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Summary Intermediate Financial Accounting

Intermediate Financial Accounting 1 (Universiteit van Amsterdam)

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Intermediate financial accounting

Users, Financial Statements, Accounting principle

Management uses accounting for: finance, investment, operations and production, marketing
and sales, human relations.
Persons with direct financial interest: Investors, Banks
Persons with indirect financial interest: tax authorities, regulators, labor unions and employees
and suppliers.

Balance sheet: Set of two lists: assets on one side, and obligations to external parties on the
other side (liabilities to creditors and the residual due to shareholders or owners). It’s a
snapshot of the financial position at a given point in time.

Assets = what the enterprise owns (the resources with which it will create future value for
customers) (you can control it and benefit from it)

Liabilities and shareholders’ equity (don’t really have an obligation, because you don’t have to
pay it back) = Obligation the enterprise has towards shareholders and third parties = source of
financing of assets.

Shareholders’ equity = share capital and (retained) earnings (what you keep over the years
and don’t pay dividends.

Balance sheet static vision of financial position

Statement of changes in equity: Equity is a claim, right, or interest one has over some net
worth. Residual interest (of the investors) in the assets of the entity after deducting all its

Notes to financial statement: Notes contain info in addition to that presented in the balance
sheet, income statement, statement of changes in equity and cash flow statement. They
provide narrative descriptions or disaggregation’s of items disclosed in those statements and
info about items that do not qualify for recognition in those statements.

Income statement: Record of what happened during the period that caused the observed
income (profit or loss). Also a “film” of the business during a given period.
It has expenses and revenues. Balance = net income ◊ transferred to retained earnings.

Performance of the fiscal year. Based on accrual accounting (depreciation). Recognition

before, at or after receipt or payment of cash

Statement of cash flows: The cash flow statement shall report cash flows during the period
classified by operating, investing and financing activities.
Based on receipt or payment of cash:
- Operating activities: selling goods and services to customers, employing managers at
work, buying and producing goods and services, paying taxes.

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- Investing activities: buying land, buildings and equipment. Purchase other resources
necessary to operate the business, selling those resources when no longer needed.
- Financing activities: Obtaining capital from creditors, securing loans, gathering funds
from owners, repaying creditors, paying returns to owners.

Cash and cash equivalents at end of the year = cash and equivalents at the beginning of the
year + operating activities + investing activities + financing activities.

Debit Credit
Expenses Liabilities
Assets Income
Dividends Capital

If a debit and credit are not equal:

- a debit was entered as a credit or vice versa

- The balance of an account was computed incorrectly
- An error was made in carrying the account balance to the trial balance, or it was
summed incorrectly

True view = financial statement do not falsify or dissimulate the financial situation of the
company at the end period, nor it’s profit or loss at the end of the period.

Fair view = accounts give accounting users complete and relevant info for decision makers.

Objectivity = Basis of valuation and measurement.

1) definition
2) recognition
3) initial measurement
4) subsequent measurement: historical cost (reliable info), current (replacement) cost,
realizable (settlement or liquidation) value, present value (relevant info)


Accrual accounting: allocating cash flows to periods (cash in/out flows don’t need to be the
same as expenses/revenues)

Matching rule: revenues assigned to the accounting period in which goods are sold, expenses
linked to those revenues.

Main adjusting enteries:

1) Revenues: - earned but not recorded ◊ accrual of unrecorded revenues. - Recorded

but unearned ◊ Earning of revenues in advance: unearned revenues, revenues
received in advance, deferred revenues.
2) Expenses: - Consumed but not recorded ◊ accrual of unrecorded expenses. –
Recorded but not consumed ◊ expenses recorded in advance, prepaid expenses.

