Financial Accounting A Global Perspective Solution Manual

Monger Financial Accounting A Global Perspective

Lecture Notes

3

Answers to Learning Outcomes Questions

6

Learning Outcome 1 Learning Outcome 2 Learning Outcome 3 Learning Outcome 4 Learning Outcome 5 Learning Outcome 6

6 7 9 11 11 12

Answers to Review Questions

14

Answers to Terminology Practice

19

Answers to Application Exercises

21

Case Analysis

25

Additional Case: Aussie Pies (A)

28

. .

2

Lecture Notes Introduction This chapter was designed based on some of the ideas of Dr. Harvey J. Brightman who teaches a master university teaching program. Dr. Brightman believes that perhaps the most important element in students’ perception of teaching quality is how organized the instructor is. Does the student understand what the ‘big picture’ is and how each topic fits into it? Dr. Brightman also believes that one of the best ways to convey the organization of the course is through what he refers to as a “visual scaffold.”

The Financial Accounting Reporting System in this chapter is intended to provide this visual scaffold.

Figure 1.9 introduces this visual based on only entities (the business, customers, suppliers and so forth) and external users. Then the Financial Accounting Reporting System is ‘fleshed out’ over the remainder of the chapter – in Figure 1.25, Figure 1.27, Figure 1.28 and finally the full version in Figure 1.30. Once students have the Financial Accounting Reporting System in mind, it should be much easier in the following chapters to demonstrate how the chapter topic fits into the overall scheme.

Dr. Brightman is also an advocate of the ‘hook.’ His view, which I share, is that students are not naturally curious and their appetite for the material at hand must be whetted. This can be done by demonstrating in a constructive way that the student does not know how to solve a particular type of problem and will be able to do so after learning the material. Or perhaps by demonstrating the usefulness of the material in a way student may not have thought about before.

I have used the second approach by discussing Warren Buffet’s success in building Berkshire Hathaway.

What I wanted to demonstrate is that whether a student chooses accounting as a major or simply studies accounting as a general business curriculum requirement, it is important to overall success in business. Dr. Brightman does not use hooks chapter-by-chapter but rather for “modules” of material.

His position on this has strongly influenced the way I have organized the book into five parts.

Also see: www.themasterteacherprogram.com Brightman, H. “Mentoring Faculty to Improve Teaching and Learning”. Decision Sciences Journal of Innovative Education. Vol. 3(2), p.191-204, 2005.

Chapter Lecture

. .

3

This chapter may take considerable time to work through but it pays off later by establishing basic concepts. I use PowerPoint to work through the concepts slowly. Although the text does not introduce an actual set of financial statements until Chapter 3, I think it is useful for students to look at them. In the web site, the financial statements for Emirates Airline are included and I would ask the students on the first day of class to download the most recent year and look it over. At least they have an idea what actual financial statements are like rather than talking about them in the abstract.

Learning Outcome 1 Learning Outcome 1 introduces external users including investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. I ask students at this point two questions: 1. Do you agree that a business has an obligation to all these external users? Or do you believe a business has an obligation only to its owners?

If students say that they have an obligation to all external users, as some will, then I ask: 2. If the interests of different users is in conflict, how do you determine which is the most important?

Learning Outcome 2 The pivotal concept in Learning Outcome 2 is the owner or owners of a business as a separate entity from the business itself. It is relatively easy for a student to see that a customer or supplier is a separate entity, but easy to confuse with the owner. Sometimes I use this example: A business has one owner. The business owns a truck which it no longer has a use for. The owner decides to take the truck and use it on his weekend farm. I then ask the students: Has a transaction taken place here or not?

Learning Outcome 3 This is where the four financial statements are introduced. In this textbook, the formal names of the statements based on IFRS are used – statement of comprehensive income, statement of financial position, statement of changes in equity and statement of cash flows. The emphasis on the formal names was to make the terminology consistent but also to reinforce the concept of comprehensive income which requires a somewhat different mindset than when the focus is only on profit or loss.

. .

4

However, once I have introduced the four statements, I then narrow the discussion to the statement of comprehensive income and statement of financial position. Thus, I spend far more time on these two statements. I tell the students that the statement of comprehensive income is the ‘recycle bin’ of accounting. It deals with only financial information of the past. Nothing on the statement of comprehensive income relates to the future.

I then tell them that all items on the statement of financial position must have future use to the business. Assets will be used by the business in the future; liabilities must be settled by the business in the future. In later chapters when I am working with students on whether to capitalize or expense an item, for example, I come back to this perspective and ask – Does the item have any future relevance to the business?

At this point, I also like to stop and work some of the back-of-chapter application exercises with the students to make sure they have practice in class putting the statements together correctly – especially the statement of comprehensive income and statement of financial position.

Learning Outcome 4 On the accounting process, I have used a synthesized version of the steps in accounting. Automated systems have rendered the trial balance less important. It is these days simply one of the various reports that can be demanded of the system. But also I wanted to focus the student on the major steps – recording transactions, adjusting the ledger accounts, preparing the financial statements and closing temporary accounts. In Chapter 1, I only introduce these steps saying that Part II covers the accounting process in detail.

Learning Outcome 5 I also do not spend much time on generally accepted accounting principles and accounting standards other than to draw the distinction between the accounting process and accounting standards. I tell students that we will examine accounting standards at a basic level in Parts III and IV. Learning Outcome 6 Again, I touch on the issues in this learning outcome only to illustrate the place they have in the Financial Accounting Reporting System, but defer more discussion until later chapters.

. .

5

Answers to Learning Outcomes Questions Learning Outcome 1 Describe the financial information needs of internal and external users.

On Your Own 1. Who are internal users and what uses do they make of accounting information?

Internal users include managers, other employees and members of the board of directors.

They use managerial accounting information for planning, decision-making and control. This information is typically not made available to external users.

2. List the types of external users and describe the information requirements of each.

Investors – Those who provide risk capital and their advisors. Their primary needs are for information to help them decide whether to buy, hold or sell equity securities in the company, and whether the company can pay dividends.

Employees – Employees and their representative groups who need information about the stability and the profitability of the business. Employees need financial information to be able to assess the company’s ability to provide employment opportunities, and to pay compensation and retirement benefits.

Lenders – The major concern of lenders is whether their loans and the associated interest will be paid when due. Financial information is needed to understand whether the business entity can pay its debts, and if not, what assets are available to secure debts.

Suppliers and other trade creditors – Suppliers and other trade creditors, like lenders, are interested in whether amounts they are owed by the company will be paid.

Customers – Customers, especially those which are dependent on the business, are interested in the long-term viability of the entity.

Governments and their agencies – Governments and agencies need information for regulatory purposes, taxation and to develop national income and other statistics.

Public – The public needs financial information for a variety of purposes such as understanding the contributions to the local economy.

3. For what does financial accounting account? . .

6

Financial accounting accounts for financial information only which is the monetary unit concept. Non-financial information is typically not included.

4. What uses do external users make of accounting information?

External users use financial accounting information to evaluate the financial position, performance and changes in financial position of the business entity.

5. Why are internal users more interested in future-oriented information?

This answer to this question is not directly addressed but is implied by the information presented. Internal users – which include managers, other employees and members of the board – are all involved in planning and decision-making that will affect future financial results. While internal users rely on financial information about the past to understand how the business has performed, they also need to make predictions about future financial performance. Examples include the amount of sales in upcoming years or the price that the business can charge its customers.

6. Why is future-oriented financial estimates typically not provided to external users?

Future-oriented financial estimates may reveal plans that management does not want the public to know. For example, management may plan to lower the price of a certain product in the coming year. If this were reported in financial accounting results, then it could alert competitors to the future plans of the business and therefore create a competitive disadvantage.

Learning Outcome 2 Define a business entity and describe the three major forms of business organization.

On Your Own 1. Give examples of the types of entities that typically engage in transactions with a business entity.

Entities which typically engage in transactions include customers, suppliers, employees, investors and creditors.

2.

. .

In a previous example, Didier Bihayintore, a sole proprietor, uses the trade name Didier’s Restaurant. Are Didier Bihayintore and Didier’s Restaurant the same business entity or separate business entities?

7

Legally Didier Bihayintore and Didier’s Restaurant are one in the same since the business is organized as a sole proprietorship. However, we would normally account for the owner and the business as separate entities. Thus, in this example, one set of accounting records would be maintained for Didier Bihayintore and another set for Didier’s Restaurant.

3.

What is the difference between a business transaction, a financial transaction and a barter transaction?

A business transaction refers to any exchange of value between a business entity and another entity such as a customer, supplier, creditor or employee. A financial transaction is a business transaction that is financial such as borrowing money. A barter transaction is a business transaction that does not involve money.

4.

What are the three forms of business organization? What are the advantages and disadvantages of each form?

Limited liability company – Advantages include the ability of the business to engage in transactions including borrowing money in its own name rather than the name of the owners. A limited liability continues operating without disruption when ownership changes which makes raising capital easier.

Owners of limited liability companies – the shareholders – have limited liability and while they can lose what they have invested in the business, they are usually not responsible to pay the debts of the limited liability company. The major disadvantage of limited liability companies is that they are more expensive to create and operate.

Sole proprietorship – The major advantages of sole proprietorships is that they are simple and inexpensive to create and operate. One disadvantages of the sole proprietorship form of business organization is that it is more difficult to raise capital. Also the sole proprietor is personally responsible for the repayment of any business debts.

Partnerships – The advantage of partnership is that it allows more than one person to combine their talents and resources in business. The disadvantages are that creditors may seek repayment of business debts from the partners personally. Also partnerships must be dissolved each time a partner leaves the business.

5.

What is the difference between a privately held and a publicly traded company? What forms of business organization can each take?

A privately held company is not publicly traded while the shares of a publicly traded company are bought and sold on stock exchanges. Thus shares of publicly traded companies can be bought and sold by the public.

Publicly traded companies are always organized as limited liability companies. A privately held company can be organized as a limited liability company, sole proprietorship or partnership.

. .

8

Ownership changes to privately held limited liability companies occur when the shares of the business are bought and sold.

Learning Outcome 3 Describe how financial information is reported to external users.

On Your Own 1. What are the elements of each financial statement? Define each of these.

Statement of financial position • Assets – What a business owns which are resources the business can use in the future.

• Liabilities – What a business owes which are obligations that must be settled in the future.

• Equity – The difference between assets and liabilities.

Statement of comprehensive income • Revenue – The flow of economic benefits during the period arising from the entity’s business activities.

• Expenses – The outflow of economic benefits during the period arising from the entity’s business activities.

• Profit or loss – Revenue less expenses. If revenue exceed expenses, a profit results. If expenses exceed revenue, a loss results.

• Other comprehensive income – Certain income and expenses which are not included in profit or loss.

Statement of changes in equity • Changes to contributed capital – Contributed capital is increased when owners invest additional capital in to the business and it is decreased when owners withdraw their capital from the business.

• Changes to retained earnings – Retained earnings is changed by the amount of profit or loss reported on the statement of comprehensive income and decreased by the amount of dividends paid to owners.

• Changes to reserves – Reserves are changed by the amount of other comprehensive income reported on the statement of comprehensive income.

Statement of cash flows • Operating activities are cash flows related to the principal revenue-producing activities of the entity that do not qualify as investing or financing activities.

• Investing activities are cash flows that relate to the acquisition of disposal of major assets.

• Financing activities are cash flows that result in changes in the size and composition of the amount that owners have invested in the business and borrowings.

Each type of activity – operating, investing and financing – can be both a source and use of cash. . .

9

2. What purposes do the notes to the financial statements serve?

Notes provide information that is not included in the four financial statements, or they expand on information presented on the ‘face’ of the four financial statements. A note can relate to any one, or more than one, of the financial statements.

3. When we say that accounting generates ‘general-purpose’ financial statements, what are we assuming about the users?

We assume that we are generating financial statements for a broad range of users. Some users may have a sophisticated understanding of business and be able to read and interpret accounting information while others may be less knowledgeable. However, all users are assumed to have a general understanding of business and accounting.

4. What is financial position? What is performance?

Financial position is the relationship of the assets, liabilities and equity of an entity as reported in the statement of financial position. Performance is the relationship of income and expenses of an entity as reported in the statement of comprehensive income.

5. Which financial statements report financial position? Which financial statement report changes in financial position? Which financial statement report performance?

Financial position is reported by the statement of financial position. Changes in financial position are reported by the statement of comprehensive income, the statement of changes in equity and the statement of cash flows. Performance is reported by the statement of comprehensive income.

6. What is the accounting equation?

Assets = Liabilities + Equity 7. What is a line item?

A line item is the most detailed level of information included in a financial statement.

8. What is the difference between profit or loss and other comprehensive income?

Profit or loss includes revenue and expenses that arise from the entity’s business activities. Other comprehensive income includes income and expenses that are specifically excluded from profit or loss.

9. What are the different ways to indicate that an amount on the financial statement sis negative?

Accountants use many different ways to indicate that an amount is negative. A negative amount could be bracketed. Sometimes a financial statement will indicate that the amount should be subtracted or the financial statement will assume that the user knows that it is negative. For

. .

10

example, it assumes that the user knows that expenses are always subtracted from revenue.

Sometimes negative amounts are shown in red if color is used in the financial statements.

Learning Outcome Practice 1. Trade accounts payable is reported as which of the following? a. A liability on the statement of financial position 2. Equity would appear on which financial statement(s)? d. The statement of financial position and the statement of changes in equity 3. Expenses would appear on which financial statement(s)? a. The statement of comprehensive income only 4. If assets are $55 000 and equity is $25 000, how much are liabilities? b. $30 000 5. Dividends appear on which financial statement(s)? d. The statement of changes in equity only

Learning Outcome 4 Explain the accounting process.

On Your Own 1. What is the major advantage of the double-entry method of accounting?

The double-entry method allows financial information to be summarized and reported in a meaningful way while allowing this information to be related back to the original transactions.

2. What are the four steps in the accounting process?

1) Analyze and record transactions 2) Adjust accounts 3) Prepare the financial statements 4) Close accounts Learning Outcome 5 Define generally accepted accounting principles and explain their role in financial accounting.

On Your Own 1. What are the four major decisions that have to be made when accounting for transactions?

1) Recognition which relates to whether a transaction should be included?

2) Measurement which relates to what amount should be used to measure a transaction?

3) Reporting which relates to how financial results should be reported in the financial statements 4) Disclosure which relates to what additional information should be provided in the notes. . .

11

2. What are generally accepted accounting principles?

Generally accepted accounting principles (GAAP) include laws, regulations, rules and commonly accepted practices that provide guidance to accounting. GAAP is influenced by academic research as well as the opinions of industry groups, companies and those who prepare financial statements.

3. How do accounting standards and generally accepted accounting principles differ?

Accounting standards are one component of generally accepted accounting principles. Accounting standards are formal, written rules created by governments, quasi-governmental organizations or professional organizations. Accounting standards are specific to nations or regions. Accounting standards are often included as part of a nation’s laws.

4. What is the International Accounting Standards Board?

The International Accounting Standards Board (IASB) is an international accounting standards setting organization.

5. What are International Financial Reporting Standards?

International Financial Reporting Standards or IFRS are international accounting standards created by the International Accounting Standards Board (IASB). Some nations have adopted IFRS as their national standards while some other nations have “harmonized” their national standards to be more similar to IFRS. Learning Outcome 6 Describe the assurance system in financial reporting.

On Your Own 1. How do external users know that financial statements provide a true and fair view of the financial results of the business?

Assurance systems provide users with assurances that the financial statements have been prepared in accordance with applicable generally accepted accounting principles and also present a true and fair view of the financial results of the business. Assurance systems include independent audits by professional accountants.

2. What is an independent audit? Who conducts an independent audit?

An independent audit is a review by an independent professional accountant to ensure that the financial statement have been prepared in accordance with applicable generally accepted accounting principles and present a true and fair view of the financial results of the business.

Independent audits are usually but not always conducted by a public accountant with professional credentials like the Certified Public Accountant or Chartered Accountant certificate.

. .

12

3. Who has the overall responsibility for overseeing financial reporting?

The board of directors in a limited liability company has oversight responsibility for all financial accounting reporting matters. Typically, the board of directors hires the independent auditors and approves the financial statements for release to external users.

4. Who is responsible for preparing the financial statements?

Management is responsible for preparing the financial statements under the oversight of the board of directors.

. .

13

Answers to Review Questions 1. Who are the external users of financial reports? What are the information requirements of each?

How do the needs of external users differ from those of internal users?

External users include the following: Investors – Those who provide risk capital and their advisors. Their primary needs are for information to help them decide whether to buy, hold or sell equity securities in the company, and whether the company can pay dividends.

Employees – Employees and their representative groups who need information about the stability and the profitability of the business. Employees need financial information to be able to assess the company’s ability to provide employment opportunities, and to pay compensation and retirement benefits.

Lenders – The major concern of lenders is whether their loans and the associated interest will be paid when due. Financial information is needed to understand whether the business entity can pay its debts, and if not, what assets are available to secure debts.

Suppliers and other trade creditors – Suppliers and other trade creditors, like lenders, are interested in whether amounts they are owed by the company will be paid.

Customers – Customers, especially those which are dependent on the business, are interested in the long-term viability of the entity.

Governments and their agencies – Governments and agencies need information for regulatory purposes, taxation and to develop national income and other statistics.

Public – The public needs financial information for a variety of purposes such as understanding the contributions to the local economy.

External users need information about the financial results of the business entity that allow them to assess financial position, performance and changes in financial position. These assessments allow them to make decisions about whether to invest in the business entity. It also permits them to determine whether to continue with the existing management or replace it.

Internal users need information for planning, decision-making and control. This information is often future-oriented and therefore must rely on estimates about the future.

2. Describe the three forms of business organization. What are the advantages and disadvantages of each? . .

14

Limited liability company – Advantages include the ability of the business to engage in transactions including borrowing money in its own name rather than the name of the owners. A limited liability continues operating without disruption when ownership changes which makes raising capital easier. Owners of limited liability companies – the shareholders – have limited liability and while they can lose what they have invested in the business, they are usually not responsible to pay the debts of the limited liability company. The major disadvantage of limited liability companies is that they are more expensive to create and operate.

Sole proprietorship – The major advantages of sole proprietorships is that they are simple and inexpensive to create and operate. One disadvantages of the sole proprietorship form of business organization is that it is more difficult to raise capital. Also the sole proprietor is personally responsible for the repayment of any business debts.

Partnerships – The advantage of partnership is that it allows more than one person to combine their talents and resources in business. The disadvantages are that creditors may seek repayment of business debts from the partners personally. Also partnerships must be dissolved each time a partner leaves the business.

3. What must a complete set of financial statements include? What question is answered by each financial statement? List and define the major elements in each financial statement. Give examples of specific line items included within each element of the statement of financial position and the statement of comprehensive income. [Example: Trade accounts receivable is an asset on the statement of financial position.]

A complete set of financial statements includes: • statement of financial position, • statement of comprehensive income, • statement of changes in financial position, • statement of cash flows, and • notes to the financial statements.

The questions answered by each financial statement are the following: Question What is the financial position of the business?

How did the business perform?

What resources have the owners invested in the business?

Where did the business obtain cash and how was it used? . .

Statement Statement of financial position Statement of comprehensive income Statement of changes in equity Statement of cash flows

15

Major elements of financial statements include: Statement of financial position • Assets – What a business owns which are resources the business can use in the future.

• Liabilities – What a business owes which are obligations that must be settled in the future.

• Equity – The difference between assets and liabilities.

Statement of comprehensive income • Revenue – The flow of economic benefits during the period arising from the entity’s business activities.

• Expenses – The outflow of economic benefits during the period arising from the entity’s business activities.

• Profit or loss – Revenue less expenses. If revenue exceed expenses, a profit results. If expenses exceed revenue, a loss results.

• Other comprehensive income – Certain income and expenses which are not included in profit or loss.

Statement of changes in equity • Changes to contributed capital – Contributed capital is increased when owners invest additional capital in to the business and it is decreased when owners withdraw their capital from the business.

• Changes to retained earnings – Retained earnings is changed by the amount of profit or loss reported on the statement of comprehensive income and decreased by the amount of dividends paid to owners.

• Changes to reserves – Reserves are changed by the amount of other comprehensive income reported on the statement of comprehensive income.

Statement of cash flows • Operating activities are cash flows related to the principal revenue-producing activities of the entity that do not qualify as investing or financing activities.

• Investing activities are cash flows that relate to the acquisition of disposal of major assets.

• Financing activities are cash flows that result in changes in the size and composition of the amount that owners have invested in the business and borrowings.

Examples of line items by element for the statement of financial position include: Element . .

Line item examples

16

Assets

Cash in bank Trade accounts receivable Inventories Equipment Land Trade accounts payable Wages payable Loan payable Contributed capital Retained earnings Reserves

Liabilities

Equity

Examples of line items by element for the statement of comprehensive income include: Element Revenue Expenses

Other comprehensive income

Line item examples Sales revenue Service revenue Cost of goods sold Wages expense Rent expense Revaluation reserve

4. What is the accounting process and what was its origin? Give a basic explanation of how the accounting process works.

The accounting process is based on the double-entry method. The double-entry method was created in the 15th century by an Italian mathematician and is used throughout the world today as the basis for accounting activity in both large and small businesses. Business transactions are analyzed and recorded, adjusted and summarized. The accounting process also generates the financial statements.

5. What are generally accepted accounting principles? Describe the difference between generally accepted accounting principles and accounting standards. How are generally accepted accounting principles used in financial accounting? What are International Financial Reporting Standards?

Generally accepted accounting principles (GAAP) include laws, regulations, rules and commonly accepted practices that provide guidance to accounting. GAAP is influenced by academic research as well as the opinions of industry groups, companies and those who prepare financial statements.

Accounting standards are one component of generally accepted accounting principles. Accounting standards are formal, written rules created by governments, quasi-governmental organizations or professional organizations. Accounting standards are specific to nations or regions. Accounting standards are often included as part of a nation’s laws.

. .

17

Generally accepted accounting principles give guidance to those who prepare financial statements about how to handle specific transactions including on questions of recognition, measurement, reporting and disclosure. Independent auditors use generally accepted accounting principles to determine whether the business entity is in compliance and has presented a true and fair view of financial results.

International Financial Reporting Standards or IFRS are international accounting standards created by the International Accounting Standards Board (IASB). Some nations have adopted IFRS as their national standards while some other nations have “harmonized” their national standards to be more similar to IFRS. 6. Who is ultimately responsible for the financial statements? Who is responsible for preparing financial statements?

The board of directors has the ultimate responsibility for the information reported in the financial statements of the business entity. Management is responsible for preparing the financial statements.

7. What is the assurance system? Describe the major parties that are involved in the assurance system and the role of each. What is the evidence that an external user can rely on the financial statements?

Assurance systems provide users with assurances that the financial statements have been prepared in accordance with applicable generally accepted accounting principles and also present a true and fair view of the financial results of the business.

The board of directors has oversight responsibility for information reported in the financial statements. Management is responsible for preparing the financial statements. And independent auditors review financial statements to give a professional opinion about whether they conform to applicable GAAP and present a true and fair view of the financial results. External users rely on this opinion.

8. Explain why professional ethics must be part of the financial accounting reporting system in order for it to function properly.

Accounting standards cannot address every conceivable transaction and thus some room always exists for judgment. Nor can businesses always prevent fraud and misrepresentation in financial information. Therefore, professional ethics help ensure that reporting is truthful and the results reliable so that a true and fair view of financial results is presented.

. .

18

Answers to Terminology Practice 1. The time period assumption is the division of time into specific time intervals such as a year, quarter or month.

2. When expenses exceed revenue, the business reports a loss which is shown on the statement of comprehensive income.

3. Revenue is the inflow of economic benefits from the ordinary activities of the business entity and is included in the statement of comprehensive income.

