Midterm 2 (9-17) Flashcards
Assets should end with a __ balance
DEBIT
- If it ends with credit it really changes accounts and becomes an account payable
- if cash has a credit balance at the end it is NOT an asset
Retained Earnings can have an ending debit balance
- RE = NI-Dividends
- NI = Rev - Exp
- if expenses cost more that revenues - in startup companies
- but would really be called a retained deficit or cumulative losses
Steps to Fin Systems
- Identify
- analyze
- record in journal
- post to general ledger
- prepare trial balance
- Journalize and post to ledger any necessary adjusting entries at end of period
- Prepare fin stmts
- Journalize and post Closing entries
Accrual basis accounting
Timing of revenues and expenses with 2 principles: Revenue recognition principle and matching principle
- required by GAAP bc statements are for creditors and investors
- don’t want to be able to manipulate timing of revenues and expenses
Revenue Recognition Principle (Accrual)
TIMING OF REVENUES
-Revenues are to be recognized/recorded in the period in which they are EARNED, not received
Matching principle
TIMING OF EXPENSES
- Expenses recognized in period in which those costs provide benefit to the business operations
- expenses matched against revenues they HELPED PRODUCE, not necessarily period in which cash is paid
Cash basis accounting
Used for personal income taxation
- allowed by IRS
- ability to pay concept
- there are opportunities for income manipulation
- —don’t have to pay income tax til next year bc didn’t receive income until the year after
Adjusting Entries required to comply with accrual basis accounting
- Prepaid expenses (matching)
- unearned revenue (revenue recognition)
- unpaid and unrecorded expenses (matching)
- uncollected and unrecorded revenues (recognition)
Prepaid expenses adjusting entry
Insurance purchased 12 months in advance on 10/1 (Asset)
-right to next 12 months of insurance
Entry at 10/1
Prepaid Insurance expense 1200
Cash 1200
Adjusting entry at year end (3 months)
Insurance expense 300
prepaid Ins. Exp 300
PREPAID INSURANCE EXPENSE (T chart) 10/1/X1 1200 300 12/31/X1 (Adjust) Balance 900 -(9 months future benefit of $900)
-MATCHING PRINCIPLE (prepaid ins exp, rent exp)
If don’t fix you:
-underestimate expenses
-overestimate assets, net income, retained earnings, and owners equity
-liabilities not affected
Unearned Revenue adjusting entries
Receives 3000 in advance on 12/1/X1 for consulting services for next 2 months (liability)
Entry at 12/1/X1
Cash 3000
Unearned fee rev. 3000
Adjusting entry 12/31/X1
Unearned fee rev 1000
fee revenues 1000
UNEARNED FEE REVENUES
3000 12/1/X1
12/31/XI (adjust) 1000
2000 (balance) 12/31/X1
-(2 months times 1000 - liability of 2000 for 2 more months)
REVENUE RECOGNITION PRINCIPLE If didn't adjust -overestimate liabilities -underestimate revenues, NI, RE, OE -no affect on assets
Unpaid and unrecorded expenses adjusting
Employees work Dec. but receive wage at 1/15/X2
-must adjust for 12/31/x1 but not previously recorded
Adjusting entry at 12/31/X1
Wage expense 10000
Wage payable 10000
1/15/X2
Wage payable 10000
Cash 10000
(Utility expense
utility payable)
MATCHING PRINCIPLE
If didn’t adjust
-overestimate NI, RE, OE
-Underestimate liabilities and expenses
Uncollected and unrecorded revenues adjust
Company earned 500 interest on a loan at end of year X1, even though expect to collect loan at end of next year
Adjusting entry 12/31/X1 Interest receivable 500 Interest income (rev) 500
(consulting receivable
consulting fee revenue)
REVENUE RECOGNITION
If didn’t fix
-underestimate revenue and net income
Real vs. Nominal accounts
REAL
- All accounts on the balance sheet (A, L, OE, CS, RE)
- Balance of account is a CUMULATIVE running balance
- reflecting all transactions since inception of the business
NOMINAL
- all INCOME statement accounts (rev/exp/dividends)
- do not maintain cumulative running balance since inception but accumulates period by period (yr by yr)
- nominal accounts are closed at end of account period and their amounts are transferred to RE, then start at 0 again for new period
Closing entries
- All rev, exp, and divined accounts must be reset to 0 to start next accounting period
- Retained earnings account must be updated to include the amount of net income (R-E) less dividends for the current year
SALES REVENUES
0 1/1/X4
550,000 X4 transactions
550,000 12/31/X4
Closing entry 550,000
0 1/1/X5
Closing entry at 12/31/X4
Sales revenues 550,000
retained earnings 550,000
Retained earnings
RETAINED EARNINGS 10000 1/1/X2 15,000 NI Dividends 5,000 20,000 12/31/X2 (balance)
- alternative to closing entries is stmt of retained earnings
- close all income stmt accounts to RE (cost of goods, expenses, revenues)
- less any dividends
DIVIDENDS entry
Retained earnings 5000
dividends 5000
Closing entries 2
DEBIT HAS TO EQUAL CREDIT
- sales revenue would close on debit side
- cost and expenses would close on credit side
- difference in the entry would be the retained earnings (whether a loss or gain)
Retained earnings 6,800 X1 net loss 2,200 dividends 500 4,100 (Balance X2)
Dividends
Can pay dividends in a net loss with retained earnings from last year
-can’t pay dividends unless you have retained earnings to do it
Inventory example
- inventory 1/1/X3 25,000
- inventory 12/31/x3 23,000
- cost of goods sold x3 - 100,000
INVENTORY Balance 1/1/X3 25,000 100,000 cost (FIND = 98,000) 12/31/X3 23,000
Inventory 98,000
Cash 98,000
Cost of goods 100,000
inventory 100,000
Problem with wages
Dec. 31 is Tues - wages paid Fri and weekly payroll (5 days) is $4000. What should adjust on 12/31/
12/31/X1 adjust
Wage expense 1,600
Wage payable 1,600
(been 2 days - owe two days of wages - bc next 3 are in new year)
Revenues
The amount of inflowing assets from the sale of goods/services to customers - ant usually reflected in the sales price charged to customers
timing - revenues are recognized when they are EARNED not when cash is received from customers
-typically earned when goods sold have been delivered to customer or services to be provided have been rendured
Complicating revenue transactions
- Providing of sales or cash discounts to credit customers to encourage early payment on account
- acceptance of merchandise returns from customers
- the uncollectibility of customer accounts receivable
- the acceptance of payment of credit cards
Sales (cash) discount adjust
Company sells merchandise costing $600 to a customer on account for $1,000 with terms of 2/10, N/30
2/10, N/30 means customer may take 2% discount of all or portion of price paid within 10 days of sale. Any portion of price not paid within the 10 day discount period is due within the next 20 days (30 days from date of sale) in full
- 2 = amount of discount (2%)
- 10 = how long discount period lasts
- N/30 = portion that has not been paid off must be paid by then
to encourage customer to pay A/R early
Entries of NOT paid within discount period
AT DATE OF SALE Accounts receivable 1000 sales revenue 1000 cost of goods sold 600 inventory 600
AT DATE OF COLLECTION
Cash 1000
A/R 1000
if a penalty or interest is charged to credit customer for payments received AFTER 30 days
Cash XXX
interest revenue XXX
Calculate discount in terms of 2/10, N/20
1000 X 2% = $20 discount available
calculate amount of interest
Interest rate X principle amount X time period = interest amt.
