#5 - Notes to Financial Statements, Balance Sheet Overview, and Working Capital and its Components Flashcards
F1.4, F4.1
Notes to Financial Statements – Summary of Significant Accounting Policies
US GAAP and IFRS require description of all significant policies
– Included as first or second note as “Summary of Significant Accounting Policies”
Description of significant policies includes:
– Measurements bases used in preparing financial statements
– Accounting principles and methods
– Criteria
– Policies
– Pricing
IFRS: Must also state compliance with IFRS in notes
– US GAAP does not require this
Notes to Financial Statements – Summary of Significant Accounting Policies: Estimates and Judgements made by management
IFRS requires disclosure of estimates and judgements made by management in the process of applying accounting prelacies and that have a significant effect on the financial statements
US GAAP only requires disclosure of estimates
Notes to Financial Statements – Other Notes
Other Notes = Relevant information not presented in body of financial statements or in Summary of Significant Accounting Policies
Notes to Financial Statements – Related Party Disclosures: Related Parties Defined
Must disclose related party transactions (US GAAP & IFRS)
Related parties
– Affiliates of an entity
– Entities accounted for using the equity method
– Parent of subsidiary entities or subsidiaries of a common parent
– Trusts for the benefit of employees
– Management of an entity and their immediate family members
- Owners of more than 10% of the voting interest of an entity i.e. principal owners, and their immediate family members (GAAP only)
Notes to Financial Statements – Related Party Disclosures: Material Related Party Transactions
Must disclose material transactions
Disclosure include:
– Nature of relationship
– Description of transactions
– Dollar amounts of transactions
– Amounts due to or from related parties at each balance sheet date
– Name of related party, if necessary to the understanding of the relationship
– Allowance for bad debts related to amounts due from related parties (IFRS only)
– Bad debt expense and/or write-offs of debts due from related parties (IFRS only)
Notes to Financial Statements – Related Party Disclosures: Material Related Party Transactions»_space;> Compensation Arrangements
US GAAP does not require disclosure of key management compensation arrangements
– Required by SEC outside of financial statements
IFRS requires disclosure of key management compensation arrangements in total and for each of the following categories:
- Short-term benefits
- Post-employment benefits
- Other long-term benefits
- Termination benefits
- Share-based payments
Notes to Financial Statements – Related Party Disclosures: Related Party Receivables, and Control Relationships
US GAAP and IFRS require disclosure of
– Notes or accounts receivables from related parties, separately from general notes and accounts receivable
– Control relationships between the reporting entity and other entities even if there were not transactions between them.
Notes to Financial Statements – Disclosure of Risks and Uncertainties
US GAAP requires disclosures of risks and uncertainties existing at the date of the financial statements in the following areas:
- Nature of operations
- Use of estimates in preparation of financial statements
- Certain significant estimates
- Currency vulnerability to certain concentrations
Notes to Financial Statements – Disclosure of Risks and Uncertainties: Nature of Operations
Describe entity’s major products or services, and its principal markets
If multiple business, disclose relative importance of each business
Notes to Financial Statements – Disclosure of Risks and Uncertainties: Use of Estimates in Preparation of Financial Statements
Include the statement below
“The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of continent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during there reporting period. Actual results could differ from those estimates”
Notes to Financial Statements – Disclosure of Risks and Uncertainties: Certain Significant Estimates
When it is reasonably possible that an estimate will change in the near term and that the effects of the change will be material, an estimate of the effect of the change should be disclosed
Notes to Financial Statements – Disclosure of Risks and Uncertainties: Vulnerability to Certain Concentrations
Vulnerability to concentrations = entity exposed to risk of loss because business not diversified.
Disclose concentration if:
- Concentration exists at financial statement date, and
- Concentration makes entity vulnerable to risk of near-term sever impact, and
- It is at least reasonably possible that the events that could cause the sever impact will occur in the near term.
Notes to Financial Statements – Disclosure of Risks and Uncertainties: IFRS
IFRS risk and uncertainty disclosure requirements are narrower and focus on sources of estimation uncertainty
Disclose
– Assumptions made about the future
– Major sources of estimation uncertainty at the end of the reporting period that have a significant risk of resulting in a material adjustment to the carrying amount of assets and liabilities within the next financial year.
