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Intermediate Accounting

Contents
CHAPTER2 Financial Accounting: ..........................................................................................................................2 Financial Statements: .........................................................................................................................2 Uses of Financial Statements .............................................................................................................. 2 Users of Financial Statements ............................................................................................................ 3 Components of Financial Statements ....................................................................................................... 2 Icome Statements ............................................................................................................................... 2 Statement of Retained earnings ......................................................................................................... 4 Balance Sheet ....................................................................................................................................... 5 Statement of Cash Flow ...................................................................................................................... 7 CHAPTER 2 Account Receivables ..........................................................................................................................9 Valuation of Account Receivables ..................................................................................................... 10 CHAPTER 3 ....................................................................................................................................... 12 Valuation of Account Receivables ..................................................................................................... 11 First-in-First-Out Method (FIFO) ..................................................................................................... 13 Last-in-First-Out Method (LIFO) ...................................................................................................... 14 Average Cost Method (AVCO) ......................................................................................................... 14 CHAPTER 4 ....................................................................................................................................... 15 Depreciations .................................................................................................................................. 14 Methods of Depreciation ................................................................................................................. 16 Straight-line Method of Depreciation ................................................................................................... 16 Activity Method of Depreciation / Variable Charge ......................................................................... 17 Reducing Balance Method ...................................................................................................................... 17 Sum of Years Digit .................................................................................................................................. 17

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Intermediate Accounting
CHAPTER 1

Financial Accounting:
Financial accounting is the process that culminates in the preparation of financial reports on the enterprise for use by both internal and external parties. Users of these reports are invertors, creditors, managers, unions, and govt. agencies.

Financial Statements:
"The financial statements provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions." A financial statement is a formal record of the financial activities of a business, person, or other entity. Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities, equity, income and expenses are directly related to an organization's financial position. If financial statements are issued strictly for internal use, there are no guidelines, other than common usage, for how the statements are to be presented.

Uses of Financial Statements


. They are useful for the following reasons:

Used as an information providing tool for decision making about new decisions. To determine the ability of a business to generate cash, and the sources and uses of that cash.

To determine whether a business has the capability to pay back its debts. To track financial results on a trend line to spot any looming profitability issues. To derive financial ratios from the statements that can indicate the condition of the business.

To investigate the details of certain business transactions, as outlined in the disclosures that accompany the statements.

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Users of Financial Statements

Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders.

Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.

Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.

Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a longterm bank loan or debentures) to finance expansion and other significant expenditures.

Components of Financial Statement A. Income Statement


An income statement shows the results of operating for a period of time. The income statement summarizes the revenues and expenses generated by the company over the entire reporting period. The income statement is also known as a profit and loss (P&L) statement, statement of earnings, statement of operations or statement of income.
Usefulness of Income Statement

Evaluate the past performance of the company Provide a basis for predicting future performance Help assess the risk or uncertainty of achieving future cash flows
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Types of Income Statement
1. Single Step Income Statement

A single step income statement uses just one subtraction. This is done by subtotaling all the revenues and gains together at the top of income statement and subtotaling all the expenses and losses together below revenues. The sum of expenses and losses is then subtracted from the sum of revenues and gains to arrive at net income. The net income calculated using the single-step income statement is equal to that calculated using a multi-step income statement. Formula Net Income = (Revenue + Gains) (Expenses + Losses) Example
ABC Company Income Statement For The Year Ended December 31, 2012 Revenues: Sales Interest Rent Total revenues Expenses: Cost of goods sold Advertising Commissions Depreciationoffice building Interest Insurancesalespersons auto Salaries and wagesoffice Suppliesoffice Income taxes Total expenses Net income 2. Multiple Step Income Statement $ 48,300 1,340 6,700 $ 56,340 $ 29,200 1,500 2,415 2,900 1,400 2,250 12,560 890 1,540 $ (54,655) 1,685

The multiple-step profit and loss statement segregates the operating revenues and operating expenses from the non operating revenues, non operating expenses, gains, and losses. The

