#5 - Notes to Financial Statements, Balance Sheet Overview, and Working Capital and its Components

Question 1

Notes to Financial Statements – Summary of Significant Accounting Policies

Answer 1

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

Question 2

Notes to Financial Statements – Summary of Significant Accounting Policies: Estimates and Judgements made by management

Answer 2

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

Question 3

Notes to Financial Statements – Other Notes

Answer 3

Other Notes = Relevant information not presented in body of financial statements or in Summary of Significant Accounting Policies

Question 4

Notes to Financial Statements – Related Party Disclosures: Related Parties Defined

Answer 4

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)

Question 5

Notes to Financial Statements – Related Party Disclosures: Material Related Party Transactions

Answer 5

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)

Question 6

Notes to Financial Statements – Related Party Disclosures: Material Related Party Transactions&raquo_space;> Compensation Arrangements

Answer 6

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:

1. Short-term benefits
2. Post-employment benefits
3. Other long-term benefits
4. Termination benefits
5. Share-based payments

Question 7

Notes to Financial Statements – Related Party Disclosures: Related Party Receivables, and Control Relationships

Answer 7

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.

Question 8

Notes to Financial Statements – Disclosure of Risks and Uncertainties

Answer 8

US GAAP requires disclosures of risks and uncertainties existing at the date of the financial statements in the following areas:

1. Nature of operations
2. Use of estimates in preparation of financial statements
3. Certain significant estimates
4. Currency vulnerability to certain concentrations

Question 9

Notes to Financial Statements – Disclosure of Risks and Uncertainties: Nature of Operations

Answer 9

Describe entity’s major products or services, and its principal markets

If multiple business, disclose relative importance of each business

Question 10

Notes to Financial Statements – Disclosure of Risks and Uncertainties: Use of Estimates in Preparation of Financial Statements

Answer 10

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”

Question 11

Notes to Financial Statements – Disclosure of Risks and Uncertainties: Certain Significant Estimates

Answer 11

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

Question 12

Notes to Financial Statements – Disclosure of Risks and Uncertainties: Vulnerability to Certain Concentrations

Answer 12

Vulnerability to concentrations = entity exposed to risk of loss because business not diversified.

Disclose concentration if:

1. Concentration exists at financial statement date, and
2. Concentration makes entity vulnerable to risk of near-term sever impact, and
3. It is at least reasonably possible that the events that could cause the sever impact will occur in the near term.

Question 13

Notes to Financial Statements – Disclosure of Risks and Uncertainties: IFRS

Answer 13

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.

Question 14

Balance Sheet – Overview

Answer 14

Classified balance sheet
– distinguishes between assets and liabilities

Sometimes balance sheet presentation based on liquidity permissible

Question 15

Balance Sheet – Overview: Classified Balance Sheet&raquo_space;> Assets

Answer 15

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

Question 16

Balance Sheet – Overview: Classified Balance Sheet&raquo_space;> Liabilities

Answer 16

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

Question 17

Balance Sheet – Overview: Classified Balance Sheet&raquo_space;> Stockholders’ equity

Answer 17

– Capital stock
   – Preferred stock
   – Common stock
– Paid in capital in excess of par
– Retained earnings
–Accumulated other comprehensive income
– Treasury stock

Question 18

Working Capital

Answer 18

Working Capital = Current Assets – Current Liabilities

Often used as a measure of solvency

Question 19

Working Capital – Current Assets

Answer 19

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

Question 20

Working Capital – Current Liabilities

Answer 20

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

Question 21

Working Capital – Cash and Cash Equivalents

Answer 21

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

Question 22

Working Capital – Restricted and Unrestricted Cash

Answer 22

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

Question 23

Working Capital – Bank Reconciliations: Simple Reconciliation

Answer 23

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

Question 24

Working Capital – Bank Reconciliations: Reconciliation of Cash Receipts and Disbursements

Answer 24

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

Question 25

Working Capital – Accounts Receivable

Answer 25

Accounts receivable are oral promises to pay debts

Trade receivables or non-trade receivables
–Non-trade receivables = accounts receivable from persons other than customs