36% X $1,000 X 1 year = $360 annual interest
$360 annual interest = $1 interest per day
10th day - borrow $980 from bank (to pay off with discount)
- 10% X $980 X 20/360 = $5
- pay back bank $985 on 30th day
Entries if paid within discount period
AT DATE OF SALE Accounts receivable 1000 sales revenue 1000 cost of goods sold 600 inventory 600
AT DATE OF COLLECTION WITHIN 10 DAYS
Cash 980
Sales discounts 20
A/R 1000
Sales discounts is a contra-revenue account (reduction of revenue account) - nominal and must be closed to RE at end of period
Income statement sales revenues 1000 Less: sales discounts (20) Net sales revenues $980 -Net sales revenues is gross sales revenues less any contra-revenues
Sales return adjust
Company sells 10 bikes which cuts $100 each to a customer on account at a price of $150 each
-2 days later the customer returns on bike for credit on his account bc he only needs 9 bikes
ENTRY AT DATE OF SALE Accounts receivable 1500 sales revenues 1500 Cost of goods sold 1000 inventory 1000
ENTRY AT DATE OF RETURN
Sales returns and allowances 150
accounts receivable 150
Inventory 100
cost of goods sold 100
Sales returns and allowances are contra-revenue account
Net sales revenues
Sales revenues less any contra-revenues
Gross Margin
Net sales revenues less cost of goods sold
- not net income bc that includes ALL expenses
- this only includes cost of goods sold
Gross Margin tells us our markup - how much we have marked up the price above the cost of goods sold
Income stmt for revenues and gross margin
Sales revenues $1500
Less: Sales discounts 0
Sales returns/allowances (150)
Net sales revenues $1350
Less: cost of goods sold (900)
Gross Margin (profit) $450
(9 bikes X $50 profit/bike)
Markup
Net sales price per unit $150
Cost of goods sold per unit ($100)
Gross margin/markup per unit $50
9X$50 = $450 = total gross margin or markup on sale
Gross margin/markup as a % of sales
450/1350 = 50/150 = 33.3%
Gross margin/markup as a percent of cost
450/900 = 50/100 = 50% (more accurace)
What would be sales price at?
100% markup on cost? $100 X 100% = $200
200% markup on cost? $100 X 200% = $300
Sales return ex continued
What was cost of company’s return policy which allowed for return of one unit?
- Gross margin before return = 10 X $50/unit = $500
- Gross margin after return = 9 X $50/unit = $450
- cost of return = $50
-worth it? decrease margin but increase customer loyalty
If returned merchandise has no future value once returned ENTRY AT DATE OF SALE A/R 1500 Sales revenues 1500 Cost of goods 1000 inventory 1000
ENTRY AT DATE OF RETURN
Sales returns and allowances 150
accounts receivable 150
-skip cost of goods credit and inventory debit bc it is no longer an asset bc no future benefit
Why use contra-revenue accounts instead of just debiting sales revenues?
-better information for management
Sales return example 2
Cost of goods is 70% its selling price
.7 X 100,000 = $70,000
4/3 JOURNAL ENTRY
A/R 100,000
Sales revenue 100,000
Cost of goods 70,000
inventory 70,000
4/13 journal entry
Cash 49,000
Sales discount 1,000
A/R 50,000
5/2 journal entry
Cash 34,000
A/R 34,000
sales returns and allowances 16,000
A/R 16,000
inventory 11,200
cost of goods sold 11,200
-return = 16,000 X .7 = 11,200 (inventory returned)
Gross margin = 24,200
% markup on cost = 41% (24,200/58,800 = gross margin/cost of goods sold)
Income stmt if returned goods were unusable
Net sales revenues 83,000
Less: cost of goods (70,000) - full cost bc returned goods cannot be resold
Gross Margin $13,000
% markup on cost = 1.9% (13,000/70,000)
Accounting for uncollectible accounts receivable
Business makes a sale on account and gives them 30 days to repay - usually B2B
-always a risk that these sales will go bad and you won’t be repaid bc customer is unable to pay
Subsidiary ledger
A set of accounts that provide detail for a general ledger
- customer by customer - more detail to keep track on each transaction
- must post to BOTH general and subsidiary ledgers - should = each others ending balance
Uncollectable accounts receivable example
Jones Wholesale candy started business on Jan X4
-revenues were $120,000 - 20% were cash sales and rest were on account - cost of goods was $70,000
Cash (20% X 120,000) 24,000
A/R 96,000
Sales revenue 120,000
Cost of goods 70,000
inventory 70,000
Made collections of A/R 85,000
Cash 85,000
A/R 85,000
ACCOUNTS RECEIVABLE
1/1/X4 0
96,000
85,000
12/31 balance 11,000
-not known if these 11,000 are uncollectible - however it is known that $920 is uncollectible
-need to reduce assets (A/R) bc there is no probable future benefit
20X5
Bad debt expense 920
A/R 920
-BUT THIS GOES AGAINST MATCHING PRINCIPLE
—-expenses must be accounted for at time they helped make revenue - revenue earned in 20x4 but this bad debt expense is in 20x5 - didm’t know this A/R would go bad
Allowance method for bad debt
Uses estimation of uncollecible A/R to reflect bad debt expense in the proper period and is required under GAAP
-we hope all accounts will go through but we must estimate a percentage that will in order to comply with the matching principle (therefore it is already accounted for)
Prepare adjusting entry for 12/31/X4 assuming 10% of the 12/31/x4 balance of A/R will be uncollectible
10% X 11,000 = 1,100
12/31/X4
Bad debt expense 1,100
Allowance/reserve for uncollectible A/R 1,100
- is a contra-asset account to reflect estimated amount of uncollectible A/R
- can’t just credit A/R bc then you have to go update subsidiary ledger on a specific customer account - and it is an estimate so you can’t guess which specific customer will be uncollectible
Balance sheet adjustment fir bad debt expense
Current assets: A/R 11,000 Less: allowance for (1,100) uncollectible A/R Net realizable value 9,900
Net realizable value - net we think we are going to collect
Allowance for uncollectible A/R is a real account - increase with credit entries and ends with a credit balance
Uncollectible A/R example continued for following year
in 20x5 revenues = 210,000, 70% on account and rest in cash
-cost of goods sold = 60% of total sales rev
Cash (30% X 210,000) 63,000
A/R 147,000
Sales revenue 210,000
cost of goods sold 126,000
inventory 126,000
Collections in 20x5 of the 11,000 12/31/X4 balance totaled 10,080 (all but the 920 we knew was uncolletible)
-and collections of 117,000 of sales on account in 20x5
Cash 10,080
A/R 10,080
Cash 117,600
A/R 117,600
920 was proven uncollectible and must be written off books
-not bad debt expense bc you already estimated this and would be double counting the expense
Allowance for uncollectible A/R 920
A/R 920
-was credited by an estimate bc you don’t know who will go bad, now you know so must debit this account
ALLOWANCE FOR UNCOLLECTIBLE A/R
1,100 12/31/X4
write-off bad 920
180 (balance - overestimated uncollectible
Accounts receivable
12/31/X4 11,000
147,000
10,080 (Collect from X4)
117,600 (Collect in X5)
Balance
before write-off 30,320
920 (Write-off)
Balance 29,400
what is affect of a write-off of A/R on the balance sheet
0 affect on balance sheet (Reduce asset and contra-asset)
also 0 affect on income stmt
-just cleans up the books - the effect was in old entries
Allowance for uncollectible A/R
- If it ends in CREDIT = Overestimated uncollectibles
- ends in DEBIT = underestimated uncollectibles
- can fix over/under estimate by compensating for prior year in estimation of current year
- —overstated bad debt expense in 20x4 by $180, so understate it by $180 in 20x5
Prepare adjusting entry at 12/31/X5 for estimated bad debt expense with 8% of the balance of A/R
- ending balance of A/R was $29,400
- –8% of 29,400 = 2,352 - 180 (overestimate) = 2,172
12/31/X5 ADJUSTMENT
Bad debt expense 2,172
Allowance for uncollectible A/R 2,172
But the ledger for Allowance would have ending balance at 12/31/X5 OF 2,352 (8% X 29,400) - it would be compensated by the adjustment
Aging of accounts receivable to estimate uncollectibles
-look at subsidiary ledgers to see how old each A/R are - oldest are more likely to go bad
current A/R = 15,000 (5% estimated uncollect) = 750
past due:
0-30 days = 8,000 (8% estimated) = 640
30-60 days = 3,000 (10% estimated) = 300
-keep multiplying by % and add up the estimates)
= $2,270 (vs. the guessed 2.352)
-aging is a better estimate from business experience than guessing the 8% previously
ALLOWANCE FOR UNCOLLECTIBLE A/R LEDGER
1,100 12/31/X4
Writeoffs 1,280
Underestimated 180
2,450 adjust
2,270 (12/31/X5 balance)
Bad debt expense 2,450
Allowance for uncollectible A/R 2450
-make sure you don’t use the 2,270 we found!! have to do the adjustment including the overestimate/underestimate