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multiple-step income statement also shows the gross profit (net sales minus the cost of goods sold). Example
ABC Company Multiple step Income Statement For The Year Ended December 31, 2012 Sales 2,400,000 Cost of goods sold Gross profit Operating expenses: Selling Administrative Income from operations Other revenue and gains Interest revenue Other expenses and losses Interest expense Income before income tax Income tax@30% Net income Earnings per share *450,800 70,000 shares. (1,250,000) 1,150,000 280,000 212,000

(492,000) 658,000

31,000 (45,000) (14,000) 644,000 (193,200) 450,800 6.44*

B. Statement of Retained Earnings


Statement of retained earnings is prepared after the income statement and before the balance sheet. The statement of retained earnings explains the changes in retained earnings from net income (or loss) and from any dividends over a period of time. This means that the statement of retained earnings reports the change in retained earnings from the beginning to end of a time period, usually a year. Retained earnings of a company refer to income that is not distributed to the stockholders. You can think of retained earnings as the amount of income that is left in the company. Retained earnings is increased by net income or decreased by net loss, and decreased by dividends. Remember that dividends are the distributions made to the stockholders.

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Formula Beginning retained earnings + Net income - Dividends = Ending retained earnings Example
ABC Company Retained Earnings Statement For The Year Ended December 31, 2012 Retained earnings at Dec 31, 2011 Net income for the year ended Less Dividends Retained earnings at Dec 31, 2012 150,000 40,000 (25,000) 165,000

C. Balance Sheet
The balance sheet presents a company's financial position at the end of a specified date. The balance sheet is based on the following fundamental accounting model: Assets = Liabilities + Owners Equity Assets can be classed as either current assets or fixed assets. Current assets are assets that quickly and easily can be converted into cash, sometimes at a discount to the purchase price. Current assets include cash, accounts receivable, marketable securities, notes receivable, inventory, and prepaid assets such as prepaid insurance. Fixed assets, also known as a non-current asset or as property, plant, and equipment, is a term used in accounting for assets and property which cannot easily be converted into cash. Such assets are recorded at historical cost, which often is much lower than the market value. Liabilities represent the portion of a firm's assets that are owed to creditors. Short-term (current) liabilities include accounts payable, notes payable, interest payable, wages payable, and taxes payable. Long-term (non-current) liabilities include mortgages payable and bonds payable. The portion of a mortgage long-term bond that is due within the next 12 months is classed as a current liability, and usually is referred to as the current portion of long-term debt. The creditors of a business are the primary claimants, getting paid before the owners should the business cease to exist.
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Equity is referred to as owner's equity in a sole proprietorship or a partnership, and stockholders' equity or shareholders' equity in a corporation. Example ABC Company Balance Sheet December 31, 2012
Assets
Current assets:

Cash Accounts receivable Inventory Prepaid rent Office supplies Total current assets
Fixed Assets:

13,230 23,450 45,730 1,500 2,340 $ 86,250 85,000 250,000

Long-term investments Property, plant, and equipment: Land Automobiles Less: Accumulated depreciation Buildings Less: Accumulated depreciation Total property, plant, and equipment Intangible assets: Patents Total assets Liabilities
Current liabilities:

112,500 22,500 200,000 40,000

90,000 160,000 500,000 40,000 711,250

$ $ 18,255 6,200 1,500 10,000 4,200 $ $

Accounts payable Income taxes payable Interest payable Notes payable, due June 30, 2013 Salaries and wages payable Total current liabilities
Long-term debt:

40,155 160,000 200,155

Bonds payable, due December 31, 2016 Total liabilities Stockholders' Equity Contributed capital: Capital stock, $10 par value, 15,000 shares issued and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