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Revenue recognition: revenues affect income statement when earned and not collected.
Net income includes revenues earned during period.
- adjustment of revenues earned but not recorded (the triggering event has not occurred
- Adjustment of revenues recorded in advance
Revenues earned, but not recorded: royalty revenue not invoiced because the department in
charge has been overworked

Matching principle: expenses affect income when consumed and not when paid.
Net Income includes expenses consumed during the period:
- Adjustment of expenses consumed but not recorded (the triggering event has not
occurred yet).
- Adjustment of expenses recorded in advance

Issues of revenue recognition

Three categories:

1) sales of goods
Conditions satisfied:
- Transfer to significant risks and rewards of ownership of the goods.
- No managerial involvement or effective control over the goods sold
- Amount of revenue measured reliably
- Probability of economic benefits
- Costs related to the transaction measured reliably.

2) Rendering of services (there is no risk you can transpare)

Conditions satisfied:
- amount of revenue measured reliable
- probability of economic benefits
- stage or percentage of completion of the transaction on the balance sheet date
measured reliably
- costs related to the transaction measured reliably
Examples: installation fees, subscriptions, event admission fees, tuition fees
3) Interest, loyalties and dividends
Interest: Proportionately to the length of the period during which the asset was actually
made available and on the basis of the agreed upon interest rate
Royalties: on an accrual basis in accordance with the substance of the relevant agreement
Dividends: when the shareholder’s right to receive payment is established (decision of the
shareholders’ General meeting).

Research and Development

Research: original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.

Development: application of research findings or other knowledge for the production of new
or substantanially improved materials, devices, products, processes, systems or services
before the start of commercial production

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Accounting for research and development:

Default position (prudence principle): to expense research and development costs when
Under certain circumstances and if specified criteria are met, some development (and applied
research – when the distinction is made) cost may be capitalized and recorded as an intangible

Accounting for development costs:

1) Identificable: completion, benefit and reliability. Documentation of future savings.
2) Probable future economic benefits (over several years). Stratigic planning, contract
and project approved
3) Intention to complete and use/sell asset. Detailed planning, resources including project
team and budget approved.
4) Recources adequate and available to complete. Software keeps in the company.
Functionalities pf software defined according to project aims.
5) Ability to use/sell asset
6) Technical feasibilty
7) Expenditure can be reliable measured

Shareholders’ equity

Equity = The residual interest in the assets of the entity after deducting all its liabilities.

Equity instrument = any contract that evidences a resdiual interest in the assets of an entity
after deducting all of its liabilities.

Overall if it’s not an asset or a liability ◊ it’s equity a residual claim. Most common is an
ordinary share.

Distinguish shareholders’ equity from liabilities.

The instrument includes no contractual obligation.

¬ holder not entitled to any fixed return o nor of its investments
¬ holder receives the residual after all liabilities settled
- periodic return (dividends after interest on liabilities paid)
- Capital returns (company wound up; liabilities are settled before shareholder entitled
to any return of their investments)

So the higher the risk ◊ the higher the return

What is the return to stakeholders? Economic profit = accounting profit less cost of equity

So there’s no obligation to pay dividends. Interest First, than dividends.

Preferred share = do not have to meet the definition of equity.
When you redeem shares it’s an obligation to pay back ◊ liability

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Compound of Financial instruments:

IAS 32: requires an issuer of a Financial instrument to determine whether it contains both
liabilities and equity components. If => classify separately as liability and equity.
It also states that classification is made on initial recognition that is not revised, regardless of
the likelihood that an option is exercised. Till it’s exercised or expires, there is a contractual
You have the right to convert the liability into shares. Not for free, you have to lower the
interest. You don’t have to, but you can. Only when the market price goes up. How to account
for it, 2% is equity, if you don’t convert it, you can loose it and then it’s you own fault.