Sales price =
Cost + markup
X + (% x X
Net realizable value =
A/R less contra-assets
- A/R - final balance of Allowance for uncollecible A/R
- (not A/R less the adjustment you used in the journal entry, it is the total A/R ending balance)
Writeoff entry
Allowance for uncollectible A/R XXX
A/R XXX
Company wrote off then ended up getting it A/R 500 Allowance 500 Cash 500 A/R 500
T/F allowance for uncollectible A/R will ALWAYS end with credit balance
TRUE
T/F allowance account will be closed to RE
False
-balance sheets are real accounts - never closed - cumulative running balance
T/F management’s estimate of uncollectible A/R at year end will always = the amount of bad debt expense for the year
FALSE
-could have over or underestimated in prior year and must compensate for this in next year
T/F matching principle requires the “bad debt expense” be accounted for on an estimated basis rather than when uncollectibility of an A/R is actually determined
TRUE
Credit Card sales
- Customer makes charges on card and must pay customer’s bank
- customer swipes at restauraunt, immediately sends credit card verification to customer’s bank
- once approved, then restaurants bank credits the restaurant’s account, but bank charges fee to restaurant
- customers bank then electronically transfers funds to restaurants bank to cover the amount charged on card
- then customer pays charges to their own bank
- restaurant gets money like cash (not A/R), but with a charge for accepting the card
Credit card sales adjust entry
Company sells merchandise costing 1000 to a customer for 2000
- customer pays with VISA
- company has agreed to pay 4% fee on all VISA sales for the right to accept VISA as payment
ENTRY AT DATE OF SALE
Cash 1920
credit card expense 80
Sales revenues 2000
cost of goods sold 1000
inventory 1000
-company pays fee for allowing customers to pay with card
Amount to charge to new $100 cash in a credit sale
Cash 97
Credit card fee 3
sales revenues 100
(X) x (97%) = 100
X = 103.09
Two ways to estimate bad debt
- The % aging of A/R method
2. % of credit sales method
A/R information
A/R ledger Beginning balance (Debit) -debit (+ credit sales) -credit (- cash collections, write-offs) ending balance (Debit)
Allowance ledger Beginning balance (Credit) -debit (- write-offs) -credit (+ estimate bad debt expense) Ending balance (Credit)
Journal entries
1. record credit sales on account (A/R increases)
A/R XXX
sales revenue XXX
- Cash collections on A/R (A/R decreases)
Cash XXX
A/R XXX - Write-offs on A/R (A/R decreases)
Allowance XXX
A/R XXX - estimate bad debt expense (ALWAYS)
Bad debt expense XXX
allowance for bad debt XXX
Estimating bad debt expense - % of A/R Aging method
USES BALANCE SHEET
Allowance ledger
beginning credit balance
write-offs
XXX
(CALC THIS #) - ending balance of A/R
EX. Aging - added percentages = 54,100
Allowance ledger
50,000 beginning
w/off 42,000
8000 (overestimate)
46,100 adjust
54,100 ending balance
JOURNAL ENTRY
Bad debt expense 46,100
Allowance for uncollectible A/R 46,100
-this method calculates the ending balance $ and you solve for the adjusting # to put in the journal entry
Estimating bad debt expense - % of credit sales method
USES INCOME STATEMENT
Allowance ledger
beginning credit balance
Write-off
(CALC THIS # - % of CR sales)
ending balance
EX. sales were 874,000 (estimates 5% will go bad) 874,000 X .05 = 43,700 Allowance ledger 50,000 beginning W/off 42,000 43,700 adjust 51,700 Ending
JOURNAL ENTRY
Bad debt expense 43,700
allowance for bad debt 43,700
-this method calculates the adjusting entry # which you use in the journal entry - then you add for the ending balance #
Perpetual inventory accounting
Means every transaction involving an inflow and outflow of inventory is recorded as it happens with a debit/credit to inventory account
-as a result, inventory account in general ledger will maintain a running balance of the amount of inventory on hand at any point in time
- most perpetual inventory accounting systems utilize a subsidiary ledger
- item by item
Effect of computerized systems in accounting for inventory
- Especially useful in managing SEASONAL INVENTORIES
- see how much is left, whether to discount day of holiday - Can help us discovery GEOGRAPHIC and DEMOGRAPHIC rends relative to sales
- Can help us identify relationships btwn different products purchased by similar costumers (snacks and diapers)
Example of perpetual inventory accounting given factors of purchase discounts/returns
11/1/X2 Joe buys inventory of 20 bikes for $100 on terms 2/10, N/30
- 2 days later Joe returns one defective bike for credit
- on 11/9/x2 joe pays balance due net of the discount
DATE OF PURCHASE
Inventory 2000
accounts payable 2000
DATE OF RETURN
Accounts payable 100
inventory 100
PAYOFF WITH DISCOUNT (2% X 1900 = $38)
Accounts payable 1900
Cash (1900-38) 1862
inventory 38
decreased the cost of the inventory by paying with discount - don’t use contra-inventory account
Accounting for inv. perpetually required accounting for the inflow and outflow of the # of units as any increase of decrease in the cost of those units
- original cost of bicycles (20 @ $100 each)
- true cost (20 @ $98 each)
- true inventory balance (19 @ $98 each = 1862)
Inventory ledger 2000 100 (return 1 unit) 38 (discount of 2% X 1900) 1862 (ending balance)
Inventory cost flows complications
Start used car business and buy 3 cars for resale
-buy old VW bug (2000), camaro (4000), pinto (6000)
Journal
- debit all inventory
- credit all cash
One car sold for 7000 Cash 7000 sales revenues 7000 cost of goods ? inv. ? -don't know which car sold?
If Pinto
cost of goods 6000
inventory 6000
-Gross margin/profit = rev-cost of goods sold = 1000
If VW bug
Cost 2000
inv. 2000
-gross margin = (7000-2000) = 5000
Inventory jellybean example
Start business that sells jellybeans purchases 3 times
- 10 lbs. @ $2/lb. = $20 (first purchase, bottom of jar)
- 10 lbs. @ $2.50/lb. = $25 (middle of jar)
- 10 lbs. @ $3/lb. = $30 (top of jar)
- total inventory is 75
if customer buys 1 lb. of jellybeans we don’t know what the cost is bc they could be jellybeans from any of the 3 purchases - price kept increasing from supplier
LIFO (Last in first out) - customer scoops in and takes 1 lb. from top of jar - would be form the last purchase ($3/lb.)
ENTRY
Cost of goods 3
inv. 3
FIFO (First in first out) - customer reaches to bottom of jar
Entry
Cost of goods 2
Inv. 2
AVERAGE COST - customer mixes around and takes a mixture of the 3 inventory costs (75 / 30 lbs. = $2.50 per pound) ENTRY Cost of goods 2.50 inv. 2.50
Depending on which method has a significant impact on PROFITABILITY IN INCOME STMT
Comparing btwn methods in jellybean example
LIFO
- net sales rev. $4
- Less: cost of goods sold (3)
- Gross margin = $1
- ending inventory balance = $72
FIFO
- net sales rev. $4
- Less: cost of goods sold (2)
- gross margin = 2
- ending inv. balance = $73
Average
- net sales rev. $4
- Less: cost of goods sold (2.50)
- gross margin = 1.50
- ending inv. balance = 72.50
THERE WOULD BE NO DIFFERENT IN AMOUNT OF COST OF GOODS SOLD BTWN METHODS IF ALL THE INVENTORY WAS SOLD
at supermarket they try to sell at FIFO and we try to buy at LIFO
What method of inventory accounting would you choose?
GAAP ALLOWS ANY METHOD
-but method must be consistently used over time
to impress investors:
-lowest cost and highest market (FIFO in ex.)
to pay less income tax
-highest expense and lowest margin (LIFO in ex.)
Whatever method you use for fin. reporting to creditors/investors you must also use for income tax reporting
- if the ex. was actually in a deflationary env. (supply cost kept decreases) - the methods of FIFO and LIFO would product the opposite results
- if there are stable prices in the env, there is no change btwn LIFO and FIFO
in the case of cars identification is required by GAAP in cost bc that is more accurate in the gross margin in the end
-any methods can be used in jellybean example because the jellybeans all appear to be alike
Effects of LIFO and FIFO
Inflation environment -cost increases as time goes on -first costs have lower price (FIFO) -last costs have higher price (LIFO) LIFO -higher cost of goods sold -lower net income and taxes FIFO -lower cost of goods sold -higher net income and taxes
Deflation env. -cost decreases with time -first costs have higher price (FIFO) -last costs have lower price (LIFO) LIFO -lower cost -higher net income and taxes FIFO -higher costs -lower net income and taxes
Which inventory cost flow method would product the highest tax liability in a period of deflation?
