be understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods. 

Ex: Imagine you have a mix of old and new boxes, and you calculate an average cost for everything. When you sell something, you use this average cost. In a period of rising price, this average might be lower than the current prices, especially if you have older, cheaper items in your inventory. 

The showcase of the average cost method : With the average-cost method, as prices go up, your calculated average might not keep up. If you have goods from previous periods( when prices were lower) , the cost assigned to your ending inventory might be lower than what it would cost to replace those items with new ones. This could lead to understating the value of your unsold items. 

Tax Effects : 

We as we can see in the statement of financial position and net income on the income statement are higher when companies use FIFO in a period of inflation. But, some companies use average-cost.  

Why? The average-cost cause a  lower income taxes (because of lower net income) during times of rising prices. ( if your net income is low the government will taxe you less in it—> you pay less taxes )  

Using Inventory Cost Flow Methods Consistently :  

The consistency concept: it means that a company uses the same accounting principles and methods from year to year. So watch ever cost flow method a company chooses, it should use that method consistently from one accounting period to another. They do this to facilitates the comparability of financial statements over successive time periods. It does not mean that a company cannot change its inventory costing method. When a company adopts a different method, it should specify in the financial statements the change and its effects on net income. 

Effects of Inventory Errors : 

Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by :  

• Failure to count  
• Price the inventory correctly  
• When companies do not properly recognize the transfer of legal title to goods that are in transit. 

When errors occur, they affect both the income statement and the statement of financial position. 

Income Statement Effects : 

The ending inventory of one period becomes the beginning inventory of the next period. So if there’s an inventory errors it can affect the calculation of cost of goods sold and net income in two periods. 

Remember: 

 An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. Note that the understatement of ending inventory in 2019 results in an understatement of beginning inventory in 2020 and an overstatement of net income in 2020. 

 Over the two years, though, total net income is correct because the errors réajustée itself. The correctness of the ending inventory depends entirely on the accuracy of taking and costing the inventory at the statement of financial position date under the periodic inventory system 

 Statement of Financial Position Effects: 

The ending inventory errors can effect  the statement of financial position by using the basic accounting equation: Assets = Liabilities + Equity.  

Same rule as before: if the error is not corrected, the combined total net income for the two periods would be correct. 

Presentation : 

Inventory is classified in the statement of financial position as a current asset above receivables.  

Lower-of-Cost-or-Net Realizable Value : 

The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to continual changes in technology or fashions. These circumstances sometimes call for inventory valuation methods other than those presented so far. 

When the value of inventory is lower than its cost, companies must “write down” the inventory to its net realizable value. This is done by valuing the inventory at the lower-of-cost-or-net realizable value (LCNRV) in the period in which the price decline. 

LCNRV is an example « prudence », meaning that the best choice among accounting alternatives is the method that is least likely to overstate assets and net income. 

Under the LCNRV, net realizable value refers to the net amount that a company excepts to receive from the sale of inventory.When the net realizable value of inventory drops below its historical cost, the inventory is written down to its lower value.  

Companies apply LCNRV to the items in inventory after they have used one of the inventory costing methods (specific identification, FIFO, or average-cost) to determine cost. 

Analysis: 

The amount of inventory carried by a company has significant economic consequences. And inventory management requires constant attention. On one hand, management wants to have a great variety and quantity available so that customers have a wide selection and items are always in stock. But this policy might cause high costs.  

On the other hand, low inventory levels lead to stock-outs and lost sales.  

Solution : inventory turnover and a related measure, days in inventory. It measures the number of times on average the inventory is sold during the period.  

Purpose: is to measure the liquidity of the inventory.  

A variant of the inventory turnover is days in inventory.  

This measures the average number of days the inventory is held in the company.  

 The result is the approximate time that it takes a company to sell the inventory once it arrives at the store. 

Note: Companies that are able to keep their inventory at lower levels and higher turnovers and still satisfy customer needs are the most successful. 

Vocabulary 

LCNRV stands for "Lower of Cost or Net Realizable Value." It's an accounting method used to value inventory, where the inventory is reported at either its historical cost or its net realizable value, whichever is lower.``  

LCNRV, or Lower of Cost or Net Realizable Value, means valuing inventory at either its cost or its estimated selling price, whichever is lower. For instance, if the cost of inventory is €200 but its selling price is only €150, LCNRV dictates that the inventory should be valued at the lower amount of €150 in financial records  

Cost of Goods Sold (COGS) refers to the direct costs associated with producing goods or purchasing inventory that a company has sold during a specific period.  

 It includes expenses such as materials, labor, and overhead directly related to the production of goods. COGS is deducted from the revenue generated by the sale of goods to determine gross profit.  

The physical flow of goods refers to the actual movement of inventory within the business.  

Inventory refers to the goods, raw materials, or finished products that a company holds for the purpose of selling or producing goods for sa

Chapter 8

Receivables: the amounts of money that people or other companies owe to a business. EX : When a company sells things on credit (allowing customers to pay later), these amounts are called receivables. It's like a promise that the company will get paid in cash at a later time.

Managing receivables is super important for a company. It's like taking care of money that's supposed to come in. Companies want to make sure they collect this money on time because it's a big part of their

Types of Receivables

• Accounts Receivable: This is money that customers owe for goods or services bought on credit. It's a big part of what a company expects to collect within a shorter time frame, typically within 30 to 60 days. Among all receivables, accounts receivable are usually the largest and most common type.

Ex: Imagine a small retail store selling electronics. A customer comes in and buys a TV worth $800 on credit, agreeing to pay within 30 days. The $800 the customer owes to the store is an "accounts receivable.

• Notes Receivable: These are written promises (usually in a formal document) from customers or others to pay back a specific amount. Notes receivable often involve interest and have longer repayment periods, usually spanning 60 to 90 days or even longer. They are considered a more formal type of receivable compared to accounts receivable.

Ex : a company lends $5,000 to a customer with a written promise (a note) to repay the amount with 5% interest in 90 days. This $5,000 loan agreement with interest is a "notes receivable."

• Other Receivables: This category includes money owed to the company that doesn't come from regular sales operations. It covers various non-trade receivables like interest owed, loans given to company officers, advances to employees, or income taxes refundable. These receivables aren't from normal sales but are still owed to the company.`

Ex: a company's CEO borrows $10,000 from the company's funds for personal reasons and promises to repay within a year. This $10,000 loan to the CEO is an example of "other receivables."

Recognizing Accounts Receivable

Recognizing accounts receivable is relatively straightforward. A service organization records a receivable when it performs service on account.

Accounts Receivable:

• When a service company does a job for someone and lets them pay later, they record an "accounts receivable."
• Similarly, when a store sells things and customers pay later, that money the customers owe is also called "accounts receivable."
• EX : if a store sells $1,000 worth of things on credit to a customer, they note down the $1,000 as an "accounts receivable."

Sales & Returns:

• If someone returns items they bought, the store reduces the accounts receivable by the amount of the returned items. If a customer returns $100 worth of things they bought earlier, the store lowers the accounts receivable by $100.
• When the store gets paid by the customer, they decrease the accounts receivable and increase their cash.
• Ex : , if the customer pays $900 of their $1,000 debt, the store reduces the accounts receivable by $900 and adds $900 to their cash.

This helps the store keep track of what customers owe and what they've paid. It's important for recording sales, returns, and collecting money from customers.

Valuing Accounts Receivable

Receivables can be found in balance sheet in assets. But it’s hard to determine the exact amount to report because some receivables might not be collectible (uncollectible). Since sometimes not all customers can pay their debts due to various reasons like financial struggles or economic downturns. These unpaid accounts are considered bad debts and are recorded as an expense called "Bad Debt Expense."(required balance)-

Two Methods to Account for Uncollectible Accounts:

1. Direct Write-Off Method:

• Companies use this method to write off specific accounts they've determined as uncollectible. They charge the Bad Debt Expense when an account is declared uncollectible.
• However, this method has disadvantages: it doesn't match expenses with revenues, and it doesn't show the true value of receivables on the financial statement.

2. Allowance Method:

• This method estimates bad debts at the end of each period, offering a better matching of expenses with revenues on the income statement.
• It uses an "Allowance for Doubtful Accounts" as a contra account to "Accounts Receivable" to reflect the estimated amount that might not be collected.
• Companies adjust the Allowance for Doubtful Accounts to reflect estimated bad debts, ensuring that accounts receivable are reported at their net realizable value.
• Estimating Allowance and Adjusting Entries:
• Companies guess how much money they might not get from customers who owe them (uncollectible accounts). They might use a part of the total money owed (receivables) as a guess. This guess helps them prepare for potential losses.
• They then adjust the allowance account based on historical losses and credit evaluations.
• Aging the accounts receivable helps estimate bad debt losses by categorizing accounts by the length of time they've been unpaid.

Recording estimated uncollectible

a store named ABC Mart that made €10,000 in credit sales last year. By the end of the year, customers still owed €2,000, but ABC Mart predicts that €200 of this might not get paid.

• Bad Debt Expense increased by €200: This represents the cost related to the estimated uncollectible amount from the previous year's sales.
• Allowance for Doubtful Accounts increased by €200: This is a contra-account, reducing the reported value of outstanding customer payments. It's an estimate of what ABC Mart doesn't expect to collect in the future.
• The €1,800 remaining after the adjustment in the accounts receivable represents the expected cash value ABC Mart anticipates receiving. The allowance helps to set aside an estimated amount for future potential losses on unpaid amounts.

The goal is to report accounts receivable on the financial statement at their net realizable value, ensuring a better reflection of what the company expects to receive in cash.