Balance Sheet – Overview
Classified balance sheet
– distinguishes between assets and liabilities
Sometimes balance sheet presentation based on liquidity permissible
Balance Sheet – Overview: Classified Balance Sheet»_space;> Assets
Current Assets – Cash and cash equivalents – Trading securities (at fair value) – Accounts receivable – Notes receivable – Inventory (at lower of cost or market) – Prepaid Expensens
Investment
– Available-for-sale-securities (at fair value)
– Held to maturity securities
Property, Plant, and Equipment – Land – Bulding – Equipment – Less: Accumulated Depreciation
Intangible Assets
– Goodwill
– Patents etc, net of amortization
Other assets
– Bond issues costs
– Pension and other post retirement benefit assets
Balance Sheet – Overview: Classified Balance Sheet»_space;> Liabilities
Current liabilities – Long term debt due within one year – Accounts payable – Notes payable – Interest payable – Salaries payable – Income tax payable – Advances from customers (unearned revenue0 – Unearned rent revenue
Long-term liabilities
– Bonds payable
± Unamortized premium (discount) on bonds
– Deferred income tax liability
– Pension and other post retirement benefit liabilities
Balance Sheet – Overview: Classified Balance Sheet»_space;> Stockholders’ equity
– Capital stock – Preferred stock – Common stock – Paid in capital in excess of par – Retained earnings –Accumulated other comprehensive income – Treasury stock
Working Capital
Working Capital = Current Assets – Current Liabilities
Often used as a measure of solvency
Working Capital – Current Assets
Resources expected to be realized in cash, sold, or consumed (prepared items) during the normal operating cycle of a business or one year, whichever is longer.
Current assets typically consist of – Cash – Trading securities – Other short investments – Accounts and notes receivable – Trade installment receivables – Inventory – Other short-term receivables – Prepaid expenses – Cash surrender value of life insurance
Working Capital – Current Liabilities
Obligations whose liquidation is reasonably expected to require the use of current asset or the creation of other current liabilities
Current liabilities typically consist of – Trade accounts and notes payable – Current portions of long-term debt – Cash dividends payable – Accrued liabilities – Payroll liabilities – Taxes payable – Advances from customers
Under US GAAP, short-term obligations that are expected to be refinanced can be excluded from current assets
– Not allowed under IFRS
Working Capital – Cash and Cash Equivalents
Cash - currency and demand deposits
Cash equivalents = short term, highly liquid investments that are readily convertible to cash and have a maturity < 90 days.
Cash and Cash Equivalents include
– Coin and currency on hand (including petty cash)
– Checking accounts
– Savings account
– Money market funds
– Deposits held as compensating balances against borrowing arrangements with a lending institution that are not legally restricted
– Negotiable paper
– Bank checks, money orders, travelers checks, bank drafts, and cashier’s checks
– Commercial paper and treasury bills
– Certificate of deposit (having original maturities of ≤ 90 days)
Not cash or cash equivalents
– Time certificates of deposit (if original maturity > 90 days)
– Legally restricted deposit its held as compensating balances against borrowing arrangements with a lending institution
Working Capital – Restricted and Unrestricted Cash
Restricted cash associated with a current asset or current liability is classified as a current asset, but kept separate from unrestricted cash
Restricted cash association with a concurrent asset or concurrent liability is classified as a concurrent asset but kept separate from the Investments or Other Assets section
Working Capital – Bank Reconciliations: Simple Reconciliation
Deposit in transit = bank’s balance understated
Outstanding checks = bank’s balance overstated
Service charge = book balance overstated
Bank collections on behalf of customer = book balance understated
Errors = depends on nature of error
Nonsufficient funds charge = book balance overstated
Interest income earned by customer = book balance understated
Working Capital – Bank Reconciliations: Reconciliation of Cash Receipts and Disbursements
Also known as four-colum reconciliation or proof of cash
Objective is to reconcile any differences between the amount the depositor has recorded as cash receipts and the amounts the bank has recorded as deposits.