LIFO
Which inv. cost flow method would result in a higher ending inventory balance in a period of inflation
FIFO
Which will result in ending inventory that utilizes the most recent costs?
FIFO
Affect on net income in stable prices
no difference between methods
-no difference on net income of all inventory is sold
FIFO example
Inventory ledger
- (1000 X $20) = 20,000 - beginning balance of inv.
- (300 X $21) = 6,300 - purchased 300 inv. @ $21 each
- sold 400 units (go to First in, so the ones that cost $20 per unit = 400 $20 = $8000 cost of goods sold - and now there are 600 left of the $20 ones
- so when sell 500 = 500 X 20 = 10,000 cost - now 100 left of the $20 ones
- sell 500 - (100 X $20) + (300 X $21) + (100 X 22) = 10,500 cost of goods - used up all $20 and $21 inv.
LIFO example
Inventory ledger
(1000 X $20) = 20,000 beginning balance
(300 X $21) = 6,300 - 300 purchased at $21 each
-sold 400 units - go to last in = (300 X $21) + (100 X $20) - now have none of the 21 left and 900 of the $20 left
-just continue using the latest inventory costs in
Moving weighted average example
Inventory ledger (1000 X $20) = 20,000 beginning inventory balance (300 X 21) = 6,300 MWA = (26,300 / 1,300) = 20.23 per unit -sold 400 (400 X 20.23) = 8,092 -purchased 400 @ $22 per unit = 8,800 MWA = (900 left X 20.23) = 18,207 + 8,800 (27,007 / 1300) = 20.77 per unit -sold 500 (500 X 20.77) = 10,385 cost -purchased 600 @ $23 each = 13,800 MWA = (800 left X 20.77) = 16,616 + 13,800 (30,416 / 1400) = 21.73 per unit -sold 500 (500 X 21.73) = 10,863
ending balance = 19,560
The three methods change:
cost of goods sold
- therefore changing gross margin
- also changing % markup (gross margin/ cost)
Physical inventory
Go out and actually count inventory
- periodic physical inv. necessary even tho we maintain subsidiary ledger bc errors can be made
- most important reason is THEFT or pilferage
- —never will be able to be determined by accounting
- can’t always rely on accounting, must look at discrepancies through physical inventory
Entry
Pilferage expense XXX
inventory XXX
-most businesses use PERPETUAL acct. system
Subtitles in income stmt
INCOME STMT For year ending 12/31/X1 Sales revenues Less: sales discounts sales returns/allowances NET SALES REVENUES Less: cost of goods sold GROSS MARGIN Less: operating expenses salaries expense utility expense payroll tax expense OPERATING INCOME Other revenues and expenses interest revenue interest expense INCOME BEFORE INCOME TAX income tax expense NET INCOME/LOSS EPS
- operating expenses are also selling and administrative expenses
- operating income reveals the true profit from operating the business
- “other revenues and expenses” = loans and expenses not part of normal operations (loaning to employees)
- interest expense is lower than operating expense bc it is not a cost of operating the business it is a cost of FINANCING the business
- interest expense is common to be large
Operating expenses
Common is salaries and wages
- not as simple as “Wage expense”
- major complicating factor is PAYROLL TAXES
Two kinds of payroll taxes
- employee’s payroll tax withholding
- employer’s payroll taxes
Employee payroll tax withholdings
- FICA taxes (social security and medicare)
- federal income taxes
- state income taxes
- union dues, contributions to retirement or investment plans, charitable contributions
- these are EMPLOYEES taxes that the employer takes out of his/her paycheck
EX. Employee’s gross wage for a month is $1000
-employer withholds $70 FICA, $170 federal income taxes and $60 state income taxes
-check for their net pay of $700
ENTRY
Wage expense 1000
Cash 700
Employee FICA payable 70
Employee FIT payable 170
Employee SIT payable 60
-desensitizes people bc employers pay the taxes on their behalf - employees don’t know how much taxes they pay
Employer’s payroll taxes
(tax for letting them have employees)
- FICA taxes (equal to employee amounts)
- Federal unemployment insurance (FUI)
- State unemployment insurance (SUI)
Ex. Employer record’s employer’s payroll tax liability arising from the $1000 employee payroll in previous ex
-FUI = 10 and SUI = 5
ENTRY
Payroll tax expense 85
employer’s FICA payable 70
employer’s FUI payable 10
employer’s SUI payable 5
Employer’s have two payroll related costs
- employee’s salary/wage expense
- employer’s payroll tax expense
State sales taxes
amount charged to consumers when they buy products from a business
Ex. Joe sells burger for $.99 but collects $1.05 including state sales tax of $.06
Cash 1.05
Sales Revenue .99
Sales tax payable .06
-liability bc you didn’t earn the 6 cents, you are obligated to pay it to the state gov.
ENTRY ON REMITTANCE OF SALES TAX TO STATE
Sales tax payable .06
Cash .06
Whose rev. is the sales tax? - state gov.
Whose expense is the sales tax? - customers
Other operating expenses
Required by matching principle to be accounted for in timing of the revenues
-Prepaid property tax expense
-utilities expense for Dec. has not yet been received/recorded but last months bill was $1500
Utilities expense 1500
utilities payable 1500
(sometimes you need to estimate)
Internal controls
Policies and procedures implemented by a business that are designed to safeguard assets and ensure accurate accounting records
- fencing around inventory/supplies
- computer passwords
- shoplifting detection procedures
Key internal controls in safeguarding cash (most attractive asset)
- Separation of duties (who collects cash, accounts for it)
- Authorization procedures (all signed by 2 ppl)
- Adequate documentation and records
- Independent checks on performance (bank reconciliation)
Who is responsible for internal controls?
Management
- if businesses don’t know who to protect and establish internal controls use SPA
- CPA expertise in the area of internal controls
- publicly held businesses are required to include in their annual report a letter that mentions a fin. report, including internal controls
Management is responsible to prepare fin. stmts. in accordance with GAAP
- checked and audited by CPAs
- many companies hire internal auditors to check internal controls
Important parts of internal control
- assets are physically safeguarded
- only authorized transactions occur
- complete and accurate records are kept
In fraud triangle, why are internal controls important?
Reduce opportunity
Fraud triangle
-opportunity, pressure, rationalization
Current assets/liabilities
Current assets
-cash or are easily converted to cash within one year
current liabilities
-obligations required to pay within one year
Capitalized costs vs. expenses
“Capitalizing an expenditure” - record as an asset and expense as used up
-expenditure NOT same as an expense
Buy 100 pencils at $10/each
Pencils (office supplies) 10
cash 10
As each pencil is used up
pencil expense .10
pencils .10
Alternative approach “expensing an expenditure”
Pencil expense 10
cash 10
-saves time, has short life as an asset - will be used up quickly and become an expense
Long-term assets (non-current assets, operating assets, capital assets)
- Property plant and equipment
- land, improvements, buildings, machinery, equipment with expected useful life longer than one year - Intangible assets
- patents, trademarks. copyrights, franchise rights, goodwill with expected future benefit in excess of one year - Natural resources
- oil wells, mineral deposits, timber tracts with expected future benefits in excess of one year
Basic accounting for operating assets
- Record the acquisition of the asset
- Allocating the cost of the asset to expense over its useful life
- recording any repairs or improvements to the asset
- recording the sale or disposal of the asset
- Record acquisition of the asset
GAAP requires costs incurred in acquiring an asset and preparing it for its original intended use to be CAPITALIZED AS PART OF THE COST OF THE ASSET
Ex. Delivery truck purchased 1/1/X1 for 60,000 paying 20,000 cash and note payable
-paid 1800 in sales tax, 1200 in shipping and prep costs, and 2000 for paint job
Truck 60,000 cash 20,000 N/P 40,000 Truck 5000 Cash 5000
- Allocation of cost of asset to expense over useful life
Required by matching principle
- depreciation expense (PP & E)
- Amortization expense (intangibles)
- depletion expense (natural resources)
Truck has estimated useful life of 6 years with estimated salvage value at end of 6 years of 5000 - prepare adjusting entry 12/31/X4 for depreciation expense using straight line method
(65000 - 5000) / 6 = 10,000 per year
12/31/X4 adjusting entry
Depreciation expense 10,000
Accumulated depreciation 10,000
Straight line method
(Total cost - salvage value) / # years of useful life
(65000 - 5000) / 6 = 10,000 per year
Accumulated depreciation
Contra-asset account
-gives most info to investors and creditors - depreciation is based on judgements
Balance sheet
Long term assets
truck 65,000
accumulated depreciation (10,000)
BOOK VALUE $55,000
Book value
original capitalized cost less any accumulated depreciation
-on balance sheet
Book value at end of 6th year of ownership
truck 65,000
less accumulated depreciation (60,000)
Book value = 5000 (salvage value)
-can modify depreciation estimates but not go back and change - it would just be applied from that point on
EX. purchase date 4/1 instead of 1/1 (10,000 X 9/12 months) = 7,500 on 12/31/X4 -7500 -Each year after would be 10,000 -final year 7 would be 2,500 (3 months)
LAND NEVER DEPRECIATES!!!