Shareholders’ equity

Decomposition of equity:

1) share capital
2) share premium
3) treasury stock (negative value) Purchase shares on the market
4) Retained earnings (makes profit)
5) Reserves (based on earnings and dirty surplus)
revaluation reserves (dirty surplus)
- revaluation of property, plant and equipment
- foreign exchange difference
- remeasurement of available-for-sale financial assets
profit / loss brought forward (Had a loss, not reduce it by reserves, but can
also take it to the next year)
see for also appendix 11.1

Share capital
- influence management decision
- receive dividends and liquidation surplus
Normal or par value
- at the time of a business incorporation, it’s laws specify the face value of the share =
par value / nominal value
- capital = the number of shares * the par value
- Market value of shares generally has no relation to the par value

Payment of share capital

Outstanding ≤ Issued shares ≤authorized shares (not issued, so not on the balance sheet)
Subscribed capital = paid-in capital + capital receivable + uncalled capital

Authorized share capital has already asked for approval

Accounting for share issuance costs.

There are 3 ways to record share issuance costs:
- Considered to be a period cost and recognized in the corresponding income statement
- Capitalized as an intangible asset and amortized (in general over a maximum of 5

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- Written of against equity (i.e., the total accumulated share premium in practice, when
you have a cost you reduce equity immediately)

Issuance of shares resulting from an increase in capital due to a conversation of liabilities.

Convert liabilities ◊ shares
- creditors may accept to receive shares of capital as a counterpart of cancelling their
- Three reasons might explain their decision:
♣ Debtor experience serious cash difficulties
♣ Issuance of convertible debt and corporation is successful
♣ Increasing control and/or less expensive access to the capital market
- Accounting entry => eliminating debt and increasing share “capital at par” and
“share premium”

Treasury shares, why do more than 67% of large companies purchase their own shares?
A treasury share is a share which is bought back by the issuing company, reducing the amount
of the outstanding share on the open market.
- reduce it’s capital by cancelling the repurchased shares
- use the stock for employee stock option plan, give them to the employees
- want to maintain a favorable market for their stock
- want to increase earnings per share or stock price per share (have less dividends to pay out)
- want to have additional shares of stock available for purchasing other companies
- attempt to prevent hostile takeovers

Profit appropriation: if you have profit, you have to allocate it

- dividends
- reserve accounts
- reporting retained earnings

Retained earnings / reserves (up the end of the previous period) + net income (after tax) of the
year – dividends declared – transfer to reserves = retained earnings / reserves (at year end)

Annual earnings – sum of allocations to reserve accounts = earnings available for distribution

Comprehensive income statement and statement of equity change

Total comprehensive income ◊ net income

Total comprehensive income ◊ other comprehensive income ◊ (directly equity)
1) foreign currency items
2) revaluation of property, plant and equipment
3) unrealized gains and losses on certain investments in debt and equity securities
Not exhaustive, dirty surplus vs clean surplus

Clean surplus means that all changes in equity that do not result from transactions with
shareholders (such as dividends, share repurchases or share offerings) are reflected in the
income statement.

Dirty surplus occurs when some items - most notably foreign currency translation and certain
pension adjustments – are adjusted from shareholders’ equity, without passing through the

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income statement. In order to adjust the income statement to reflect a clean surplus, an
investor can replace “net income” with “total comprehensive income”

Stock option plan

Basic idea of an employee share option is:

- An employee receives the right to buy shares of the entity during a certain period in
the future at a predetermined price.
This right is valuable. The employees receives this right as a compensation for his/her
services, e.g. instead of payment in cash.

Most employees share options have special conditions (not exhaustive):

- non transferability
- vesting period
- black out periods (not aloud to sell the options)
- forfeitures (after a period, the sell option is gone)

Time value money = represents the interest one might earn on the payment received today, if
held, earning interest, until that further date.

What’s time value?

Suppose someone offers you the following option:
- the option is at the money and the current share price is 100
- the probability that the share price increases to 110 is 50%
- The probability that the share price decreases to 90 is 50%
Would you be willing to pay anything for this option? YES
Speculative value = 5 dollar.
- If the share price decrease, the loss would be zero (you just don’t exercise)
- If the share price increases you have a gain of 10 dollars
- Hence the expected gain is 5, 50% of 10
- So you would be willing to pay an amount, lower than 5
Speculative value

Main principle = the fair value of option at grand date is expensed over the vesting period.