Recording the write-off of an uncollectible account

Imagine a company, Hampson Furniture, where the financial VP decides to write off a €500 debt owed by R. A. Ware on March 1, 2021. Here's how the entries work:

• Allowance for Doubtful Accounts: Increases by €500
• Accounts Receivable: Decreases by €500

This write-off doesn't impact the Bad Debt Expense as it's already recognized when estimating bad debts. The write-off only affects the balance sheet, reducing both the Accounts Receivable and the Allowance for Doubtful Accounts. This keeps the cash realizable value (an indicator of collectible cash) unchanged.

Recovery of an Uncollectible Account:

Occasionally, a company can collect on a debt that was previously written off. In this scenario:

1. Reverse Write-Off Entry: Hampson reverses the write-off entry by:
   • Allowance for Doubtful Accounts: Reduces by €500
   • Accounts Receivable: Increases by €500
2. Collection Entry: When R. A. Ware pays the €500 on July 1:
   • Cash: Increases by €500
   • Accounts Receivable: Decreases by €500

The recovery process also affects only the balance sheet, not the income statement. Both the Accounts Receivable and Allowance for Doubtful Accounts increase with the recovery entry. It reflects that the previously written-off amount has now been collected, improving both the company's cash position and the Accounts Receivable balance.

Estimating the allowance

Companies must predict the amount of uncollectible accounts they might face using different methods .

• Percentage-of-receivables basis. This method establishes a percentage relationship between the receivables amount and expected losses from uncollectible accounts. For example:

Suppose Steffen Ltd. has £200,000 in Accounts Receivable and estimates 5% of this will be uncollectible🡪 5% of £200,000 = £10,000. To adjust the Allowance for Doubtful Accounts from £1,500 to £10,000, Steffen debits (increases) Bad Debt Expense and credits (increases) Allowance for Doubtful Accounts by £8,500 (£10,000 – £1,500).

• Aging Schedule for Accounts Receivable: To make more accurate estimates, companies often prepare an aging schedule for accounts receivable. This schedule categorizes outstanding receivables by the length of time they've been unpaid, using percentages based on past experience to estimate potential bad debt losses. The longer a receivable is past due , the less likely it is to be collected. So, the estimates % of uncollected debts increases as the number of days past due increases
• EX: Xi Electronics categorizes its receivables and applies increasing uncollectible percentages from 2% to 40% based on the number of days past due.
• Adjusting the Allowance Account: The adjusted balance in the allowance account reflects the expected uncollectible amount. To adjust this balance, a company considers the existing balance in the allowance account. If there's a debit balance due to write-offs exceeding previous estimates, the company includes this in the adjusting entry.

--> If the unadjusted balance in Allowance for Doubtful Accounts is £528, and the estimated uncollectibles are £2,228, an adjusting entry of £1,700 (£2,228 – £528) is necessary. This entry would increase Bad Debt Expense and Allowance for Doubtful Accounts.

Disposing of Accounts Receivable

When companies sell their account receivables to someone else in exchange for immediate cash.

There are two main reasons why companies do this:

• Need for Quick Cash: Sometimes, businesses need cash urgently, but they might not be able to borrow money easily from banks or other sources. So, they sell their accounts receivable to get immediate cash.
• Time and Cost Savings: Handling bills and collecting payments can be a time-consuming and expensive task. To make things simpler, companies often sell their receivables to experts in billing and collecting. For instance, retail stores might sell their owed money to companies specializing in collecting payments, like credit card companies such as MasterCard and Visa.

Sale of Receivables to a Factor

A common sale of receivables is a sale to a factor. A factor is a finance company or bank that buys receivables from businesses and then collects the payments directly from the customers.

Typically, the factor charges a commission to the company that is selling the receivables. This fee often ranges from 1–3% of the amount of receivables purchased.

Ex: If Keelung Jewelry sells NT$600,000 of receivables to Federal Factors and the service charge is 2%, the journal entry to record this sale on April 2, 2020, looks like this:

National credit card sales

Credit card sales involve three main parties:

• the credit card issuer
• the retailer
• the customer.

When a customer uses a credit card for a purchase:

The retailer considers the credit card sale as a cash sale. The retailer receives cash more quickly from the credit card issuer, which is advantageous.

The retailer pays a fee, typically between 2% to 4% of the invoice price, to the credit card issuer for its services. This fee is for processing the credit card transactions.

Ex: if a customer, Ling Lee, buys NT$6,000 of products from Wu Supplies using a Visa First Bank Card that charges a service fee of 3%, the entry by Wu Supplies to record this transaction on March 22, 2020, would look like this:

Note receivable.

A promissory note is a written promise where one party agrees to pay a specified amount of money to another party, either immediately upon demand or at a future date. It serves as a formal credit instrument used for lending, borrowing, or settling transactions.

These notes involve a maker (promisor) and a payee (recipient), specifying the amount owed, due date, and any applicable interest.

Notes receivable, like accounts receivable, offer a stronger legal claim and can be transferred to other parties. They're commonly used to extend payment periods or manage higher-risk transactions. Managing notes involves considerations such as maturity dates and interest calculation.

Determining the maturity date

Promissory notes have different due dates. If it says "On demand," payment happens whenever requested. When a specific date is mentioned, like "On July 23, 2020," payment is due on that day. Notes that say "One year from now" mature after a year.

For notes in months, count from the issue date. Ex: a three-month note from May 1 is due on August 1. If days are given, count the days from the issue date, excluding that day but including the due date. For instance, a 60-day note dated July 17 is due on September 15.

Computing interest

The interest rate mentioned in the note is usually an annual rate. The time factor in the formula represents the part of a year that the note remains unpaid. When the due date is in days, the time factor is often the number of days divided by 360. Remember, exclude the issue date but include the due date when counting days. If the due date is in months, the time factor is the number of months divided by 12.

Interest = Principal × Rate × Time

Recognizing notes receivables

To recognize a notes receivable, a company records the note at its face value, which is the amount stated on the note itself. When a note is received from another party, it's initially recorded without recognizing interest revenue. This is because revenue is recognized only when the performance obligation is fulfilled.

Ex: if Calhoun plc issues a £1,000, two-month, 12% promissory note to settle an open account with Wilma Ltd., Wilma makes the following entry upon receiving the note:

As time passes and the note remains outstanding, interest starts accruing. When the company collects the note along with interest earned, the entry would involve recognizing both the principal and the interest revenue:

When a company issues cash in exchange for a note, it records a debit to Notes Receivable and a credit to Cash for the amount of the loan.

Valuing notes receivable

Short-term notes receivable, like accounts receivable, are reported at their cash value. Companies set up an allowance, called Allowance for Doubtful Accounts, for potential losses. Estimating cash value and accounting for possible losses follow a similar approach to accounts receivable, involving estimations and recording bad debt expenses.

Disposing of notes receivables

Honor of notes

A note is honored when it’s maker pays in full at it’s maturity date. For each interest bearing note , the amount due at maturity date is the face value of the note + interest for the length of time specified on the note .

Dishonor of notes

A dishonored note is a note that’s not paid in full maturity. A dishonored receivable is no longer negotiation. However, the payee still has a claim against the maker of the note. If the noteholder.

1. Expects collection, he transfers the note receivable to accounts receivables. However, the payee still has a claim against the maker of the note.
2. Don’t expect collection, he would write-off the face value of the note by debiting the allowance for doubtful accounts. No interest revenue would be recorded, bcuz collection will not occur.

Chapter 9

Financial reporting concepts

Determining the Cost of Plant Assets

Companies must record their plant assets at their original cost, which covers all the necessary spending to buy and set up the asset for its intended use. For example, when purchasing factory machinery, this cost includes the buying price, shipping fees, and installation expenses. This initial cost serves as the foundation for accounting purposes throughout the asset's useful life.

Land

When companies acquire land, they consider various expenses in its cost calculation, such as the cash purchase price, closing costs, commissions, and accrued taxes or liens. Ex: if land is bought for NT$50,000 with an additional NT$5,000 for taxes, the total cost amounts to NT$55,000.

Land improvement

like driveways, parking lots, or landscaping, have limited lives and are recorded separately. Their costs are included in Land Improvements and depreciated over their useful life.

Buildings

Used as stores, offices, or warehouses, incur costs related to purchase or construction, including closing costs, remodeling, or repair expenses. Interest costs associated with building construction may also be added to the building's cost.

Ex: when Zhang Ltd. purchases factory machinery for HK$500,000, the total cost considering taxes, insurance, installation, and testing amounts to HK$545,000.

Equipement

when buying equipment like delivery trucks, companies consider various expenses like taxes, painting, or insurance. If a delivery truck is bought for HK$420,000 with additional expenses totaling HK$438,200 including taxes, painting, and a three-year insurance policy, the company records this purchase by debiting the Equipment account.

Expenditures During Useful Life

The cost associated with maintaining the operational efficiency and extending the life of plant assets can be classified into two types:

1. Ordinary Repairs (revenue expenditures):
   • These are small, frequent costs (like regular maintenance, painting, minor fixes) to keep the assets in good shape and running smoothly.
   • Companies treat these costs as immediate expenses (they're debited to "Maintenance and Repairs Expense"). They're considered as day-to-day costs that reduce the income earned in the same period.
2. Additions and Improvements (capital expenditures):
   • These are larger, less frequent expenses (like significant upgrades, major renovations) that enhance the asset's value, efficiency, or lifespan.
   • Companies add these costs to the asset's value (they're debited to the related asset account), considering them as long-term investments. This increases the asset's worth on the balance sheet and is gradually deducted over time through depreciation.

Depreciation

Depreciaton :

Depreciation is about spreading out the cost of a plant asset over its useful life in a logical and systematic way.

It's not about determining the asset's current value; instead, it's a way to match the cost of the asset with the revenue it generates over time.

Depreciation is used for assets like land improvements, buildings, and equipment, not for land itself because land usually doesn't wear out or lose its value due to use.