Units of production method
Other way to estimate depreciation than straight line
Ex. capital cost = 65000 but instead of estimated useful life of 6 years, the trucks usefulness is estimated at 100,000 total miles - truck annually driven 13,000 miles in 20x4
($65000 - $5000) / 100,000 miles = $.60 per mile
$.60 X 13,000 miles = $7,800 for year X4
Depreciation expense 7800
accumulated depreciation 7800
-changes per year depending how much they use it
- would use general ledger for equipment, accumulated depreciation
- subsidiary ledger for truck #1, #2….
- Record any repairs, maintenance or improvements to operating assets
GAAP requires any costs incurred in REPAIRS or MAINTENANCE to be expensed in the period incurred
-Ex. tuneup and oil change on truck cost 250 in cash
repair and maintenance expense 250
cash 250
GAAP requires costs incurred in IMPROVEMENTS to be CAPITALIZED an in increase in the original cost of the assets
-improvements are costs that significantly increase the original productivity of an asset or extend the useful life beyond what was originally estimated
-Ex. in 20x7 truck’s engine give out and must be replaced by 7000 - it is estimated to increase estimated useful life by 4 years of original estimate
truck 7000
cash 7000
Revised capitalized cost:
original cost 65000
cost of improvement 7000
$72,000
Revised book value
revised capitalized cost $72,000
Less: accumulated depreciation (30,000) - in 3rd yr
Book value $42,000
-would have to change depreciation amount for future bc of these changes
- Recording the sale or disposal of an asset
Upon sale/disposal of asset, the book value of the asset must be removed from accounting records
-the difference btwn sales price and book value will generate a gain or loss on the sale
Ex. Truck purchased 1/1/X4 with a capitalized cost of 65,000 - is depreciated on straight-line basis and no improvements have been made
-truck sold 1/1/X6 (journal entries for 3 scenarios)
- Truck sold for $47,000 cash
Cash 47000
Accumulated depreciation 20000
truck 65000
gain on sale of truck 2000
Accum. deprec ledger 10000 (x4) 10000 (x5) sale 20,000 0
- Truck sold for 40,000
Cash 40,000
Accumulated depreciation 20,000
Loss on sale of truck 5,000
truck 65,000 - Truck disposed of with hauling fee of $500 - completely worn out
Accumulated depreciation 20,000
loss on disposal of truck 45,000
truck 65,000
cash 500
Gain on sale
Gain = sales price - book value
“gain on sale” is a revenue account! on income stmt - below operating income under “other rev. and exp.”
Loss on sale is an expense
Trademark
Intangible asset
- Right to use a name, logo, picture, sound, or any other distinguishing symbol
- trademark rights can be sold or licensed to others
Patent
Intangible asset
- an exclusive right to use an invention or discovery in the production and sale of goods/services - right issued by gov. for 20 year
- can be sold or licensed
Franchised rights
Intangible asset
- exclusive right to sell a certain product/service within a designated geographic area
- these rights usually purchased from existing business and the terms of the right are governed by contract
Copyrights
Intangible asset
- Exclusive rights that protect the works of authors and other creative persons or businesses against copying or unauthorized use
- can be sold or licensed
Intangible assets on balance sheet
Can’t be valued so not on balance sheet
- only reflected on balance sheet if there is an identifiable HISTORICAL COST attributable to it
- usually raised from a purchase of it
- trademarks are recorded only when purchased by another company
- advertising is valued by trademark? NO, it is an expense at the time they are purchased
- patents are recorded as assets if patent rights are purchased
- internally developed patents are recorded only to the extent of filing fees and legal costs in application
Under GAAP - R & D costs are to be expensed when incurred even if such costs may contribute to a patentable discovery - due to subjectivity (don’t know will have benefit)
-franchise rights are recorded only when purchased
Any legal fees and court costs incurred in successful defense of any of these rights should be capitalized to the asset - if they sue to protect rights
-important to remember when looking at the BS that there may be some intangible assets not recorded that greatly enhance the value of the company
Intangible assets capitalized cost
Any capitalized costs of intangibles must be reflected on the balance sheet to expense over its life
-called AMORTIZATION - life established by contract/law
AMORTIZATION CALCULATED ON STRAIGHT-LINE BASIS WITH NO SALVAGE VALUE
Amortization expense XXX
Accumulated amortization XXX
-contra-asset account
Ex. patent with remaining legal life of 5 years is purchased at 50,000 cash
DATE PURCHASED
Patent 50,000
Cash 50,000
(50,000 - 0) / 5 years = 10,000 per year
12/31/X1
Amortization expense 10,000
Accum. amortization 10,000
Book value after 2nd year
50,000 - 20,000 = 30,000
Goodwill
Exists if the business is actually worth more than the value of its assets less liabilities
- 2 companies with same assets and liabilities, therefore same OE
- but one is worth more bc their NI is 150,000 and the other is only 30,000 - goodwill is the difference
Goodwill is recorded as an asset only when a business is purchased (bc can’t put it on BS bc subjective - can’t determine unless buyer)
-amount to be recorded is excess price paid in the purchased of a business above the FMC of the assets purchased less any liabilities assumed
Ex. Taco shop purchased for 500,000 cash and the assumption of business liabilities
current FMV of assets/liabilites are:
Total assets = 335,000
Account payable (25,000)
Net assets purchased = 310,000
purchase price = 500,000
goodwill purchased = 190000 (diff. btwn net assets and price)
Entry
Assets (actually write out each asset) 335,000
Goodwill 190,000
Accounts payable 25,000
Cash 500,000
Goodwill amortization
GAAP used to require goodwill to be amortized to expense over an estimated life not to exceed 40 years
-most companies however would increase goodwill
Current rules now require an annual comparison of recorded goodwill to its current FMV
- the FMV refers to excess price above current value of assets less liabilities, that would be paid today if business were available for purchase
- determined by appraisal
- if amount of goodwill is increased from one year to next, no gain is reported
- if amount of goodwill decreases, a loss is recorded in income stmt and reduction reflected in goodwill amount on balance sheet
Natural Resources
Recorded at their historical cost
Oil rights/well 10,000,000
cash 10,000,000
Reduced by DEPLETION - using units of production
Ex. oil well has approx. 20 million barrels in reserve, depletion expense calc. at:
(10 million - 0) / 20 million barrels = $.50 per barrel
-500,000 barrels extracted and sold in current year
(500,000 X .50) = 250,000 depletion expense
Depletion expense
Accumulated depletion
T/F intangible assets not on BS bc they have no physical substance and cannot be sold
FALSE
T/F Costs of R & D resulting in a patented tech. should be capitalized as part of the cost of the patent and amortized over a 17 year life
FALSE
T/F Amortization of intangibles and depletion of natural resources are both cost allocation to expense required under the matching principle
TRUE
T/F Goodwill is only recorded on the books of the company that purchases another company
TRUE
T/F Depletion of natural resources is typical calculated based on units of production
TRUE
Goodwill
represents the costs associated with the purchase of the company in excess of the FMC of its assets less any assumed liabilities
Long term liabilities
Obligations due after the next 12 month period
- long term N/P
- Morgage N/P
- Bonds payable
Long term note payable
100,000 borrowed from bank on 9/1/X5. Note bears 8% annual interest payable every 6 months (4000) and matures in 3 years (must be paid)
9/1/X5 (only incur interest as time passes)
Cash 100,000
N/P 100,000
Adjust 12/31/X5
Interest expense 2,667
interest payable 2,667
(amt. X rate X time) = (100,000 X .08 X 4/12)
Entry 3/1/X6 - interest due
interest payable 2,667
interest expense 1,333
cash 4000
9/1/X6
interest expense 4000
cash 4000
Adjust 12/31/X6
interest expense 2667
interest payable 2667
Interest expense ledger 1,333 3/1 4000 9/1 2667 12/31 -total = 8000 (100,000 X .08 X 1) = yearly rate
Entry at maturity Interest expense 4000 Cash 4000 Note payable 100,000 Cash 100,000
Mortgage Note payable
Note payable in which real estate (land/building) is pledged as collateral through legal document called trust deed
- trust deed authorizes 3rd party (trustee) to sell property in default of note payable and disperse proceeds from sale to lender
- sometimes in disclosure, the trustee gives debt to bank and you keep rest
Characteristics of MNP
- Typically long term (15, 25, 30 years)
- Bears fixed or adjustable rate of interest (change due to market)
- Require a monthly payment
- includes monthly interest and a portion of the principle such that at maturity the entire amount of principal will have been repaid in full - FULLY AMORTIZING - Most provide that monthly payments be applied first to any interest due at the time of payment with any excess paid applied to the principal
MNP example
4/1/X7 real estate purchased for 300,000 (land and building valued 50,000 and 250,000)
-pay 30000 cash and rest MNP
Land 50,000 - Separate bc land does not depreciate
Building 250,000 - buildings do depreciate
Cash 30,000
MNP 270,000
270,000 MNP is fully amortizing over 30 years and bears 9% annual interest compounded monthly (means if you fail to pay, next month has interest on the unpaid interest)
-monthly payments of 2,172.48 payable on the first of each month beginning 5/1/X7 for next 30 years
First entry 5/1/X7
Interest expense 2025
Mortgage N/P 147.48
Cash 2,172.48
-interest expense = (270,000 X .09 X 1/12) = 2025
6/1/X7 second month
Interest expense 2023.89
MNP 148.59
Cash 2,172.48
-int exp = (269,852.52 X .09 X 1/12) = 2023.89
-change # of principal balance bc you pay of the amt. each month by a little
Mortgage amortization schedule
Shows reduction of principal amount of the note each month
- decrease shows change in interest portion paid each month and change in principal portion
- each month, interest portion decreases and principal portion increases
- in last years, interest is very low - majority of monthly payment is principal portion
How do you build equity in real estate?