4. Evidence of ownership of a limited liability company takes the form of shares, also known as stock, common shares or ordinary shares.

5. Liabilities are what a business owes and are expected to be settled in the future.

6. Sources and uses of cash are known as cash flows.

7. Goods held for resale are inventories and are included as assets on the statement of financial position.

8. Trade accounts payable are obligations to suppliers that are included on the statement of financial position.

9. Formal, written guidelines for accounting developed at the national level are accounting standards.

10. The monetary unit assumption refers to the fact that we account for information that can be expressed in terms of money.

11. The accounting process uses the double-entry method, which accounts for transactions between the business entity and other entities.

12. Notes accompany the financial statements and either explain information contained in the financial statements or provide additional information.

13. When a company’s shares are not publicly traded, the company is closely held or privately held.

14. Financial accounting provides information for external users. Managerial accounting provides information for internal users.

15. When revenues exceed expenses, the business reports a Profit, which shown on the statement of comprehensive income.

16. Trade accounts receivable are obligations that customers have to the business, which are included in assets on the statement of financial position.

17. Assets are what a business owns and are expected to have economic benefits in the future.

18. The three forms of business organization are Limited liability company, sole proprietorship and partnership.

19. Equity shares are traded on the bourse, equity securities market or stock market.

20. Expenses are an outflow of economic benefits from ordinary activities of the business entity and are included in the statement of comprehensive income.

21. The reporting date is the date of the statement of financial position and a reporting period is the time in between.

22. The accounting equation is assets = liabilities + equity. The income equation is revenues – expenses = profit or loss. . .

19

23. Three categories of cash sources and uses are operating activities, investing activities and financing activities.

24. Profit and loss and other comprehensive income are added to calculate total comprehensive income.

25. When the expenses are subtracted from revenues, the result is profit or loss.

. .

20

Answers to Application Exercises 1. Place a tick in the appropriate boxes to indicate which financial statements the items in the lefthand column apply to.

Statement of comprehensive income Assets Cash from investing activities Contributed capital including changes Trade accounts payable Retain earnings Revenue Cash from financing activities Expenses Trade accounts receivable Liabilities Wages payable Cash from operating activities Profit or loss Beginning equity balance Loan payable Ending equity balance Inventories Cash in bank

. .

Statement of financial position √

Statement of changes in equity

Statement of cash flows

√ √ √

√

√ √

√

√ √ √ √ √ √ √ √

√ √ √ √ √ √

√ √

21

2. Complete the items in the following diagram by writing in the appropriate name of the financial statement, financial statement element or line item.

. .

22

3. Complete the following schedule by supplying the missing information for each of the three companies: Company A Company B Company C

Expenses Assets Profit (loss) Equity Revenue Liabilities

£105 000 £1 250 000 (£25 000) £200 000 £812 000 £2 400 000

4. Complete the following schedule by supplying the missing information for each of the three companies.

Company A

Company B

Company C

Equity (2010) Liabilities Profit (loss) Liabilities Equity (2010) Assets Revenue Equity (2010) Equity (2011) Revenue Profit (loss)

$1000 $13 500 $1 500 $15 000 $14 700 $28 000 $2 000 $433 000 $440 000 $350 000 $230 000

5. Complete the following schedule by supplying the missing information for each of the four companies: Company A Company B Company C Company D

Dividends Ending equity balance Sale of ordinary shares Profit (loss)

€50 €745 €200 €25

6. Complete the following schedule by supplying the missing information: Company A Company B Company C

. .

Cash from (used by) investing activities Ending cash balance Cash from (used by) operating activities Net change in cash balance Cash from (used by) financing activities Beginning cash balance

(€3000) €12 500 (€12 000) (€12 500) (€225 000) €1 200 000

23

7. Based on the information below for Maize Industries LLC, construct a statement of financial position, statement of comprehensive income, statement of changes in equity and statement of cash flows for the year ended 31 December 2010. Use appropriate headings for each statement.

Assets Cash in bank Other assets TOTAL ASSETS

Maize Industries, LLC Statement of Financial Position 31 December 2010 – Euros € Liabilities 6 310 000 Equity 6 290 000 1 2600 000 TOTAL LIABILITIES AND EQUITY

11 250 000 1 350 000 12 600 000

Maize Industries, LLC Statement of Comprehensive Income For the year ended 31 December 2010 – Euros € Revenue 3 750 000 Expenses 2 800 000 Profit 950 000 Other comprehensive income 0 Total comprehensive income 950 000

Maize Industries, LLC Statement of Changes in Equity For the year ended 31 December 2010 – Euros € Beginning balance, 1 January 2010 Ordinary shares sold Profit Dividend Ending balance, 31 December 2010

700 000 200 000 950 000 (500 000) 1 350 000

Maize Industries, LLC Statement of Cash Flows For the year ended 31 December 2010 – Euros € Net cash from operating activities 8 400 000 Net cash used by investing activities (4 790 000) Net cash from financing activities 2 000 000 Net increase in cash 5 610 000 Cash balance, 1 January 2010 700 000 Cash balance, 31 December 2010 6 310 000

. .

24

Case Analysis To the Instructor This case asks students to examine three years of financial statements about Italian Naturals, SpA, a start-up company which manufactures soaps. It is, of course, too early for students to perform a meaningful analysis. Instead the purpose of this case is three fold: 1) to give students practice reading and becoming familiar with financial statements, 2) practice thinking about what financial statements are reporting, and 3) practice thinking about differences between financial statement elements (e.g., that in 2011 the company had a €2000 profit but at the same time reported a use of cash by operating activities of €2000).

First question set: We will learn about some techniques later in the textbook to analyze the financial statements but at this point we can make a few observations.

1. What is the financial position of the business?

To answer this question, we would examine the statement of financial position. We can make two observations about assets. First over the three year period, the amounts for trade accounts receivable, inventories and supplies increase with the biggest change coming between 2009 and 2010. Second we can see that in 2011, the company purchased €50 000 in equipment which appears in assets for the first time.

Liabilities also increase. The biggest change comes in 2011 when the €50 000 loan payable appears.

This is the money Paolo’s parents have lent the company.

In the equity section, we can see that 2009 shows the share capital of €20 000 that Paolo initially invested to begin the business. This increases to €40 000 in 2010 because Matt Hopes invested a like amount. The amount of share capital does not change between 2010 and 2011. We can also see that the total amount of equity is only €13 500 for 2009, less than the amount Paolo invested because the Italian Naturals had a loss that resulted in a negative retained earnings balance. In 2010, the company had another loss for €5000 which caused the negative retained earnings balance to increase to €11 500. This resulted in total equity of €28 500 which is less than the total amount Paolo and Matt have invested of €40 000. In 2011, the Italian Naturals reports its first profit of €2 000. This increases retained earnings but the balance is still negative €9 500 [ =(11 500) + 2 000].

2. How did the business perform?

Performance is reported by the Statement of Comprehensive Income. As noted above, the business reported a loss for 2009 and 2010. It reported its first profit in 2011.

. .

25

3. What resources have the owners invested in the business?

This question is answered by the Statement of Changes in Equity. We can see that the owners invested a total of €40 000 -- €20 000 by Paolo in 2009 and €0 000 by Matt in 2010. No additional investment was made in 2011. However, since the company has losses that exceed profits over the three years, the amount invested has decreased.

4. Where did the business obtain cash and how was it used?

This question is answered by the Statement of Cash Flows. We can see that operating activities have been a use of cash in all three years though the amount being used is decreasing from €15 000 in 2009 to €21 500 in 2010 to €2 000 in 2011. The only cash flow related to investing activities was in 2011 when the company acquired €50 000 of equipment. Financing activity was the sole source of cash in all three years. In 2009, Paolo’s investment was a source for €20 000, in 2010 Matt’s investment was a source for €20 000 and in 2011 Paolo’s parent loan was a source of cash to the company for €50 000.

Second question set: 1. In 2009, did Paolo do a good job managing the business? What did he do well? What needed improvement? What specific recommendations would you have for Paolo related to the business in 2009?

It’s impossible to answer this question definitively. Clearly, starting a new business is time consuming and it’s typical for entrepreneurs like Paolo to spend a lot of time learning the business.

To his credit, Paolo did add a few new customers. It is not unusual for a business to report a loss in its first years of operations so that too is not a cause for much concern in 2009. But also the business used up the majority of its cash in the first year and this is a concern especially since trade accounts receivable, inventories and supplies are all large numbers.

Could Paolo have done a better job collecting amounts owed to the business by his customers? Did he really need to have such a large inventory and purchase so many supplies at this point? But these are questions worth asking? Maybe Paolo would have been better off if he had a business partner from the start that focused on financial issues and sales or perhaps he could have hired someone to manage this.

2. In 2010, did Paolo and Matt do a good job managing the business? What did they do well? What needed improvement? Again, what specific recommendations would you have for Paolo and Matt related to the business in 2010?

Paolo and Matt were able to increase the amount of sales revenue as shown on the Statement of Comprehensive Income. Expenses also increased only slightly over 2009 expenses which resulted in . .

26

a smaller loss than what had been reported in 2009. However, what is worrisome is the big increase in the trade accounts receivable, inventories and supplies balances on the statement of financial position. The other concern is the large amount of cash that was used by operating activities. Paolo and Matt should make an effort to control these balances and also pay close attention to the amount of cash they will need. Most new businesses fail because they run out of cash!

3. In 2011, did Paolo and Matt do a good job managing the business? What did they do well? What needed improvement? Again, what specific recommendations wuld you have for Paolo and Matt related to the business in 2011?

2011 is a significant improvement over the previous two years. Sales revenue has increased significantly and for the first time the company has reported a profit. On the statement of financial position, there is more reason to be hopeful because trade accounts receivable, inventories and supplies balances have increased only by a small amount over 2010. Also, on the statement of cash flows, cash used by operating activities has decreased significantly.

Though it’s still too early to tell, the company appears to be headed in the right direction. The interesting questions for 2012 will be whether the business reports an increase in profit and also whether operating activities becomes a source of cash.

. .

27

Additional Case Aussie Pies (A) Graeme Rankine Thunderbird, The Garvin School of International Management Distributed by ECCH, A01-06-0012 There are four cases in the Aussie Pie series (A, B, C and D). Others are included in later chapters. Aussie Pies (A) is a brief case that asks the students to consider what the monthly cost would be to run a new business that makes Aussie-style meat pies. The student is given the selling price and a list of costs.

Some are variable and some are fixed which of course is appropriate to managerial accounting.

However, the student does not need to understand cost behavior in order to complete the case.

Suggested case questions: Financial information is presented for only one month.

1. What would the statement of comprehensive income be for this company assuming that it sold 30,000 meat pies each month? Would the business make a profit or loss?

2. What would the statement of financial position be for this company assuming that it sold 30,000 meat pies each month?

Given the facts in the case, all items belong on the statement of comprehensive income. These should appear as shown below: Statement of Comprehensive Income Revenue 30 000 x $3.25 Less: Expenses Ingredients 30 000 x $1.20

. .

$97 500 36 000

Store rent Cooking equipment rental Fixture rental Chefs 2 chefs x $1800 Sales assistant Utilities per pie 30 000 x $0.03 Pie boxes 30 000 x $0.02 Utilities costs for lighting the store Total expenses

11 900 8 000 5 000 3 600 1 200 900 600 300 67 500

Profit Other comprehensive income Total comprehensive income

$30 000 0 $30 000

28

The business made a profit of $30 000.

A statement of financial position cannot be prepared because the case provides no evidence of assets, liabilities or equity.

. .

29

Instructor Manual Chapter 2 Accounting Standards and Ethics . .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

6

Learning Outcome 1 Learning Outcome 2 Learning Outcome 3

6 7 9

Answers to Review Questions

10

Answers to Terminology Practice

11

Case Analysis

14

. .

2

Lecture Notes Introduction Students are often overwhelmed when first introduced to financial accounting. I believe that a major reason is that instructors do not make an adequate distinction between the accounting process and accounting standards. This is why Chapter 1 discussed the centuries old accounting process still in use today. I remind students that Part II is a detailed looks at the accounting process.

But, this chapter introduces accounting standards. Again, I remind students in an effort to keep them oriented to where we are in the course that in Parts III and IV we will examine some accounting standards (IFRS) in more detail. I also point out that a thorough examination is what accounting majors will experience in the intermediate and advanced financial courses.

Learning Outcome 1 The textbook uses IFRS as a ‘template’ for the concept of accounting standards. So I explain to students that IFRS are perhaps the most common set of accounting standards that they will work with but it’s also possible that they will also work with national standards. Obviously, we cannot take up all the variations of accounting standards though I remind them that many similarities exist between national accounting standards.

The material in this section is straight-forward. Instructors will have different preferences about how much detail they want students to know at the graduate and undergraduate levels. But the information is there to use or not use.

Learning Outcome 2 This section includes a discussion of the basic concepts in the Framework for the Preparation and Presentation of Financial Statements. These include the underlying assumptions, qualitative characteristics of financial statements, the constraints on relevant and reliable information and other issues. The material is itself straight-forward however you may want to consider supplementing the discussion with the following questions: 1) Do you think that the Framework is more needed in a rules-based system or a principles-based system? Or does it matter?

Instructors will have their own views on this. However the question is designed to provoke students’ thinking about the difference between rules-based and principles-based standards and the need for a general or conceptual framework. . .

3

Learning Outcome 4 This section deals with the four measurement concepts dealt with in the Framework for the Preparation and Presentation of Financial Statements – historical cost, current cost, realizable value and present value. Fair value is introduced later. To me, there are two objectives in teaching this material at this point. First, students must know these measurement concepts so this section introduces them. Second, it’s important for students to understand that financial information can and does differ because of the measurement basis used. So instructors might use these questions to supplement the discussion on measurement: 1) Why would the historical cost and current cost of an asset differ? Can you give an example?

2) Why would the current cost and realizable cost of an asset differ? Again, can you give an example?

Learning Outcome 5 Most instructors agree that professional ethics must be taught as part of the accounting curriculum.

However, questions about what approach to use and how much time to devote the topic of professional ethics results in far less consensus. My view is that ethics is a broad topic and best left to a course devoted to the topic, which most university curricula include. I remind my students that they will most likely study ethics in a broader and deeper sense elsewhere.

However, in this section I narrow the discussion by focusing on professional ethics. And on this I point out to students that the following: 1) professional codes of ethics or conduct are a common feature in the accounting profession and business in general, 2) these codes are an important feature for improving ethical behavior in their respective organizations and 3) a practicing professional may be subject to several codes. The remainder of the material then focuses on examples of actual codes from British Airways, PricewaterhouseCoopers and the Hong Kong Institute of Certified Public Accountants.

. .

4

Answers to Learning Outcome Questions Learning Outcome 1 Explain how accounting standards are established.

On Your Own 1. Why would nations want to have control over the standard-setting process?

Nations have a variety of social, economic and legal circumstances that need to be reflected in that nation’s accounting standards.

2. Compare and contrast the rules-based and principles-based approaches to setting accounting standards.

Rules-based standards provide specific guidelines for accounting versus principles-based standards which focus on broad objectives.

Rules-based standards need to be clear and understandable as well as comprehensive in order to provide guidance in all circumstances whereas principles-based standards are flexible and can be applied in a way that satisfies local laws and culture.

Rules-based standards are criticized because managers can circumvent the rules by applying them by the ‘letter of the law’ rather than ‘spirit’. Principles-based standards are criticized because it is sometimes difficult to determine whether a company is in compliance or not.

3. Which approach was used for IFRS; rules-based or principles-based standards?

IFRS are based on a principles-based standards approach.

4. What do IFRS include?

IFRS include International Financial Reporting Standards provided by the IASB, International Accounting Standards as well as Interpretations by the International Financial Reporting Interpretations Committee (IFRIC) and the former Standing Interpretations Committee.

5. What are the objectives of the International Accounting Standards Board? a) To develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the various capital markets of the world and other users of the information to make economic decisions; b) To promote the use and rigorous application of those standards, and c) To work actively with national standard-setters to bring about convergence of national accounting standards and IFRSs to high quality solutions. . .

5

6. What is the structure of the IASB and related organizations? What is the role of each IASB-related organization?

• International Accounting Standards Committee Foundation – This U.S. based organization overseas the IASB and its activities. It also provides funding a support. The Foundation also appoints members to serve on the International Accounting Standards Board.

• International Accounting Standards Board (IASB) – This 14 person board sets International Financial Reporting Standards.

• International Financial Reporting Interpretations Committee (IFRIC) – This Committee handles situations where not authoritative guidance is yet available. It addresses newly identified financial reporting issues and issues where unsatisfactory or conflicting interpretations have developed or seem likely to develop in the absence of authoritative guidance.

• Standards Advisory Council – The Council provides advice on the IASB agenda, project timetables and priories and on the practical application and implementation of existing standards.

7. Describe the six standard-setting stages used by the IASB. 1. Setting the agenda 2. Project planning which can be done alone or jointly with another standard-setter.

3. Development and publication of a discussion paper with an invitation for comments.

4. Development and publication of an exposure draft setting out the proposed standard with an invitation for comments.

5. Development and publication of a standard.

6. Gathering feedback after a standard is issued on unintended issues that arise in practical implementation or with the standard’s potential impact.

8. What are the mandatory steps in the IASB standard-setting process? What are the non-mandatory steps?

Mandatory Non-Mandatory 1. Develop and pursue the IASB technical 1. Publish a discussion document (e.g., agenda discussion paper) 2. Prepare and issue standards and 2. Establish working groups or other exposure drafts, each of which is to types of specialist advisory groups include any dissenting opinions 3. Establish procedures for reviewing 3. Hold public hearings comments made within a reasonable period on documents published for comment 4. Consult the SAC on major projects, 4. Undertake field tests (both in agenda decisions and work priorities developed countries and in emerging markets) 5. Publish bases for conclusions with standards and exposure drafts . .

6

9. What are the three requirements for setting international accounting standards?

1) Transparency and accessibility. The IASB considers topics on its agenda based on consultations with constituents and research conducted with IASB staff. Comment letters from interested organizations, IASB meeting observer notes, IASB decisions and other materials are made available through the organization’s website (www.iasb.org) and other media.

2) Extensive consultation and responsiveness. The IASB solicits views and suggestions by inviting public comment on discussion papers and exposure drafts. The IASB may also arrange public hearings and working sessions. Comments from interested parties are summarized, analyzed and considered by the staff which makes recommendations to the IASB. 3) Accountability. The IASB uses the ‘comply or explain’ approach. If the IASB omits a nonmandatory step, it is required by the organization’s constitution to state its reasons.

Learning Outcome Practice 1. IFRS include all of the following except b.

Decisions by the Standards Advisory Committee 2. The advantages of the principles-based approach to setting accounting standards do not include: a.

Specific guidance for those who prepare financial statements 3. The requirements for setting international accounting standards do include which of the following: 1. Transparency and accessibility 2. Accountability 3. Public acceptability 4. Extensive consultation and responsiveness c.

1, 2, and 4 only Learning Outcome 2 Explain the Framework for the Preparation and Presentation of Financial Statements.

On Your Own 1. What are the three levels of authoritative guidance identified in the Framework?

In order, the three levels of authoritative guidance are: a. International Financial Reporting Standards b. The Framework for the Preparation and Presentation of Financial Statements c. Management judgment 2. Explain the two underlying assumptions in the Framework.

The two underlying assumptions are: Accrual basis which means that the effects of transactions are reported when they occur, not when cash is received or paid, and going concern which assumes that

. .

7

the business entity will continue operating without the threat of liquidation in the foreseeable future.

3. List the qualitative characteristics of financial information and describe each of them.

• Understandability – Users are assumed to have a reasonable knowledge of business, economic activities, and financial accounting, and will study the information with reasonable diligence to comprehend its meaning.

•

Relevance – Information is relevant when it makes a difference to the users’ decisions.

4.

•

Reliability of information means that it is free from material error and is faithfully represents what it purports to represent.

•

Comparability provides the ability for users to identify trends (similarities and differences) over time in a business entity’s financial position and performance, and also between the financial statements of different entities to evaluate their relative financial position, performance and changes in financial position.

What are the constraints on relevant and reliable information?

• Timeliness refers to whether the information is available to users before it loses its capacity to influence decisions.

•

Balance between benefit and cost means that the benefits of reporting information should justify the cost associated with providing and using it.

•

Balance between qualitative characteristics refers to the trade-off between qualitative characteristics when necessary, which is based on professional judgment about the relative importance of information.

•

The information should present a true and fair view. The Framework does not provide an explicit definition of true and fair view, and it is therefore a matter of professional judgment.

Learning Outcome Practice 1. Someone seeking guidance about how to prepare, audit or interpret financial statements would follow which sequence to determine the appropriate accounting treatment of a transaction? d. IFRS, Framework, management judgement 2. The qualitative characteristics of financial statements include which of the following?

1. Understandability . .

8

2. Relevance 3. Neutrality 4. Reliability 5. Comparability 6. Prudence c. 1, 2, 4 and 6 only 3. The constraints on relevant and reliable information include which of the following?

1. Balance between qualitative characteristics 2. Completeness of qualitative characteristics 3. True and fair view 4. Balance between benefit and cost 5. Timeliness 6. Comparability and consistency b. 1, 3, 4 and 5 only LEARNING OUTCOME 3 Discuss the general features of accounting in the Framework.

On Your Own 1. How frequently are businesses required to report under IFRS? Businesses are required to report once annually.

2. What information must be included in the financial statements to achieve comparability under IFRS? Comparable information is to be included for the previous year. If financial statements are for one year, then the previous year must be included. If the financial statements are for one quarter, then the same quarter for the previous year must be included.

3. How does a business achieve consistency in financial reporting?

Consistency means that the same policies and procedures are used by a business from period to period which results in the same presentation and classification of financial information.

4. How does a business determine materiality?

If the information’s omission or misstatement could influence the economic decisions of users of financial statements, then an item is material and should be included. As a practical matter, businesses sometimes set limits. For example, an item below £1000 might be considered immaterial.

5. Under what circumstances can a reporting entity claim to have complied with IFRS? A reporting entity can claim compliance with IFRS only when it has conformed to all IFRS requirements.

Learning Outcome Practice . .

9

1. Which concept requires the effects of transactions and other events to be reported in the period to which they relate? c. Accrual basis 2. What is the concept that the omission or misstatement of information could influence users’ decisions? d. Materiality

. .

10

Answers to Review Questions 1. What are primary factor is driving the convergence of national and regional standards with international accounting standards?

The primary factor driving the convergence of national and regional standards is economic globalization that increases the dependency between the world’s economies.

2. What are rules-based standards? What are principles-based standards? What are the advantages and disadvantages of each?

Rules-based standards provide specific guidelines for those who prepare financial statements while principles-based standards provide broad objectives that leave room for interpretation. Principlesbased accounting standards have the advantage of being flexible so they can be adapted to local laws and culture. The disadvantage of rules-based standards is that they give management an incentive to circumvent specific rules while the disadvantage of principles-based standards is that some uncertainty exists about whether the company is in compliance with the standards.

3. What is the International Accounting Standards Committee Foundation, and what purposes does it serve?

The International Accounting Standards Committee Foundation oversees and supports the activities of the International Accounting Standards Board. It appoints the members of the Board and also provides funding.

4. What are the responsibilities of the International Accounting Standards Board? International Financial Reporting Interpretations Committee? Standards Advisory Committee?

The International Accounting Standards Board (IASB) establishes International Financial Reporting Standards.

The International Financial Reporting Interpretations Committee (IFRIC) handles situations where no authoritative guidance is available especially in areas where no authoritative guidance is currently available or likely to be available soon.

The Standards Advisory Committee provides advice to the IASB on its agenda, project timetables and priorities as well as the practical application and implementation of existing standards.