Question 26

Working Capital – Accounts Receivable Account Analysis Format

Answer 26

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

Question 27

Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns

Answer 27

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

Question 28

Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns&raquo_space;> Discounts: Gross Method

Answer 28

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

Question 29

Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns&raquo_space;> Discounts: Net Method

Answer 29

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)

Question 30

Working Capital – Accounts Receivable: Valuation of A/R with Discounts and Returns&raquo_space;> Sales Returns

Answer 30

Recording Sales
Dr Accounts Receivable
Cr Sales Revenue

Recording a Sales Return
Dr Sales returns and allowances (contra sales)
Cr Accounts receivable

Question 31

Working Capital – Accounts Receivable: Uncollectible A/R

Answer 31

A/R should be presented on the balance sheet at their net realizable value

Methods for recognizing uncollectible accounts

1. Direct Write-off Method (not GAAP)
2. Allowance Method (GAAP)

Question 32

Working Capital – Accounts Receivable: Uncollectible A/R&raquo_space;> Direct Write-Off Method

Answer 32

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

Question 33

Working Capital – Accounts Receivable: Uncollectible A/R&raquo_space;> Allowance Method

Answer 33

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

Question 34

Working Capital – Accounts Receivable: Uncollectible A/R&raquo_space;> Estimating Uncollectible A/R

Answer 34

3 methods

1. % of sales method (income statement approach)
2. % of A/R at year-end method (balance sheet approach
3. Aging of receivables Method (balance sheet approach)

Question 35

Working Capital – Accounts Receivable: Uncollectible A/R&raquo_space;> Estimating Uncollectible A/R: % of sales method

Answer 35

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

Question 36

Working Capital – Accounts Receivable: Uncollectible A/R&raquo_space;> Estimating Uncollectible A/R: % of A/R at Year-End Method

Answer 36

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 &raquo_space;> Difference = $600

Journal entry
DR. Bad Debt Expense $600
CR Allowance Account $600

Question 37

Working Capital – Accounts Receivable: Uncollectible A/R&raquo_space;> Estimating Uncollectible A/R: Aging of Receivables Method

Answer 37

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

Question 38

Working Capital – Accounts Receivable: Uncollectible A/R&raquo_space;> Allowance for Doubtful Accounts Analysis Format

Answer 38

Allowance Account Beginning Balance
\+ Bad Debt Expense
– Recoveries of Bad Debt
– Accounts receivables written off
= Allowance Account Ending Balance

Question 39

Working Capital – Accounts Receivable: Pledging (Assignment)

Answer 39

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

Question 40

Working Capital – Accounts Receivable: Factoring

Answer 40

Company converts receivable into cash by assigning them to a factor

Factoring with or without recourse

Question 41

Working Capital – Accounts Receivable: Factoring Without Recourse

Answer 41

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

Question 42

Working Capital – Accounts Receivable: Factoring With Recourse

Answer 42

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

Question 43

Working Capital – Transfers of Financial Assets

Answer 43

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

Question 44

Working Capital – Transfers of Financial Assets: Control

Answer 44

Control has been surrounded when

1. Transferred assets have been isolated from transferor, and
2. Transferee has right to pledge or exchange asset, and
3. 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

Question 45

Working Capital – Transfers of Financial Assets: Serving Assets and Liabilities

Answer 45

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.

Question 46

Working Capital – Notes Receivable

Answer 46

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

Question 47

Working Capital – Notes Receivable: Valuation and Presentation

Answer 47

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

Question 48

Working Capital – Notes Receivable: Discounted Notes Receivables

Answer 48

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

Question 49

Working Capital – Notes Receivable: Notes Discounted With Recourse

Answer 49

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

Question 50

Working Capital – Notes Receivable: Notes Discounted Without Recourse

Answer 50

Note discounted without recourse = holder assumes not future liability

Note discounted without recourse have essentially been sold&raquo_space; remove from balance sheet

Question 51

Working Capital – Notes Receivable: Dishonored Discounted Notes Receivable

Answer 51

Remove contingent liability as follows
DR Notes Receivable Discounted
CR Notes Receivable

Notes Receivable Discounted should be recorded to the estimated recoverable amount