150,000 50,000 200,000 311,095 511,095

711,250

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D. Statement of Cash Flow
A financial statement lists how a firm has obtained its funds and how it has spent them within a period of time. It answers the questions Where the money came (will come) from? And where it went (will go)? The cash flow statement organizes and reports the cash generated and used in the following categories: Operating activities converts the items reported on the income statement from the accrual basis of accounting to cash. Investing activities reports the purchase and sale of long-term investments and property, plant and equipment. Financing activities reports the issuance and repurchase of the company's own bonds and stock and the payment of dividends. Example
ABC Company Statement of Cash Flow December 31, 2012

Operating Activities Cash from customers Cash paid to employees Cash paid to suppliers Cash paid for interest Cash paid for income taxes Cash provided by operating activities Investing Activities Proceeds on the sale of land Purchase of equipment Cash provided (used) by investing activities Financing Activities Proceeds on the issuance of preferred shares Dividends paid Repurchase of common shares Repayment of bonds payable Cash provided (used) by financing activities Increase in cash and equivalents Cash and equivalents, end of year Cash and equivalents, beginning of year Increase in cash and equivalents Institute of Business & Information Technology

1,880,625 (461,056) (1,145,179) (31,200) (71,790) 171,400 50,000 (107,000) (57,000) 51,000 (49,000) (10,000) (100,000) (108,000) 6,400 13,325 6,925 6,400 Page 8

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CHAPTER 2

Account Receivables
Accounts receivables (alternately receivables) are created when a customer purchases goods or services from a company but do not pay for them at the time of purchase. Current Receivables: expected to be collected within one year or one operating cycle, whichever is longer. Trade Receivable (A/R): oral promises of the purchasers to pay for goods sold and services rendered. They are usually collected in 30-60 days. Thus, A/R is always reported as a current asset with the net realizable value. Notes Receivable (N/R): written promises to pay a certain sum of money on a specific future date. N/R can be long-term or short-term and can be interest-bearing or noninterest bearing. Transaction
Sale of Inventory on credit Account Receivables Dr Sales Cr Receive Cash from Customer Cash Accounts Receivables Dr Cr

Types of Discount 1. Trade Discount The amount by which a manufacturer reduces the retail price of a product when it sells to a reseller, rather than to the end customer. The reseller then charges the retail price to its customers in order to earn a profit on the difference between the amount by which the manufacturer sold the product to it and the price at which it then sells the product to the final customer. 2. Cash Discounts Cash discounts are used to . . . Increase sales Encourage early payment by customers Increase the likelihood of collections of accounts receivable

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Transaction
Sale of Inventory on credit Account Receivables Dr Sales Cr Receive Cash from Customer with in discounted period Cash Dr Accounts Receivables Cr Receive Cash from Customer after discounted period Cash Dr Sales Cr

Valuation of Account Receivables


Two method are used in accounting the uncollectable accounts 1. Direct write of method Under the direct write-off method, no entries are made for bad debts until an account is determined to be uncollectible at which time the loss is charged to Bad Debts Expense. The expense is recognized when the account is written-off. This method is required for most tax purposes Transaction
Bad Debt expense Account Receivables Dr Cr

2. Allowance method Under the allowance method, an adjustment is made at the end of each accounting period to estimate bad debts based on the business activity from that accounting period. Established companies rely on past experience to estimate unrealized bad debts, but new companies must rely on published industry averages until they have sufficient experience to make their own estimates. The specific customer accounts that will become uncollectible are not yet known when the adjusting entry is made, a contra-asset account named allowance for bad debts, which is sometimes called allowance for doubtful accounts, is subtracted from accounts receivable to show the net realizable value of accounts receivable on the balance sheet

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Recognition Entry The first step in the allowance method is to pass an adjusting entry at the end of the period to recognize bad. But unlike direct write-off method, we cannot credit accounts receivable because it is actually a control account of many individual debtor accounts and we do yet not know which particular debtor will make a default. We only know the estimated amount of receivable which are likely to end up uncollected. Therefore a provision account called allowance for doubtful accounts is credited in the adjusting entry. Example Bad Debts Expense Allowance for Doubtful Accounts In Balance sheet The bad debts expense account, just like any other expense account, is closed to income Statement account of the period. The allowance for doubtful debts is contra-asset account. It is presented on balance sheet by subtracting it from accounts receivable as shown below: Accounts Receivable Less: Allowance for Doubtful Accounts Accounts Receivable, net Write-off Entry When a debt is actually determined as uncollectible, the following journal entry is passed to write it off. Allowance for Doubtful Debts Accounts Receivable 70 70 $15,000 600 $14,400 600 600