5. What are the IASB’s six standard-setting stages? What are the three requirements for setting IFRS? 1) Setting the agenda 2) Project planning 3) Development and publication of a discussion paper 4) Development and publication of an exposure draft 5) Development and publication of a standard . .

11

6)

Follow-up after a standard is issued

Answers to Terminology practice 1. Applied ethics concerns how ethical theory is applied to real-world situations.

2. Completeness is required for information to be reliable, since omission of information can cause it to be false or misleading.

3. Business ethics concerns how ethical theories and principles are applied in the business environment.

4. Liquidation refers to the process by which a business entity is brought to an end.

5. Neutrality means that information is free from bias and does not influence a decision or judgement in order to achieve a predetermined result or outcome.

6. Consistency refers to the use of the same set of accounting policies and procedures from period to period within an entity and between entities 7. A Qualitative characteristic is an attribute that makes information provided in financial statements useful to users.

8. Principles-based standards focus on broad objectives that leave room for interpretation, while rules-based standards provide specific guidelines.

9. Relevance is when information makes a difference to users’ decisions.

10. Accrual basis accounting classifies the effects of transactions in the reporting period in which they occur, not necessarily when cash is received or paid.

11. Employers and professional organizations set out rules of appropriate ethical behaviour in Codes of conduct or ethical codes.

12. Professional ethics concern how professionals make independent judgements on business ethics.

13. Materiality means that the omission or misstatement of information could influence the economic decisions of users taken on the basis of the financial statements.

14. Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s-length transaction.

15. International Financial Reporting Standards include all standards and interpretations adopted by the International Accounting Standards Board, including IFRS, IAS and interpretations by IFRIC. 16. Going concern is the assumption that a business entity will continue operating without threat of liquidation in the foreseeable future.

17. Reliable information should be presented in a way that emphasizes substance over form and to provide a faithful representation of the transactions that it is supposed to represent.

18. Understandability means that users are assumed to have a reasonable knowledge of business, economic activities and financial accounting and will study the information with reasonable diligence to comprehend its meaning.

19. Comparability provides the ability for users to identify trends over time in a business entity’s financial position and performance.

20. Reliability means that information is free from material error and faithfully represents what it is supposed to represent.

21. Timeliness refers to whether information is available to users before it loses its capacity to influence decisions.

22. Realizable value is the amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal. . .

12

23. Current cost is the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was currently acquired – or the amount of cash or cash equivalents that would be required to currently settle an obligation.

24. Historical cost is a measurement basis in which assets are recorded for an amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are measured by the amount of proceeds received in exchange for the obligation or in some circumstances, at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

25. Present value is a current estimate of the present discounted value of the future net cash flows in the normal course of business

. .

13

Case Analysis Practice Case 1 Students might offer several answers to the question posed in this case: Discuss the implementation challenges faced by the International Accounting Standards Board (IASB) if there is to be a successful move to International Financial Reporting Standards.

1) Nations are reluctant to give up control over accounting standards because they are part of their ability to regulate commerce.

2) Differences between nations make establishing one set of IFRS that serves all needs a challenge. For example, nations with developed public securities markets have different needs than nations with a more localized economy and for which IFRS are too complex.

3) Nations or regions, such as the European Union, may not accept IFRS in the form pronounced by the IASB, but may make minor modifications. Though substantially the same as IFRS, even small differences make them non-compliant as ‘pure’ IFRS. Instructors might extend the discussion of this case by asking the following questions: 1) Why do some nations have a greater need for international accounting standards than others?

Instructors will have their own views. My view is that international accounting standards are being driven by two important trends. The first is the globalization of capital markets which has substantially increased the cross-border flow of capital. The second reason is that many developing nations (China and the United Arab Emirates are two examples) have adopted IFRS more or less in their entirety to demonstrate their commitment to international standards.

2) Is it likely that we will ever have a single set of international accounting standards that all nations comply with?

Again, instructors will have their own views. My view is that in practice, international standards add another layer of complexity to accounting. National standards will be a significant factor for the foreseeable future. However, international accounting standards will create greater commonality in accounting practices among many nations and regions, especially for publicly traded companies.

Undergraduates often take the view that the world should adopt uniform international standards across all nations. Graduate students will, of course, be more accepting of both complexity and plurality, and will not see the issue of uniform global standards as particularly important.

Practice Case 2 In this case, Professor Cheung remarks at a conference that professional ethic codes are more trouble than they are worth. Indeed, he argues that they are not needed if professional accountants observe the highest values of probity and integrity. The questions asked are as follows: . .

14

1) Critically evaluate Professor Cheung’s views on codes of professional ethics. Use examples of ethical codes, where appropriate, to illustrate your answer.

Students will have different views, obviously. At this point in the course I let them express their opinion. After some discussion, I avoid bringing the discussion to a definitive conclusion and offer two observations. First, evidence suggests that having a code of ethics or conduct in place does improve the ethical behavior of employees including professional accountants if for no other reason than ethical behavior is defined. Therefore, the employee understands the difference between ethical and unethical behavior.

To illustrate this point to the students, instructors’ might ask: Without a written code of ethics or conduct, will all employees agree on what constitutes ethical behavior? The answer is ‘of course not.’ And this point is demonstrated by the difference in views expressed by the students about whether a written code is needed or not.

Instructors might also point out that a code of ethics or conduct is effective only if supported by the board and management. If employees perceive that the code of ethics is for ‘show only’ then they will not take it seriously. Enron, the company introduced at the beginning of the chapter, is a case in point.

Second, I also point out that the last chapter in the textbook deals with systems that codify acceptable behavior including codes of ethics or conduct, but also corporate governance, internal control and so forth.

2) With reference to Professor Cheung’s comments, explain what is meant by ‘integrity’ and assess its importance as an underlying principle in corporate governance.

Ask students what is integrity means. Generally, integrity is defined by adherence to a code of values, though other definitions are possible. The critical issue here is what is that code of values?

Thus one business might have a code of values, ethics or conduct that promote honest and fair dealing whereas another business may have a code that favors behaviors that cause the investors to benefit financially. So the question is integrity with respect to what? If a person has integrity, this only explains that he or she will behave by adhering to a code of values. But what is that code?

Integrity must also be consistent throughout the organization, as explained in the answer to question #1). If employees perceive that the board or senior management do not themselves abide by or believe in the formal code of ethics or conduct, then they will not themselves feel the need to demonstrate integrity.

. .

15

Instructor Manual Chapter 3 The Financial Statements

. .

1

Lecture Notes

3

Answers to Learning Outcomes

5

Learning Outcome 2 Learning Outcome 3 Learning Outcome 4 Learning Outcome 5

5 7 8 9

Answers to Review Questions

13

Answers to Terminology Practice

15

Answers to Application Exercises

17

. .

2

Lecture Notes Introduction This chapter bridges the gap between the basic structure for the statement of financial position and statement of comprehensive income introduced in Chapter 1 and actual set of financial statements – Emirates Airline. The chapter provides a more detailed breakdown of assets and liabilities into their current and noncurrent components. In addition, it takes a deeper look at the components of the statement of comprehensive income.

At the beginning, the chapter discussed the annual report. When I teach financial accounting fundamentals I always give my students some assignment that requires them to obtain an actual set of financial statements so they can see the end product. I find that the most common error and confusion is that they find data presented as part of the annual report and cannot distinguish between the annual report and the financial statements. So I inevitably end up giving a brief lecture on the differences between the two. This introductory session tries to address the issue upfront.

Learning outcome 1 This is a brief explanation of the notes to the financial statements. Later in the chapter, students have an opportunity with the Emirates Airline example to see how the notes explain items on the face of the financial statements, one of the functions served by the notes. Emirates is a good example because like many companies they keep the face of the financial statements as simple as possible consistent with IFRS, then elaborate in the notes.

Learning outcome 2 This section provides a breakdown of the elements on the statement of financial position. For assets and liabilities, current and non-current criteria are discussed then examples of specific line items for each are provided and defined (or at least explained). A discussion of working capital is included at this point because it helps explain why we bother to break down assets and liabilities into current and noncurrent.

When I teach this section I slow down and pay a lot attention to form. I explain the different ways that data is presented like underlining the total in a column, insetting amounts in a multi-column statement and so forth. Plus at this point, the student has a crisp, clean example from Emirates Airline to compare.

When I ask students to look at actual financial statements, in the overwhelming majority of cases they usually pick known-name companies that operate as a group. So immediately we confront the issue of what does consolidated mean? And what is a non-controlling or minority interest. At this point, the chapter provides a brief explanation.

. .

3

Frankly, not much space is devoted to equity in this chapter. Emirates Airline is not publicly traded but is owned by parent EK Group. So that keeps equity issues simple at this point though Emirates Airline has a non-controlling interest and therefore offers the opportunity for example along these lines.

Learning Outcome 3 This section expands the discussion of line items in the statement of comprehensive income. It makes the distinction between income, revenue and gains as well as the different categories of expense. Again, the idea is to ramp the students up to the actual statement of comprehensive income example provided from Emirates Airline.

Learning Outcome 4 This section is critical because it explores the relationship between the statement of comprehensive income and the statement of financial position. It lays the groundwork for closing entries which are presented in Chapter 5.

Many accounting professors argue that, especially with graduate students, the mechanics of the accounting process (covered in Part II) are not needed. However, most inappropriate accounting comes from failures to properly classify items into the statement of comprehensive income versus the statement of financial position. The textbook returns to this topic later. So at this point, it makes sense to get students thinking about this relationship.

Learning Outcome 5 This final chapter segment explores the difference between cost, expense and expenditure. The IASB glossary provides definitions of cost and expenses, but not expenditure. The major task of this section is to lay the groundwork for accrual basis accounting discussed in Chapter 5. Figure 3.29 in particular is helpful for getting students to think about how asset costs ‘morph’ into expenses on the statement of comprehensive income.

. .

4

Answers to Learning Outcomes Questions Learning Outcome 2 Describe financial position as reported by the statement of financial position.

On Your Own 1. What criteria must an asset meet to be classified as a current asset? What criteria must an asset meet to be classified as a non-current asset?

An entity shall classify an asset as current when: (a) it expects to realize the asset or intends to sell or consume it in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; (c) it expects to realize the asset within twelve months after the reporting period; or (d) that asset is cash or a cash equivalent.

If an asset does not meet this criterion, it is classified as non-current.

2. What is an operating cycle?

An operating cycle is the time between the acquisition of assets for processing and their realization in cash or cash equivalents.

3. To what does the term short term refer? To what does long term refer?

Short term is another term for current and therefore long term is another term for non-current.

Usually a twelve month time horizon divides short term from long term 4. What is a trade accounts receivable? What is a trade accounts payable? How is each classified on the statement of financial position?

Trade accounts receivable are amounts owed by customers to the business entity for goods and services purchased. Trade accounts payable are amounts owed to suppliers by the business entity for goods and services purchased. Usually trade accounts are classified as current though it is possible to have a non-current trade account.

5. What are inventories? How are they classified on the statement of financial position?

Inventories are assets (a) held for sale in the ordinary course of business; (b) in the process of production for such sales; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. Inventories are almost always classified as current assets however it is possible to have inventories classified as non-current.

6. What are property, plant and equipment? How are they classified on the statement of financial position?

. .

5

Property, plant and equipment refer to assets used in production of goods and services, rental to others or for administrative purposes, and are expected to be used for more than one period.

Property, plant and equipment are classified as non-current assets.

7. What is an intangible asset?

Intangible assets are assets with no physical substance including copyrights, patents, brands and customer lists.

8. To what does the term current portion of noncurrent borrowings refer?

The current portion of noncurrent borrowings represents an amount that the business must pay within the next twelve months on long-term borrowings.

9. What is contributed capital? How is it classified on the statement of financial position?

Contributed capital is the amount that the owners have invested in the business.

10. Define reserves. How are reserves classified on the statement of financial position?

Reserves are usually a portion of retained earnings that has been set aside by management for a specific reason. Or reserves can be established through other comprehensive income.

11. Define retained earnings.

Retained earnings are the accumulated past earnings of the business that have not been distributed to owners as dividends. Profit increases retained earnings. Losses and dividends decrease retained earnings.

12. What are consolidated financial statements?

Consolidated financial statements present the financial statements of a parent and its subsidiaries – referred to as a group – as if they were one entity.

13. Define parent. Define subsidiary.

A parent is an entity that has one or more subsidiaries. A subsidiary is an entity that is controlled by the parent.

14. What is a minority interest?

Also known as a non-controlling interest which is the equity in a subsidiary not attributable, directly or indirectly to a parent.

Learning Outcome Practice 1. Which of the following is not an asset? b. Trade accounts payable

. .

6

2. Which of the following is not a current liability? a. Prepaid expense 3. Retained earnings is part of which of the following? c. Equity 4. Which of the following should be classified as current liabilities?

1) Trade accounts receivables 2) Sales tax payable 3) Trade accounts payables 4) Contributed capital a. 1 and 2 5. On 1 March 2010 Andrew took out a loan for $50 000. The loan is to be repaid in five equal annual instalments, with the first repayment falling due on 1 March 2011. How should the balance on the loan be reported on Andrew’s year-end statement of financial position as at 30 April 2009? c. $10 000 as a current liability and $40 000 as a noncurrent liability

Learning Outcome 3 Describe performance as reported by the statement of comprehensive income.

On Your Own 1. Define cost of sales. Define operating expense.

The cost of sales refers to an expense that is related to a good or serve sold by the company during the reporting period. Operating expenses are those expenses that are not related to the goods or services sold.

2. What are the components of operating expense?

Operating expenses are comprised of 1) selling expenses which include sales, marketing, and advertising and distribution costs and 2) administrative expenses which include general administrative costs.

3. What other expenses are parts of profit or loss?

Financing expenses and income tax expense.

4. How is gross profit calculated?

Gross profit is calculated by subtracting the cost of sales or cost of goods sold from revenue.

5. Describe the difference between profit or loss and other comprehensive income.

Added together profit or loss plus other comprehensive income equals total comprehensive income.

Profit or loss is the total of income less expenses, excluding components of other comprehensive . .

7

income. Other comprehensive income includes amounts for the revaluation of assets plus other items in IFRS required to be included in other comprehensive income.

Learning Outcome Practice 1. Canel Company had $950 000 in profit for the recent accounting period. Income tax expense was $225 000. Interest expense was $100 000. Sales were $2 500 000 and cost of sales was 40% of sales. Administrative expenses were $75 000. What were the sales and marketing expenses? b. $150 000 2. Al Taya Corporation reported revenue of £1 250 000 for 2009. Tax expense was £145 000 and operating expenses were £850 000. Which of the following is true? a. The company had a profit of £255 000 3. Al Taya Corporation reported revenue of £1 250 000 for 2009. Tax expense was £145 000 and operating expenses were £850 000. What was operating profit? b. £400 000 4. The cost of an automobile purchased from the manufacturer by an automobile dealership for resale to a customer and then sold would be in which expense category on the statement of comprehensive income? d. Cost of sales 5. Where would the company president’s salary typically appear on the statement of comprehensive income? b. Operating expenses

Learning Outcome 4 Explain the relationship between the statement of financial position and the statement of comprehensive income.

On Your Own 1. When revenue increases, what is the effect on equity?

When revenue increases, income increases which causes retained earnings to increase. Therefore, equity increases.

2. When expenses decrease, what is the effect on equity?

When expenses decrease, income increases which causes retained earnings to increase. Therefore, equity increases.

3. When dividends increase, what is the effect on equity?

When dividends increase, retained earnings decreases which means that equity decreases. . .

8

4. When a reserve is increased, what is the effect on equity?

When a reserve increases, equity increases.

Learning Outcome 5 1. The retained earnings balance is calculated as follows: Retained earnings balance 30 June 2010 2011 profit 2011 dividends Retained earnings balance 30 June 2011

€855 000 175 000 (110 000) €920 000

2. The liabilities balance is calculated as follows: Liabilities balance 30 June 2010 2011 increase in liabilities balance Liabilities balance 30 June 2011

€700 000 45 000 €745 000

3. The change in total stockholders’ equity during 2012 is calculated as follows:

2012 Profit 2012 dividends 2012 decrease in total stockholders’ equity

€65 000 (110 000) (€45 000)

4. The change in total assets during 2013 is calculated as follows: 2013 profit 2013 dividends 2013 decrease in liabilities 2013 decrease in total assets

€50 000 (40 000) (75 000) (€65 000)

5. The statement of comprehensive income and statement of financial position would be constructed as follows:

. .

9

Gulf Research, LLC Statement of Comprehensive Income For the Year Ended 31 December 2010 Revenue Cost of sales Gross profit Operating expenses Selling expenses Administrative expenses Operating profit Financing expense Profit before taxes Tax expense PROFIT Other comprehensive income TOTAL COMPREHENSIVE INCOME

€2 750 000 1 325 000 1 425 000 €220 000 300 000

520 000 €905 000 110 000 €795 000 250 000 €545 000 0 €545 000

Gulf Research, LLC Statement of Financial Position 31 December 2010 Assets Non-current assets Property, plant and equipment Intangible assets Investments in associates Financial assets Total non-current assets Current assets Cash and cash equivalents Investments in financial assets Trade accounts receivable Inventories TOTAL ASSETS

. .

€800 000 100 000 270 000 320 000 €1 870 000

225 000 40 000 100 000 50 000

415 000 €1 905 000

10

Equity Capital Retained earnings Reserves Total Equity Non-current Liabilities Borrowings Mortgage payable Current Liabilities Trade accounts payable Short-term note payable Salaries payable Current portion of non-current borrowings Total liabilities

325 000 660 000 25 000 €1 010 000

440 000 100 000

105 000 180 000 20 000 50 000

TOTAL EQUITY AND LIABILITIES

540 000

355 000 €895 000 €1 905 000

Learning Outcome 5 Explain the difference between expenditure, cost and expenses.

On Your Own 1. What is expenditure? What is cost? What is expense?

An expenditure refers to any outlay of cash or other consideration. A cost refers to the amount given to acquire an asset. And an expense is an expired cost.

2. Describe the difference between cost and expense.

A cost may be expired or unexpired while an expense is an expired cost.

3. On what financial statements does an expense appear?

An expense appears on the statement of comprehensive income.

4. On what financial statements does a cost appear?

Costs appear on both the statement of financial position when unexpired on the statement of comprehensive income when expired.

. .

11

Learning Outcome Practice 1. A truck dealership purchases a truck for resale to a customer. Where does the cost of the truck appear in the financial statements if the truck has been sold? a. Cost of goods sold 2. A truck dealership purchases a truck to use for delivery of parts. Where does the cost of this truck appear in the financial statements? c. Property, plant and equipment 3. A truck dealership purchases a truck to sell to a customer. Where does the cost of this truck appear in the financial statements if the truck has not been sold? b. Inventories 4. Rashid Corporation purchased fuel for its delivery trucks that it used. Where does the cost of the fuel appear in the financial statements? c. On the statement of comprehensive income as sales expense 5. Rashid Corporation purchased chemicals for use in the manufacturing of a cleaning solvent. After manufacture, the cleaning solvent was sold to customers. Where does the cost of the chemicals appear in the financial statements? b. On the statement of comprehensive income as cost of goods sold 6. Rashid Corporation purchased chemicals for use in manufacturing a cleaning solvent. After manufacture, the cleaning solvent remained unsold. Where does the cost of the chemicals appear in the financial statements? b. On the statement of financial position as inventories 7. Rashid Corporation purchased supplies of £11 000 during the year. At the end of the year, only £1500 of these supplies remained on hand. What amount related to the total supplies purchased should appear on the statement of comprehensive income? d. £11 000 8. Rashid Corporation purchased supplies of £11 000 during the year. At the end of the year, only £1500 of these supplies remained on hand. What amount related to the total supplies purchased should appear on the statement of financial position? a. £1500

. .

12

Answers to Review Questions 1. What are the elements of the expanded statement of financial position?

Assets are classified as current and noncurrent. Liabilities are also classified as current and noncurrent. Equity is classified as contributed capital, retained earnings and reserves.

2. Explain the difference between current assets and noncurrent assets. What are examples of current assets? What are examples of noncurrent assets?

An entity classifies and asset as current when it expects to realized the asset or intends to sell or consume it in its normal operating cycle; it holds the asset primarily for the purpose of trading; it expects to realize the asset within twelve months after the reporting period; or that asset is cash or a cash equivalent. Any asset not classified as current is noncurrent.

Examples of current assets include: cash and cash equivalents, short-term investments in financial assets, trade accounts receivable, prepaid expenses and inventories. Examples of noncurrent assets include property, plant and equipment; intangible assets; investments in associates and long term investments in financial assets.

3. Explain the difference between current liabilities and noncurrent liabilities. What are examples of current liabilities? What are examples of noncurrent liabilities?

An entity classifies a liability as current when it expects to settle the liability in the normal operating cycle; it holds the liability primarily for the purpose of trading ; the liability is due to be settled within twelve months after the reporting period; or the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period.

Examples of current liabilities include: trade accounts payable, short term notes payable and current portion of long term borrowings. Examples of noncurrent liabilities include: long term borrowings and mortgages payable.

4. What is an operating cycle?

An operating cycle is the time between the acquisition of assets for processing and their realization in cash or cash equivalents.

5. What are the components of equity?

Equity includes contributed capital, retained earnings and reserves.

6. What is a reserve? Provide examples. How are reserves created?

Reserves are an element in equity. For example, management may set aside a reserve in anticipation of having to settle a lawsuit. The amount by which a fixed asset is revalued is also maintained in a reserve. Reserves can be created by management actions of through items required

by IFRS to be recognized directly in equity. . .

13

7. What are the categories and line items of the expanded statement of comprehensive income?

The statement of comprehensive income begins with revenue. Expenses are then deducted. Major categories of expenses include cost of sales or cost of goods sold, operating expenses which include selling expenses and administrative expenses, financing expense and tax expense.

8. What is gross profit and how is it calculated? What is an alternative name for gross profit? What two types of businesses would calculate gross profit?

Gross profit, also known as gross margin, is the difference between revenue and cost of sales or cost of goods sold. Normally, manufacturing firms and merchandisers would calculate gross profit.

However, if a service firm can identify costs that are directly associated with the production of its services, these would be recorded as costs of sales. When cost of sales is deducted from revenue, the result would also be gross profit.

9. What is operating income and how is it calculated?

Operating profit is calculated by deducting operating expenses from gross profit. Or if no cost of sales or cost of goods sold is reported, operating expenses would be deducted from revenue.

10. What is the difference between cost of sales and operating expenses?

Cost of sales, also cost of goods sold, represents costs that can are attributable to the production of the product or service. Operating expenses are selling and administrative expenses that are not attributable to the production of the product or service. These are sometimes referred to as period costs.

11. What is expenditure? What is cost? What is expense? Explain the difference between these terms.

An expenditure refers to any outlay of cash or other consideration. A cost refers to the amount given to acquire an asset. And an expense is an expired cost. An expenditure and cost may be expired or unexpired. Expense is an expired cost.

12. What is the difference between inventories and cost of sales?

Inventories are unexpired product costs and are related to a product that has not yet been sold. Cost of sales or cost of goods sold is an inventory cost that has expired or the cost of a service that has already been rendered and thus included in revenue.

13. How is a gain different from revenue?

Revenue relates to economic benefits that arise in the course of ordinary activities of the entity. A gain is any form of income. Thus revenue would be a gain or income but a gain could also be unusual and not related to the ordinary activities of the business. For example, the business prevails in a lawsuit and receives a substantial settlement in cash. Typically, this would be referred to as a gain, but not revenue.

. .

14

Answers to Terminology practice 1. A(n) parent is a company that controls another company called the subsidiary.

2. Current assets are assets that the entity expects to realize or intends to sell or consume within 12 months or in its normal operating cycle.