Grant date: this is the date the fair value of the option is measured:
- when the employer confers the option right to the employee, provided the vesting
conditions will be met
- if subject to an approval process (e.g. by shareholders): the date of approval

During the vesting period

¬ the fair value of the option is normally not remeasured after the grant date
¬ The fair value at grant date is expensed linearly over the vesting period, adjusted for
expected forfeitures


Accounting for strategic investments (two companies) and legal mergers (one company)

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Different types of equity investments

1) Controlling: subsidiary. You control ≥ 50%, financial statements consolidated

Power to govern the financial and operating policies of an entity so as to obtain
benefits from its activities. Subsidiary: entity that is controlled by another entity
(known as the parent)
2) Influential but not controlling: associate. You control between 20 % – 50 %. Equity
method, recorded at cost initially; costs subsequently adjusted for investor’s share or
net income or loss and for dividends received.
Power to participate in the financial and operating policy decisions of the investee but
it’s not control or joint control over those policies. Associate is an entity over which
the investor has significant influence and that is neither a subsidiary nor an interest in
joint venture.
3) Joint controlling: Joint venture. You have sharing control. Equity method, recorded at
cost initially; costs subsequently adjusted for investor’s share or net income or loss
and for dividends received or proportional consolidation. Contractually agreed
sharing of control (between two or more legal entities) over a third economic activity.
When you build up a new entity, use the equity method.
4) Non influential: others, less than 20 %. Available for sale: Recorded as cost initially;
cost adjusted after purchase for changes in market value; unrealized gains and losses
reported to stockholders’ equity. Held for trading: unrealized gains and losses
reported on income statement.

Control concept
¬ ownership > one half of the voting power
¬ ownership ≤ one half of the voting power (arrangements with others to get more rights
and control)
- power > one half of the voting rights by virtue of an agreement with other
- power to govern the financial and operating policies of the entity under a
statute or an agreement
- power to appoint or remove the majority of votes at meetings of the board of
directors or equivalent governing body, or
- power to cast the majority of votes at meetings of the board of directors or
equivalent governing body

Significant influence
¬ Ownership ≥ 20 % of the voting power of the investee
¬ Evidence of significant influence: look at the contract
- representation on the board of directors or equivalent governing body of the
- participation in policy making processes
- Material transaction between the investor and the investee
- Interchange of managerial personnel
- Provision of essential technical information
Joint control

¬ joint verntures take on many different forms and structures

- jointly controlled operation
- jointly controlled assets

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- jointly controlled entities

Does not mean that everyone has the same proportion.

¬ all joint ventures result from a contractual arrangement between two or more
economic entities in which joint control is established. They work together, no new

Percentage of control and percentage of interest

¬ percentage of control (percentage of vote, or of voting rights) = degree of
dependency in which a parent company holds its subsidiaries or associates.
¬ Proportion of voting rights held by the parent in its related company
¬ Determines which method of consolidation used
¬ Percentage of interest (called percentage of ownership or of stake) = claim held by
the parent company over the shareholders’ equity (including net income) of it’s
subsidiaries or associates
¬ Percentage is used in the process of consolidation of accounts and calculations to
define majority and minority interest

Business combination
Types of business combinations:
- acquisition of shares, consolidation: 2 entities parents and subsidiary
- acquisition of the shares of a company which is dissolved. Merger ◊ only one
company is left
- two companies merge to become a third entity
- acquisition of assets: buy the assets and put them on the balance sheet

multiple choice
¬ the percentage of interest reflects the interest that are controlled directly and indirectly
¬ Minority interest can be reported as a part of shareholders’ equity, long-term liabilities
¬ Associates and affiliates are often considered as synonymous
¬ Minority interest is reported with full consolidation

Two different forms of legal mergers

¬ The assets and liabilities of one company (the merged company) are transferred to the
other company (the merging company) and the former (merged) company is dissolved,
¬ The assets and liabilities of both companies are transferred to a new company and both
original companies are dissolved.

So in the end there will be only one company

Some formulas
New shares = number of shares van merged company * ½

Capital increase = par value * new shares

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