Need reconciliation information for the present fourth and that of the prior month
Working Capital – Accounts Receivable
Accounts receivable are oral promises to pay debts
Trade receivables or non-trade receivables
–Non-trade receivables = accounts receivable from persons other than customs
Working Capital – Accounts Receivable Account Analysis Format
A/R Beginning Balance \+ Credit Sales – Cash collected on account – A/R converted to notes receivable – A/R written off as bad debt = A/R Ending Balance
Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns
Sales of Cash discounts quoted as 2/10, n/30 (2% discount if pay within 10 days, iif discount not taken gross amount due in 30 days
Trade discounts quoted in percentages, and applied sequentially
e.g. apply discount of 40%, then apply discount of 10%
Can report using gross or net method
– Gross method records sale without regard to available discount
– Net method records sale with regards to available discount
Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns»_space;> Discounts: Gross Method
Recording Sale at gross amount:
Dr. Accounts receivable @ gross amount
Cr Sales revenue @ gross amount
If discount taken
Dr Cash @ net amount
Dr Sales discount taken (amount of discount)
Cr Accounts receivable @ gross amount
If discount not taken, no entry needed
Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns»_space;> Discounts: Net Method
Recording Sale at gross amount:
Dr. Accounts receivable @ net amount
Cr Sales revenue @ net amount
If discount taken, no entry needed
If discount not taken
Dr Cash @ gross amount
Cr Accounts receivable @ net amount
Cr Discount not taken (amount of discount)
Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns»_space;> Sales Returns
Recording Sales
Dr Accounts Receivable
Cr Sales Revenue
Recording a Sales Return
Dr Sales returns and allowances (contra sales)
Cr Accounts receivable
Working Capital – Accounts Receivable: Uncollectible A/R
A/R should be presented on the balance sheet at their net realizable value
Methods for recognizing uncollectible accounts
- Direct Write-off Method (not GAAP)
- Allowance Method (GAAP)
Working Capital – Accounts Receivable: Uncollectible A/R»_space;> Direct Write-Off Method
Not GAAP, but used for federal income tax purposes
Account written off and bad debt recognized when account becomes uncollectible
A/R always overstated
Journal entry to record sale
DR Accounts Receivable
CR Sales Revenue
Journal entry to record account that becomes uncollectible
DR Bad debt expense
CR Accounts Receivable
If previously written-off account, is later collected:
DR Cash
CR Uncollectible accounts recovered
Working Capital – Accounts Receivable: Uncollectible A/R»_space;> Allowance Method
Estimate uncollectible accounts based on past experience
Journal entry to record sale
DR Accounts Receivable
CR Sales Revenue
At the same time charge bad debts to Allowance account
DR Bad Debt Expense
CR Allowance for Uncollectible Accounts
When specific account becomes uncollectible, debit Allowance account
DR Allowance for Uncollectible Accounts
CR Accounts Receivable
If previously written-off account, is later collected:
DR Accounts Receivable
CR Allowance for Uncollectible Accounts
DR Cash
CR Accounts Receivable
Working Capital – Accounts Receivable: Uncollectible A/R»_space;> Estimating Uncollectible A/R
3 methods
- % of sales method (income statement approach)
- % of A/R at year-end method (balance sheet approach
- Aging of receivables Method (balance sheet approach)
Working Capital – Accounts Receivable: Uncollectible A/R»_space;> Estimating Uncollectible A/R: % of sales method
Income statement approach
Percentage of each sale is dr to Bad Debt Expense and CR to Allowance for Uncollectible Accounts
– % based on company’s experience
Working Capital – Accounts Receivable: Uncollectible A/R»_space;> Estimating Uncollectible A/R: % of A/R at Year-End Method
Balance sheet approach
Percentage of A/R at year-end = amount that should be in Allowance for Uncollectible Accounts
If amount in Allowance for Uncollectible Amounts is less than %, Dr difference to Bad Debt Expense, and CR to Allowance for Uncollectible Accounts
E.g. Uncollectibles = 2% of year-end A/R
A/R at year end = $80,000. Balance in Allowance for Uncollectible Accounts = $1,000 CR
Balance in Allowance for Uncollectible Accounts should be 2% of $80,000 = $1,600 CR »_space;> Difference = $600
Journal entry
DR. Bad Debt Expense $600
CR Allowance Account $600
Working Capital – Accounts Receivable: Uncollectible A/R»_space;> Estimating Uncollectible A/R: Aging of Receivables Method
Balance sheet approach
Categorize accounts by number of days or months outstanding
Apply % representing uncollectibility based on past experiences
Sum product for each category to get ending balance in allowance account
Adjust allowance account to reflect estimated ending balance
i.e. charge difference to bad debt expense and allowance account
Working Capital – Accounts Receivable: Uncollectible A/R»_space;> Allowance for Doubtful Accounts Analysis Format