3. Liabilities are present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

4. Assets with no physical substance are intangible assets.

5. The cost of physical goods that a business owns and is holding for future sale to customers is classified as inventories and is sometimes referred to as merchandise or merchandise inventories.

6. A(n) trade accounts payable is the amount the business owes to its suppliers created when the business purchased goods or services on account.

7. A minority interest – also a non-controlling interest – refers to owners of a subsidiary other than the parent.

8. The ownership of part of another business over which the entity has significant influence is classified as a(n) investment in associates.

9. Working capital is calculated by subtracting current liabilities from current assets.

10. Any outlay of cash or other consideration is a(n) expenditure.

11. Operating profit is calculated by subtracting operating expenses from gross profit.

12. Accumulated earnings of the business entity that have not been distributed to the owners are referred to as retained earnings.

13. Contributed capital - also paid-in capital or capital – represents the amount that owners have invested in the business.

14. Amounts paid to governments are classified as tax expense.

15. When a business has the right to collect cash in the future based on the customer’s promises to pay for goods or services purchased before the reporting date this is referred to as trade accounts receivable.

16. Assets are resources controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.

17. A prepaid expense represents a good or service that has been paid for in advance of its use.

18. Gross profit - also gross margin – is calculated by subtracting cost of sales from revenue.

19. A(n) cost is created by expenditure or an estimate of a future decrease in economic benefits to the business entity.

20. Profit or loss is the total income less expenses of a business entity, excluding the components of other comprehensive income 21. When an amount is owed on a non-current obligation within 12 months of the reporting date it would be classified as current portion of non-current borrowings.

22. Cost of goods sold refers to an expense that is related to goods produced or sold by a merchandiser or manufacturer 23. A(n) expense is a cost that has expired.

24. The residual interest in the assets of the entity after deducting all its liabilities is equity.

25. Interest on debt is classified as financing expense on the statement of comprehensive income.

. .

15

26. Property – also referred to as plant and equipment or capital assets, - are used in the production of goods or services, rental to others or for administrative purposes, and are expected to be used for more than one period.

27. A (n) mortgage is a debt related to the purchase of real estate.

28. Other comprehensive income includes items of income and expense that are not recognized in profit or loss.

. .

16

Answers to Application Exercises 1. The calculation of ending retained earnings is as follows: Beginning retained earnings Profit Dividends Ending retained earnings

$200 000 65 000 (133 000) $132 000

2. The statement of comprehensive income and statement of financial position for Deborah’s Bridal Shoppe Inc. are as follows: Deborah’s Bridal Shoppe Inc. Statement of Comprehensive Income For the Year Ended 31 December 2010 Revenue Gowns Alterations Less: Cost of goods sold Gross profit Operating expenses Employee compensation Rent expense Advertising expense Insurance expense Operating profit Tax expense 30% PROFIT Other comprehensive income TOTAL COMPREHENSIVE INCOME

. .

$550 000 70 000

$80 000 36 000 23 000 12 000

$620 000 247 500 $372 500

151 000 $221 500 66 450 $155 050 0 $155 050

17

Deborah’s Bridal Shoppe Inc. Statement of Financial Position 31 December 2010 Assets Non-current assets Store fixtures and equipment Current assets Cash Short-term investments Trade accounts receivable Inventories Total current assets TOTAL ASSETS

$56 000 17 000 6 000 150 000 $229 000 $304 200

Equity Contributed capital Retained earnings Total Equity

$83 150 140 050 $223 200

$75 200

Non-current Liabilities Noncurrent note payable Current Liabilities Trade accounts payable Total liabilities TOTAL EQUITY AND LIABILITIES

$60 000 21 000 $81 000 $304 200

3. The line items are as follows:

Cost of goods sold An office furniture retailer purchases furniture to sell to a customer. The furniture has been sold.

An office furniture retailer purchases furniture for use in its reception area.

An office furniture retailer purchases furniture to sell to a customer. The furniture has not been sold.

. .

Inventories

Property, plant and equipment

Short-term investment

X X

X

18

4. Items would be classified as follows:

Repayments of borrowings Trade and other payables Trade accounts receivable Investment in own shares Operating income Noncurrent assets Notes payable Selling costs Tax expense Contributed capital Cash and cash equivalents Inventories Dividends Gross margin A cash purchase of property, plant and equipment Salary expenses Profit Current liabilities Interest expense Beginning retained earnings

. .

Statement of comprehensive income ----X --X X ----X -X X -X --

Statement of financial position -X X X -X X --X X X -----X ---

19

5. The statement of comprehensive income and statement of financial position for Care-Mart LLC are as follows: Care-Mart, LLC Statement of Comprehensive Income For the Year Ended 31 December 2011 € thousands Revenue Merchandise sales Other revenue Cost of sales Gross profit Operating expenses Selling expenses General and administrative expenses Operating profit Interest expense Profit before taxes Tax expense 30% PROFIT Other comprehensive income TOTAL COMPREHENSIVE INCOME

. .

€612 000 3 227

€130 000 36 733

€615 227 240 391 €374 836

166 733 €208 103 1 171 €206 932 62 080 €144 852 0 €144 852

20

Care-Mart, LLC Statement of Financial Position 31 December 2011 € thousands Assets Non-current assets Buildings and improvements Property, plant and equipment Land Fixtures and equipment Transportation equipment Current assets Cash and cash equivalents Prepaid expenses Trade accounts receivable Inventories TOTAL ASSETS

€56 163 75 875 16 643 22 750 1 746 €56 414 2 557 32 662 32 191

Equity Capital Retained earnings Total Equity Non-current Liabilities Long-term debt Current Liabilities Trade accounts payable Short-term note payable Long-term debt due within one year Taxes payable Total liabilities TOTAL EQUITY AND LIABILITIES

. .

€173 177

123 824 €297 001

€53 946 185 925 €239 871

12 357 €25 373 13 465 4 595 1 340

44 773 €57 130 €297 001

21

6. The missing numbers are as follows: Statement of comprehensive income 2011 Sales Cost of goods sold Gross profit Operating expenses Operating income Interest expense Income before taxes Taxes Profit (loss)

2010 $19 723

$17 006

2009 $14 796 3 557

2 990 486

1 065 576 323 208

106 239

Statement of financial position

Inventories Total current assets Intangible assets Total assets Trade accounts payable Other current liabilities Total current liabilities Long-term debt Total liabilities Reserves Total shareholders’ (deficit) equity Total Liabilities and Shareholders’ Equity

. .

2011 $2 789 10 179 17 029 2 037

2010 $8 616 6 989 15 605 671

4 666 4 742 15 532 1 398 (758) 17 029

22

7. The comparative statement of financial position for CNZ Group is as follows: CNZ Group Statement of Financial Position 31 December € millions 2010

2009

11 285 5 312 815 744 401 378 60 18 995

11 087 4 593 643 772 1 178 613 94 18 980

1 336 3 134 17 865 2 258 2 272 6 794 33 659 52 654

1 621 2 654 17 202 2135 1955 6 527 32 094 51 074

Equity Share capital Retained earnings Reserves Total Equity

654 9 733 1 911 12 298

674 7620 1 971 10 265

Non-current Liabilities Trade accounts receivable – noncurrent Pension liabilities -- noncurrent Taxes payable

5 178 7 882 2 758

5 455 8 498 2 522

Assets Non-current assets Property, plant and equipment Intangible assets Financial assets Miscellaneous assets – noncurrent Other investments – noncurrent Other assets – noncurrent Investments in other companies Total noncurrent assets Current assets Cash and cash equivalents Financial assets – current Receivables from sales financing Trade accounts receivable Other assets -- current Inventories Total current assets TOTAL ASSETS

. .

23

. .

Other liabilities – noncurrent Total noncurrent liabilities Current Liabilities Trade accounts payable Financial liabilities – current Other current payables Current tax payable Total current liabilities Total liabilities

1932 17 750

1659 18 134

3 737 17 636 567 666 22 606 40 356

3 544 17 838 462 831 22 675 40 809

TOTAL EQUITY AND LIABILITIES

52 654

51 074

24

Instructor Manual Chapter 4 The Accounting Process

. .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

5

Learning Outcome 1 Learning Outcome 2 Learning Outcome 3 Learning Outcome 6 Learning Outcome 7 Learning Outcome 8 Learning Outcome 9

5 5 6 6 7 8 8

Answers to Review Questions

9

Answers to Terminology Practice

10

Case Analysis

11

. .

2

Lecture Notes Introduction This chapter introduces the accounting process, and then examines in detail the first step – analyzing and recording transactions. It therefore introduces basics like the journal entry, journal, ledger and trial balance as well as source documents and the concept of normal balances.

Learning Outcome 2 The material on what can be exchanged in a transaction comes from an accounting theory course taught

by Dr. John Willingham when I was a doctoral student. It is worthwhile in my experience to focus students on what can be exchanged – goods or services, money and promises. The first two are obvious, but I have found that if I take a few minutes to discuss the idea of exchanging a promise, and the later redemption of that promise, it gives students a solid foundation to think about the great variety of financial instruments like notes, bonds and equity as well as trade accounts.

I have inset a brief table for the first transactions to force the students to think through what the journal entry means. What accounts are affected? How are they affected? What financial statement elements are involved? And what financial statements are affected?

Learning Outcome 4 However, with the brief introduction described in Learning Outcome 2, I immediately begin posing transactions and ask students to construct the journal entry. “A customer purchases merchandise with cash. What is the debt account title? What is the credit account title?” I develop this mantra early and use it throughout the course. Then sometimes I will extend it by asking “What is the effect on the statement of comprehensive income? What is the effect on the balance sheet?”

Some instructors will feel that the examples in this and some later chapters are overly long. Yet my objective is to give the student practice understanding the process.

Learning Outcome 8 The trial balance is presented as a reporting option in an automated accounting system. Professional exams continue to emphasize the role of the trial balance in error discovery so this material must be covered for those wanting to take those exams. However, most students will see the trial balance as simply another report from the automated accounting system when they are in practice.

. .

3

Comments on Li Designs LLC case – At the end of the chapter is a case which requires students to straighten out a financial mess created by a young woman, a talented designer, who has not maintained the financial records properly. This case is valuable because it requires the students to practice what they have learned in the chapter. The case is continued in later chapters.

. .

4

Answers to Learning Outcome Questions Learning Outcome 1 Describe the four major steps in the accounting process.

On Your Own 1. What are the four major steps in the accounting process?

1) Analyze and record transactions 2) Adjust accounts 3) Prepare financial statements 4) Close accounts 2. What is the sequence of the four major steps in the accounting process?

The sequence is the same as for answer #1 above.

Learning Outcome 2 Explain how transactions are analyzed.

On Your Own 1. What three types of items can be exchanged in a transaction?

Goods or services, money and promises 2. Give examples of exchanges between goods or services, money and promises.

Students may have examples other than those that follow: • A good or service is exchanged for good or service – This is a barter transaction such as exchange of land for equipment with no cash involved.

• A good or service is exchanged for money – Supplies are purchased for cash.

• A good or service is exchanged for a promise – Supplies are purchased on credit.

• Money is exchanged for a good or service – Merchandise is sold to a customer for cash.

• Money for money – A business exchanges euros for Hong Kong dollars.

• Money for a promise – Money is borrowed from a creditor.

• Promise for a good or service – A credit sale is made to a customer.

• Promise for money – Money borrowed from a creditor is repaid.

• Promise for a promise – Not applicable.

3. Give examples of exchanges between financial statement elements.

The exchanges in question #2 above could also be described in terms of financial statement elements as follows: • An asset (or expense) for an asset– This is a barter transaction such as exchange of land for equipment with no cash involved.

• An asset (or expense) for an asset – Supplies are purchased for cash.

• An asset for a promise – Supplies are purchased on credit.

• An asset for revenue – Merchandise is sold to a customer for cash. . .

5

• • • •

An asset for an asset – A business exchanges euros for Hong Kong dollars.

An asset for a liability – Money is borrowed from a creditor.

An asset for revenue – A credit sale is made to a customer.

A liability for an asset – Money borrowed from a creditor is repaid.

4. Why is revenue ‘given up’ in a transaction? When revenue is given up, what can be received in exchange?

Revenue is what was given up in a sales transaction. It is the opportunity that has been forfeited to sell a good or service to another party. In exchange, the business usually receives either cash or the customer’s promise to pay which is trade accounts receivable although an asset or reduction to a liability can be exchanged.

Learning Outcome 3 Explain how transactions are recorded.

On Your Own 1. What is the purpose of a journal entry?

A journal entry records a business transaction in the journal.

2. List the five basic components of a complete journal entry.

1) Date of the transaction 2) What was received or given in the transaction classified by account titles 3) The amounts received in the transaction (debits) 4) The amounts of given in the transaction (credits) 5) An explanation of the transaction 3. How is a journal entry structured?

Debits are shown on top and the left of credits. Credits are shown below and to the right of debits.

Learning Outcome 6 Describe the journal and explain its role in the accounting process.

On Your Own 1. Describe the journal.

The journal is a listing in chronological order of all journal entries and is therefore sometimes referred to as the ‘books of original entry’. Journal entries are recorded in the journal.

2. What information is available in the journal?

All the information contained in a journal entry is available in the journal – date, account titles, debit and credit amounts and the explanation.

. .

6

3. What is the journal entry most likely to be used for?

The journal is used to determine what entries are recorded on a particular date and also what the explanation for the journal entry is.

Learning Outcome 7 Describe the ledger and explain its role in the accounting process.

On Your Own 1. What is a ledger?

A ledger classifies all debits and credits from the journal by account title. Debits and credits from the journal are posted to the ledger.

2. What information is available in the ledger?

The ledger also contains the date of each debit or credit entry. A net balance is calculated for each account.

3. The ledger account for trade accounts receivable has a beginning balance of €1113. The following debits are posted during the month: €125, €517 and €362. The following credits are posted during the month: €600 and €744. What is the ending balance in the trade accounts receivable?

Trade accounts receivable DR Beginning balance €1113 125 517 362

CR

600 744 Ending balance

€773

4. The ledger account for trade accounts payable has a beginning balance of €1113. The following debits are posted during the month: €125, €517 and €362. The following credits are posted during the month: €600 and €744. What is the ending balance in the trade accounts receivable?

Trade accounts receivable DR CR Beginning balance €1113 125 517 362 600 744 Ending balance €1453 . .

7

Learning Outcome 8 Describe the trial balance and explain its role in the accounting process.

On Your Own 1. What is a trial balance? What purpose does a trial balance serve in a manual system?

The trial balance is a report that lists all accounts and the net debit or credit balance in each account. In manual systems, the trial balance was used to insure that all debits and credit were posted correctly from the journal. However, in automated accounting systems, this function is handled by the computer. Therefore, automated trial balances are used to determine the balances of accounts at any particular time.

2. Explain the difference between a trial balance and a ledger.

Both the trial balance and the ledger list all accounts. However, the trial balance has only the net debit or credit balance for each account whereas the ledger contains detail on all postings from the journal as they affected accounts.

Learning Outcome 9 Describe the trial balance and explain its role in the accounting process.

On Your Own 1. Which financial statement elements have a normal debit balance?

Expenses, losses, assets and dividend accounts all have normal debit balances.

2. Which financial statement elements have a normal credit balance?

Revenue, profit, liability and equity accounts all have normal credit balances.

. .

8

Answers to Review Questions 1. What is a source document? Give examples. Why is a source document important?

A source document is a verifiable source of information about a transaction from which the journal entry is recorded. Examples include customer invoices, supplier invoices, purchase orders, time cards, deposit slips, notes for loans, cash receipts, credit card receipts, cash register tapes and cancelled cheques. Source documents provide proof that the transaction occurred and that the details recorded are correct.

2. Describe the accounting process, listing all steps and reports generated at each stage.

The accounting process has four major stages: 1) Analyzing and recording transactions -- Reports generated at this stage are the journal, ledger and trial balance.

2) Adjust accounts – Reports generated are the journal with adjusting entries added, ledger with adjusting entries posted and the adjusted trial balance.

3) Prepare financial statements – The reports generated are the four financial statements: the statement of financial position, statement of comprehensive income, statement of changes in equity and statement of cash flows as well as the notes.

4) Close accounts – The report generated is the post-closing trial balance.

3. How is a transaction analyzed and then recorded as a journal entry? What are the components of a journal entry?

Transactions are analyzed to determine what was given and what was received. The result is then coded as a journal entry which contains the transaction date, account titles, debit and credit amounts and explanation.

4. What is the chart of accounts? Why do companies create and maintain a formal chart of accounts?

A chart of accounts is a listing of the account titles authorized for use within the reporting entity.

Formal charts of accounts are based on how management decides to report information on the financial statements.

5. What is the difference between a journal, a ledger and a trial balance? Describe what each contains and how it is organized. What purpose does each serve in the accounting process?

A journal is a chronological listing of all journal entries recorded by the business. The ledger is a reorganization of the information contained in the journal by account title. Ledgers thus have all detail affecting a specific account as well as a net debit or credit total. The trial balance contains a listing of all accounting titles with only the net debit or credit balance in each account. The journal provides an historical record of transactions. The ledger provides information on all transactions that make up the balance in each account. And the trial balance provides the current status of each account.

6. At what stage in the accounting process are the financial statements prepared? Where is the information to generate the financial statements obtained?

Financial statements are prepared after adjusting entries are recorded and are based on the adjusted trial balance.

. .

9

7. What is a normal balance? What is the normal balance of revenue? Expenses? Profit? Loss? Assets?

Liabilities? Equity? Dividends?

A normal balance is either a debit or credit depending on the financial statement element. Normal balances are as follows: Financial statement element Revenue Expenses Profit Loss Assets Liabilities Equity Dividends

Normal balance Credit Debit Credit Debit Debit Credit Credit Debit

Answers to Terminology Practice 1.

2.

3.

4.

5.

6.

Transactions are recorded in the journal based on information from a source document.

A chart of accounts is a formal list of account titles authorized by the business entity.

Debits and credits are summarized by account titles by posting to the ledger.

The journal entry is a method accounting uses to code a transaction.

What is given in transaction is recorded as a credit while what is received is recorded as a debit.

When rent has been paid but not used it is referred to as prepaid rent which is an asset on the statement of financial position.

7. A listing of accounts with the net balances of each is the trial balance.

. .

10

Case analysis To the instructor This case should be done in teams. Perhaps the most important contribution you can make to the teams is to step through the various source documents at the end of the case and explain what they are. Then remind the students that they are being asked to accomplish three specific tasks: 1) record journal entries, 2) post the journal to the ledger and 3) create a trial balance. All amounts in £.

This case forces students to bring together information given by the business’ owner, Mai Li, along with information from source documents like bank statements, invoices, customer contracts and so forth. In addition, the case has the complication that Li Designs has overdrawn its bank account by a large amount. In fact, the purpose of the case exercise is to get together financial statements so the company can ask for a loan to make up the shortfall.

In this chapter, the case only asks for the basic journal entries for the second quarter. Accrual and closing entries and the preparation of the financial statements is handled in Chapter 5. At the conclusion of the case, you might discuss their results with the students and ask them some questions like these: 1.

2.

3.

4.

Why does the company have no revenue?

If the company bought all the supplies, why is there no supplies expense?

Why is the trade accounts receivable balance zero?

Why is there no balance for salaries and wages payable?

Journal entries for April 2010 Date 9 April 2010

Account titles

Cash Share capital Mai Li purchases shares in Li Design LLC

Date 9 April 2010

. .

DR 5 000

5 000

Account titles Cash Share capital Qing and John Li purchases shares in Li Design LLC

DR 5 000

Date 10 April 2010

Account titles Cash Unearned service revenue Advance from Worthington Clothiers.

DR 12 000

Date 12 April 2010

DR 1 300

Account titles Travel expense Trade accounts payable

CR

CR 5 000

CR 12 000

CR 1 300

11

British Airways and Rotana Hotels charges from 25 April 2010 MasterCard statement.

Date 14 April 2010

Account titles

Rent expense Prepaid rent Cash Prepayment of lease to Whitehall Properties.

Account titles Equipment Cash Payment to Brooks Office Furnishings, LLC for furniture and equipment.

DR 9 540

Date 20 April 2010

DR 13 400

Account titles

Improvements Cash Advance payment to Thomas Holdings LLC for office space design.

Date 22 April 2010

Date 25 April 2010

DR 1 033

Supplies Cash Purchase office supplies from Knightsbridge Stationery.

Account titles

Interest expense Trade accounts payable Finance charge on MasterCard statement.

Date 28 April 2010

Account titles

Equipment Cash Purchase of Dell Computer equipment.

Date 29 April 2010

Account titles Salaries and wages expense Cash

CR 13 400

DR 512

Account titles

CR 9 540

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

Date 25 April 2010

CR

6 300

Date 17 April 2010

. .

DR 2 100 4 200

CR 512

CR 1 033

DR

CR 26 26

DR 2 640

CR 2 640

DR 512

CR 512

12

Compensation for Marvin Wycherly.

Date 30 April 2010

Account titles Trade accounts payable Cash

DR 200

CR 200

Payment on MasterCard.

Date 30 April 2010

Account titles

Bank service expenses Cash Bank service charge as shown on the 30 April 2010 bank statement.

DR

CR 11 11

Journal entries for May 2010 Date 1 May 2010

Account titles Rent expense Cash Payment of rent for May to Whitehall Properties.

DR 2 100

Date 3 May 2010

Account titles Supplies Cash Purchase office supplies from Knightsbridge Stationery.

DR 474

Date 6 May 2010

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

DR 512

Date 6 May 2010

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

DR 730

Date 7 May 2010

DR 244

Account titles Supplies Cash Computer supplies purchased from London Computer Supplies.

. .

CR 2 100

CR 474

CR 512

CR 730

CR 244

13

Date 10 May 2010

Account titles Cash Unearned service revenue Advance from Rawashdeh Hotelier on design work to be completed 30 May.

DR 5 000

Date 10 May 2010

Account titles Travel expense Trade accounts payable British Airways ticket charged to MasterCard.

DR 1 245

Date 11 May 2010

Account titles Office maintenance expense Cash Monthly payment to Aces Office Maintenance for office maintenance.

DR 130

Date 12 May 2010

Account titles Travel expense Trade accounts payable Marriott Suites charged to MasterCard.

DR 855

Date 13 May 2010

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

DR 512

Date 13 May 2010

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

DR 730

Date 18 May 2010

Account titles Supplies Cash Computer paper and cartridges purchased from Chelsea Computer Supplies.

DR 245

Date 20 May 2010

DR 512

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

. .

CR 5 000

CR 1 245

CR 130

CR 855

CR 512

CR 730

CR 245

CR 512

14

Date 20 May 2010

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

DR 730

Date 21 May 2010

Account titles Supplies Cash Purchase office supplies from Knightsbridge Stationery.

DR 802

Date 25 May 2010

Account titles Cash Unearned service revenue Advance payment from Evangellos of Santorini.

DR 5 000

Date 25 May 2010

DR 1 000

Account titles

Travel advances Cash Travel advance to Jane Foo.

Date 25 May 2010

730

CR 802

CR 5 000

CR 1 000

Account titles Interest expense Trade accounts payable Finance charge on MasterCard statement.

DR

Date 27 May 2010

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

DR 512

Date 27 May 2010

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

DR 730

Date 29 May 2010

DR 800

Account titles Trade accounts payable Cash

CR

CR 38 38

CR 512

CR 730

CR 800

Payment on MasterCard.

. .

15

Date 31 May 2010

Account titles Bank service expenses Cash Bank service charge as shown on the 31 May 2010 bank statement.

DR

CR 14 14

Journal entries for June 2010 Date 1 June 2010

Account titles Prepaid insurance Cash Prepayment of insurance to Massey Insurance LLC

DR 5 400

Date 2 June 2010

Account titles Rent expense Cash Payment of rent for May to Whitehall Properties.