Reasons for Depreciation:

• Depreciation happens because assets lose their usefulness or become outdated.

EX: a delivery truck becomes less valuable after extensive use, and technology advancements can make computers outdated sooner than expected.

• But remember, accounting for depreciation doesn't set aside cash for a new asset. It's about recognizing the asset's gradual wear and tear or technological obsolescence over time. (Not a cash expense)

When a business assumes it will continue operating into the future ("going concern assumption"), it expects its assets to gradually lose value over time due to wear and tear or becoming outdated. Depreciation is the method used to account for this decline in value.

But if a business doesn't expect to continue its operations for a long time or faces significant uncertainty about its future, it might need to value its assets differently. In such cases, the company might have to report its plant assets at their current market value rather than using depreciation to allocate the asset's cost over time.

Factors in Computing Depreciation

1. Cost: This is what the company initially pays for the asset. It's recorded as the asset's historical cost and follows the principle that assets should be recorded at the amount paid to acquire them.
2. Useful life: This is an estimate of how long the asset will be useful to the company. It can be measured in years, units of activity (like hours of use), or units of output (products made). The company considers how long they expect to use the asset based on its purpose, maintenance needs, and potential for becoming outdated.
3. Residual value: This is an estimate of the asset's value at the end of its useful life. It could be the amount the company expects to get from selling the asset at that point, whether as scrap or through trade-in. Similar to useful life, this is an estimation based on the company's disposal plans and experience with similar assets.

Depreciation Methods

Companies choose the method that best matches how the asset contributes to revenue over its useful life. Once chosen, they use that method consistently to ensure financial statement comparability. Depreciation affects both the balance sheet (through accumulated depreciation) and the income statement (through depreciation expense).

1. Straight-line
2. Units-of-activity
3. Declining-balance

The depreciable cost of an asset represents the total amount that will be depreciated over its useful life. (Cost of asset – residual value)

1. Straight-line method

The straight-line depreciation method allocates the same amount of depreciation expense evenly over each year of an asset's useful life.

Example

If a delivery truck was bought by Barb's Florists for €13,000 on January 1, 2020, with a residual value of €1,000 and an estimated useful life of 5 years, the depreciable cost would be €12,000 (€13,000 - €1,000). Thus, the annual depreciation expense would be €2,400 (€12,000 ÷ 5 years).

If the asset was purchased on a date other than January 1 (like April 1), you'd need to prorate the first year's depreciation based on the time it was owned during that year.

Ex: if Barb's Florists purchased the truck on April 1, 2020, the depreciation for that year would be €1,800 (€12,000 × 20% × 9/12 of a year).

1. Units of activity

The Units-of-Activity method, also known as the units-of-production method, calculates depreciation based on the total units of production or usage expected from the asset over its useful life. It's applicable to assets whose depreciation is more related to usage than time, such as factory machinery, delivery equipment (miles driven), or airplanes (hours in use).

To apply this method, companies estimate the total units of activity the asset will generate throughout its life and then divide this into the depreciable cost to find the cost per unit. The cost per unit is then multiplied by the actual units of activity during the year to determine the annual depreciation expense.

EX: in the case of Barb’s Florists, if the delivery truck was expected to last 100,000 miles and had a depreciable cost of €12,000, the cost per mile would be €0.12 (€12,000 ÷ 100,000 miles). If the truck was driven 15,000 miles in the first year, the depreciation expense would be €1,800 (€0.12 × 15,000 miles).

1. Declining-balance

The Declining-Balance method, also known as the double-declining-balance method, calculates annual depreciation by applying a constant depreciation rate to the book value of the asset at the start of each year. This method produces higher depreciation expenses in the earlier years of an asset's life and gradually decreases them over time.

*book value : It represents the amount of value the asset still holds on the company's financial records. (Original Cost of the Asset−Accumulated Depreciation)

It allows for accelerated depreciation, reflecting the higher benefit derived from the asset in its earlier years, especially for assets that rapidly lose their usefulness due to obsolescence.

When an asset is purchased during the year, the first year's depreciation is prorated based on the time the asset was owned during that year. For instance, if the truck was purchased on April 1, 2020, the depreciation for 2020 would be calculated for nine months (from April to December).

The declining-balance method is considered suitable for assets expected to be significantly more productive in the initial years of their useful life. It aligns with the expense recognition principle by matching higher depreciation expense with higher benefits received from the asset in the earlier years.

Example :

Component Depreciation

Component depreciation involves splitting the cost of different parts of an asset, acknowledging that some parts wear out faster than others. It's used when an asset has distinct components with separate lifespans and depreciation rates. This method ensures each part gets its own depreciation treatment based on its unique useful life.

Example

The total cost of the building is HK$4,000,000. However, it consists of distinct components: an HVAC system costing HK$320,000 and flooring costing HK$600,000. These components have different useful lives, with the HVAC system having a life of 5 years and the flooring having a life of 10 years.

Using component depreciation, Lexure separates the costs of these components and depreciates them based on their respective useful lives.

• Building cost adjusted: HK$4,000,000 - HK$320,000 (HVAC) - HK$600,000 (Flooring) = HK$3,080,000
• Building cost depreciation per year: HK$3,080,000 ÷ 40 years (total useful life) = HK$77,000 per year
• HVAC system depreciation: HK$320,000 ÷ 5 years (useful life) = HK$64,000 for the first year
• Flooring depreciation: HK$600,000 ÷ 10 years (useful life) = HK$60,000 for the first year
• Total component depreciation in the first year: HK$77,000 (Building) + HK$64,000 (HVAC) + HK$60,000 (Flooring) = HK$201,000

Depreciation and Income Taxes

Companies use different methods to calculate depreciation for their financial statements and tax returns. For financial reporting, they might choose a method like straight-line depreciation to evenly spread out costs over time. But for taxes, they might use accelerated methods to deduct more depreciation early, lowering taxable income and reducing taxes owed in the short term.

Revaluation of Plant Assets

• Gains: If the market value of an asset increases compared to its recorded value, the company records a gain. For instance, if equipment bought for $1,000,000 is now valued at $1,100,000, there's a $100,000 gain. To reflect this, the company adjusts the asset's value upwards, eliminates any accumulated depreciation, and records the gain under the "revaluation surplus" in the balance sheet's comprehensive income section.
• Losses: Conversely, if the market value decreases below the recorded value, a loss occurs. For example, if the equipment drops in value to $900,000, there's a $100,000 loss. To account for this, the company reduces the asset's value, recognizing the loss directly in the income statement.

Plant Asset disposals

Plant asset disposals occur when a company gets rid of assets that are no longer useful. There are three ways a company can dispose of such assets:

1. Retirement: Assets are scrapped or discarded.
2. Sale: Assets are sold to another party.
3. Exchange: Existing assets are traded for new ones.

when a company gets rid of an asset, it takes out all the related amounts it had recorded, like the original cost and the accumulated depreciation. To see if there's a gain or loss from the disposal, the company calculates the book value of the asset at the disposal date (which is the cost minus accumulated depreciation).

If the disposal doesn't happen at the beginning of the year, the company records the depreciation for the part of the year leading up to the disposal date.

Accounting for plant asset disposals involves reducing both the accumulated depreciation and the asset account to remove the book value.

Retirement of Plant Assets

When a company decides to retire a fully depreciated plant asset, it means the asset has reached the end of its useful life and has been completely written off from the company's accounting records. Here's a simplified breakdown:

1. Retirement of Fully Depreciated Asset: When an asset is fully depreciated, it means its book value (original cost minus accumulated depreciation) is reduced to zero. At this point, the company eliminates both the asset and its accumulated depreciation from its financial statements.

Ex: If a printer originally cost €32,000 and accumulated depreciation reached €32,000, making the printer fully depreciated, the company will remove it from the books with an accounting entry that clears both the asset and its accumulated depreciation.

1. Useful Asset but Fully Depreciated: If an asset is still useful to the company but has reached full depreciation, it remains on the financial statements without any further depreciation adjustments. The company indicates that the asset is still in use even though no additional depreciation is taken.

Ex : Let's assume Sunset Shipping retires delivery equipment that originally cost €18,000 and has accumulated depreciation of €14,000, resulting in a loss on disposal.

1. Retiring an Asset Before Full Depreciation: If the company decides to retire an asset before it's fully depreciated, and no cash is received in return (for example, if the asset is discarded or no longer useful), a loss on disposal occurs. This loss is recorded by removing both the asset and its accumulated depreciation from the books, resulting in a loss reported in the income statement's "Other income and expense" section.

Sale of Plant Assets

When a company sells a plant asset, it compares the asset's book value (its cost minus accumulated depreciation) with the proceeds received from the sale.

• If the proceeds from the sale are higher than the book value, it results in a gain on disposal.
• If the proceeds are lower than the book value, it results in a loss on disposal.

Ex : if the company sells an asset for more than its book value, it records a gain; if it sells it for less, it records a loss. These gains or losses are common since rarely the book value matches the actual sale value.

Gain on Sale:When the proceeds exceed the book value, it creates a gain.

Ex : if an office furniture initially cost €60,000, had accumulated depreciation of €49,000, and is sold for €16,000, resulting in a gain of €5,000, the company records this gain:

Loss on Sale: When the proceeds are less than the book value, it results in a loss. For example, if the office furniture book value was €11.000 and was sold for €9,000, resulting in a loss of €2,000, the company records this loss:

Natural Resources and Depletion

Depletion of Natural Resources:

Depletion is the process of allocating the cost of natural resources over their useful life, similar to how depreciation works for plant assets.

Companies often use the units-of-activity method to calculate depletion because it's based on the units of the resource extracted during the year.