Equity = among of cash left over to owner in the event of sale of property
Purchase property
Cash down (equity) 30,000
mortgage NP 270,000
Total purchase price 300,000
Cash proceeds upon sale -after 2months (no selling costs) Sales price 300,000 payoff of MNP (269,704) Net cash upon sale 30,296
Build up in equity over 2 months
cash proceeds upon sale 30,296
cash invested at purchase (30000)
build up in equity (Cash) = 296
296 = principal portion of monthly mortgage payments for 2 months
-most build up in equity on real estate comes from appreciation in property value over time
Build up in equity in 2 ways - sell after 1 year
1. appreciation in value:
net sales price 306,900 (what u sell it for)
Less: original cost (300,000)
NET APPRECIATION 6,900
- plus any payments of principal on note during year
(270,000 - 268,155) = 1,845
Build up in equity = 8.745
Build equity slightly by paying principal but MAJORITY comes from appreciation (less selling costs)
What happens if depreciation expenses increases
Net income decreases and income taxes decrease
Bonds payable
Note payable arising from borrowing cash from the public
- can be issued at premium (Get more than repay 1500 - pay 1000)
- can be issued at discount (get less than pay)
Ex. 11/1/X3 XYZ issued (borrowed) 1,000,000 cash through bonds issued at face value
-bear interest at annual rate of 7% payable semi-annually on 5/1 and 11/1 each year through maturity at 11/1/X6
11/1/X3
Cash 1,000,000
Bonds payable 1,000,000
12/31/X3
Interest expense 11,667
interest payable 11,667
5/1/X4
interest payable 11,667
interest expense 23,333
cash 35,000
11/1/X4
interest expense 35,000
cash 35,000
11/1/X6 - maturity
Bonds payable 1,000,000
Cash 1,000,000
Interest expense 35,000
Cash 35,000
Bond indenture
Written contract that spells out legal terms and conditions of the bond issuer and the rights of the bondholder
-the NP that explains everything (monthly rate, maturity)
Debentures
Unsecured bonds
-no collateral, if bus. fails to make payments the lender has no right to anything
Secured/mortgage backed bonds
bonds for which property or real estate are specified as collateral
-usually lower interest bc less risk
Junk bonds
Unsecured bonds issued by companies with low credit ratings
- low confidence if they will repay
- high interest rates
Senior/ subordinated bonds
Typically unsecured bonds that are designated as having priority or subordinated rights to other unsecured creditors
- priority
- low interest and low risk
Term bonds
Bonds that require principal repayment in full at maturity
Serial bonds
Bonds that require principal repayment periodically throughout the term of the bond
-pay portion of principal along the way
Convertible bonds
Bonds which may be converted to other securities (stock) after a specified period of time, at the option of the bond holder
Callable bonds
Bonds which can be paid off prior to maturity at the option of the company issuing the bonds
-lose $ bc interest rates - not god to investor
Bonds issued on premium/discount
Bonds which are issued for cash in an amount greater or less than the face amount or principal of the note
Bond exchange
A market where bondholders may sell their bonds to other investors
- bonds worth more when interest rates are lower
- when interest rates increase bond price decreases
- look at interest rates to decide when to purchase bonds
Financing of a business
Debt financing (borrowing)
- notes payable
- account payable
- bonds payable
Equity financing (investors/owners)
- capital contributions
- retained earnings
Two forms of corporate ownership (capital stock)
COMMON STOCK
- basic ownership in corporations
- right to vote (elect board of directors)
- right to share equally per share in corp. profits as dividends or any distributions to owners if bus. terminates
- all companies issue common stock and are controlled or owned by the common stockholders or owners
PREFERRED STOCK
- supplemental form of ownership which provides preferential but limited rights to those of common
- no voting rights but have limited priority right over common shareholders to dividend and distributions in termination
- many companies do not issue preferred, but it is an option
Common Sotck
Company issues 10,000 shares of $.01 pat value (value required by state, must be above par value) common stock for $50 per share
Cash 500,000
Common stock, at par ($.01) per share 100
Paid in capital in excess of par,
common stock 499,900
-accounts on BS under OE, contributed capital
BS stockholder’s equity
contributed capital 100
common stock, $.01 par val 499,900
paid in capital in excess of par, 500,000
common stock
retained earnings 250,000 Total OE 750,000
Par value
may also be called “State value”
-same as everything with par but write stated value instead
Par value is just the lowest # a business has to issue per share
-most states have eliminated par val
Cash 500,000
Common stock (no par val) 500,000
Disadvantages of raising capital thru common stock/ debt
Thru common stock
- others have a vote and say in business
- others have rights to dividends or distributions in termination, or increased stock values
Disadvantages of raising capital thru debt
- capital borrowed (principal) must be paid back plus interest - regardless of ability to pay
- Potential forced liquidation of assets in default
Preferred stock
Equity ownership designed to avoid disadvantages of common stock without debt
- non voting
- limited in the sharing of dividend distributions
- capital under OE on BS bc does not need to be repaid
Why someone contribute capital to a company in exchange for preferred stock?
- have dividend limitations but also have dividend priority over common
- also have priority in liquidity of a business - terminates
- Some tax benefits to corporate investors
How id dividend preference determined?
Ex. in addition to 10,000 shares of no par value common stock issued at 50 per share, the company issued 5000 shares of 7%, $100 par value preferred stock for $105 per share (7%, $100 = amount of preference for preferred)
Cash 525,000
Preferred stock 525,000
-par value more significant for preferred stock
.07 X 100 = $7 per share, per year
7 (dividend) / 105 (investment) = about 7% annual return on investment
-must repay par value but never the investment
How does preferred shareholder get their money back?
- wait until business terminates
- preferred paid before common - sell to other investors
- trade like a bond, but does not mature - stays 7% return as long as business can pay
-common stock is more risky but return will reflect appreciation in value - preferred is less risk and return stays on par value
Preferred stock ex.