DR 2 100

Date 3 June 2010

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

DR 512

Date 3 June 2010

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

DR 730

Date 4 June 2010

Account titles Administrative expense Cash Recruitment fee paid to Mathias Recruitment Agency.

DR 1 300

Date 10 June 2010

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

DR 512

Date 10 June 2010

DR 730

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

. .

CR 5 400

CR 2 100

CR 512

CR 730

CR 1 300

CR 512

CR 730

16

Date 10 June 2010

Account titles Salaries and wages expense Cash Compensation for Tom Johnson.

DR 320

Date 10 June 2010

Account titles Salaries and wages expense Cash Compensation for David Weeks.

DR 700

Date 11 June 2010

Account titles Office maintenance expense Cash Monthly payment to Aces Office Maintenance for office maintenance.

DR 130

Date 13 June 2010

Account titles Administrative expense Cash

DR

Account titles Administrative expense Cash Federal Express delivery charge.

DR

Date 17 June 2010

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

DR 512

Date 17 June 2010

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

DR 730

Date 17 June 2010

DR 320

CR 320

CR 700

CR 130

CR 34 34

Soho Delivery Service.

Date 13 June 2010

Account titles Salaries and wages expense Cash Compensation for Tom Johnson.

. .

CR 60 60

CR 512

CR 730

CR 320

17

Date 17 June 2010

Account titles Salaries and wages expense Cash Compensation for David Weeks.

DR 700

Date 18 June 2010

DR 7 000

Account titles Cash Notes payable

CR 700

CR 7 000

Loan from Ni Li.

Date 20 June 2010

Account titles Supplies Cash Purchase office supplies from Knightsbridge Stationery.

DR 1 113

Date 24 June 2010

Account titles Salaries and wages expense Cash Compensation for Marvin Wycherly.

DR 512

Date 24 June 2010

Account titles Salaries and wages expense Cash Compensation for Jane Foo.

DR 730

Date 24 June 2010

Account titles Salaries and wages expense Cash Compensation for Tom Johnson.

DR 320

Date 24 June 2010

Account titles Salaries and wages expense Cash Compensation for David Weeks.

DR 700

Date 25 June 2010

DR 500

Account titles Salaries and wages expense Cash

CR 1 113

CR 512

CR 730

CR 320

CR 700

CR 500

Compensation for Mai Li.

. .

18

Date 25 June 2010

Account titles Interest expense Cash Finance charge on 25 June 2010 MasterCard statement

DR

CR

Date 29 June 2010

Account titles Trade accounts payable Cash

DR 700

Account titles

DR 268

29 29

CR 700

Payment to MasterCard.

Date 30 June 2010

Travel expenses Cash

CR 268

Payment to MasterCard.

Date 30 June 2010

Account titles Supplies Cash Purchase supplies from London Computer Supplies.

DR 1 320

Date 30 June 2010

Account titles Bank service expenses Cash Insufficient funds charge on 30 June 2010 bank statement.

DR

Date 30 June 2010

DR

Account titles Bank service expenses Cash Bank service charge on 30 June 2010 bank statement.

. .

CR 1 320

CR 90 90

CR 18 18

19

Ledger for Second Quarter (April, May and June) 2010 Li Designs LLC Ledger 30 June 2010 £ (British pounds) Date

DR

CR

SERVICE REVENUE Ending balance 30 June 2010

-SALARIES AND WAGES EXPENSE

22 April 2010 29 April 2010 6 May 2010 6 May 2010 13 May 2010 13 May 2010 20 May 2010 20 May 2010 27 May 2010 27 May 2010 3 June 2010 3 June 2010 10 June 2010 10 June 2010 10 June 2010 10 June 2010 17 June 2010 17 June 2010 17 June 2010 17 June 2010 24 June 2010 24 June 2010 24 June 2010 24 June 2010 25 June 2010 Ending balance 30 June 2010

512 512 512 730 512 730 512 730 512 730 512 730 512 730 320 700 512 730 320 700 512 730 320 700 500 14 520 RENT EXPENSE

14 April 2010 1 May 2010 2 June 2010 Ending balance 30 June 2010

2 100 2 100 2 100 6 300 SUPPLIES EXPENSE

Ending balance 30 June 2010

-TRAVEL EXPENSE

12 April 2010 10 May 2010 12 May 2010 30 June 2010 Ending balance 30 June 2010

1 300 1 245 855 268 3 668 INSURANCE EXPENSE

. .

20

Ending balance 30 June 2010

-ADMINISTRATIVE EXPENSE

4 June 2010 13 June 2010 13 June 2010 Ending balance 30 June 2010

1 300 34 60 1 394 OFFICE MAINTENANCE EXPENSE

11 May 2010 11 June 2010 Ending balance 30 June 2010

130 130 260 DEPRECIATION EXPENSE

Ending balance 30 June 2010

-INTEREST EXPENSE

25 April 2010 25 May 2010 25 June 2010 Ending balance 30 June 2010

26 38 29 93 BANK SERVICE EXPENSES

30 April 2010 31 May 2010 30 June 2010 30 June 2010 Ending balance 30 June 2010

11 14 90 18 133 CASH

9 April 2010 9 April 2010 12 April 2010 14 April 2010 17 April 2010 20 April 2010 22 April 2010 25 April 2010 28 April 2010 29 April 2010 30 April 2010 30 April 2010 1 May 2010 3 May 2010 6 May 2010 6 May 2010 7 May 2010 10 May 2010 11 May 2010 13 May 2010 13 May 2010 18 May 2010 20 May 2010 20 May 2010 21 May 2010 25 May 2010

. .

5 000 5 000 12 000 6 300 9 540 13 400 512 1 033 2 640 512 200 11 2 100 474 512 730 244 5 000 130 512 730 245 512 730 802 5 000

21

25 May 2010 27 May 2010 27 May 2010 29 May 2010 31 May 2010 1 June 2010 2 June 2010 3 June 2010 3 June 2010 4 June 2010 10 June 2010 10 June 2010 10 June 2010 10 June 2010 11 June 2010 13 June 2010 13 June 2010 17 June 2010 17 June 2010 17 June 2010 17 June 2010 18 June 2010 20 June 2010 24 June 2010 24 June 2010 24 June 2010 24 June 2010 25 June 2010 29 June 2010 29 June 2010 30 June 2010 30 June 2010 30 June 2010 30 June 2010 Ending balance 30 June 2010 – Overdrawn TRADE ACCOUNTS RECEIVABLE Ending balance 30 June 2010 SUPPLIES 25 April 2010 3 May 2010 7 May 2010 18 May 2010 21 May 2010 20 June 2010 30 June 2010 Ending balance 30 June 2010 PREPAID INSURANCE 1 June 2010 Ending balance 30 June 2010 PREPAID RENT

. .

1 000 512 730 800 14 5 400 2 100 512 730 1 300 512 730 320 700 130 34 60 512 730 320 700 7 000 1 113 512 730 320 700 500 29 700 268 1 320 90 18 27 015 -1 033 474 244 245 802 1 113 1 320 5 231 5 400 5 400

22

14 April 2010 Ending balance 30 June 2010

4 200 4 200 TRAVEL ADVANCES

25 May 2010 Ending balance 30 June 2010

1 000 1 000 IMPROVEMENTS

20 April 2010 Ending balance 30 June 2010

13 400 13 400 EQUIPMENT

17 April 2010 28 April 2010 Ending balance 30 June 2010

9 540 2 640 12 180 ACCUMULATED DEPRECIATION -- EQUIPMENT

Ending balance 30 June 2010

-TRADE ACCOUNTS PAYABLE

12 April 2010 25 April 2010 30 April 2010 10 May 2010 12 May 2010 25 May 2010 29 May 2010 29 June 2010 Ending balance 30 June 2010

1 300 26 200 1 245 855 38 800 700 1 764 SALARIES AND WAGES PAYABLE

Ending balance 30 June 2010

-NOTES PAYABLE

18 June 2010 Ending balance 30 June 2010

7 000 7 000 UNEARNED SERVICE REVENUE

10 April 2010 10 May 2010 25 May 2010 Ending balance 30 June 2010

12 000 5 000 5 000 22 000 SHARE CAPITAL

9 April 2010 9 April 2010 Ending balance 30 June 2010

5 000 5 000 10 000 RETAINED EARNINGS

Ending balance 30 June 2010

--

Trial balance for Second Quarter (April, May and June) 2010

. .

23

Li Designs LLC Trial Balance 30 June 2010 £ (British pounds) Account Titles Service revenue Salaries and wage expense Rent expense Supplies expense Travel expense Insurance expense Administrative expense Office maintenance expense Depreciation expense Interest expense Bank service expense Cash Trade accounts receivable Supplies Prepaid insurance Prepaid rent Travel advances Improvements Equipment Accumulated depreciation – equipment Trade accounts payable Salaries and wages payable Notes payable Unearned service revenue Share capital Retained earnings

DR

-14 520 6 300 -3 668 -1 394 260 -93 133 27 015 -5 231 5 400 4 200 1 000 13 400 12 180

67 779

. .

CR

-1 764 -7 000 22 000 10 000 -67 779

24

Instructor Manual Chapter 5 Accrual and Closing

. .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

5

Learning Outcome 2 Learning Outcome 4 Learning Outcome 5

5 8 10

Answers to Review Questions

11

Answers to Terminology Practice

12

Answers to Application Exercises

13

Case Analysis

17

. .

2

Lecture Notes Introduction: In this chapter, I began with a brief introduction to accounting “shenanigans” in an attempt to pique the interest of students. The basic point here is that one of the most frequent issues in misreporting financial information is the erroneous classification of a capital cost as an expense or vice versa -- or reporting erroneously reporting unearned revenue or another credit as revenue.

I also use the example on pages 234-5 of Iluh who lives in Bali to explain the basic idea of allocating capital costs. The example is simple to make a simple point – the method of allocation capital costs can change how performance is reported. I also make the point to students that in the “real world” managers are typically more concerned with how profit or loss is reported. Thus any item that affects the statement of comprehensive income will usually be seen by management as more important.

Managers are less concerned with the statement of financial position.

Learning Outcome 1 Describe the difference between cash-basis and accrual accounting In modern international business, cash-basis accounting is infrequently encountered. Thus, I tend to deemphasize this in class and use the contrast between cash-basis and accrual as a starting point to understand accrual concepts.

Learning Outcome 2 Describe four types of adjusting entries When teaching both undergraduates and graduates, I emphasize the ‘list’ of the four types of adjusting entries in order to give some structure to the concept of adjusting accounts to the accrual basis. In Figure 5.3 I provide a framework to show that two of the entry types are revenue-related and two are expense-related. Then two have to do with recognition and two with reclassification of previously recorded items. When reviewing examples of reclassification adjusting entries, I am careful to first go through the original business transaction that gave rise to the need for the adjusting entry. For example, in Learning Outcome 2.2.2 at the bottom of page 247 in the shaded box, the prepayment of rent entry on 1 January 2009 is discussed to ‘set the stage’ for the adjusting entry shown on page 248.

Learning Outcome 3 Demonstrate how adjusting entries are recorded

. .

3

This learning outcome is intended to bring together in additional examples the four types of adjusting entries discussed in Learning Outcome 2. I also remind students that after the adjusting entries are recorded, the adjusted trial balance can be generated and that it is from the adjusted trial balance that the financial statements are prepared.

Learning Outcome 4 Describe the four closing entries and explain the purpose of each This learning outcome covers the standard closing entries. In Figures 5.7-5.11 I have provided a diagram of the extended accounting equation to show step-by-step how the temporary (or nominal) accounts are closed into permanent (or real) accounts. The actual process of recording closing entries is, of course, straightforward. But I use these diagrams in class as the last opportunity to reinforce the distinction between a temporary and permanent (or nominal and real) account.

In Figure 5.12, I also try to give the students one last look at the accounting process in its entirety.

Harvey Brightman, whose teaching ideas I discussed in the Instructor Manual Chapter 1, believes that it is important to give students an idea visually of how the topics fit together. So I use Figure 5.12 to accomplish that objective. But also the traditional step-wise accounting process has been blurred by automated systems. So I also try to make the point to students that in automated systems the accounting process is continuous even thought concepts like accounting periods and adjusting entries are the same.

Learning Outcome 5 Prepare financial statements using the extended trial balance worksheet Briefly, I show students how the information in the adjusted trial balance is used to prepare the financial statements. The extended trial balance worksheet is an excellent tool for doing that.

. .

4

Answers to Learning Outcome Questions Learning Outcome 2 Describe the four types of adjusting entries.

Learning Outcome 2.1.1 How is unrecorded revenue accrued?

On Your Own 1. Explain the circumstances that create the need to make an adjusting entry to accrue revenue.

Four general circumstances create the need to make an adjusting entry: 1) Revenue that needs to be recognized in the reporting period.

2) Expenses that need to be recognized in the reporting period.

3) Cash received for goods or services to be delivered in the future and recorded as unearned revenue but which now need to be recognized as earned revenue in the reporting period.

4) Cash paid for goods or services to be consumed in the future and recorded as pre-paid expenses but which now need to be recognized as expenses for the reporting period.

2. What are the two tests that an adjusting entry must meet?

The two tests for an adjusting entry are: 1) They do not involve cash.

2) Both the statement of comprehensive income and statement of financial position are affected.

Learning Outcome Practice 1. What is the appropriate journal entry? d. No entry is made 2. What is the appropriate journal entry?

DR a. Trade accounts receivable 550 Service revenue

CR 550

3. What is the appropriate journal entry?

DR CR c. Cash 550 Service revenue 550

. .

5

Learning Outcome 2.1.2 How are unrecorded expenses accrued?

On Your Own 1. Explain the circumstances that create the need to make an adjusting entry to accrue expenses.

An adjusting entry must be made to accrue expenses when a good or service has been consumed during the reporting period but has not been recorded. For example, employees have already rendered services but will not be paid for those services until after the reporting date.

Learning Outcome Practice 1. A company accrues salaries for the week just ended that will be paid at the end of the month. The debit in the journal entry would be to which financial statement category? c. Expenses 2. What is the appropriate journal entry for the work performed by the employees?

DR CR a. Wage expense 225 Cash 225 3. What is the appropriate journal entry for the work performed by the employees?

DR CR c. Wage expense 225 Wages payable 225

Learning Outcome 2.2.1 How is unearned revenue recognized as revenue?

On Your Own 1. Explain what circumstances cause an adjusting entry for unearned revenue to be recorded.

An adjusting entry for unearned revenue is needed because cash was previously received from a customer for goods or services to be delivered in the future. As a result, a business transaction was recorded crediting unearned revenue. However, an entry must now be made because the revenue is earned.

2. How is accrued revenue different from unearned revenue?

Accrued revenue is earned and therefore appears on the statement of comprehensive income.

Unearned revenue is a liability and appears on the statement of financial position.

. .

6

3. Which adjusting entry increases assets? Accrued revenue or unearned revenue?

When revenue is accrued a trade accounts receivable is recorded.

4. Which adjusting entry decreases liabilities? Accrued revenue or unearned revenue?

When unearned revenue, a liability, is reclassified as earned revenue, the liability is decreased.

5. Which adjusting entry increases profit? Accrued revenue or unearned revenue?

Both entries increase revenue and therefore increase profit.

6. Which adjusting entry increases equity? Accrued revenue or unearned revenue?

Both. When revenue is accrued equity is increased because assets (trade accounts receivable) are increased). When an adjusting entry is made to reclassify unearned revenue as earned, liabilitie are decreased.

Learning Outcome Practice 1. What figure for rental income should be included in the statement of income of Baity for 2009? a. $341 000 2. What figure for rental income should be included in the company’s statement of income for the year ended 30 June 2009? a. $84 000 Learning Outcome 2.2.2 How are prepaid expenses recognized as expenses?

On Your Own 1. What is the journal entry to record prepayment for rent for the next three months in the amount of $33 000 on 1 June 2012?

Date 1 June 2012

Account titles Prepaid rent Cash

DR $33 000

CR $33 000

2. What is the adjusting entry related to the prepayment of rent in Item 1 above for the month of June 2012?

Date 30 June 2012

. .

Account titles Rent expense Prepaid rent

DR $11 000

CR $11 000

7

3. What is the adjusting entry related to the prepayment of rent in Item 1 above for the month of September 2012?

None. The prepayment of rent covered only three months – June, July and August.

4. A company has a supplies balance in its trial balance for 1 May 2012 for $45 000. A physical count reveals that $22 000 remains at the end of the month. What is the adjusting entry related to supplies for May? Date 31 May 2012

Account titles Supplies expense Supplies

DR $23 000

CR $23 000

5. A company has a supplies balance in its trial balance for 1 May 2012 for $45 000. Records indicate that $27 000 of the supplies were used during the month of May. What is the adjusting entry related to supplies for May? Date 31 May 2012

Account titles Supplies expense Supplies

DR $27 000

CR $27 000

Learning Outcome Practice 1. What should be reported on Alison’s statement of financial position at 30 November 2010? c. A prepayment of $3900 2. What rent expense and end-of-year prepayment should be included in the financial statements for the year ended 30 April 2013?

Expense Prepayment d. $94 000 $16 000

Learning Outcome 4 Describe the four closing entries and explain the purpose of each.

On Your Own 1. What is a temporary account? What is a permanent account?

Temporary or ‘nominal’ accounts include revenues, expenses and dividends. Permanent or ‘real’ accounts include assets, liabilities and equity. Or we can also say that accounts on the statement of comprehensive income plus dividends are temporary and accounts on the statement of financial position are permanent. . .

8

2. Which accounts are closed – temporary or permanent?

Only temporary accounts are closed.

3. Explain the four closing entries.

The four closing entries are as follows: 1) Dividends are closed directly to retained earnings.

2) Revenues are closed to income summary.

3) Expenses are closed to income summary.

4) Income summary is closed to retained earnings.

Learning Outcome Practice 1. The closing entry for dividends is as follows: Date 30 September 2009

Account titles Retained earnings Dividends

DR €500

CR €500

2. The closing entry for revenue is as follows: Date 30 September 2009

Account titles Revenue Income summary

DR €72 500

CR €72 500

3. The closing entry for expenses is as follows: Date 30 September 2009

Account titles Income Summary Expenses

DR €84 200

CR €84 200

4. The closing entry for revenue is as follows: Date 30 September 2009

Account titles Retained earnings Income summary

DR €11 700

CR €11 700

Notice that retained earnings is decreased because the business reported a loss.

5. The following accounts are temporary: Revenue, expenses, dividends and depreciation expense. And the following accounts are permanent: Cash, trade accounts payable, share capital, reserves, trade accounts receivable and accumulated depreciation.

. .

9

Learning Outcome 5 Prepare financial statements using the extended trial balance worksheet.

Learning Outcome Practice 1. When completing an extended trial balance that includes balances for depreciation expense and accumulated depreciation, into which columns should these balances be extended?

Depreciation Expense Accumulated Depreciation c. Statement of comprehensive income debit Statement of financial position credit 2. Heather is completing her extended trial balance. Into which columns should she extend the balance to close profit?

Statement of Comprehensive Income Statement of Financial Position a. Debit Credit 3. What is the profit for the period? a. A loss of $7209

. .

10

Answers to Review Questions 1. Why are adjusting entries made at the end of the reporting period? What are the four types of adjusting entries? Explain each type and provide an example. What are the two criteria that every adjusting entry must meet?

Adjusting entries are made at the end of the reporting period to record the effects of transactions in the period in which they occurred rather than the period when cash is received or paid. The four adjusting entries are: 1) accrue revenue, 2) accrue expenses, 3) reclassify unearned revenue to earned revenue and 4) reclassify prepaid expenses to expenses.

Examples: • • •

•

Accrue revenue – Furniture has been sold to a customer and delivered but the revenue has not been recorded as of the reporting date.

Accrue expenses – An entry to record the cost of goods sold for the furniture sold to a customer (based on the preceding example) has not been recorded as of the reporting date.

Reclassify unearned revenue – A customer purchased custom tailored clothes paying in advance. The clothes have been completed and delivered to the customer so the unearned service revenue must be reclassified as earned revenue.

Reclassify prepaid expenses – The business entity pays in advance for one year’s rent on its office space. Part or all of the year has passed so that the prepaid rent must be reclassified as rent expense.

The two criteria for an adjusting entry are: 1) the entry cannot involve cash and 2) the entry must affect both the statement of comprehensive income and the statement of financial position.

2. What is the difference between a temporary and permanent account? Which accounts are temporary accounts? Which accounts are permanent accounts?

Temporary accounts are closed and permanent accounts are not closed. Temporary accounts include all revenue, expenses and dividends. Permanent accounts include all asset, liability and equity accounts.

3. Which accounts – temporary or permanent – show a balance of zero on the post-closing trial balance? Which accounts temporary or permanent – have a balance in the post-closing trial balance?

Temporary accounts have zero balances on the post-closing trail balance while permanent account balances will appear on the post-closing trail balance.

4. What are temporary accounts closed? Why are permanent accounts not closed?

. .

11

Temporary accounts are closed because they accumulate information only for the reporting period.

Permanent accounts are not closed because all debits and credits are relevant to the future of the business.

5. What are the four closing entries?

The four closing entries are: 1) Dividends are closed to retained earnings 2) Revenue is closed to income summary 3) Expenses are closed to income summary 4) Income summary is closed to retained earnings.

Answers to Terminology Practice 1. Entries that remove balances in temporary accounts to the retained earnings reserve are called closing entries.

2. Permanent accounts (also referred to as real accounts) include the statement of financial position accounts.

3. Accrual is the process of classifying debits and credits into the appropriate reporting period.

4. Temporary accounts (also referred to as nominal accounts) include the statement of comprehensive income accounts and the dividend account.

5. Permanent accounts are not closed. Temporary accounts are closed at the end of the reporting period.

6. When revenue should be recognized in the current reporting period but it has not been recorded, then we must accrue the revenue. The same is true with expenses that have been incurred but not yet recorded.

7. A worksheet version of the adjusted trial balance called a(n) extended trial balance can be used to construct the financial statements.

8. Entries that convert accounts to accrual basis are called adjusting entries.

. .

12

Answers to Application Exercises 1. The adjusting entries for the Bayan Café are: a.

The loan interest must be accrued. The loan was outstanding for 1.5 months so the calculation for the accrued interest is $700 = $70 000 x (1.5 ÷ 12 months) x 8% annually.

Date 31 March 2010

b.

Account titles Salaries expense Salaries payable

DR $960

CR $960

Account titles Rent expense Prepaid rent

DR $5400

CR $5400

Account titles Unearned revenue Revenue

DR $1500

CR $1500

e.

Estimates are not recorded as adjusting entries.

f.

Since the work has been completed, the revenue is earned and should therefore be accrued.

Date 31 March 2010

Account titles Trade accounts receivable Revenue

DR $3330

CR $3330

The entry to accrue the expired insurance cost for 15 days would be recorded as follows assuming that no entry has yet been made to record the prepaid insurance. The expired portion of the insurance is $583 (rounded to the nearest dollar) = $14 000 x (0.5 ÷ 12 months)

Date 31 March 2010

. .

$700

The $1500 advance would have been recorded as unearned revenue but this was earned 2 March 2010.

Thus this must be classified as earned.

Date 31 March 2010

g.

CR

Prepaid rent recorded on 1 December 2009 must be reclassified as rent expense. The period to be reclassified is January through February 2010. The calculation is $5400 = $10 800 x (3 ÷ 6 months).

Date 31 March 2010

d.

DR $700

Four days salary costs (Sunday through Wednesday) must be accrued. The calculation is $960 = $300 per week x 4 employees x (4 ÷ 5 days).

Date 31 March 2010

c.