Allowance Account Beginning Balance \+ Bad Debt Expense – Recoveries of Bad Debt – Accounts receivables written off = Allowance Account Ending Balance
Working Capital – Accounts Receivable: Pledging (Assignment)
Company uses A/R as collateral for loan
Company retains title to receivable, but pledges proceeds to pay loan
Pledging requires disclosure in notes
No adjustment to A/R account
Working Capital – Accounts Receivable: Factoring
Company converts receivable into cash by assigning them to a factor
Factoring with or without recourse
Working Capital – Accounts Receivable: Factoring Without Recourse
Without recourse = sale is final
– Assignee (the factor) assumes risk of loss
Journal Entries Dr Cash Dr Due from factor (factor's margin) Dr Loss on sale of receivables Cr Accounts Receivable
Due from factor
– Factor retains some of proceeds to protect the factor against sales returns, sales discounts, and allowances, and customer disputes
Working Capital – Accounts Receivable: Factoring With Recourse
With recourse = factor has option to sell uncollectible receivables back to seller
2 possible treatments
– Sale
– Borrowing = receivables treated as collateral for a loan per pledging
Factoring with recourse = sale if:
– Seller’s obligation for uncollectible accounts can be reasonably estimated, and
– Seller surrenders control of future economic benefits of receivables to buyer, and
– Seller can’t be require to repurchase the receivables, but may be required to replace the receivables with other similar receivables
Working Capital – Transfers of Financial Assets
Accounting treatment of transfers of financial assets hinge on if the transaction is a sale (of all part of the financial assets) or a secured borrowing
To account focus on control
– Recognize only the assets entity has control over, and related liabilities incurred in the process, and
– Derecognize those assets only when control over them has been surrendered
– Derecognize those liabilities when they have been extinguished
Financial-components approach – Assets and liabilities may be divided into many components, and each component may have different accounting methods applied to them
Working Capital – Transfers of Financial Assets: Control
Control has been surrounded when
- Transferred assets have been isolated from transferor, and
- Transferee has right to pledge or exchange asset, and
- Transferor does not maintain control over transferred assets under a repurchase agreement
Control is surrendered
– If no continuing involvement, transfer = sale, recognize gain or loss
– If continuing involvement, apply financial-components approach = transferred assets are divided between those deemed sold (recognize gain or loss, and those deemed not sold
Control is not surrendered = secured borrowing with pledge collateral
– recognize asset/liability amounts
– recognize revenue/expense amounts
Working Capital – Transfers of Financial Assets: Serving Assets and Liabilities
Entity has contract to service financial assets
Record a servicing asset or liability (at price paid or fair value)
Amortize contract in proportion to estimated net servicing income (loss)
Determine fair value at regular intervals, and assess for impairment based on the fair value.
Working Capital – Notes Receivable
Written promises to pay debt (“promissory note”)
Classified in similar manner as A/R
Can be current or long-term asset – depends on when collection will occur
Working Capital – Notes Receivable: Valuation and Presentation
State receivable at present value
– unearned interest and finance charges deducted from face amount of related promissory note
Non-interest bearing or below-market interest rate notes
- Determine value by imputing the market rate of interest and applying effective interest method
Working Capital – Notes Receivable: Discounted Notes Receivables
Discounted notes receivable arise when holder endorses the note to a third party and receives cash.
Difference between cash received by holder and maturity value of the note is the discount
Discounted notes may be endorse with or without recourse
Working Capital – Notes Receivable: Notes Discounted With Recourse
Note discounted with recourse = holder remains contingently liable for ultimate payment of note when it becomes due
Discounted note reported on balance sheet with contra account (Notes Receivable Discounted) to indicate that they have been discounted to a third party
– Alternative = remove note from balance sheet and disclose a contingent liability in the notes
Working Capital – Notes Receivable: Notes Discounted Without Recourse
Note discounted without recourse = holder assumes not future liability
Note discounted without recourse have essentially been sold»_space; remove from balance sheet
Working Capital – Notes Receivable: Dishonored Discounted Notes Receivable
Remove contingent liability as follows
DR Notes Receivable Discounted
CR Notes Receivable
Notes Receivable Discounted should be recorded to the estimated recoverable amount