Ex: if Lane Coal invests HK$50 million in a coal mine estimated to contain 10 million tons of coal with no remaining value at the end, the depletion cost per ton is HK$5.

= HK$5.00 per ton

= Depeletion cost per unit

Ex : If Lane extracts 250,000 tons of coal in the first year, the total depletion cost for the year is HK$1,250,000 (250,000 tons x HK$5). To account for this, Lane reduces the coal inventory value by crediting the Accumulated Depletion account.

Intangible Assets

Intangible assets are non-physical assets with long-term value, such as patents, copyrights, trademarks, and franchises, providing competitive advantages or rights.`

Accounting for Intangible Assets:

1. Recording Intangible Assets: Intangible assets are initially recorded at cost, comprising all expenditures necessary to acquire the asset. They are classified with either limited or indefinite lives.
2. Amortization: For intangibles with a limited life, the cost is allocated over their useful life using the amortization process, similar to depreciation for tangible assets. Companies debit Amortization Expense and credit the specific intangible asset.
3. Patents: Exclusive rights granted for inventions, amortized over their legal or useful life, whichever is shorter. Legal costs defending the patent's validity are added to the patent's cost.
4. Copyrights: Provide exclusive rights to reproduce artistic or published work, amortized over a relatively shorter period than their legal life.
5. Trademarks & Trade Names: Symbols identifying products or enterprises. Purchased trademarks are recorded at their purchase price, while self-developed trademarks' costs are expensed as incurred. They usually have indefinite lives and are not amortized.
6. Franchises & Licenses: Contracts granting rights to use certain trademarks or perform specific services, with amortization for limited-life ones. Indefinite-life ones are not amortized.
7. Goodwill: Represents a company's favorable attributes not tied to any specific asset. Recorded when purchasing an entire business as the excess of cost over acquired net assets' fair value. Goodwill is not amortized but must be written down if permanently impaired.

These intangible assets are reported in the statement of financial position under intangible assets

Chapter 10

What Is a Current Liability?

a current liability : a debt that a company expects to pay within one year or the operating cycle, whichever is longer.

• Debts that do not meet this criterion are non-current liabilities.

Current liabilities help assess a company's short-term liquidity. When current liabilities exceed current assets, it might indicate potential liquidity issues.

The types and amounts of liabilities play a crucial role if a company declares bankruptcy, determining the priority of payments to creditors.

These liabilities are reported on the balance sheet under the "Current Liabilities" section and are expected to be settled within the next operating cycle or within one year, whichever is longer.

Notes Payable

Notes payable serve as a formal written acknowledgment of a debt owed by a company to a creditor, typically outlining the principal amount borrowed, the repayment terms, and any interest obligations.

• They’re reported on the balance sheet under current liabilities if they are due for payment within one year and under long-term liabilities if the repayment is more than one-year period.

Example:

In the December 31 financial statements, the current liabilities section of the statement of financial position will show notes payable ¥100,000 and interest payable ¥4,000. In addition, the company will report interest expense of ¥4,000 under “Other income and expense” in the income statement. If Yang prepared financial statements monthly, the adjusting entry at the end of each month would be for ¥1,000 (¥100,000 × 12% × 1/12). At maturity (January 1, 2021), Yang must pay the face value of the note (¥100,000) plus ¥4,000 interest (¥100,000 × 12% × 4/12). It records payment of the note and accrued interest as follows

Initial Issuance of the Note (September 1, 2020):

• Yang receives ¥100,000 cash and issues a ¥100,000, 12%, four-month note to First Hunan Bank. This entry records the initial issuance of the note.

Accrual of Interest Expense (December 31, 2020)

• As of December 31, Yang adjusts its records to recognize interest expense of ¥4,000 for the four months (¥100,000 × 12% × 4/12) and records a liability for the accrued interest payable.

Payment at Maturity (January 1, 2021):

• On the maturity date (January 1, 2021), Yang settles the note by paying the face value of the note (¥100,000) plus the accrued interest of ¥4,000 (¥100,000 × 12% × 4/12) to First Hunan Bank.

Value-Added and Sales Taxes Payable

Consumption taxes are generally either a value-added tax (VAT) or sales tax. The purpose of these taxes is to generate revenue for the government similar to the company or personal income tax. These two taxes accomplish the same objective–– to tax the final consumer of the good or service. However, the two systems use different methods to accomplish this objective.

Value-added taxes payable

Value-Added Taxes (VAT) and sales taxes both impact the final buyer, yet they’re collect differently. VAT is collected at multiple stages of production and sale, This tax gets added whenever value is increased during production and when the item is sold. While a sales tax is collected only at the consumer's purchase point. VAT involves businesses in the supply chain collecting tax when buying from one another, distinguishing it from a sales tax that's collected solely at the consumer's purchase.

Ex: Hill Farms Wheat grows wheat and sells it to Sunshine Baking for €1,000. Hill Farms Wheat makes the following entry to record the sale, assuming the VAT is 10%.

Sales taxes payables

Ex : Cooley Grocery sells loaves of bread totaling €800 on a given day. Assuming a sales tax rate of 6%, Cooley make the following entry record the sale.

Remittance of Sales Taxes to Taxing Agency:

When Cooley Grocery remits the collected taxes to the government:

• The company debits Sales Taxes Payable and credits Cash when forwarding the collected sales taxes to the government. Cooley Grocery acts as a collection agent, transferring the sales tax amount paid by customers to the taxing authority.

Determining Sales Amounts When Sales Tax Not Separately Entered:

If sales taxes aren't separately recorded in the cash register, the sales amount can be determined using the total receipts and the sales tax rate. For example

• Ex ; If total receipts were €10,600 and the sales tax rate was 6%:
  • Divide total receipts by (1 + sales tax rate) to find the sales amount: €10,600 ÷ 1.06 = €10,000.
  • Sales tax amount can be found by subtracting sales from total receipts (€10,600 - €10,000 = €600) or multiplying sales by the sales tax rate (€10,000 × 0.06 = €600).

This process helps to compute sales amounts when sales taxes are not separately identified in the receipts or transactions

Salaries and Wages

Companies report as current liabilities

Salaries or Wages Owed: Money owed to employees for work done but not paid yet.

2 types

1. Payroll Deductions: Amounts held from pay for taxes, insurance, etc.
2. Accrued Bonuses: Promised bonuses earned but not yet paid to employees.

Payroll deductions

The most common types of payroll deductions are taxes, insurance premiums, employee savings, and union dues.

• Social Security Taxes: Both the employer and employee contribute to Social Security taxes, which are withheld from employee pay. Employers report these unremitted taxes as a current liability.
• Income Tax Withholding: Employers withhold income taxes from employees' wages based on government formulas. The withheld amount is a current liability until paid to tax authorities.

Example: If Cumberland Company has a weekly payroll of $10,000, deductions for income taxes ($1,320), Social Security taxes ($800), and union dues ($88) are recorded as liabilities.

Employee’s side .

Recording payment :

Employers’s side

Profit-Sharing and Bonus Plans: Companies can offer bonuses to employees, which are accrued as liabilities until paid.

Ex: Company will a company will record a bonous of $10,700 as a liability in Dec 3& 2020 and pay it in Jan 2021

In jan 2021 when they pay the bonus

Current Maturities of Long-Term Debt

Companies sometimes have a part of their long-term debt that becomes due in the current year. This portion is labeled as a "current maturity of long-term debt," considered a current liability.`

EX: Wendy Construction issuing a €25,000, five-year, interest-bearing note on January 1, 2020, with €5,000 due annually starting from January 1, 2021. When Wendy prepares financial statements on December 31, 2020:

• €5,000 of the note, due within the next 12 months, is classified as a current liability.
• The remaining €20,000 is treated as a non-current liability.

Companies typically list the current maturities of long-term debt on their financial statements, specifically as long-term debt due within one year.

No adjusting entry is required to recognize the current maturity of long-term debt. At the statement of financial position date, all obligations due within one year are classified as current, while others remain non-current.Reporting Uncertainty

Provisions: an estimated liability with uncertain timing or amount they can be current or non-current, depending on the date of expected payment

Example

• Litigation Provision: Setting aside funds for a potential lawsuit settlement.
• Warranty Provision: Reserving money for potential future warranty claims on products sold.
• Environmental Provision: Allocating funds for potential costs related to environmental damage cleanup.

Recognition of a Provision

Companies accrue an expense and related liability for a provision only if the following three conditions are met:

1. A company has a present obligation as a result of a past event;
2. It is probable that an outflow of resources will be required to settle the obligation; and
3. A reliable estimate can be made of the amount of the obligation.

Reporting provision

Product warranties are an example of a provision and the accounting for warranty costs is based on the expense recognition principle (should be recognized as an expense in the period in which the sale occur).

Ex : a manufacturer sells 10,000 washers at a price of $600, with a one-year warranty. They expect 500 units defective with repair costs of $80. In 2020 they honor warranty contracts on 300 units, at total cost of $24,000

To account for the estimated remaining warranty liability, Denson computes it as €16,000.

They make an adjusting entry:

Reporting of Current Liabilities

Current liabilities are listed after non-current liabilities on the statement of financial position

Analysis of Current Liabilities

Current and non-current classifications allow for liquidity analysis, evaluating the ability to meet financial obligations and unexpected cash needs.

Working Capital: It represents the surplus of current assets over current liabilities. While it offers a figure, this alone might not provide sufficient insight. For instance, the same amount might be suitable for one company but insufficient for another.

Current assets – Current liabilities = Working Capital

Current Ratio: This ratio is computed by dividing current assets by current liabilities. It enables comparisons across companies and over time. Traditionally, a ratio of 2:1 was deemed ideal, but modern companies often maintain healthy operations with ratios below this mark. Ex: croix Beverages' ratio of 1.29:1 is considered acceptable but falls short of the traditional 2:1 standard.