Account titles Interest expense Interest payable

Account titles Insurance expense Prepaid insurance Insurance payable

DR $583 13 417

CR

$14 000

13

2. The extended trial balance worksheet, statement of comprehensive income and statement of financial position for Al Awad Systems, Inc. would be: Al Awad Systems, Inc. Extended Trial Balance 30 September 2011 £ British pounds Adjusted Trial Statement of Balance Financial Position DR. CR. DR. CR.

Account Title Cash and cash equivalents

2 310

2 310

Trade accounts receivable

1 260

1 260

770

770

Prepaid insurance

1 330

1 330

Property, plant and equipment

4 620

4 620

Inventories

Accumulated depreciation Other assets

1 680 6 930

1 680 6 930

Trade accounts payable

5 390

5 390

Income taxes payable

420

420

Other liabilities

1 540

1 540

Ordinary shares

3 430

3 430

Beginning retained earnings

3 150

3 150

Dividends

1 190

Sales revenue

1 190 28 700

28 700

Cost of sales

17 500

17 500

Operating expenses

7 000

7 000

Income tax expense

1 400

1 400

Totals

44 310

44 310

25 900

Profit Worksheet totals

. .

Statement of Comprehensive Income DR. CR.

44 310

44 310

18 410

2 800

2 800

18 410

28 700

28 700

28 700

14

Al Awad Systems, Inc. Statement of Comprehensive Income For the Year Ended 30 September 2011 £ British pounds Sales revenue Cost of sales Gross profit Operating expenses Income tax expenses PROFIT Other comprehensive income TOTAL COMPREHENSIVE INCOME

28 700 17 500 11 200 7 000 1 400 2 800 0 2 800

Al Awad Systems, Inc. Statement of Financial Position 30 September 2011 £ British pounds Assets Non-current assets Property, plant and equipment Less: Accumulated depreciation Other assets Total non-current assets Current assets Cash and cash equivalents Trade accounts receivable Inventories Prepaid insurance Total current assets TOTAL ASSETS

2 310 1 260 770 1 330

Equity Ordinary shares Retained earnings ($3 150 + $2 800 - $1 190) Total Equity

3 430 4 760

Liabilities Trade accounts payable Income taxes payable Other liabilities Total liabilities

5 390 420 1 540

TOTAL EQUITY AND LIABILITIES

. .

4 620 (1 680) 6 930

9 870

5 670 15 540

8 190

7 350 15 540

15

3. The closing entries for Christophe Ceramics S.A. are:

Date 30 June 2014

Date 30 June 2014

Date 30 June 2014

Date 30 June 2014

. .

Account titles Retained earnings Dividends

DR €70 000

€70 000

Account titles Sales revenue Income summary

DR €635 000

CR €635 000

Account titles Income Summary Cost of sales Selling expenses Administrative expenses Interest expense

DR €455 000

Account titles

DR €180 000

Retained earnings Income summary

CR

CR €250 000 70 000 110 000 25 000

CR €180 000

16

Case Analysis Li Designs LLC Continued from Chapter 4 The adjusting entries for second quarter (April, May and June) 2010: Prepaid rent – No adjusting entry is needed for this. On 14 April 2010 Li Designs prepaid £6300 which represented a deposit, the last month’s rent and one month’s rent. This was expensed on the date payment was made. The £4200 prepaid rent is therefore correct.

Date 30 June 2010

Account titles DR CR Depreciation expense £645 Accumulated depreciation £645 Depreciation of office equipment £3180 per year = $9540 ÷ 3 years. In 2010, the equipment was in use 74/365 days. Thus depreciation expense is £645 (rounded to the nearest dollar).

Date 30 June 2010

Account titles DR CR Depreciation expense £228 Accumulated depreciation £228 Depreciation of the Dell computer is £1320 per year = £2640 ÷ 24 months. In 2010, the computer was in use 63/365 days. Thus depreciation expense is £228 (rounded to the nearest dollar).

The adjusting entry for the insurance would be as follows. Li Designs paid £5400 on 1 June 2010 but this was required by the landlord as part of the lease terms. Thus this amount must have applied to the total lease which has a three year term.

Date 30 June 2010

Account titles

Insurance expense Prepaid insurance Lease expense is £5400 x (3 ÷ 36 months)

DR £450

CR £450

The following entry records the revenue earned on the Evangello of Santorini work that was completed on 30 June 2010. Revenue has not been recognized. Therefore the adjusting entry would be: Date 30 June 2010

Account titles Unearned service revenue Trade account receivable Service revenue

DR £5000 21 000

CR

£26 000

The Worthington Clothiers agreement specifies that work is to be done from 1 April to 30 September 2010. The total amount of the contract was £36 000. Half the revenue would be recognized on 30 June 2010 since revenue is recognized evenly over the life of the agreement. However, Worthington Clothiers advanced £12 000 when work commenced. The adjusting entry would be:

. .

17

Date 30 June 2010

Account titles Unearned service revenue Trade account receivable Service revenue

DR £12 000 6000

CR

£18 000

The designs for office space from Thomas Holdings LLC were capitalized and would be amortized over the term of the office lease which is 36 months. The adjusting entry would be: Date 30 June 2010

Account titles

DR £1117

Rent expense Improvements The amount to be amortized is £1117 = £13 400 x 3/36 months (rounded to the nearest dollar)

CR £1117

The following entry records the revenue earned on the Rawashdeh Hoteliers work that was completed on 30 May 2010. Revenue has not been recognized. Therefore the adjusting entry would be: Date 30 June 2010

Account titles Unearned service revenue Trade account receivable Service revenue

DR £5000 2500

CR

£7500

The following entry records supplies expense based on the ending supplies count from the documents found in Mai’s cardboard boxes. Supplies expense is £3191 = £5231 - £2040. The adjusting entry would be: Date 30 June 2010

. .

Account titles Supplies expense Supplies

DR £3191

CR £3191

18

The adjusted trial balance for second quarter (April, May and June) 2010 Li Designs LLC Adjusted Trial Balance 30 June 2010 £ (British pounds) Account Titles Service revenue Salaries and wage expense Rent expense Supplies expense Travel expense Insurance expense Administrative expense Office maintenance expense Depreciation expense Interest expense Bank service expense Cash Trade accounts receivable Supplies Prepaid insurance Prepaid rent Travel advances Improvements Equipment Accumulated depreciation – equipment Trade accounts payable Salaries and wages payable Notes payable Unearned service revenue Share capital Retained earnings

DR

51 500 14 520 7 417 3 191 3 668 450 1 394 260 873 93 133 27 015 29 500 2 040 4 950 4 200 1 000 12 283 12 180

98 152

. .

CR

873 1 764 -7 000 -10 000 -98 152

19

The financial statements would be: Li Designs LLC Statement of Comprehensive Income For the Year Ended 30 June 2010 £ British pounds Sales revenue Less: Salaries and wage expense Rent expense Supplies expense Travel expense Insurance expense Administrative expense Office maintenance expense Depreciation expense Interest expense Bank service expense Total expenses PROFIT Other comprehensive income TOTAL COMPREHENSIVE INCOME

. .

51 500 14 520 7 417 3 191 3 668 450 1 394 260 873 93 133 31 999 19 501 0 19 501

20

Li Designs LLC Statement of Financial Position 30 June 2010 £ British pounds Assets Non-current assets Improvements Equipment Accumulated depreciation Total non-current assets Current assets Bank overdraft Trade accounts receivable Supplies Prepaid insurance Prepaid rent Travel advances Total current assets TOTAL ASSETS

23 590

(27 015) 29 500 2 040 4 950 4 200 1 000 14 675 38 625

Equity Share capital Retained earnings Total Equity

10 000 19 501

Liabilities Trade accounts payable Notes payable Total liabilities

1 764 7 000

TOTAL EQUITY AND LIABILITIES

. .

12 283 12 180 (873)

29 501

8 764 38 265

21

Closing entries for Li Designs would be: Date 30 June 2010

Date 30 June 2010

Date 30 June 2010

Account titles Revenue Income summary

DR £51 500

CR £51 500

Account titles Income summary Salaries and wage expense Rent expense Supplies expense Travel expense Insurance expense Administrative expense Office maintenance expense Depreciation expense Interest expense Bank service expense

DR £31 999

Account titles

DR £19 501

Income Summary Retained earnings

CR £14 520 7 417 3 191 3 668 450 1 394 260 873 93 133

CR £19 501

No dividends were paid thus no closing entry for dividends is necessary.

. .

22

The post-closing trial balance would be: Li Designs LLC Post-Closing Trial Balance 30 June 2010 £ (British pounds) Account Titles Service revenue Salaries and wage expense Rent expense Supplies expense Travel expense Insurance expense Administrative expense Office maintenance expense Depreciation expense Interest expense Bank service expense Cash Trade accounts receivable Supplies Prepaid insurance Prepaid rent Travel advances Improvements Equipment Accumulated depreciation – equipment Trade accounts payable Salaries and wages payable Notes payable Unearned service revenue Share capital Retained earnings

DR

CR -----------27 015

29 500 2 040 4 950 4 200 1 000 12 283 12 180

66 153

. .

873 1 764 -7 000 -10 000 19 501 66 153

23

Instructor Manual Chapter 6 Accounting Information Systems

. .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

4

Learning Outcome 1 Learning Outcome 2 Learning Outcome 3 Learning Outcome 4 Learning Outcome 5

4 5 7 8 9

Answers to Review Questions

10

Answers to Terminology Practice

13

Answers to Application Exercises

14

. .

2

Lecture Notes Introduction Accounting information systems is usually covered in an upper division undergraduate course while graduate students receive little exposure to the topic. Yet when students begin their professional careers, especially in large companies, they are most likely to encounter accounting activity in the form of automated accounting information systems as part of a larger Enterprise Resource Planning system.

The accounting process, as discussed in Chapters 4 and 5, is likely to be veiled by the complex financial information flows that students will encounter in practice.

This chapter provides students with an overview of accounting information systems from three perspectives: 1) it places the accounting information system within the context of larger Enterprise Resource Planning systems, 2) it introduces accounting coding structures, and 3) it breaks down the accounting information system into its major cycles – sales and cash receipts, purchases and cash disbursements, employee compensation, fixed assets and inventories. The other reason I favor a chapter on accounting information systems at this point in the text is that it serves as a vehicle to discuss returns and allowances and discounts.

The discussion of coding structures is particularly important because it allows students to grasp the idea that financial information can be analyzed in many ways beyond the simple classification into accounts.

While the account classification scheme is usually sufficient for preparing financial statements which are usually highly summarized in practice, detailed financial information is the norm for internal decisions.

Thus, a basic understanding of coding structures in the financial accounting course helps prepare students when for managerial accounting particularly as it pertains to cost accumulation and analysis. In a sense, the idea of a detailed coding structure, common in practice, goes hand-in-hand with concepts like activity-based costing encountered in managerial accounting.

Also this chapter takes time to discuss the audit trail which I have found to be a very useful tool for tying together the accounting process. Even though many instructors would argue that this rightfully belongs to an audit course, from an accounting process point of view the audit trail is a powerful concept for showing how the different elements of the accounting system – journals, ledgers, trial balance and financial statements – are related.

. .

3

Answers to Learning Outcome Questions Learning Outcome 1 Define the accounting information system and describe its components.

On Your Own 1. Compare and contrast the accounting information system with the accounting process discussed in Chapters 4 and 5.

An accounting information system is the overall accounting system maintained by a business entity, including computerized software modules that handle the accounting process. Accounting information systems include the business’s accounting policies and procedures as well as the human organizations that handle accounting activities. Accounting information systems incorporate the accounting process which is the double-entry method by which financial information is recorded, summarized and used to prepare financial statements.

2. Compare and contrast a general journal entry and a special journal entry. How are they similar?

How are the different? Why are special journal entries used in accounting?

A general journal entry is recorded in the general journal. A special journal entry is used to record like transactions in a special journal which provides detail on a specific ledger account such as trade accounts receivable. The amounts entered into the special journal are then summarized and entered into the general journal.

3. Compare and contrast a general ledger and a subsidiary ledger. How are they similar? How are the different? What are subsidiary ledgers used in accounting?

A general ledger contains all account balances. A subsidiary ledger contains all detail that make up some general ledger account balances. For example, the receivables subsidiary ledger would contain detail on all customers but this information would be in summary form in the general ledger.

Otherwise, the two ledgers are the same. Subsidiary ledgers are used to maintain large amounts of detail that would be too cumbersome to maintain in the general ledger.

4. Compare and contrast a chart of accounts with an account code structure. How are they similar?

How are they different?

A chart of accounts and an account code structure serve the same purpose – each provides a listing of authorized account titles or codes used by the business. However, a chart of accounts normally has only the account title whereas a coding structure has codes which allow the business to analyze financial information in different ways. For example, the account code structure allows the business to analyze information by geographic area, product line, customer, or supplier in addition to the account code. . .

4

Learning Outcome Practice 1. What would be the appropriate account code for the credit side of the journal entry when cash is received from Sydney Doctors’ Group to Melbourne Sales on the trade accounts receivable that was recorded for a purchase of blood pressure devices? See Figure 6.4. c. 03-3200-4400-10400 2. What would be the appropriate account code for the debit side of the journal entry when cash is received from Sydney Doctors’ Group to Melbourne Sales on the trade receivable that was recorded for a purchase of blood pressure devices? See Figure 6.4. b. 03-3100-4400-10400

Learning Outcome 2 Describe the sales and cash receipts cycle.

On Your Own 1. Explain what the following documents are and how they are used in the sales and cash receipts cycle: customer purchase order, sales order and sales invoice.

The customer purchase order is the document that the customer uses to order goods or services. A sales order is an internal documents that verifies that the appropriate internal approvals have been given to sell the goods or services to the customer including approval of credit if the sale has been made on account. A sales invoice is a bill sent to a customer showing the date, what goods were shipped or services provided, and the total amount owing.

2. What is the difference between a sales return and a sales allowance? Why would a business use one or the other?

A sales return is when a customer returns goods to the business because the goods are unneeded, defective or incorrectly shipped. Thus a return provides credit for the returned goods. An allowance is a credit that can be made for a variety of reasons. The customer may not want the goods or the goods may have been defective or incorrectly shipped and the cost of returning the goods is too much. Therefore a credit memo is issued to the customer’s account. An example would be unsold magazines for a magazine distributor if the distributor gives credit for unsold items. It is cheaper to simply give the retailer credit and allow him to destroy the magazines rather than paying for the return shipment.

3. What is a contra-account?

A contra-account offsets another account. For example sales returns and allowances and sales discounts are both contra-revenue accounts.

. .

5

4. Compare and contrast invoice payment with the statement method of paying for sales.

When the invoice payment is used, the customer pays for each order of goods or services separately.

The statement method accumulates all purchases for a period such as a month, and bills the customer for the total.

5. What is the difference between gross sales and net sales? How is each calculated?

Net sales is calculated be deducing sales returns and allowances and sales discounts from gross sales.

Learning Outcome Practice 1. A company sells $25 000 in merchandise to a customer on terms 2/8, net 30 on 29 October 2012.

The customer pays on 7 November 2012 in full. What is the journal entry to record the payment?

The journal entry would be as follows: Date 7 November 20012

Account titles Cash Trade accounts receivable

DR $ 25 000

CR $ 25 000

The customer does not receive the discount since payment was made after eight days.

2. A company sells $25 000 in merchandise to a customer on terms 2/8, net 30 on 29 October 2012.

The customer pays on 5 November 2012 in full. What is the journal entry to record the payment?

The journal entry would be as follows: Date 5 November 20012

Account titles Cash Sales discounts Trade accounts receivable

DR $ 24 500 500

CR

$ 25 000

The customer does receive the discount since payment was made on the seventh day and the customer was given eight days to pay in order to receive the discount.

3. Achillios Industries extends credit to its customers on terms 4/12, net 25. On 11 December 2014 a customer purchases €210 799 in merchandise. On 25 December 2014 payment is received by Achillios. The journal entry to record the payment would contain: b. No entry to sales discount or sales returns and allowances 4. Lorenz-Wilhelm Steel receives an order for €3 324 885 from a construction company on August 2013 on terms 3/10, net 30. On 17 August 2013, the customer returns merchandise for €215 300.

The customer sends payment via EFT on 25 August 2013. What amount of sales discount is given, if any? a. €93 287.55

. .

6

5. Tekko Fabrics reported $1 455 000 in revenues for fiscal 2011. Sales returns and allowances were $23 400, sales discounts $57 200, purchase discounts $77 990 and purchase returns and allowances $49 222. What were net sales? a. $1 374 400

Learning Outcome 3 Describe the purchases and cash disbursements cycle.

On Your Own 1. Explain what the following documents are and how they are used in the purchases and cash disbursements cycle: purchase requisition, purchase order, receiving report, vendor invoice and remittance advice.

Purchase requisition – This is an internal document which requests that a purchase be made.

Purchase order – This document is the actual order sent to the chosen supplier.

Receiving report – This is an internal document that verifies that items ordered have been received.

Vendor invoice – This is the bill sent by the supplier demanding payment for the goods or services that have been purchased on account.

Remittance advice – This document accompanies payment to the supplier advising the purpose of the payment.

2. What is the difference between purchase returns and a purchase allowance? Why would a business use one or the other?

A purchase returns account is used to record merchandise returned to the supplier because the incorrect goods were shipped or the goods were defective or some other reason. A purchase allowance account is used to record any allowances given on goods received even though the goods may not have been returned.

Learning Outcome Practice 1. Which document should accompany a payment made to a supplier? b. Remittance advice 2. Which of the following is correct when recording a discount received from a supplier? c. Debit trade accounts payable; credit discount received 3. The sequence of events to account for a purchase on credit for a contract cleaning company would be which of the following? d. prepare purchase requisition, prepare purchase order, receive vendor invoice, record purchase in purchase journal, summarize purchase journal and post to general ledger . .

7

4. What document provides proof of payment in a business transaction? c. Cheque 5. Manish buys goods on credit from Lisa but finds that some of them are faulty. What document would Manish return to Lisa with the faulty goods? b. Debit note 6. Jonathan sends a debit note to one of his suppliers. In which of Jonathan’s books of prime entry would this be recorded? d. Purchase returns Learning Outcome 4 Describe the employee compensation, fixed assets and inventories and conversion cycles.

On Your Own 1. What activities does the employee compensation cycle address?

The major activity is the payroll, the payment of employees for services rendered. However, depending on the country and other factors, payroll may involve taxation, trade unions, pension funds and other benefits.

2. What is the difference between gross pay and net pay?

Gross pay is the total amount of compensation owed to the employee. Net pay is calculated by deducting taxes, health insurance, retirement fund and other items to be paid by the employee from gross pay.

3. What is an asset register and what information does it contain?

The asset register is a list of all noncurrent assets with information in their identity (serial number, location and description, cost and date of purchase.

4. What major accounting entries are generated by the fixed assets cycle?

The asset register is used to generate depreciation expense journal entries.

5. What is the difference between work in process and finished goods?

Work in process refers to goods on which a manufacturer has begun but not completed production.

Production has been completed on finished goods and they are ready for sale to a customer.

6. What are direct materials, direct labor and overhead?

Direct materials are goods that to into the product itself. Direct labor includes the costs of labor that are used in the production of the goods. Overhead includes indirect material and indirect labor consumed in the production process but which cannot be directly associated with the product. . .

8

Learning Outcome Practice 1. Sophie has the following information about a recently acquired noncurrent asset that was financed by taking out a loan. (i) serial number (ii) cost (iii) provider of loan (iv) date of purchase c. i, ii and iv 2. Which of the following are reasons for maintaining a noncurrent asset register? (i) To calculate the total balance outstanding on loans raised to buy noncurrent assets (ii) To help in carrying out the physical verification of noncurrent assets (iii) To calculate the profit and loss on disposal of noncurrent assets d. ii and iii only 3. Which of the following is/are correct? (i) The noncurrent asset register is part of the double-entry system (ii) A noncurrent asset register is required in every organization’s accounting system (iii) Assets should be removed from the noncurrent asset register when they have been fully depreciated d. None of the statements

Learning Outcome 5 Explain the audit trail.

On Your Own 1. Define audit trail.

An audit trail provides links that allow a transaction to be traced through an accounting system from the source document to the final account balance that appears on the financial statements.

2. What purposes do audit trails serve?

The audit trail allows a complete explanation of an account balance by identifying all transactions that affected that account.

. .

9

Answers to Review Questions 1. Define accounting information systems. How does an accounting information system differ from the accounting process?

An accounting information system is the overall accounting system maintained by a business entity, including computerized software modules that handle the accounting process. Accounting information systems include the business’s accounting policies and procedures as well as the human organizations that handle accounting activities. Accounting information systems incorporate the accounting process which is the double-entry method by which financial information is recorded, summarized and used to prepare financial statements.

2. What are the cycles typically found in large accounting systems?

The major cycles include sales and cash receipts, purchases and cash disbursements, employee compensation (or human resources), fixed assets and inventories (or conversion) for merchandisers and manufacturers.

3. Define account coding structures and explain how they function.

A coding structure is a means of organizing accounting information so that it can be analyzed in a variety of ways. Coding structures typically involve multiple codes (e.g., geographic region, product or service code, ledger account, customer, supplier). Coding structures are unique to each business.

4. What is a special journal? How and why are special journals used? What are examples of typical special journals?

A special journal records detailed information on a particular account. They are used to prevent the general journal from containing too much detail. Special journals are used for sales, cash receipts, purchases, cash disbursements, payroll payments and so forth.

5. What is a subsidiary ledger? How and why are subsidiary ledgers used? What are examples of typical subsidiary ledgers?

A subsidiary ledger contains detailed information on particular ledger accounts. They are used to prevent the general ledger from containing too much detail. Subsidiary ledgers are used for sales, cash, payroll and other ledger accounts which have numerous transactions that are similar in nature.

6. For each cycle in the accounting information system (sales and cash receipts, purchases and cash disbursements and payroll), describe the sequence of events. What documents are typically used in each cycle?

Sales subsystem 1) Customer orders equipment using a purchase requisition 2) The customer’s credit is approved and a sales order is issued 3) The warehouse ships the goods with a bill of lading . .

10

4) A demand for payment is sent to the customer as an invoice (or statement) 5) The journal entry to record the sale and trade accounts receivable is recorded in the sales journal 6) The sales journal is posted to the receivables subsidiary ledger 7) The sales journal entries are summarized and the total is recorded in the general journal 8) The summarized general journal entry is posted to the general ledger Cash receipts subsystem 1) Payment is received from the customer and listed on a cash receipts list 2) The payment is deposited which the bank verifies with a deposit slip 3) The cash receipt is recorded in the cash receipts journal 4) The cash receipts journal is posted to the receivables subsidiary ledger 5) The cash receipts journal entries are summarized and the total is recorded in the general journal 6) The summarized general journal entry is posted to the general ledger Sales returns and allowances subsystem 1) A sales return or allowance is requested by a customer 2) The customer is given credit for the return or allowance by issuing a credit memo 3) A journal entry is recorded in the sales returns and allowances journal 4) The journal entry is posted to the receivables subsidiary ledger 5) The sales returns and allowances journal entries are summarized and recorded in the general journal 6) The summarized general journal entry is posted to the general ledger Purchases subsystem 1) An internal department orders goods or services by issuing a purchase requisition 2) The order is approved and a purchase order is prepared and sent to the supplier 3) The goods or services are received and listed on the receiving report 4) The supplier sends an invoice demanding payment for the goods or services.

5) The amount due to the supplier is recorded in the purchases journal 6) The purchase journal entry is posted to the payables subsidiary ledger 7) The purchase journal entries are summarized and recorded in the general journal 8) The summarized general journal entry is posted to the general ledger Cash disbursements subsystem 1) Cash disbursements are processed normally on the due date by preparing a cheque or electronic funds transfer payment 2) The payment is recorded in the cash disbursements journal 3) The cash disbursements journal is posted to the payables subsidiary ledger 4) The cash disbursement journal entries are summarized and recorded in the general journal . .