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

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CHAPTER 3

Valuation of Inventory
Inventory
Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods. The following equation expresses how a company's inventory is determined:

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

Recording Inventory Transactions


Two methods of recording inventory transactions

3. Periodic inventory system


Merchandise purchases are recorded in the purchases account, and the inventory account balance is updated only at the end of each accounting period Transactions
Purchase of Inventory Purchases Dr Accounts Payable Cr Sale of Inventory Accounts Receivables Sales End of Period

Dr Cr

Ending Inventory Dr Cost of Goods sold Cr Purchases Dr Beginning Inventory Cr

4. Perpetual inventory system Purchases, purchase returns and allowances, purchase discounts, sales, and sales returns are immediately recognized in the inventory account, so the inventory account balance should always remain accurate, assuming there is no theft, spoilage, or other losses.
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Transactions
Purchase of Inventory Inventory Accounts Payable Sale of Inventory Accounts Receivables Sales Cost of Goods sold Inventory Dr Cr Dr Cr Dr Cr

Inventory Valuation Methods


Inventory valuation methods are used to calculate the cost of goods sold and cost of ending inventory. Following are the most widely used inventory valuation methods: 3. First-in-First-Out Method (FIFO) According to FIFO, it is assumed that items from the inventory are sold in the order in which they are purchased or produced. This means that cost of older inventory is charged to cost of goods sold first and the ending inventory consists of those goods which are purchased or produced later. FIFO method is closer to actual physical flow of goods because companies normally sell goods in order in which they are purchased or produced. Example
Date Mar1 5 14 27 29 31 Institute of Business & Information Technology 70 16.00 1,190 10 20 15.50 16.00 155 320 Purchases Unit Cost 15.50 Sales Unit Cost Balance Unit Cost 15.00 15.00 15.50 15.50 15.50 16.00 16.00 16.00

Units 140

Total 2,170

Units

Total

60 130

15.00 15.50

900 2,015

Units 60 60 140 10 10 70 50 50

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4. Last-in-First-Out Method (LIFO) This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is assumed that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower. This is because the cost goods sold mostly consists of newer higher priced goods and ending inventory cost consists of older low priced items. Example
Date Units Mar 1 5 14 27 29 31 70 16.00 1,190 30 16.00 480 140 Purchases Unit Cost 15.50 Sales Unit Cost Balance Unit Cost 15 15 15 15 15 16 15 16 15 16

Total 2,170

Units

Total

140 50

15.50 15.00

2,170 750

Units 60 60 140 10 10 70 10 40 10 40

Total 900 900 2170 150 150 1,120 150 640 150 640

5. Average Cost Method (AVCO) Under average cost method, weighted average cost per unit is calculated for the entire inventory on hand which is used to record cost of goods sold. Weighted average cost per unit is calculated as follows:

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

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Example
Date Mar 1 5 Purchases Unit Cost 15.50 Sales Unit Cost Balance Unit Cost 15 15 15.50 15.35 15.35 15.35 16 15.92 15.92 15.92

Units 140

Total 2,170

Units

Total

14 27

190 70 16 1,190

15.35

2,916

29 31

30

15.92

478

Units 60 60 140 200 10 10 70 80 50 50

Total 900 900 2,170 3,070 154 154 1,120 1,274 796 796

CHAPTER 4 Depreciation
Depreciation is a means of cost allocation. It is a non cash expense. Depreciation is the accounting process allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of asset For example, if a PC cost 60,000 and was expected to be used for three years, it might be estimated at the end of the first year that a third of its overall usefulness had been consumed. Depreciation would then be charged at an amount equal to one third of the cost of the PC, i.e. 20,000. Profit would be reduced by 20,000 and the value of the PC in the balance sheet would be reduced from 60,000 to 40,000.