Current assets Current liabilities = Current ratio

Chapter 12

• 1. The Corporate Form of Organization

Corporation : is a legal entity created by law, separate from its owners, often called shareholders. It's like an "artificial person" with many rights and responsibilities, similar to an individual, but with some exceptions, such as the right to vote or hold public office.

🡪 Corporations exist according to the laws of the region where they are established.

Classifications:

• Purpose: Can be for-profit (aiming to make money) or not-for-profit (charitable, educational).
• Ownership: Publicly held (shares traded publicly, traded on exchanges like stock market) or privately held (shares not traded publicly, fewer shareholders, shares not publicly available).

Characteristics of a Corporation

1. Separate Legal Existence: A corporation is like a separate person in the eyes of the law. It can do things on its own, such as owning things, borrowing money, making agreements, and paying taxes, separately from the shareholders.
2. Limited Liability of Shareholders: Shareholders are generally only liable for the amount they've invested in the corporation. Personal assets aren't typically at risk, except in cases of fraud.
3. Transferable Ownership Rights: Ownership in the corporation is represented by shares, which are easily transferable among shareholders without affecting the corporation's operations.
4. Ability to Acquire Capital: Corporations can easily raise capital by offering shares to investors in return for funding.
5. Continuous Life: The corporation's existence isn't affected by changes in ownership or deaths of shareholders; its life is determined by its charter or can be perpetual.
6. Corporation Management: Shareholders elect a board of directors, who oversee corporate policies, while officers (e.g., CEO, CFO) manage day-to-day operations.

Advantages:

• Separate existence, limited liability, transferable ownership, access to capital, continuous existence, professional management.

Disadvantages:

• Separation of ownership from management, government regulations, additional taxation.

Forming a Corporation

To form a corporation, you apply to the government, stating details like the company's name, shares, and purpose. Choosing a location with favorable laws is important. Once approved, the government grants a charter. The corporation then sets up internal rules (by-laws) for its operations. If the corporation operates outside its jurisdiction, it needs additional licenses in those places.

The costs involved in setting up a corporation, like legal fees and promotional expenses, are called organization costs. These costs are usually expensed immediately due to the difficulty in estimating future benefits.

Shareholder Rights

Shareholders holding ordinary shares possess certain privileges, including:

1. Voting rights in board elections and important shareholder decisions.
2. Entitlement to corporate dividends, a portion of the company's earnings.
3. Pre-emptive right to maintain their ownership percentage when new shares are issued.
4. Claim on company assets during liquidation proportional to their shareholding, known as a residual claim.

Shareholders receive a share certificate, representing their ownership, with details such as the corporation's name, shareholder's name, share class, quantity owned, and authorized signatures. These certificates provide proof of ownership and may be issued in any quantity.

Share Issue Considerations

Authorized shares

The number of authorized shares in a corporation represents the total quantity of shares that the company is allowed to issue or sell, as specified in its charter.

🡪 This authorization typically covers both initial and future needs for raising capital.

When a corporation authorizes shares, it doesn't need a formal accounting entry because it doesn't immediately impact the company's assets or equity. However, the number of authorized shares is often disclosed in the equity section of financial statements. `

The formula to determine the number of unissued shares available for future issuance in a corporation is:

Nbr of Unissued Shares = Total Authorized Shares - Total Shares Issued

EX : If a company is initially authorized to sell 100,000 shares and has already issued 80,000 shares to investors, the calculation for unissued shares would be:

Number of Unissued Shares = 100,000 - 80,000 = 20,000 shares

Issuance shares

When a corporation issues shares, it can directly sell them to investors or do so indirectly through an investment banking firm. Direct issuance is common in smaller companies, while bigger ones often use indirect issuance.

In indirect issuance, an investment bank may underwrite the entire share issue by buying shares from the corporation and reselling them to investors. This helps the corporation avoid unsold shares and immediately access the received cash. The bank charges a fee for this service.

Setting the price for new shares involves multiple considerations, including future earnings expectations, anticipated dividend rates, current financial standing, economic conditions, and the state of the securities market.

Market price shares

The market price of shares for publicly held companies is determined by the interactions between buyers and sellers on organized exchanges. This price is influenced by a company's earnings, dividends, and other market conditions. However, external factors like geopolitical events or economic changes can also lead to daily fluctuations in share prices.

When shares are traded on exchanges, existing shareholders sell their shares to new investors. However, these transactions of already issued shares don’t directly impact a company's financial standing.

Par and No-par value shares

Par value shares are ordinary shares that have a fixed value per share set in the corporate charter. They used to be important in determining a company's legal capital per share, protecting creditors. But over time, their importance faded as their value often didn't match the actual market price.

Meanwhile, no-par value shares have no specified value in the charter. Instead, some countries let the board of directors assign a stated value to these shares. Companies like Nike and Anheuser-Busch InBev have opted for no-par shares.

Corporate Capital

Corporate capital, often referred to as shareholders' equity or stockholders' equity, represents the residual interest in a corporation's assets after deducting its liabilities. It’s made up of 2 parts:

1. Share Capital: This refers to the total amount of cash or other assets that shareholders invented in the company in exchange for shares. Represents the initial investment made by shareholders.
2. Retained Earnings: Retained earnings consist of the accumulated profits earned by the corporation over time that have not been distributed to shareholders as dividends. It reflects the net income retained in the business for future use or reinvestment in company operations.

Examples

Issuing Shares for Cash: Suppose a corporation, XYZ Inc., issues 10,000 ordinary shares at $5 per share, receiving the full payment in cash.

Recording Net Income in Retained Earnings: Suppose Delta Robotics reports a net income of HK$1,300,000 at the end of its first year of operations.

Closing entry for net income :

Calculating Equity: At the end of its first year, Doral AG has €750,000 of ordinary shares and net income of €122,000. Prepare the closing entry for net income and the equity section at year-end

Closing Entry for Net Income:

Equity section :

2. Accounting for Share Transactions

Accounting for Ordinary Shares

Issuing Par Value Ordinary Shares for Cash

When a company issues par value ordinary shares for cash, the proceeds may be equal to, greater than, or less than the par value. The accounting entry for such transactions involves crediting the par value to Share Capital—Ordinary and recording any excess or shortfall separately.

Example 1: Issuing Shares at Par Value

Scenario: Hydro-Slide SA issues 1,000 shares of €1 par value ordinary shares at par for cash.

Example 2: Issuing Shares Above Par Value

Scenario: Hydro-Slide issues an additional 1,000 shares of €1 par value ordinary shares for cash at €5 per share, with €4 above the par value.

Total Capital and Equity Section

Assuming a total capital of €6,000 and a legal capital of €2,000 and considering retained earnings of €27,000, the equity section would be represented as shown in Illustration 12.7.

Equity Section:

Issuing No-Par Ordinary Shares for Cash

When dealing with no-par ordinary shares having a stated value, the accounting treatment parallels that for par value shares. The corporation credits the stated value to Share Capital—Ordinary. Any amount above this stated value is credited to Share Premium—Ordinary.

Example: No-Par Shares with Stated Value

Scenario: Hydro-Slide SA has €5 stated value no-par shares and issues 5,000 shares at €8 per share for cash.

Now, what if no-par shares lack a stated value? In such cases, the corporation credits the entire proceeds to Share Capital—Ordinary.

Ex: if Hydro-Slide does not assign a stated value to its no-par shares and issues 5,000 shares at €8 per share for cash:

Issuing Ordinary Shares for Services or Non-Cash Assets

When corporations issue shares for services or non-cash assets, determining the cost for such exchanges adheres to the historical cost principle. In a non-cash transaction, cost is the cash equivalent price, which is either the fair value of the consideration given up or the fair value of the consideration received, whichever is more determinable.

Shares Issued for Services: Jordan Company incorporates with assistance from attorneys who bill €5,000. They agree to receive 4,000 shares of €1 par value ordinary shares as payment.

Shares Issued for Land : Athletic Research AG, a publicly held corporation, issues 10,000 shares valued at €8 per share to buy land valued at €90,000.

This entry records the issuance of 10,000 €5 par value shares for land. Although the par value is €5, the cost is based on the most clearly evident value in this non-cash transaction, which is the market price of the consideration given, amounting to €80,000.

Accounting for Preference Shares

To attract a broader range of investors, corporations often introduce another class of shares known as preference shares. These shares come with specific contractual provisions that provide them with certain priority rights over ordinary shares. Typically, preference shares have priority in receiving dividends and claiming assets in case of liquidation, but they usually do not possess voting rights.

Issuing Preference Shares : Corporations can issue preference shares either for cash or non-cash assets. The accounting entries for these transactions resemble those for ordinary shares. When a corporation has multiple classes of shares, each capital account title should specify the shares it represents.

Example Entry: Florence SpA issues 10,000 €10 par value preference shares at €12 cash per share.

• Structure in Financial Statements : Preference shares, whether with a par value or no-par value, are listed first in the equity section of the statement of financial position.

Accounting for Treasury Shares

Treasury shares are a corporation's own shares that it previously issued and has now rebought but not retired. Corporations may buy back treasury shares for many reasons:

1. Reissuing Shares: To redistribute to officers and employees under bonus or share compensation plans.
2. Market Perception: To signal to the market that the shares are undervalued, potentially enhancing market price.
3. Acquisition Use: To have available shares for acquiring other companies.
4. Earnings per Share (EPS): To decrease the number of outstanding shares, potentially boosting EPS.
5. Eliminating Hostile Shareholders: To buy out or reduce the influence of hostile shareholders.

Purchase of Treasury Shares

Companies usually account for treasury shares using the cost method. Under this method, the cost of repurchasing the shares becomes the value at which the treasury shares are recorded. When companies sell treasury shares, they debit the treasury shares account for the cost of the shares and adjust Share Premium—Treasury for any difference between the cost and the selling price.