11

5) The summarized general journal entry is posted to the general ledger Purchase returns and allowances subsystem 1) A request is made to the supplier for a return or allowance and is granted 2) A debit memo is prepared 3) A journal entry is recorded in the purchase returns and allowances journal 4) The purchase returns and allowance journal entry is posted to the payables subsidiary ledger 5) The purchase returns and allowances journal entries are summarized and recorded in the general journal 6) The summarized general journal entry is posted to the general ledger Employee compensation cycle 1) The business hires an employee and a personnel record is established 2) The employee provides services and is paid by cheque or electronic funds transfer 3) A journal entry to record payment to the employee is recorded in the payroll journal 4) The payroll journal is posted to the payroll subsidiary ledger 5) The payroll journal entries are summarized and recorded in the general journal 6) The summarized general journal entry is posted to the general ledger 7. Describe the major functions of the fixed-asset cycle.

The fixed assets cycle processes records for noncurrent assets like property, plant and equipment and intangible assets. The fixed assets cycle generates entries for depreciation expense and also maintains an asset register which is used to verify the physical existence of the assets.

8. Describe the major functions of the inventories and conversion cycle.

The conversion cycle, which can be quite complex, accumulates production costs. These include direct materials, direct labour and overhead. These costs are associated with specific inventories.

The inventories subsystem maintains a record of all inventory in stock, and also is the basis for determining what costs are allocated to cost of goods sold once the inventories are sold.

9. Define audit trail and describe how an audit trail is created. What is the purpose of an audit trail?

An audit trail is a system of cross-references within the accounting system that allows each transaction element (debit or credit) to be associated with the ledger account it affects. Thus any amount reported on the financial statements can be traced back to the specific journal entries that created that balance. And any journal entry can be traced forward in the accounting system to determine how it affected the financial statements.

. .

12

Terminology practice 1. Similar transactions are recorded using special journals, as referred to as day books.

2. To find all items that have affected a customer’s account, you would examine the receivables subsidiary ledger. For all items that have affected an account that the business owes, you would examine the payables subsidiary ledger.

3. When sales returns and allowances and sales discounts are subtracted from gross sales, the result is net sales.

4. The audit trail allows a transaction to be traced from the source document through the accounting system to the financial statement.

5. An invoice is a bill for goods or services.

6. Cheques sent in payment of a good or service are accompanied by a remittance advice.

7. A subsidiary ledger provides detailed information on a particular general ledger account.

8. A customer makes a request to purchase goods or services by submitting a customer purchase order. When this is is received by the business, an internal document called a sales order is prepared.

9. A bill for goods or services that has been received from a supplier is referred to as a purchase invoice.

10. In the conversion process, indirect materials and indirect labor are included in overhead.

11. When a customer requests an allowance for defective goods, a credit memo is issued. When a business requests that a supplier provide an allowance for defective goods, a debit memo is recorded.

12. When a good or service is received by a business, an internal document called a receiving report is prepared.

13. Sales discounts are reductions are offered by a business to a customer if the customer pays within a specified time period.

14. A contra account offsets another account.

15. A list of noncurrent assets including information like original cost, date purchased and serial number can be found on the asset register.

16. When production of goods has begun but has not been completed at the reporting date, we classify related costs in work-in-process. If production has been completed at the reporting date, these costs are classified as finished goods.

17. A statement is a summary of all account activity for a period of time and is used to request payment from the customer.

18. When purchase returns and allowances and purchase discounts are subtracted from gross purchases, the result is net purchases.

19. The amount an employee receives in his or her pay cheque is net pay. This is calculated by deducting payroll deductions from gross pay.

20. A department within a company uses a purchase requisition to submit a request to purchase goods.

21. Purchase discounts are reductions offered by a supplier if the business pays within a specified time period.

. .

13

Answers to Application Exercises 1. The sales subsystem flowchart would appear as follows:

Customer orders equipment

Customer purchase order

Customer’s credit approved

Sales order

Warehouse ships equipment

Sales invoice sent to customer

Shipping document (bill of lading)

Sales invoice Journal entry for sale recorded in sales journal Sales journal

Receivables sub-ledger

Sales journal posted to general ledger

General ledger

. .

14

2. The cash receipts subsystem flowchart would appear as follows: Payment received from customer

Cash receipts list

Deposit cash Bank deposit slip

Record in cash receipts journal and sub-ledger

Cash receipts journal

Receivables subledger

Post cash receipts journal to general ledger

General ledger

. .

15

3. The sales returns and allowance subsystem flowchart would appear as follows:

Sales return or allowance request from customer Customer credited for return or allowance Credit memo

Journal entry recorded in returns and allowances journal

Sales returns and allowance journal

Receivables subsidiary cu ledger

Sales and returns journal summary posted to general ledger

General ledger

. .

16

4. The purchases subsystem flowchart would appear as follows:

Internal department orders goods or services

Purchase order prepared

Goods or services received from supplier

Supplier sends invoice for payment

Purchase requisition

Purchase order for goods or services (sent to supplier)

Receiving report

Vendor invoice Journal entry recorded in purchases journal Purchases journal

Payables subsidiary ledger Purchase journal posted to general ledger General ledger

. .

17

5. The cash disbursements subsystem flowchart would appear as follows:

Cash disbursement processed

Check or electronic funds transfer sent to vendor with remittance advice

Journal entry recorded in cash disbursements journal

Cash disbursements journal Payables subsidiary ledger

Cash disbursements journal summary posted to general ledger

General ledger

. .

18

6. The purchase returns and allowances subsystem flowchart would appear as follows:

Request for purchase return or allowance Supplier grants purchase return or allowance Debit memo

Journal entry recorded in purchase returns and allowances journal

Purchase returns and allowance journal

Payables subsidiary ledger

Purchase returns and allowance journal summary posted to general ledger

General ledger

. .

19

7. The payroll subsystem flowchart would appear as follows: Business hires employee

Personnel record including deductions

PAYROLL RECORD Davis Oluyide 15 January 2011 Gross pay

Employee provides services

Checks to employee, government for income tax, insurance company for health insurance, and investment fund for retirement benefits

Deductions: Income tax Health insurance Retirement fund Total deductions

Net pay

Employee paid

$2,200

(400) (70) (130) (600)

$1,600

Record payment in payroll journal Payroll journal

Payroll subsidiary ledger

Summarize payroll journal and post to general ledger

General ledger

Answers to Comprehensive Application Exercises 1. The correcting journal entries would be as follows: Date 30 November 2010

Account titles Trade accounts receivable Sales revenue Item a. To record sales invoice.

DR €288

Date 30 November 2010

DR

Account titles Sales discount Trade accounts receivable Item b. To record sales discount on balance of €1309.

. .

CR €288

CR €9 €9

20

Date 30 November 2010

Account titles Sales Trade accounts receivable Item c. Reverse entry as invoice entered in error.

DR €120

Date 30 November 2010

Account titles Sales returns and allowances Trade accounts receivable Item c. Record credit note.

DR €120

Date 30 November 2010

Account titles Trade accounts receivable Sales Item d. Reverse entry as invoice entered in error.

DR €27

Date 30 November 2010

Account titles Cash Trade accounts receivable Item e. Record payment lodged with bank.

DR €325

Date 30 November 2010

Account titles Trade accounts receivable Sales Item f. Correct sales invoice.

DR €178

Date 30 November 2010

Account titles Cash Trade accounts receivable Item g. Reverse entry in error.

DR €47

Date 30 November 2010

DR €47

Account titles Cash Trade accounts receivable Item g. Record correct entry for customer payment.

CR €120

CR €120

CR €27

CR €325

CR €178

CR €47

CR €47

Notice for Item g. that two identical entries must be made – first to reverse the erroneous entry and then to record the entry correctly. . .

21

The corrected receivables balance is calculated as follows: Trade accounts receivable DR Beginning balance €39 982 288

CR

9 120 120 27 325 178 47 47 Ending balance

€39 807

2. The correcting journal entries would be as follows: Date 31 December 2011

Account titles Purchase Trade accounts payable Item a. to record supplier invoice.

DR £739

Date 31 December 2011

Account titles Trade accounts payable Purchase Item b. Reverse entry made in error.

DR £266

Date 31 December 2011

Account titles Trade accounts payable Purchase return and allowances Item b. Record entry for credit memo from supplier.

DR £266

Date 31 December 2011

DR £864

Account titles Trade accounts payable Trade accounts receivable Item c. Record entry to offset payable and receivable balances.

CR £739

CR £266

CR £266

CR £864

Note: Under IFRS, trade accounts receivable and trade accounts payable would not be offset on the statement of financial position. However, this is a different issue. Here the business entity has apparently reached an agreement with a customer who is also a supplier to offset amounts owed and owing. . .

22

Date 31 December 2011

Account titles Trade accounts payable Cash Item d. Record payment to supplier.

DR £1 800

Date 31 December 2011

Account titles Trade accounts payable Purchase discount Item e. Record purchase discount.

DR £85

Date 31 December 2011

DR £90

Account titles

Cash Trade accounts payable Item f. Record entry to correct payment made to supplier.

. .

CR £1 800

CR £85

CR £90

23

Instructor Manual Chapter 7 Nonfinancial Assets . .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

4

Learning Outcome 1 Learning Outcome 2 Learning Outcome 3 Learning Outcome 4 Learning Outcome 5

4 4 9 12 14

Answers to Review Questions

16

Answers to Terminology Practice

18

Answers to Application Exercises

20

Case Analysis

28

Additional Case: Aussie Pies (A)

. .

2

Lecture Notes Introduction This chapter covers basic non-financial assets including inventories; property, plant and equipment; intangible assets; and investment properties. Though different instructors will have their own approaches, I teach this chapter with an emphasis on how asset costs are allocated to the statement of comprehensive income. The chapter begins with a brief discussion on capitalization and then examines the techniques for reallocating asset costs to expense – for example, inventory costs flow assumptions, depreciation methods and amortization of intangibles. In addition, other issues like what costs are capitalized, revaluations and impairments of assets and ratio analysis are included.

. .

3

Answers to Learning Outcome Questions Learning Outcome 1 Define capitalization On Your Own 1. What is a capital expenditure? Which financial statement does it appear on?

Capital expenditure refers to an expenditure that is capitalized as an asset and therefore appears on the statement of financial position.

2. What is revenue expenditure? Which financial statement does it appear on?

Revenue expenditure refers to an expenditure that is classified as an expense and therefore appears on the statement of comprehensive income.

Learning Outcome Practice 1. A business’s statement of comprehensive income for the year ended 31 December 2009 showed a profit of $83 600. It was later found that $13 500 was paid for the purchase of a motor van that had been debited to the motor expenses account. What would the profit be after adjusting for this error? c. $97 100 2. If a capital expenditure is incorrectly classified as revenue expenditure, how will net profit and net assets be affected?

Net Profit Net assets a.

Understated Understated Learning Outcome 2.1 What costs should be included in inventories?

On Your Own 1. What costs should be included in inventories?

Inventory costs include the cost of purchase, the cost of conversion for manufacturers and other costs incurred to bring the inventories to their present location and condition.

2. Are carriage-inwards costs capital expenditures or revenue expenditures?

. .

4

Carriage-inwards costs are capitalized since they relate to bringing the inventories to their present location and condition.

3. Are carriage-outwards costs capital expenditures or revenue expenditures?

Carriage-outwards costs are revenue expenditures since they relate to the shipment of goods to customers. They are therefore a sales cost – not an inventories cost.

4. What is the cost of goods available? How is the cost of goods available calculated?

The cost of goods available is the total costs of all goods available for sale during the period. It is calculated by adding beginning inventories and net purchases for the period. Net purchases is calculated by adding purchases, carriage-inwards and other costs and then subtracting purchase returns and allowances and purchase discounts.

Learning Outcome Practice 1. Which of the following costs should be included in the inventories of a manufacturing company? i. Carriage inwards ii. Carriage outwards iii. Factory costs iv. Administrative expenses d. i and iii only Learning Outcome 2.2.1 What is specific identification?

On Your Own 1. The journal entries to record the sale transaction would be as follows: Date 1 February 2009

Date 1 February 2009

Account titles Cash Sales revenue

CR €29 800

Account titles Cost of goods sold Inventories

DR €29 800

DR €14 500

CR €14 500

Learning Outcome 2.2.2 What are cost flow assumptions?

On Your Own . .

5

1. What are the two inventory cost flow assumptions permitted under IFRS? First in, first out and average cost.

2. What is meant by FIFO? FIFO refers to first-in, first-out. Under FIFO the oldest costs (first-in) are allocated to costs of goods sold. The newest costs (last-in) are allocated to ending inventory.

3. Where are the first costs assigned under FIFO? To cost of goods sold or ending inventories?

Cost of goods sold.

Learning Outcome Practice 1. Following are the inventory cost calculations.

Date 1 Oct 2011 3 Oct 2011 7 Oct 2011 16 Oct 2011 25 Oct 2011 30 Oct 2011 Totals

Quantity 7800 2000 3500 1500 4400 1700 20 900

Cost per plank $3.10 3.10 3.12 3.17 3.18 3.20

Average cost per plank Units sold

Total cost $24 180 6 200 10 920 4 775 13 992 5 440 $65 507

$3.1343 = $65 507 ÷ 20 900 12 700 = 20 900 – 8200

a) Under the AVCO method, calculate the cost of ending inventory. $25 701 = 8200 x $3.1343 b) Under the AVCO method, calculate the cost of goods sold. $39 806 = 12 700 x $3.1343 c) What is the month-end entry to record the cost of goods sold under AFCO? Date 31 October 2011

. .

Account titles Cost of goods sold Inventories

DR $39 806

CR $39 806

6

d) Under the FIFO method, calculate the cost of ending inventory.

Date 7 Oct 2011 16 Oct 2011 25 Oct 2011 30 Oct 2011 Ending inventories

Quantity 600 1500 4400 1700 8200

Cost per plank 3.12 3.17 3.18 3.20

Total cost $1 872 4 775 13 992 5 440 $26 079

e) Under the FIFO method, calculate the cost of goods sold.

Date 1 Oct 2011 3 Oct 2011 7 Oct 2011 Totals f)

Quantity 7800 2000 2900 12 700

Cost per plank $3.10 3.10 3.12

Total cost $24 180 6 200 9 048 $39 428

What is the month-end entry to record the cost of goods sold under FIFO?

Date 31 October 2011

Account titles Cost of goods sold Inventories

DR $39 428

CR $39 428

Learning Outcome 2.3 How frequently are inventory costs updated?

On Your Own 1. Explain the difference between perpetual and periodic methods.

Under the perpetual method, inventory values are updated each time a sale transaction occurs. This requires two entries – one to record the revenue transaction and the second to record the allocation of the inventories costs for that transaction to cost of goods sold. The perpetual method can be used with both FIFO and AVCO. Under the periodic method, inventories costs are allocated to cost of goods sold at the end of the period.

2. Is specific identification a perpetual or periodic inventory method?

Specific identification is by definition a perpetual method of inventory. As each sale occurs, the related inventory cost which can be specifically identified for the goods sold is reclassified to cost of goods sold. . .

7

Learning Outcome 2.4 What inventory adjustments should be made when inventory values decline?

On Your Own 1. What is the value of the company’s closing inventory of engines on 30 April 2011? a. $188 500 2. What was the effect of the error on the profit reported in Colin’s accounts for each of the two years?

2009 2010 b. Overstated by $900 Understated by $900 3. At what value should the clock be included in Kieron’s inventory? b. $15 800 4. What adjusted figure should be included in the financial statements for inventories at 31 December 2009? c. $859 500 5. Based on this information, what is the cost of the inventories destroyed in the fire? b. $140 000 Learning Outcome 2.5 How are inventories evaluated?

On Your Own 1. Explain the two approaches for interpreting ratios.

The first approach is to hold the denominator constant and look at changes to the numerator. For example, for the inventories turnover ratio, one would ask: “If average inventories remain the constant, should sales increase or decrease?”

The second approach is to hold the numerator constant and look at changes to the denominator. For example, for the inventories turnover ratio, one would ask: “If sales remain the same, should average inventories increase or decrease?”

2. What are the two key ratios used to evaluate inventories? . .

8

Inventories turnover ratio and days in inventory

Learning Outcome Practice 1. A company has beginning inventories of ¥1 500 000 and ending inventories of ¥1 400 000 for the reporting period. Gross profit is ¥4 000 000 and revenue is ¥10 000 000. Profit for the period is ¥1 000 000. What is the inventories turnover ratio? b.

6.9 2. A company has beginning inventories of ¥1 500 000 and ending inventories of ¥1 400 000 for the reporting period. Gross profit is ¥4 000 000 and revenue is ¥10 000 000. Profit for the period is ¥1 000 000. What are the days in inventory? c.

52.9

Learning Outcome 3 Explain accounting for property, plant and equipment Learning Outcome 3.1 What costs are included in property, plant and equipment?

On Your Own 1. What conditions must be met in order to recognize an asset?

An asset is recognized when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.

2. What are trade discounts and rebates?

Trade discounts and rebates are reductions to list price provided to valued customers or as incentives to purchase, respectively.

3. What is residual value? What is useful life?

Residual value is the estimated amount that an entity would currently obtain from disposal of an asset, after deducting the estimated costs of disposal, if the asset were already at the age and in the condition expected at the end of its useful life.

Useful life is either (a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by the entity. . .

9

4. How is the depreciable amount calculated?

The depreciable amount = cost less residual value

5. Explain the difference between depreciable amount and asset cost.

The difference is residual value.

6. Explain the difference between residual value and depreciable amount.

Depreciable amount is the amount to be allocated to expense over the useful life of the asset.

Residual value will not be allocated to expense.

Learning Outcome Practice 1. An asset cost ¥850 000. Its residual value is ¥150 000 and the useful life is estimated at eight years.

What is the depreciable amount? d. ¥700 000

Learning Outcome 3.2 How it the cost of property, plant and equipment expensed?

On Your Own 1. Name the principal methods of allocating the depreciation amount over the useful life of property, plant and equipment.

The depreciable amount can be allocated using straight-line method, units-of-production method or diminishing balance method.

2. What is the difference between depreciation expense and accumulated depreciation?

Depreciation expense is the amount of the asset’s cost allocated to the current period while accumulated depreciation is the sum total of all depreciation expense over the asset’s useful life.

3. How is depreciation expense calculated under the straight-line method?

The depreciable amount is calculated by subtracting residual value from cost. Depreciable amount is then divided by useful life to obtain depreciation expense.

4. How is depreciation expense calculated under the units-of-production method?

The depreciable amount is calculated by subtracting residual value from cost. Depreciable amount is then divided by the number of units the equipment is expected to produce or operate over its useful

. .

10

life. This unit cost is then multiplied times the actual number of units to obtain the current period’s depreciation expense. Units can be any base such as production units or hours of operation.

5. How is depreciation expense calculated under diminishing balance method?

First, useful life is divided into one to give a fraction. This faction is then multiplied by two (in the case of double diminishing balance) to calculate the diminishing balance depreciation rate. The diminishing balance depreciation rate, which remains constant, is then multiplied by the carrying value to calculate depreciation expense for the period.

6. Which depreciation method increases profit during the earliest years of the asset’s useful life?

The straight-line method increases profit during the earliest years of an asset’s useful life. This is because the amount of depreciation expense is less than it would be under the diminishing balance method which depreciates more of the asset cost in the early years of the asset’s useful life.

7. Which depreciation method results in the highest carrying amount for an asset during the earliest years of its useful life?

Because the straight-line method allocates less of the asset cost to depreciation expense in the early years of the asset’s useful life, its carrying value would be higher.

8. Which amount is temporary: depreciation expense or accumulated depreciation?

Depreciation expense is a temporary account and is closed at the end of the period. Accumulated depreciation is a permanent account.

Learning Outcome Practice 1. What is the depreciation charge on the machine for the year to 31 October 2009? a. $3100 2. How will the business’s profit for the year ended 31 December 2010 be affected by the error? a. Understated by $18 400

Learning Outcome 3.3 How do we account for a change in the value of property, plant and equipment expensed?

On Your Own 1. To what does impairment refer?

Impairment refers to a decline in value of an asset. . .

11

2. How can a business determine whether an asset is impaired?

An impairment loss has occurred if the if the amount of the carrying amount of the asset exceed its recoverable amount.

3. Define recoverable amount, fair value less costs to sell and value in use.

Fair value less costs to sell is the amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal. The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use. Value in use is the present value of the future cash flows expected to be derived from an asset or cash-generating unit.

4. What are the two models for revaluing property, plant and equipment?

The cost model and the revaluation model Learning Outcome Practice 1. Under the revaluation model, how often should management determine the fair value of the asset? b. Once per year 2. A company originally purchased equipment at $45 000. Its carrying amount is now $25 000. The equipment is now valued at $47 000. The journal entry to adjust the asset value under the revaluation model would include a: c. Credit revaluation reserve for $2000

Learning Outcome 3.4 How do we account for the disposal of property, plant and equipment expensed?

On Your Own Learning Outcome Practice 1. What is the depreciation charge on the new machine for the year ended 31 October 2010? d. $3578

Learning Outcome 4 Explain accounting practices for intangible assets.

On Your Own . .

12

1. What are examples of intangible assets?

Common examples of intangibles include computer software, patents, copyrights, motion picture films, customer lists, franchises and marketing rights.

2. When an intangible asset is acquired externally, what is the appropriate accounting?

An externally acquired intangible asset is recorded at cost.

3. When an asset is developed internally, what is the appropriate accounting?

Research costs to develop an intangible asset are always expensed. Development costs can be capitalized if certain criteria are met.

4. What is the difference between research and development?

Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge tgo a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of current production or use.

5. How are research costs accounted for?

Research costs are immediately expensed.

6. What two models can a reporting entity use to account for changes to the value of intangible assets?

Cost model and revaluation model 7. What is goodwill? How is it created?

Goodwill is an intangible asset that is created when the amount paid for a business exceeds the fair value of the net assets acquired.

Learning Outcome Practice 1. Which of the following statements is/are correct? i. Capitalized development expenditure must be amortized over a period not exceeding five years. ii. Capitalized development costs are shown in the statement of financial position under the heading of noncurrent assets. iii. If certain criteria are met, research expenditure can be recognized as an intangible asset. a. ii only 2. At 31 December 2012, Manchester Software Systems Ltd had capitalized software costs of €900 000. The useful life was estimated at four years, with no residual value. Sales for 2013 were 10% of . .

13

the total expected sales of the software. At the 2013 year-end, the software had a recoverable amount of €720 000. What amount should Manchester report as the net capitalized software on its 31 December 2013 statement of financial position? c. €720 000

3. Netherland Company acquired a patent on 1 January 2011 for $112 500. This amount was to be amortized over 15 years with no residual value. In 2014, Netherland sued another company for infringement of its patent rights. Legal fees were $37 500, although no settlement was received.

That year, Netherland sold the patent for $187 500. Assuming that no amortization expense was recognized in 2014, what amount would Netherland report in its 2014 statement of comprehensive income for gain on sale of patent? c. $67 500 4. Which of the following statements about intangible assets are correct? i. If certain criteria are met, research expenditure may be recognized as an intangible asset. ii. Goodwill may not be revalued upwards. iii. Internally generated goodwill should not be capitalized. a. ii and iii only 5. Which of the following statements about intangible assets in company financial statements are correct according to international accounting standards? i. Internally generated goodwill should not be capitalized. ii. Purchased goodwill should normally be amortized through the statement of comprehensive income. iii. Development expenditure may be capitalized if certain conditions are met. a. i and iii only

Learning Outcome 5 Explain accounting practices for investment properties On Your Own 1. How is an investment property different from property, plant and equipment?