Issued 5000 shares of 6%, $15 par value preferred stock for 100,000 cash (100,000 / 5000 = $20 per share)
Cash 100,000
Preferred stock, par value 75,000 (5000 X $15)
paid in capital in excess of 25,000
par, preferred stock
dividend preference for preferred stock
$75,000 X .06 = $4,500 annually
$15 X .06 = .9 dividend preference per share
Process of dividend declaration and payment
11/1/X5 company’s board of directors declare total dividend of 100,000 to be paid to shareholders of record as of 12/1/X5 with actual payment on 1/1/X6 (once declared it becomes a liability - declared must be paid)
-board of directors determines how much will be given to shareholders in dividends (or should $ go to RE?)
11/1/X5 - date of declaration
Dividends preferred stock 35,000
Dividends, common stock 65,000
dividends payable 100,000
-from previous ex. (5000 shares par value $100 per share, 7% preference rate) = 5000 X .07 X 100 = 35,000
board elected by common - common don’t get dividends until preferred are paid first
- preferred receive $7 for every share held
- common receive $6.50 (65,000 / 10000 shares) for every share held
constantly trading stocks in stock market so board meets and sets date and whoever owns stock on that date receive dividend
12/1/X5 - date of record
-NO ENTRY! Whoever owns it will get it
Closing entry 12/31/X5
Retained earnings 100,000
dividends, preferred stock 35,000
dividends, common stock 65,000
Entry at 1/1/X6 - date of payment
dividend payable 100,000
cash 100,000
Complications with dividend payments
Assume 11/1/X5 declared 20,000 dividends
-dividend preference = 7% X 100 X 5000 shares = 35,000
Dividends preferred stock 20,000
Dividends payable 20,000
preferred would get all and common none
- preferred also missing 15,000 that weren’t paid
- if “cumulative” preferred shareholders have ongoing carryover balance preference for any prior year dividend
- “non-cumulative” preferred stock has no carryover rights on dividend shortages in any year
Where are dividends disclosed in fin stmts
- NOT LIABILITY - never required to declare or pay dividend
- dividends are disclosed in footnotes of fin. stmts
- only if dividend is declared are preferred shareholders guaranteed their dividend preference plus ant dividends from prior years - rest to common
Dividends in arrears
Cumulative preference stock
- prior year short 15,000
- declared for 20x6 75,000
Preferred would get 50,000 (35,000 + 15,000)
Common would get remaining 25,000
If you are an aggressive investor looking to max. profits (common stock)
If you want less risk with fixed amount (preferred stock)
DIVIDENDS IN ARREARS ARE NOT LIABILITIES
- no legal obligation to pay dividends unless BOD officially declares dividend
- amt. of dividends of arrears usually in footnotes
Balance sheet RE vs. Stmt of retained earnings
Statement of retained earnings beg balance Add: net income Less: dividends Ending balance -the ENDING balance is what appears on the balance sheet
Finding dividend prefereance
($50 x X x 10,000 shares) = $50,000 dividends actually given
X = 50,000 / 500,000 = 10%
Financial analysis
Process designed to examine a business current status and future potential so as to determine its worthiness for debt or equity investment
DEBT INVESTMENT
- will the company be able to make timely payments of principal and interest on a loan?
- what are the risks of loss in default? - if bus liquidates could assets be sold to repay debts? - look at assets
- what are appropriate terms/conditions for loan?
- look at fin. stmts if company has been profitable
EQUITY INVESTMENT
- what are the future prospects for dividends and appreciation in the company’s stock price? - to future sell stock for profit - 2 ways you make $ in stocks
- is today’s stock price over or undervalued relative to the companies prospects for profitability in the future
Ratio analysis
comparisons of info. provided in the fin stmts designed to provide insights on a company’s status and prospects for the future
Measure LIQUIDITY - a company’s ability to meet its short term obligations - (illiquid = can’t pay)
Ratios are NOT governed by GAAP or any standardized methods - up to the person and what they want to know
Current ratio
Current assets / current liabilities
- NOT TOTAL - does not include long term assets/liabilities
- measures liquidity
20X1 = 41817 / 21,015 = 1.99
20X2 = 86,673 / 43,516 = 1.99
-means we have $1.99 assets for every $1 liability
-almost twice as much assets as liabilities
Acid test ratio (quick ratio)
Selected current assets / current liabilities
-cash or close to cash (cash or A/R)
24415 / 21015 = 1.15
-can also do cash only valuations
-higher ratio = more liquid
-company can have acid test ratio less than 1:1 to have adequate liquidity - would have to look at liabilities to see how soon they need to be paid off
-also maybe sell inventory quickly for cash - also sell inventory marked up from cost - so it would be more cash coming in than shown in assets as inventory
acid test is more stringent test of liquidity based on how harsh you wish to be in evaluating liquidity
Measure of Leverage
Leverage is a measure of a company’s debt ratio relative to equity financing
Debt ratio (debt to total asset ratio)
Total liabilities/ total assets
Home purchased 300,000 with 30,000 cash down payment and 270,000 MNP
270,000 / 300,000 = 90% leverage
HCL company 21,015 / 56,517 = 37%
-means 37% of all assets financed by debt, or 37 cents for every $1 of assets was financed by debt
Debt to equity ratio
Total liabilities / total OE
-tells us how much debt financing we have relative owner financing
= .59 means for every $1 of owners capital there is debt equity of 59 cents
-if it was 1:1 ratio, means debt = PE and 50% of capital provided by debt and 50% by owners
-leverage is good if you can get return on the money, not good if you can’t generate returns in excess of cost of investment (repay + profit)
-leverage can make company grow quickly if used carefully
Calc. percentage increases
% growth in assets = different / (base amy - growth from this point in time)
20x1 total assets = 56,517
20x2 total assets = 124,067
increase = 67,550
67,550 / 56,517 = 1.20 or 120% (assets more than doubled - company growing quickly)
-100% increase means doubled
Important to evaluate quality of management when deciding to invest
How they control A/R
A/R turnover
Net credit sales revenues (total A/R sold and collected) / average balance of A/R during period
-net sales sometimes not given and have to use total (includes cash so not as accurate)
denominator = beginning balance + ending balance of A/R / 2
20x1 = 185,043 / (11750 + 11750 / 2) = 15.7 times
-made sale and collected 16 times
Days sales in A/R
365 DAYS / A/R turnover
-tells how many days it takes for a turnover, or how many days to collect an A/R
365/ 15.75 = 23.18 days
faster turnover = decrease days
why it would increase
- management not as aggressive in collecting A/R
- or taking more risky A/R to increase sales (look at NI to see if sales rev. increased)
- also look at allowance for A/R account - if increased means company is reducing credit caution to increase sales
Inventory turnover
Cost of goods sold / average inv. balance during period
-cost of goods represents inv. as it flows from company
denomiator = beginning + ending balance inv. / 2
111,026 / 11,432 = 9.71 times
-process of buying and selling inv. happened about 10 times
Days sales inv. (ave. inv. holding period)
365 / inv. turnover
-how many days since inv. purchased is it held and then sold
365 / 9.71 = 37.59 days
What causes increase
- overordering inv.
- not as many sales
- highly comp. industry
- depends on type of company (Cars 60-90 days, grocery 10 days)
- can increase inv. turnover by buying less but this reduces sales bc others can’t buy the products
Measure Profitability (EPS)
Earnings per share
net income / # shares of stock outstanding
-complicated bc it is common stock or preferred
-# of shares of stock per year
-look at # of shares for beginning of this year
-earnings represent the amount of increased assets through operations of the business to the owners
Measures of stock value
Look at BOOK VALUE PER SHARE
Total assets - total liabilities / # shares of stock outstanding
-OE / Shares of stock
-tells how many assets would be available to owners if bus. liquidates
72,551 / 4250 = 17.07 per share
- book value looks at reflection of valuations on BS - GAAP required historical cost so not necessarily accurate
- look at assets and determine value in case of liquidation
Selling shares that he already owns
Selling 1000 shares for $60 - he already owns 4250 that he paid 10 per share for
Sales price per share 60
Less: contribution per share (10)
profit per share 50
Sellers total profit 50,000 (50 X 1000)
Price earning ratio (P/E Ratio)
How many times its earning the stock is being sold for
- also called price earning multiples
- common way to measure a stocks FMV, or price it should be sold
Market price per share (amt. each share is being sold) / EPS
$60 / 4.52 = 13.27 (low)
- represents an index of the investor’s expectations of the comp. earning potential in future
- stock selling at multiple of 13.27 times its most recent earnings
P/E Ratio important in determining what a stock is really worth
most important is to forecast earnings when evaluating stocks - drives a stock’s value and P/E multiple
-economy and competition affect forecasts
Return on investment
FLIP P/E ration
EPS / Market price per share
4.52 / 60 = 7.5 % return on investment
increase price means public thinks company is going to get higher returns than others - expectations
- company’s that sell at high percent ratio are perceived to have a lot of growth potential in future
- P/E ratio of only 13.27 means $60 price is bargain bc it is expected to grow
% increase in sales rev.
difference / base = 261,950 - 185,043 / 185043 = 41.6%
% increase in net income
19224 - 4931 / 4931 = 290! (almost quadrupled in one year)
What causes change in sales rev.