EX : Assuming Mead Ltd. acquires 4,000 of its own shares at HK$80 per share

Disposable of treasury shares : Treasury shares are usually sold or retired. The accounting for their sale differs when treasury shares are sold above cost than when they are sold below cost.

Example Entries

Sale of Treasury Shares Above Cost: Assuming Mead Ltd. sells 1,000 of the 4,000 treasury shares acquired previously at HK$100 per share:

Sale of Treasury Shares Below Cost: Assuming Mead Ltd. sells an additional 800 treasury shares at HK$70 per share:

Final Sale of Remaining Treasury Shares Below Cost:Assuming Mead Ltd. sells the remaining 2,200 shares at HK$70 per share:

1. Dividends and Splits

Accounting for Cash Dividends

When a company declares a cash dividend, it involves accounting entries that reflect the distribution of cash to its shareholders.

1. Retained Earnings and Legal Requirements:
   • Dividends must be paid out of the company's retained earnings. Laws in different jurisdictions specify the legality of cash dividends.
   • Distributing dividends from the share capital or share premium might be illegal, referred to as a liquidating dividend, as it reduces the original amount paid by shareholders.
2. Cash Availability:
   • Adequate cash reserves are essential to pay dividends. A company should evaluate both current financial obligations and future capital needs before declaring dividends.
3. Board Declaration:
   • Dividends are not automatically paid; they are declared by the company's board of directors. The board determines the amount to distribute as dividends and the amount to retain for the business.
4. Considerations for Management:
   • The amount and timing of dividends are crucial decisions. Large cash dividends might impact the company's liquidity, while small or missed dividends can affect shareholder satisfaction.
   • Some companies pay dividends periodically, often quarterly, meeting shareholder expectations. Others, particularly high-growth companies, might opt to retain earnings for future investments rather than distributing dividends.

Entries for Cash Dividends

Three dates are important in connection with dividends:

• the declaration date,
• the record date,
• the payment date.

Normally, there are two to four weeks between each date. Companies make accounting entries on the declaration date and the payment date.

1. Declaration Date:
   • The board of directors officially declares and announces the cash dividend to shareholders.
   • It legally obligates the company to pay the dividend.
   • Accounting Entry: The company records the increase in Cash Dividends and adds to the liability account called Dividends Payable.
2. Record Date:
   • This date is used by the company to identify shareholders eligible to receive the declared dividend.
   • No accounting entry is made on this date. It's about determining who gets the dividend.
3. Payment Date:
   • The company actually pays the declared dividend to shareholders of record.
   • Accounting Entry: The company reduces the liability in the Dividends Payable account and decreases its cash by paying out the dividend to shareholders.

Example

Declaration Date (December 1, 2020): The board of directors authorizes and publicly announces the cash dividend.

Journal Entry: Recognizing the obligation to pay dividends:

Record Date (December 22, 2020): No journal entry is made on this date. It's meant for the company to identify shareholders eligible to receive the dividend.

Payment Date (January 20, 2021):The company distributes cash dividends to shareholders.

Journal Entry: Recording actual payment of the dividend:

Closing Entry at Year-End: At the end of the accounting year, any remaining balance in the Cash Dividends account is closed to Retained Earnings.

Closing Entry: Transferring Cash Dividends to Retained Earnings:

Dividend Preferences

Preference shareholders have priority over ordinary shareholders in receiving dividends. If preference shares have a set dividend rate, ordinary shareholders can’t get dividends until preference shareholders receive that amount. Dividend payments rely on factors like the company's earnings and available cash. If a company doesn't pay preference shareholders, it can't pay ordinary shareholders either.

Preference shares typically state dividends as a percentage of the share value or a fixed amount. These shares often hold priority in getting assets if the company fails.

Cumulative dividends

Preference shares often have a cumulative dividend feature, meaning preference shareholders must receive both current and past unpaid dividends before ordinary shareholders get any dividends. Unpaid dividends are termed "dividends in arrears."

Companies can't pay ordinary shareholders if there are unpaid preference dividends. Though not a liability until formally declared, companies should disclose dividends in arrears in financial statements. Failing to meet dividend obligations, especially cumulative preference dividends, is viewed negatively by investors. Companies must prioritize paying these dividends before distributing to ordinary shareholders.

Ex: At December 31, 2019, IBR Industries possesses 1,000 shares of 8% cumulative preference shares with a par value of €100 each, along with 50,000 shares of €10 par value ordinary shares outstanding. The dividend per share for preference shares is €8 (€100 par value × 8%). The directors of IBR Industries declare a €6,000 cash dividend on December 31, 2019.

At December 31, 2019 - Declaration of a €6,000 cash dividend:

🡪 The entire €6,000 dividend amount goes to preference shareholders due to their dividend preference.

At December 31, 2020 - Declaration of a €50,000 cash dividend and allocation to preference and ordinary shares:

🡪 The allocation of the dividend is €10,000 to preference shares and €40,000 to ordinary shares based on the dividend preferences.

Accounting for Share Dividends

A share dividend is when a company distributes its own shares to shareholders instead of cash.

🡪 When a shareholder receives more shares due to a dividend, their ownership percentage remains the same despite having more shares.

Purpose: Used to meet dividend expectations without using cash, make shares more accessible to small investors by reducing the market price, and show reinvestment of equity in the company.

Accounting treatment: When companies issue small share dividends (less than 20-25% of all shares), they often set the value of each share based on the current market price. This assumes small dividends won't affect existing share prices much. For larger dividends (more than 20-25% of shares), the value is usually set at the par or stated value per share.

Entries for share dividends

The company, Danshui Ltd., declared a 10% share dividend on its 50,000 shares of NT$100 par value. The fair value of its shares is NT$150 each. To record the declaration of the share dividend:

Declaration of dividend shares :

Issuance of Dividend Shares:

Effects of share dividends

Share dividends impact equity by redistributing retained earnings to share capital and share premium. Although the makeup of equity changes, the total equity remains constant. Share dividends don't alter the par or stated value per share but result in an increase in the number of outstanding shares.

the combination of share capital—ordinary and share premium—ordinary rises by NT$750,000 (calculated as 50,000 shares × 10% × NT$150), while retained earnings decreases by an equivalent amount. Total equity remains constant at NT$8,000,000. The number of shares grows by 5,000 (10% of 50,000).

Accounting for Share Splits

A share split increases the number of shares for each shareholder in proportion to their existing ownership, while reducing the par or stated value per share. This action aims to enhance share marketability by lowering the share price. Despite the increase in shares and decrease in par value, a share split doesn't impact share capital, share premium, retained earnings, or total equity.`

🡪 Unlike a share dividend, which redistributes a portion of retained earnings to share capital, a share split doesn't alter any equity balances and doesn't require journal entries.

Ex: in a 2-for-1 split, one $10 par value share becomes two $5 par value shares. Although the number of shares outstanding grows and par value per share drops, equity balances remain unaffected.

1. Reporting and Analyzing Equity

Retained Earnings

Retained earnings symbolize a company's accumulated profits kept for business use, not tied to specific assets. It doesn't directly equate to available cash. The balance changes with profits added or losses subtracted. If losses exceed profits over time, it creates a deficit in retained earnings.

This balance is often used for paying dividends to shareholders, unless there are restrictions, such as obligations from debt agreements. These limitations might prevent a portion of retained earnings from immediate dividend pay-outs.

A retained earnings statement summarizes these changes over time, indicating the beginning balance, profits added, dividends subtracted, and the final balance for a specific period.

When a company experiences a net income, it closes it by debiting Income Summary and crediting Retained Earnings. It’s the same thing, if a company has a net loss, it closes it by debiting Retained Earnings and crediting Income Summary.

Ex: If Chen Company records a net loss of HK$400,000 in 2020, the closing entry is:

Presentation of Statement of Financial Position

Reserves”: forms of equity other than that contributed by shareholders; includes retained earnings → used to report the equity impact of comprehensive income items (Revaluation Surplus, results from the revaluation of property, plant and equipment

Statement of Changes in equity : shows changes in (1) each equity account and (2) in total that occurred during the year

Analysis

The return on ordinary shareholders' equity measures how much profit a company generates per euro invested by ordinary shareholders.

Return on Ordinary Shareholders’ Equit y=

Ex : Carrefour's ordinary shareholders' equity started the year at €8,047 million and ended at €8,597 million. The company reported a net income of €1,263 million during that period, with no outstanding preference shares.

Statement of Changes in Equity

The "Statement of Changes in Equity" is a report that tracks how different equity accounts and the total equity change over a year. It's organized in columns, showing transactions affecting various equity accounts. This statement often includes details about issued and treasury shares. When this statement is provided, a separate report for retained earnings isn't usually necessary because the changes in retained earnings are already covered within the statement of changes in equity.

Book Value per Share

The book value per share represents the equity an ordinary shareholder has in the company's net assets per share.

For a Company with Only Ordinary Shares:

1. Calculate Total Ordinary Shareholders' Equity: Share Capital + Retained earnings.
2. Book Value per Share: Total Ordinary Shareholders’ Equity / Number of Outstanding Ordinary Shares 

For a Company with Both Preference and Ordinary Shares:

1. Calculate Preference Share Equity:
   • If there are dividends in arrears, Preference Share Equity = Call Price of Preference Shares + Dividends in Arrears.
   • If no dividends are in arrears, use the par value of preference shares instead of the call price.
2. Calculate Ordinary Shareholders' Equity:
   • Ordinary Shareholders' Equity = Total Equity - Preference Share Equity
3. Calculate Book Value per Share:
   • Ordinary Shareholders’ Equity / Number of Outstanding Ordinary Shares

Book Value versus Market Price

Book value per share represents the equity attributed to each share based on recorded costs. Market price per share is the actual price in the stock market, influenced by investors' views on the company's future. Sometimes, the market price might be higher or lower than the book value due to investor perceptions about the company's potential, but it doesn't necessarily mean the shares are over or undervalued.