Factors to Consider in Asset Depreciation


Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?)
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Methods of Depreciation
There are several methods of depreciation. 1. Straight-line method. 2. Activity based method. 3. Decreasing charge methods (accelerated): a) Sum-of-the-year-digit. b) Declining-balance method\ Reducing balance method.

Straight-line Method of Depreciation


In straight line depreciation method, depreciation is charged uniformly over the life of an asset. In this method, salvage value of the asset is subtracted from its cost to get the depreciable amount. The depreciable amount is then divided by the useful life of the asset in number of periods to get the depreciation expense per period. Due to the simplicity of the straight line method of depreciation, it is the most commonly used depreciation method. Formula The formula to calculate the straight-line depreciation of an asset for a period is:

Example
On Jan 1, 2011 Company A purchased a vehicle costing 20,000. It is expected to have a value of 5,000 at the end of 4 years. Calculate depreciation expense on the vehicle for the year ended Dec 31, 2011.

Solution

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Activity Method of Depreciation / Variable Charge
The activity method of depreciation (also called the variable charge approach or unit of production approach) assumes that depreciation is a function of use or productivity instead of the passage of time. The life of the asset is considered in terms of either the output it provides (units of produces), or an input measure such as the number of hours it works. Conceptually, the proper cost association is established in terms of output instead of hours used, but often the output is not easily measurable. In such cases, an output measure such as machine hours is a more appropriate method of measuring the dollar amount of depreciation charges for a given accounting period. Formula The following formula is used for the calculation of depreciation charge under activity method: ( )

Example Plastic LTD purchases a steel mould costing 1,000,000 to be used in the production of plastic glasses. The mould could be used in 8 production batches after which it will have a scrap value of 20,000. During the first year, the company manufactures 2 batches of glasses.
Solution ( )

Reducing Balance Method


The reducing balance method allows you to consider a certain depreciation percentage to depreciate the alignment machine rate annually. This method takes into consideration an accelerated rate of depreciation. This is useful for those assets in which a higher value is lost during the beginning years of usage. The only flaw of this method is it does not take into account the scrap or residual value of the asset.

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It is calculated on the book value of asset. The book value of an asset is obtained by deducting depreciation from its cost. The book value of asset gradually reduces on account of charging depreciation. To find the book value of last year we subtract the salvage value from the book value of second last year. Example A business has an asset with 500,000 original cost, 50,000 salvage value, and 5 years useful life. 40% depreciation rate would be used. Solution Book value at the Depreciation beginning of the year 500,000 300,000 180,000 108,000 64,800 *64,800 50,000 = 14,800 rate @ 40% 200,000 120,000 72,000 43,200 *14,800 Book value at the end of the year 300,000 180,000 108,000 64,800 50,000

Sum-of-the-year-digit method
Here also the depreciation charge constantly reduces based on decreasing fraction of depreciable cost his method is normally applied to fairly long lived assets. Unlike the diminishing balance method, a constantly decreasing rate is applied on the original cost. At the end of the assts useful life, the balance remaining should equal the salvage value. Formula ( )

Example A business has an asset with 750,000 original cost, 30,000 salvage value, and 8 years useful life. Solution
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( )

Year Opening Book value

Depreciation Remaining Base Life in years

Depreciation Fraction

Depreciation Expense

Book value at the end of year

1 2 3 4 5 6 7 8

750,000 590,000 450,000 330,000 230,000 150,000 90,000 50,000

720,000 720,000 720,000 720,000 720,000 720,000 720,000 720,000

8 7 6 5 4 3 2 1

8/36 7/36 6/36 5/36 4/36 3/36 2/36 1/36

160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000

590,000 450,000 330,000 230,000 150,000 90,000 50,000 30,000

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