2 factors
- affected by amt. of VOLUME sold and PRICE changes
- cause of changing affects forecasts
Vertical analysis
Calc. each element of income stmt. as a percentage of sales rev.
cost of goods sold / sales rev. = 111026 / 185043 = 60%
-for every $1 sales rev. the cost was 60 cents
Salaries exp. 49,500/185043 = 26.8%
-for every $1 in sales rev., salary expense is 29 cents
Strips out affect of VOLUME as you compare btwn years
-compare every element of income stmt per dollar od sales revenue
if percent cost increases btwn years - inflation from suppliers or sales price increased and it did not increase enough to cover cost increase
Gross margin decreases
-sign of competitive env. (Cannot increase sales price even tho cost increased)
Financial analysists are most focused on
making future forecasts of earnings in future
-analaysis of fin. stmts are important to understand price of stock in considering investment and coming up with questions for owner
When is it good to have high debt ratio?
If you make enough sales to repay debt and keep excess of profit
-uses someone else’s money to increase profits, owners less at risk
not good if you lose sales in trying to increase A/R turnover
Book value ex. 2
694,000 - 582,000 / 10,000
$11.20 Per share
-if they were to liquidate today the stockholders would get 11.20 per share
Net income as a % of investment
flip P/E/ ratio equation
- 40/12 = 20% return
- 40/36 = 67% return
Most critical factor in deterring price of stock is
how investors perceive future profitability of the bus.
Increase in gross margin in vertical analysis means
revenue exceeded cost of goods sold
- due to selling more or price increase
- sign there is not much competition in industry
Stock worth ex.
If XYZ can triple NI over next 2 years and P/E ratio for company is 25 times earnings
-what would share of stock be worth in 2 years
P/E ratio = Market price per share / EPS
25 = X/7.20 (3 X 2.40) = 180 per share
Gross margin decreased and cost stayed same
-what happens to sales price
Must of decreased
-NOT VOLUME
Definition of asset
TO BE MEASURED ON BALANCE SHEET ASSETS MUST:
- Meet definition of asset
- future economic benefit
- owned/controlled by company
- result of past transactions - be measurable
Judgment heriarchy
Outside the company:
- Congress
- SEC
- FASB (GAAP)
Inside company:
- Board of directors
- CFO
- division controllers
- accounting clerks
Judgement in valuation of assets
Tight (1) - few differing estimates by experts
average (2) - some differing estimates
wide (3) - lots of differing estimates
-trying to determine monetary value of assets - look if estimates are closely bunched or widely dispersed
explain estimates and judgements in footnotes
Balance sheets are ___ of bus. financial position
NOT Snapshots of business financial position
- are actually fuzzy medical pictures of company’s financial position bc full of estimates and judgements - x-ray or medical image that helps us identify a companies financial position
- numbers may range, subject to change
not all assets son the balance sheet bc of measurement concerns
-not always precise - use judgements
Where does fraud usually occur?
In REVENUE journal entries
- make them look good
- revenue recognition = #1 reason for fraud
any company loses 7% to fraud
How much does it cost to have an employee?
Salary = 50,000 Fica = 3825 Fui = 1000 sui = 1500
Add them all = 56,325
compensation expense
payables
cash
In MNP example, what adjusting entries also need to be made at the end of the year?
Building was 337, 500 - depreciates each year
337,500 - 5000 / 40 years = 3,313
(8,313 X 5 months) = 3,464
Depreciation expense 3464
Accum. depreciation 3464
Long term bond - debt
Mandatory annual payments
- fixed payments
- have to be repaid in set time (100 years)
- in bankruptcy, first to receive assets from the business
Common stock - equity
Optional annual payments
- variable amounts of payment
- never repaid for investment
- last to receive assets from business in bankruptcy
Preferred stock - equity
Optional annual payments
- fixed amount of payments
- never required to be repaid for investment
- 2nd to last to receive assets in bankruptcy
Debt - mandatorily redeemable preferred stock liability
Optional annual payments
- fixed amount of payments
- repaid in set time (10 years)
- near last to receive assets in bankruptcy
Convertible bonds - debt
Mandatory annual repayments
- fixed amount of payments
- repaid in set time (10 years) - or trade for common stock
- near last to receive assets in bankruptcy
What happens when you pay principle quickly on MNP
It makes interest rate go down - interest rate is based on current principal balance
Depreciation expense
Closed to retained earnings each year!!
-accumulated depreciation is a running balance - adds each year as credit until sold or disposed (Debit)
Stocks vs. bonds for a corporation
Equity
-stocks make company look more profitable, doesn’t affect taxes
Debt
-liabilities as an expense will decrease income taxes and net income
Return on equity =
net income/assets X sales/assets X assets/equity
-for every $1 i invest, how much return will I get?
net income/ OE
< 10% = not likely to invest
10-20% = normal
> 20% = doing very well
Dupont framework ROE
ROE = profitability X efficiency X leverage
= profit margin X asset turnover X asset to equity ratio
= net income/sales X sales/assets X assets/equity
Walmart higher ROE than Google
Profitability in ROE equation
Net income/ sales
(return on sales)
-for every $1 i invest, how much profit did we generate?
Google has higher profitability ratio than Walmart
Efficiency in ROE equation
sales/assets
- For every $1 in assets, how many sales will that generate
- increased # = MORE efficient
- walmart has higher efficiency ratio than google
- # of dollars of sales generated by each $1 of assets
3.2/1 = 3.2 sales for every $1 assets
Leverage in ROE equation
assets/equity
- # of dollars of assets that can be purchased with each one dollar of equity investment
- increased # means more contributed to assets in debt
- Walmart higher leverage ratio than google
3/1 = means $3 in assets for every $1 contributed in equity
- means $1 in debt/liabilities
- increased number means more leveraged company is in debt
Common size fin. stmts
Take all accounts in Balance sheet and income stmt as a percent of sales
- increased # means LESS efficient - for every $1 in sales, i have this much tied up in A/R cost (OPPOSITE AS EFFICIENCY RATIO FOR ROE)
- tells us which account on the balance sheet is least efficient and requiring the most of our sales
EBITDA
Earnings before interest, taxes, depreciation, and amortization
- earnings from operating
- revenues minus operating expenses
if comp. spent $100 million on new vehicles, would not be included
Compensation expense
Costs to the employer/company for the privilege of having employees
- their wage plus the companies portion of FICA payables
- plus SUI, FUI
- any other expenses the company pays that are costs to benefit the employees
capitalizing an expenditure
Means it is capitalized as an asset, not an expense
Why does a company’s stock market price exceed its book value?
A stock’s market price is typically NOT based on the liquidation of the company but is instead based on the assumption that the company will continue to operate and generate profits in the future
Why does a company’s stock market price exceed its book value?
A stock’s market price is typically NOT based on the liquidation of the company but is instead based on the assumption that the company will continue to operate and generate profits in the future
Who’s ROE is higher..walmart or google?
WALMART - ROE higher
- -Google ROS higher
- -walmart efficiency and leverage higher
Who’s ROE is higher..walmart or google?
WALMART - ROE higher
- -Google ROS higher
- -walmart efficiency and leverage higher
defective returned inv.
returned inv. costing 1200 can only be resold at 350 - what is COGS in journal entry
inv. 350
COGS 350
350 bc thats all its worth but on books it still says original 1200 for determining markup and others
defective returned inv.
returned inv. costing 1200 can only be resold at 350 - what is COGS in journal entry
inv. 350
COGS 350
350 bc thats all its worth but on books it still says original 1200 for determining markup and others
P/E ratio serves as an index of the investors expectations for…
the earning potential in the future
P/E ratio serves as an index of the investors expectations for…
the earning potential in the future
when do dividends become a liability
on date of declaration
what is NOT concern when deciding whether to debt or equity finance a business
are there any existing deferred tax liabilities?