Statement of cash flows: Usefulness and Format  

The statement of financial position, income statement, and retained earnings statement provide only limited information about a company’s cash flows (cash receipts and cash payments). 

Chapter 14

Statement of cash flows: Usefulness and Format

The statement of financial position, income statement, and retained earnings statement provide only limited information about a company’s cash flows (cash receipts and cash payments).

Rappel:

• When you compare the statements of financial position from one period to another it shows the increase in property, plant, and equipment.
• The income statement shows net income.
• The retained earnings statement shows dividends declared.

Usefulness of the statement of cash flow:

The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities during a period.

The statement of cash flows provides information to investors, creditors…. With this information:

1. The entity’s ability to generate future cash flows: By examining relationships among items in the statement of cash flows, investors can make predictions of the amounts, timing, and uncertainty of future cash flows.

2. The entity’s ability to pay dividends and meet obligations: If a company does not have enough cash, it cannot pay employees, pay their debts and pay dividends. Making this document very useful for employees, creditors, and shareholders.

3. The reasons for the difference between net income and net cash used by operating activities: Net income provides information on the success or failure of a business. However, for some financial statement usersnet income is not trustworthy because it requires many estimations. But this is not the case with actual cash ( liquide ) . These users want to know the reasons for the difference between net income and *net cash provided by operating activities. Then, they can assess for themselves the reliability of the income number.

* net cash (trésorier nette) —> Net cash refers to the amount of money a person, business, or organization has after subtracting their total expenses from their total income or revenue.

4. The cash investing and financing transactions during the period: By examining a company’s investing and financing transactions, a financial statement reader can have a better understanding why assets and liabilities changed during the period.

Classification of Cash Flows:

The statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities.

1. Operating activities include transactions that create revenues and expenses. this category is the most important because it shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company’s ability to generate sufficient cash to continue operating.

2.Investing activities include :

A) acquiring and disposing of investments and property, plant, and equipment ( PPE)

B) lending money and collecting the loans.

3. Financing activities include :

• • • 1. obtaining cash from issuing debt and repaying the amounts borrowed
      2. obtaining cash from shareholders, repurchasing shares, and paying dividends.

A lists typical cash receipts and cash payments within each of the three classifications.

Note the following general guidelines:

1. Operating activities involve income statement items.

2.Investing activities involve cash flows resulting from changes in investments and non-current asset items.

3. Financing activities involve cash flows resulting from changes in non-current liability and equity items.

Significant Non-Cash Activities :

Not all a company’s significant activities involve cash.

They won’t be reported in the statement of cash flow because they don’t involve cash transaction.

Examples of non-cash activities :

1. Direct issuance of ordinary shares to purchase assets.

2. Conversion of bonds into ordinary shares.

3. Direct issuance of debt to purchase assets.

4. Exchanges of plant assets.

They are but at the bottom of the statement of cash flow enter « note »

Format of the Statement of Cash Flows :

The general format of the statement of cash flows presents the results of the three activities —> operating, investing, and financing.

The cash flows starts

1. operating activities
2. investing activities section,
3. Financing activities section.
4. The sum of the operating, investing, and financing sections equals the net increase or decrease in cash for the period. This amount is added to the beginning cash balance so it will result to the ending cash balancethe same amount reported on the statement of financial position.

Preparing the Statement of Cash Flows— Indirect Method:

Step by step preparing the statement of cash flows:

1) . We need information about the changes in account balances that occurred between two points in time. (An adjusted trial balance will not provide the necessary data.)

2) this statement deals with cash receipts and payments. the company adjusts the effects of the use of accrual accounting to determine cash flows.

The information to prepare this statement usually comes from three sources:

• • • Comparative statements of financial position: Information in the comparative statements of financial position indicates the amount of the changes in assets, liabilities, and equities from the beginning to the end of the period. (You will have to compare 2 statement of financial position) (An adjusted trial balance will not provide the necessary data.
    • Current income statement: Information in this statement helps determine the amount of net cash provided or used by operating activities during the period.
    • Additional information. Such information includes transaction data that are needed to determine how cash was provided or used during the period.

Indirect and Direct Methods:

To be able to compare accounts between 2 period a company must convert net income from an accrual basis to a cash basis. And this can be done by either of two methods:

- The indirect method -The direct method.

🡪 Both methods arrive at the same amount for “Net cash provided by operating activities.” They differ in how they arrive at the amount.

The indirect method: adjusts net income for items that do not affect cash. A great majority of companies use this method because:

• • • • • it is easier and less costly to prepare.
        • it focuses on the differences between net income and net cash flow from operating activities.

The direct method: shows operating cash receipts and payments, making it more consistent with the objective of a statement of cash flows.

Both methods are allowed by IFRS and produce the same results

Indirect Method—Computer Services International :

Step 1: Operating Activities:

Net income needs to be adjusted to represent cash receipts and payments. Because net income is created using accrual accounting.

This means events are recorded when they affect the economic position, not when cash is paid or received so, net income might be higher or lower than actual cash flows

Steps in converting net income to cash flow:

• Start with Net income form the current year

1. Add back any non - cash expenses (depreciation)

2. Deduct gains and add back losses resulting from investing or financing activities (these are part of net income, but should not be part of operating cash flows)

3. Add or deduct any changes in non - current assets and non- current liabilities

Remember this rules :

1. End Cash flow from operating activities

SUMMARY

Direct method:

This method does not adjust net income as a total measure, but adjusts each item on the income statement.

This method provides more detail to investors and preferred by IFRS but it’s also more time - consuming and more additional information is needed to be able to apply it. This is why companies prefer the indirect method.

How can the direct method be applied ?

• Go over the elements reported in the income statement and check whether the amount reported as revenue/expense is also actually received/paid

•If an item (revenue or expense) has a change in its related current asset/liability, there is an indication that a different amount of cash is

exchanged than the amount recorded in the income statement.

The major elements for which the cash flow needs to be determined:

1)

Cash receipts from customers = Sales Revenue + decreases in Accounts Receivable

OR

Cash receipts from customers = Sales Revenue – increases in Accounts Receivable

2)

Cash receipts to suppliers = Cost of Goods Sold + increases in inventory + decreases in Accounts

Or

Cash receipts to suppliers = Cost of Goods Sold – decreases in inventory – increases in Accounts

3) For each operating expense (wages, interest, utilities) the following formula works the same:

Cash payments for each operation expense = Expense + increases in Prepaid expense + decreases in the payable

Or

Cash payments for each operation expense = Expense — decrease in Prepaid expense — increase in the payable

4)

Cash payments for income taxes = Income tax expense + decreases in income taxes payable

Cash payments for income taxes = Income tax expense – increases in taxes payable

Or

Some notes:

• In the direct method, we do not need to take depreciation into account. As depreciation is non - cash, there will never be a cash outflow
• If a revenue or expense item on a company's income statement doesn't involve changes in short-term assets or liabilities (like cash, accounts receivable, or accounts payable), then the cash payments or receipts will be exactly equal to the amount stated on the income statement. In simpler terms, the money shown on the income statement directly matches the cash moving in or out of the business.

Investing and Financing Activities :

The Investing and Financing cash flows are always prepared in the same way:

🡪 For both investing and financing , go over the financial statements and additional information, to determine whether there were changes

🡪 For investing: check for changes in non - current assets and investment assets

Ex:

Buying and selling PPE (Property, Plant & Equipment):

Investing activities involve buying and selling these long-term assets.

• Ex: If a company buys new machinery (PPE), it's an investing activity that increases the non-current asset. If it sells a building, it's also an investing activity that decreases the non-current asset.

Buying or selling equity and debt securities of other companies (shares and bonds).This involves activities related to investments in securities of other companies. These could be equity securities (shares/stocks) or debt securities (bonds).

• Ex: If a company buys shares of another company, it's an investing activity that increases the investment asset. If it sells bonds it holds, it's an investing activity that decreases the investment asset.

🡪 Lending and Collecting on Loans:

--> Investing activities also include lending money to other firms (buying

debt securities) and collecting on these loans.

• • Ex: If a company loans money to another and receives repayment, it's an investing activity. If it invests in a bond issued by another company, it's also an investing activity.

🡪 For financing: check for changes in non - current liabilities and equity items

Ex:

• Check for Changes in Liabilities and Equity:
• Financing activities involve changes in a company's capital structure, including liabilities (debts) and equity (ownership).

Ex: If a company issues new bonds to raise money, it's a financing activity that increases liabilities. If it buys back its own shares, it's a financing activity that decreases equity.

• Dividends and buying back Shares:
• Payment of dividends to shareholders and repurchasing company shares are financing activities.
  • Ex: If a company pays dividends to shareholders, it's a financing activity that decreases equity. If it buys back its own shares from the market, it's also a financing activity.

Finalizing the cash flow statement:

After the cash flows from operating, investing and financing activities are determined:

• You know the change in cash balance for the period
• Adding this change to the beginning amount gives the end balance of cash
• This can be compared and checked with the cash balance in the balance sheet

Using Cash Flows to Evaluate a Company :

Traditionally, investors and creditors used ratios based on accrual accounting.

Free Cash Flow:

In the statement of cash flows, net cash provided by operating activities is indicate the capacity of a company to generate cash. For analysts the net cash provided by operating activities doesn’t consider that a company must invest in new fixed assets just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors.

The measurement of free cash flow provides additional insight regarding a company’s cash-generating ability.

Free cash flow is the money a company has left over after it takes care of all its regular expenses and investments to keep the business running. It's the cash that can be used for paying dividends to shareholders, reducing debts, or investing in new opportunities. In simple terms, it's the cash a company has available to use freely after covering its necessary costs and investments.

( DEF, from the book : describes the net cash provided by operating activities after adjustment for capital expenditures and dividends.)

Free cash flow = net cash provided by operating activities - capital expenditures - cash dividends

Chapter 15

1.Basics of Financial Statement Analysis

Analyzing financial statements involves assessing three characteristics:

1. Liquidity:
   • Concerns a company's ability to meet short-term debts.
   • Vital for short-term creditors (like banks) to ensure timely loan repayment.
2. Profitability:
   • Indicates how efficiently a company generates profits.
   • Crucial for long-term creditors and shareholders to assess consistent earnings.
3. Solvency:
   • Evaluates a company's ability to meet long-term obligations.
   • Important for long-term creditors and shareholders to understand stability and growth potential.

Need for Comparative Analysis

Comparative analysis is crucial in understanding the context and significance of financial statement items. For instance, when a company like Marks and Spencer plc (M&S) reports its cash and cash equivalents, the reported amount alone doesn't provide the full picture.

Here are three key ways to conduct comparative analysis:

1. Intracompany Basis:
   • Involves comparisons within the same company to identify trends and changes over time.
   • For example, comparing M&S's current cash with the prior year's amount reveals whether cash has increased or decreased.
   • Comparing year-end cash with total assets at year-end indicates the proportion of assets held in cash.
2. Industry Averages:
   • Involves comparing a company's financial data with industry benchmarks or averages.
   • Helps understand a company's standing within its industry.
   • Comparing M&S's financials with industry averages from organizations like Dun & Bradstreet, Moody's, or Standard & Poor's provides context regarding its industry position.
3. Intercompany Basis:
   • Involves comparing a company's performance against its competitors.
   • Investors may compare a company’s metrics, like total sales, with similar data from its competitors.
   • Offers insight into a company's competitive position and market share.

By employing these comparative analyses, stakeholders gain deeper insights into a company's financial health, industry position, and competitive standing, allowing for better-informed decisions regarding investments, performance evaluation, and strategic planning.

Tools of Analysis

The three tools used to evaluate financial statement data:

1. Horizontal Analysis:.
2. Vertical Analysis:.
3. Ratio Analysis:
   • .

Each tool offers a different perspective on financial data: horizontal tracks trends over time, vertical assesses proportions within statements, and ratio analysis dives into financial relationships for better insights into a company's performance.

Horizontal Analysis

Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time and is used primarily in intracompany comparisons.

Purpose: Tracks changes in financial data over time and to determine the increase or decrease that has taken place.

Commonly applied to the statement of financial position, income statement, and retained earnings statement

Ex: Analyzing how revenue or expenses have changed annually

Change Since base period =

Current results in relation to base period =

EX : Evaluate Dubois SA's net sales changes over three years using 2018 as the base year.

Calculation :

Percentage Change Formula:

• For 2019: [(€19,903 - €18,781) ÷ €18,781] = 6% increase
• For 2020: [(€19,860 - €18,781) ÷ €18,781] = 5.7% increase

Sales as a Percentage of Base Year:

• 2019: Net sales at 106.0% compared to 2018.
• 2020: Net sales at 105.7% compared to 2018.

Purpose: Assess the growth or decline in net sales for Dubois SA relative to the base year (2018), indicating changes in performance over the three-year period.

Statement of financial position

Assets Changes:

• Plant assets increased by €167,500, a rise of 26.5%.
• Current assets increased by €75,000, a rise of 7.9%.

Total Assets:

• Total assets increased by €240,000, marking a 15.0% rise from 2019 to 2020.

Key Observations:

• Quality Department Store expanded its asset base in 2020, primarily by increasing plant assets and current assets.
• The growth was financed majorly through retained earnings instead of taking on additional long-term debt.

Income Statement Analysis (Illustration 15.6):

Sales Changes:

Net sales increased by €260,000, marking a 14.2% rise.

Expenses Changes:

Cost of goods sold rose by €141,000, a rise of 12.4%.

Total operating expenses increased by €37,000, marking an 11.6% rise.

Retained Earnings Changes:

Comparing 2020 and 2019:

Retained earnings increased by €148,500, indicating a rise of 39.4%.

Net Income and Dividends:

Net income surged by €55,300, marking a 26.5% increase.

Dividends on ordinary shares rose by only €1,200, showing a marginal 2.0% increase.

Retained Earnings Growth:

Ending retained earnings grew by 38.6%, highlighting significant retention of net income for further investments.

Vertical Analysis

Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount.

is commonly applied to the statement of financial position and the income statement

Example: Expressing expenses as a percentage of total revenues

Statement of Financial position

Vertical analysis shows the relative size of each category in the statement of financial position. It alsocan show the percentage change in the individual asset, liability & equity items.

Income Statement

Formula for calculating these income statement percentage is:

Each item on I/S: Net sales = %

2.Ratio Analysis

Ratio analysis expresses/evaluates the relationship among selected items of financial statement data using percentages, rates, or proportions.

Assesses a company’s performance and financial health concerning liquidity, profitability, and solvency.

Ex:if a company has £1,267.9 million in current assets and £2,238.3 million in current liabilities, the current assets to current liabilities ratio is 57% or 0.57, or it can be expressed as a proportion of 0.57:1.

Comparison Types Using Ratios:

• Intracompany: Comparing a company's ratios over two years (e.g., for Quality Department Store).
• Industry Averages: Assessing a company's ratios against median industry standards (e.g., for department stores).
• Intercompany: Comparing a company's ratios against a direct competitor (e.g., Park Street compared to Quality Department Store).

Liquidity Ratios

Liquidity ratios assess a company's capacity to meet short-term financial obligations and address unforeseen cash requirements, which is crucial for short-term creditors like banks and suppliers.

Current ratios

The current ratio assesses a company's ability to cover short-term liabilities with its short-term assets. A higher ratio indicates better liquidity.

Limitations: The current ratio doesn't consider the composition of current assets. For instance, it doesn't differentiate between easily liquidated assets like cash and less liquid assets like slow-moving inventory. So, even with a good current ratio, some assets might not quickly turn into cash.

Current ratio =

Acid-test ratio

The acid-test (quick) ratio measures immediate short-term liquidity by considering only the most liquid assets (cash, short-term investments, and net accounts receivable) against current liabilities.

Acid-test ratio =

Accounts receivable turnover

The accounts receivable turnover ratio gauges how quickly a company collects outstanding receivables during a period.

Acounts receivable turnover =

The ratio used to assess the liquidity if the receivables is the accounts receivable turnover. It measures the number of times, on average, the company collects receivables during the period. Unless seasonal factors are significant, average net accounts receivables can be computes from the beginning & ending balances of the net accounts receivable

The average collection period calculates how many days, on average, it takes a company to collect its outstanding receivables.

Average Collection =

EX : a turnover ratio of 10.2 times equates to an average collection period of roughly 36 days. This means the company collects its receivables, on average, every 36 days, or about every 5 weeks. Analysts use this to evaluate how effective a company is in collecting payments. It's important that this period isn't significantly longer than the credit term allowed for payment.

Inventory Turnover

Inventory turnover is a measure of how many times a company sells its inventory within a given period. It determines the inventory's liquidity, calculated by dividing the cost of goods sold by the average inventory. The faster the turnover, the less cash the company has tied up in inventory and the lower the risk of inventory obsolescence.

Days in inventory measures the average number of days it takes to sell the entire inventory.

Days in Inventory =

longer period may indicate slower inventory movement, higher holding costs, or potential obsolescence. Different industries have different average turnover rates; for instance, grocery store chains might turn inventory more frequently than jewelry stores

Profitability Ratios

It assesses a company's ability to generate income or profit during a specific period. They indicate how effectively a company operates and impacts its capacity to secure financing, manage liquidity, and foster growth.

Both creditors and investors keenly analyze profitability to evaluate the company's earning potential. It serves as a crucial measure to gauge management's efficiency in operating the business.

Top of Form

Bottom of Form

It measures the income or operating success of a company for a given period of time.

• Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow.
• Ratios include the profit margin, asset turnover, return on assets, return on ordinary shareholders’ equity, earnings per share, price-earnings, and payout ratio.

Profit margin

Profit margin, also known as the rate of return on sales, measures the percentage of profit obtained from each euro of sales.

Profit margin =

Asset turnover

Asset turnover measures how effectively a company uses its assets to generate sales. By dividing net sales by average total assets, this ratio shows how many euros of sales each euro invested in assets produces.

Asset turnover =

Return on assets

Return on Assets (ROA) is a key profitability measure, indicating how efficiently a company generates earnings from its assets.

Return on assets =

Return on Ordinary Shareholders’ Equity

Return on Ordinary Shareholders' Equity is a key measure of profitability from ordinary shareholders' perspective, indicating how much profit a company generates for each euro invested by owners.

Return on Ordinary Shareholders’ Equity =

Earnings per share (EPS)

A measure of the net income earned on each ordinary share.

EPS=

Price-earnings ratio

Reflects investors’ assessments of a company’s future earnings.

Price-earnings ratio =

Payout ratio

The payout ratio measures the portion of earnings distributed as cash dividends.

Payout ratio =

Solvency Ratios

Solvency ratios measure the ability of a company to survive over a long period of time.(la capacité d’une entreprise de repayer ses dettes)

Debt to assets ratio

The debt to assets ratio calculates the portion of total assets provided by creditors, revealing the company's leverage level.

Debts to ratio =

Times interest earned

Provides an indication of the company’s ability to meet interest payments as they come due.

Times interest Earned =

Summary of Ratios