Investment property is held to earn rental income or for capital appreciation while property, plant and equipment is for use in production, administration or for sale in the ordinary course of business.

2. Under IFRS, what are the two accounting methods businesses can choose for accounting for investment property?

Cost model or fair value model . .

14

Learning Outcome Practice 1. Which of the following would not qualify as an investment property? c.

Trademark

2. Which is inaccurate regarding the accounting for investment property? a.

The carrying amount cannot be historical cost.

. .

15

Review Questions 1. If a capital expenditure has been expensed before the cost has expired, what is the impact on profit or loss? If a capital expenditure has not been expensed once the cost has expired, what is the impact on profit or loss?

If a capital expenditure is expensed before the cost has actually expired, the profit would be understated. Or if the entity has a loss then the loss would be overstated. If a capital expenditure has not been expensed when the cost has in fact expired, profit is overstated and if the entity has a loss, it is understated.

2. How do a manufacturer’s or merchandiser’s inventories differ from a service firm’s?

Manufacturers, merchandisers and service firms can all have inventory costs reported on the statement of comprehensive income. However, the service firm’s inventories are not physical as would be the manufacturers’ and merchandisers’.

3. What choices does management have for allocating the cost of goods available between ending inventories and cost of goods sold?

Management can use specific identification of inventory costs. Or it can use a cost flow assumption; first-in, first-out or average cost. In addition, management can choose to allocate inventory costs on either the perpetual or periodic basis.

4. What costs are included in property, plant and equipment? How are these costs allocated to reporting periods? What accounting options does management have after acquisition of property, plant and equipment? What effect does the choice of depreciation have on profit or loss? How do we account for the disposal of property, plant and equipment?

Costs include purchase price, import duties, taxes and any other cost to bring the asset to the location and condition necessary for use as management intended. Property, plant and equipment costs are allocated to expense based on one of three methods; straight-line, units-of-production or diminishing balance.

The choice of depreciation method affects profit or loss. Use of the diminishing balance method accelerates the recognition of depreciation expense and therefore reduces the amount of profit in the earlier years of the asset’s life. If straight-line method is used, profit is higher when compared to the diminishing balance method. No prediction can be made about profit under the units-ofproduction methods since the amount of depreciation expense is based on actual usage.

When an asset is disposed of, the gain or loss is calculated as the difference between the amount of consideration received for the asset and its carrying amount.

. .

16

5. Which intangible asset costs are capitalized? Which are expensed? How are capitalized intangible asset costs allocated to reporting periods? What is goodwill and how is it accounted for?

If an intangible asset is acquired externally, the cost is capitalized. If it is developed internally, research costs are always expensed. Development costs may in some cases be capitalized.

Intangible asset costs are amortized similarly to the way in which tangible assets are depreciated.

Allocation can be based on straight-line, units-of-production or diminishing balance.

Goodwill is the difference between what is paid to acquire a business and the fair value of the acquired net assets. Goodwill is not amortized though impairment losses must be recognized.

6. What is investment property? How is a gain or loss on investment property accounted for?

Investment properties are land or buildings held for rental income or capital appreciation. Any gains and losses from changes to the investment property’s fair value are recognized in profit or loss.

. .

17

Answers to Terminology Practice 1. Cost of goods available is equal to beginning inventory plus net purchases for the reporting period.

2. Useful life is either the period over which an asset is expected to be available for use by an entity or the number of production units expected to be obtained from the asset by the entity.

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

4. The inventories turnover ratio is calculated by dividing sales by average inventories.

5. Property, plant and equipment are tangible items that are held for use in production or supply of goods or services for rental to others or for administrative purposes, and expected to be used during more than one period.

6. The method of allocating property, plant and equipment costs to a reporting period that expenses the depreciable amount in equal instalments is the straight-line method.

7. The systematic allocation of the depreciable amount of an asset over its useful life is depreciation for property, plant and equipment, and amortization for intangible assets.

8. The carrying amount is the amount at which an asset is recognized in the statement of financial position. This amount is sometimes referred to as book value or net book value.

9. The method of determining whether inventories have declined below the carrying amount is called the lower of cost and net realizable value.

10. The first-in, first-out method assigns the oldest costs to cost of goods sold and the most recent costs to ending inventories.

11. In consignment sales, ownership of the goods does not pass to the seller.

12. Fair value is the amount for which an asset could be exchanged, or a liability settled between knowledgeable, willing parties in an arm’s-length transaction.

13. Research assets are not capitalized but expressed immediately.

14. Residual value is the estimated amount that an entity would currently obtain from disposal of an asset, after deducting the estimated costs of disposal, if the asset were already at the age and in the condition expected at the end of its useful life.

15. The method of allocating property, plant and equipment costs to a reporting period that is based on use of the asset rather than time is the units-of-production method.

16. An intangible asset is an asset without physical substance.

17. The method of allocating property, plant and equipment costs to a reporting period that accelerates depreciation when compared to the straight-line method is diminishing balance method, also referred to as the declining balance method or reducing balance method.

18. Assets held for sale in the ordinary course of business, in the process of production for such sale or in the form of materials and supplies to be consumed in production are inventories.

19. Under the periodic inventory method the cost of goods available is allocated between ending inventories and costs of goods sold at the end of the reporting period.

20. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use. . .

18

21. Investment property is a land or building held to earn rentals or for capital appreciation or both rather than for use in the production or supply of goods or services or for administrative purposes, or sale in the ordinary course of business.

22. When property, plant and equipment and intangible assets decline in value below their carrying amounts, then an impairment loss may need to be recorded.

23. The average cost method calculates an average cost of inventory items for the reporting period and then allocates the cost of goods available based on the result.

24. The method of inventory used when goods or services produced are not normally interchangeable is the specific identification.

25. Net realizable value is the estimated selling price in the ordinary course of business less the estimated selling costs of completion and the estimated costs necessary to make the sale.

26. Trade discounts and rebates are reductions to the selling price provided by a seller to customers as an incentive to purchase.

27. A property - which are also referred to as plant and equipment, fixed assets or depreciable assets, means that a cost has been capitalized.

28. Days in inventory is calculated by dividing the number of days in the year by the inventories turnover ratio.

29. Work-in-process are goods or services on which production has begun but not been completed.

30. The perpetual inventory method calculates the amount of inventory costs allocated to cost of goods sold with each sale transaction.

31. Goodwill is an asset representing the future economic benefits arising from other assets being acquired in a business combination that are not individually identified and separately recognized.

. .

19

Answers to Application Exercises 1. Inventory calculations under FIFO and average cost are as follows: Date No. of Units Unit Cost 1 June 2009 1000 €85 15 June 2009 2200 90 20 June 2009 3100 100 25 June 1900 110 Totals 8200 Average cost = €802 000 ÷ 8200 = €97.8049

Total cost €85 000 198 000 310 000 209 000 €802 000

8200 units available – 700 units in ending inventory = 7500 units sold FIFO Category Cost of goods sold

Quantity 7500

Cost €85 000 = 1000 x €85 198 000 = 2200 x 90 310 000 = 3100 x 100 132 000 = 1200 x 110 €725 000 7500 700 €77 000 = 700 x 110 8200 €802 000 8200

Ending inventory Totals Average cost Category Cost of goods sold Ending inventory Totals

Quantity Cost 7500 €733 536 = 7500 x €97.8049 700 €68 463 = 700 x €97.8049 8200 €801 9991 8200

2. Inventory transactions under the perpetual method are as follows: FIFO Date 12 March 2009

Account titles Inventories Cash

DR $46 560

CR $46 560

$46 560 = 60 x $776 1

. .

Rounding difference.

20

Date 15 April 2009

Account titles Cash Sales revenue

DR $88 000

CR $88 000

$88 000 = 80 x $1100

Date 15 April 2009

Account titles Cost of goods sold Inventory

DR $63 400

CR $63 400

$63 400 = (55 x $800) + (25 x $776) 35 units remain in inventory at $776 each

Date 20 April 2009

Account titles Inventories Cash

DR $52 500

CR $52 500

$52 500 = 70 x $750

Date 25 April 2009

Account titles Cash Sales revenue

DR $88 000

CR $88 000

$63 000 = 60 x $1050

Date 25 April 2009

Account titles Cost of goods sold Inventory

DR $45 910

CR $45 910

$45 910 = (35 x $776) + (25 x $750) 45 units remain in inventory at $750 each

Date 5 May 2009

Account titles Cash Sales revenue

DR $10 700

CR $10 700

$63 000 = 10 x $1070

Date May 5 2009

. .

Account titles Cost of goods sold Inventory

DR $7500

CR $7500

21

$7500 = 10 x $750 35 units remain in inventory at $750 each

Date 18 May 2009

Account titles Inventories Cash

DR $153 000

CR $153 000

$153 000 = 200 x $765

Cost of goods sold $116 810 = $63 400 + $45 910 + $7500 Ending inventories $179 250 = (35 x $750) + (200 x $765)

Average cost Date 12 March 2009

Account titles Inventories Cash

DR $46 560

CR $46 560

$46 560 = 60 x $776 Inventory average cost $786.96 = [(55 x 800) + (60 x 776)] ÷ 115

Date 15 April 2009

Account titles Cash Sales revenue

DR $88 000

CR $88 000

$88 000 = 80 x $1100

Date 15 April 2009

Account titles Cost of goods sold Inventory

DR $62 957

CR $62 957

$62 957 = 80 x $786.96 35 units remain in inventory at $786.96 each

Date 20 April 2009

Account titles Inventories Cash

DR $52 500

CR $52 500

$52 500 = 70 x $750 Inventory average cost $762.32 = [(35 x 786.96) + (70 x 750.00)] ÷ 105 Date

. .

Account titles

DR

CR

22

25 April 2009

Cash Sales revenue

$88 000 $88 000

$63 000 = 60 x $1050

Date 25 April 2009

Account titles Cost of goods sold Inventory

DR $45 739

CR $45 739

$45 739 = 60 X $762.32 45 units remain in inventory at $762.32 each

Date 5 May 2009

Account titles Cash Sales revenue

DR $10 700

CR $10 700

$63 000 = 10 x $1070

Date May 5 2009

Account titles Cost of goods sold Inventory

DR $7623

CR $7623

$7623 = 10 x $762.32 35 units remain in inventory at $762.32 each

Date 18 May 2009

Account titles Inventories Cash

DR $153 000

CR $153 000

$153 000 = 200 x $765 Inventory average cost $764.60 = [(35 x 762.32) + (200 x 765.00)] ÷ 235

Cost of goods sold $116 319 = $62 957 + $45 739 + $7623 Ending inventories $179 681 = 235 x $764.60

. .

23

3.

Following are the missing amounts.

Company A Revenue Cost of goods sold Profit or loss Total cost of goods available Purchases Gross profit Beginning inventories

Company B

$900 250 1200

$900

800

700 280

1110

Company C $1620

840 670 930

4. Following is the schedule for depreciation expense and carrying amount.

Date 31 December 2009 31 December 2010 31 December 2011 31 December 2012

Annual depreciation expense $448 500 224 250 112 125 56 063

Carrying amount at year end $448 500 224 250 112 125 56 063

5. Following is the schedule for depreciation expense and carrying amount.

Date 31 December 2009 31 December 2010 31 December 2011 31 December 2012

Annual depreciation expense $186 750 186 750 186 750 186 750

Carrying amount at year end $710 250 523 500 336 750 150 000

6. Following is the schedule for depreciation expense and carrying amount.

Date 31 December 2009 31 December 2010 31 December 2011 31 December 2012

. .

Annual depreciation expense $138 195 150 147 164 340 156 870

Carrying amount at year end $758 805 608 658 444 318 287 448

24

7. Following are the schedules for FIFO and AVCO. FIFO Revenue Beginning inventories Purchases Cost of goods available Less: Ending inventories Cost of goods sold Gross profit Other expenses Profit or loss

AVCO $44 000

$44 000

$3 000 16 900 19 900 5 600

$3 000 16 900 19 900 7 164 14 300 $29 700 11 000 $18 700

12 736 $31 264 11 000 $20 264

8. Following is the inventory schedule for Prater Luxury Linens.

Date No. of Units 1 February 2011 1 250 3 February 2011 550 14 February 2011 400 Goods available 2 200 Average cost per unit £18.25

Unit Cost £18 19 18

Total cost £22 500 10 450 7 200 £40 150

Units sold 1 320 = 600 + 720 Ending inventory 880 = 2 200 – 1 320 FIFO Cost of goods sold £23 830 = (1 250 x £18) + (70 x £19) Ending inventory £16 320 = (480 x £19) + (400 x £18) Average cost Cost of goods sold £24 090 = 1 320 x £18.25 Ending inventory £16 060 = 880 x £18.25 9. Following are the calculations for Simon. (a) The depreciation charge for the machinery for the year to 31 October 2011.

Carrying value of machinery for year Subtract: Carrying amount of machine traded in Add: Carrying amount of new machine* Total amount depreciable amount

$94 570 (5 000) 66 000 $155 570

*The journal entry to record the acquisition of the new machine on trade would be as follows. . .

25

Date 31 October 2011

Account titles New machine Accumulated depreciation – old machine Machine – old Cash ($50 000 - $14 000)

DR $66 000 5 000

CR

$35 000 36 000

Depreciation charge $31 114 = 20% x $155 570 (b) Ledger accounts would show the following balances at year end: Machinery at cost Cost at 1 November 2010 Subtract: Cost of machinery traded in Add: Cost of new machine Cost at 31 October 2011

$140 900 (35 000) 66 000 $171 900

Accumulated depreciation Accumulated depreciation at 1 November 2010 Accumulated depreciation of machine traded in Accumulated depreciation of new machine Accumulated depreciation at 31 October 2011

$46 330 (30 000) 13 200 $29 530

(c) Depreciation expense would reported on the statement of comprehensive income for the year ended 31 October 2011 would be $31 114 (see a above) (d) The balances reported on the statement of financial position at 31 October 2011 would be as follows.

Machinery at cost Less: Accumulated depreciation Carrying amount

$171 900 (29 530) $142 370

10. Figures for the wholesale firm would be as follows.

The number of items in inventory: Items in beginning inventory Add purchases: 1140 + 1310 + 620 Subtract sales: 1040 + 1840 Items in ending inventory

480 3 070 (2 880) 670

The value of ending inventory at 31 October 2010 on a FIFO basis: . .

26

$103 600 = (50 x $150) + (620 x $155) Cost of sales for October 2010 Purchases $411 900 = (480 x $120) + (1140 x $145) + (1260 x $150) Cost of sales $415 650 = $411 900 + $3 750 Gross profit for October 2010 Based on the erroneous loss reported by the trainee: Revenue – purchases – other costs = loss Revenue - $57 600 - $138 080 = -$35 580 Revenue = $160 100 Gross profit -$255 550 = $160 100 - $415 650 Net profit for October 2010 Revenue Cost of sales including carriage inwards Gross profit Other costs: Wages of staff Premises expenses Administrative expenses Selling and marketing costs Carriage outwards Depreciation Net profit (loss)

$160 100 (415 650) ($255 550) $44 700 42 750 13 620 17 890 4 120 11 250

134 330 ($389 880)

Net assets at 31 October 2010 Net assets as reported by trainee Closing inventory (see above) Corrected net assets

. .

$283 468 103 600 $387 068

27

Case Analysis Botswana Wildlife Safaris, LLC Following are all journal entries and adjusting entries for 2009 through 2011. In addition, the noncurrent sections of the statement of financial position are included.

Journal entries for 2009 New river campsite. To record purchase of the land and building for the new river campsite.

DATE 30 Jan 2009

ACCOUNT TITLES Land – new campsite Building – new campsite Cash

DR. €30 000 120 000

CR.

€150 000

New river campsite. To record the cost of painting the fence at the new campsite.

DATE 23 Mar 2009

ACCOUNT TITLES Maintenance expense Cash

DR. €1 800

CR. €1 800

2009 Year-end adjusting entries Storage and repair facility. To recognize depreciation expense for the storage and repair facility at yearend. The depreciation expense is calculated at €4 000 (€125 000 – 25 000/25 years).

DATE 31 Dec 2009

ACCOUNT TITLES Depreciation expense – Storage and repair facility Accumulated depreciation - Storage and repair facility

DR. €4 000

CR.

€4 000

Old river campsite. To recognize depreciation expense for the old river campsite. This is calculated at €5 600 (€160 000 – 20 000/25 years).

DATE 31 Dec 2009

. .

ACCOUNT TITLES Depreciation expense – river campsite Accumulated depreciation – river campsite

DR. €5 600

CR. €5 600

28

New river campsite. To recognize depreciation expense for the new river campsite. The land value would be €30 000 of the €150 000 purchase price. The building cost is thus €120 000 which is 80% of the purchase price. Thus, the depreciable amount is €100 000 (€120 000 – 20 000). Depreciation expense would be calculated at €4 000 (€100 000/25 years) per year. Since the asset was acquired on 30 January 2009 depreciation expense would be €4 000 x 11/12 or €3 667.

DATE 31 Dec 2009

ACCOUNT TITLES Depreciation expense – new campsite Accumulated depreciation – new campsite

DR. €3 667

CR. €3 667

Equipment. To recognize depreciation expense for the equipment calculated at €65 000 (€350 000 – 25 000 ÷ 5).

DATE 31 Dec 2009

ACCOUNT TITLES Depreciation expense – equipment Accumulated depreciation – equipment

DR. €65 000

CR. €65 000

Vehicles. To recognize depreciation expense for the three vehicles. Depreciable cost is calculated as €450 000 (€510 000 – 60 000 residual value) divided by a total estimated 900 000 kilometers to give €0.50 per kilometer. This is then multiplied times the actual kilometers driven since 1 January 2009 when the company was acquired, or 72 000 kilometers to give €36 000.

DATE 31 Dec 2009

ACCOUNT TITLES Depreciation expense – Vehicles Accumulated depreciation – Vehicles

DR. €36 000

CR. €36 000

Software. To recognize amortization expense for the software at €9 500 (€28 500 ÷3).

DATE 31 Dec 2009

ACCOUNT TITLES Amortization expense – software Software

DR. €9 500

CR. €9 500

Revaluation and impairment entries Equipment. The impairment loss is recognized for the defective tents. The carrying amount of the tents is now zero.

DATE 31 Dec 2009

ACCOUNT TITLES Loss on impairment of equipment Accumulated impairment loss - equipment

Investment in property . .

DR. €145 000

CR. €145 000

29

Investment carrying amount

€35 000

Fair value Less: current carrying amount Revaluation

€50 000 35 000 €15 000

The journal entry for the investment in property recognizes the change in value in profit and loss: DATE 31 Dec 2009

ACCOUNT TITLES Investment in property Gain on investment in property

DR. €15 000

CR. €14 000

The statement of financial position would appear as follows at 31 December 2009.

Botswana Wild Tours Statement of Financial Position As at 31 December 2009 € thousands Non-current assets Storage and repair facility Land Buildings Accumulated depreciation – facility

50 000 125 000 (36 000)

139 000

Old river campsite Land Building Accumulated depreciation – campsite

40 000 160 000 (50 400)

149 600

New river campsite Land Building Accumulated depreciation – campsite

30 000 120 000 (3 667)

116 333

Equipment - tents Accumulated impairment loss Accumulated depreciation – equipment

350 000 (145 000) (205 000)

0

Vehicles Cost Accumulated depreciation – vehicles

510 000 53 000

457 000

Intangible assets – software

. .

9 500

30

Investment in property Total non-current assets

50 000 921 433

Journal entries during 2010 New vehicle. On 30 September 2010 Tony trades Vehicle #3 for a new vehicle. The calculation of the new vehicle cost would be as follows: List price of new vehicle Less: 5% trade discount Net price Trade-in allowance old vehicle Cash payment required

€180 000 (9 000) 171 000 20 000 €151 000

The accumulated depreciation for Vehicle #3 would be calculated at €136 000 (272 000 miles x €0.50).

The journal entry would be as follows: DATE 09-30-2010

ACCOUNT TITLES Vehicles -- new Accumulated depreciation – Vehicle #3 Vehicles (remove Vehicle #3 at cost) Cash

DR. €185 000 136 000

CR.

€170 000 151 000

2010 Year-end adjusting entries Storage and repair facility. To recognize depreciation expense for the storage and repair facility at yearend.

DATE 31 Dec 2010

ACCOUNT TITLES Depreciation expense – Storage and repair facility Accumulated depreciation - Storage and repair facility

DR. €4 000

CR.

€4 000

Old river campsite. To recognize depreciation expense for the river campsite. This is calculated at €5 600 (€160 000 – 20 000/25 years).

DATE 31 Dec 2010

. .

ACCOUNT TITLES Depreciation expense – old campsite Accumulated depreciation – old campsite

DR. €5 600

CR. €5 600

31

New river campsite. To recognize depreciation expense for the new campsite. Depreciation expense would be calculated at €4 000 (€120 000 – 20 000/25 years).

DATE 31 Dec 2010

ACCOUNT TITLES Depreciation expense – new campsite Accumulated depreciation – new campsite

DR. €4 000

CR. €4 000

Vehicles. To recognize depreciation expense for the three vehicles. Depreciable cost for the existing vehicles was calculated €0.50 per kilometer. The vehicle mileage chart shows that 136 000 miles were driven by Vehicles #1, #2 and #3. This means that the related depreciation expense is €68 000 (136 000 x €0.50). However, the depreciation rate for the new vehicle is €0.52 (€185 000 cost - €30 000 residual value ÷ 300 000). During 2010 the new vehicle was driven 26 000 miles and therefore depreciation expense would be €13 520 (26 000 x €0.52). When the two amounts are added together, depreciation expense for all vehicles is €81 520 (€68 000 + €13 520). The entry would be as follows: DATE 31 Dec 2010

ACCOUNT TITLES Depreciation expense – Vehicles Accumulated depreciation – Vehicles

DR. €81 520

CR. €81 520

Software. To recognize amortization expense for the software at €9 500 (€28 500 ÷3). At this point, the software is fully amortized.

DATE 31 Dec 2010

ACCOUNT TITLES Amortization expense – software Software

DR. €9 500

CR. €9 500

2010 Revaluation and impairment entries Storage and repair facility

. .

Buildings Accumulated depreciation Carrying amount

€125 000 40 000 €85 000

Fair value Less: current carrying amount Revaluation

€148 000 85 000 €63 000

32

The journal entry to revalue the storage and repair facility would be as follows: DATE 31 Dec 2010

ACCOUNT TITLES Storage and repair facility Accumulated depreciation – storage and repair facility Revaluation reserve

DR. €23 000 40 000

CR.

€63 000

Old river campsite land Fair value Less: current carrying amount Revaluation

€70 000 40 000 €30 000

The journal entry to revalue the river campsite land would be as follows: DATE 31 Dec 2010

ACCOUNT TITLES River campsite land Revaluation reserve

DR. €30 000

CR. €30 000

The statement of financial position would appear as follows at 31 December 2010.

Botswana Wild Tours Statement of Financial Position As at 31 December 2010 € thousands Non-current assets Storage and repair facility Land Buildings Accumulated depreciation – facility

50 000 148 000 (0)

198 000

Old river campsite Land Building Accumulated depreciation – campsite

70 000 160 000 (56 000)

174 000

New river campsite Land Building Accumulated depreciation – campsite

30 000 120 000 (7 667)

112 333

Equipment - tents Accumulated impairment loss

350 000 (145 000)

. .

33

Accumulated depreciation – equipment

(205 000)

0

Vehicles Cost Accumulated depreciation – vehicles

525 000 (134 520)

390 480

Investment in property Total non-current assets

50 000 924 813

Journal entries during 2011 Old Equipment (Tents). To record disposal of old tents.

DATE 1 January 2011

ACCOUNT TITLES Accumulated depreciation -- equipment Accumulated impairment loss Equipment – tents

DR. €205 000 145 000

CR.

€350 000

New Equipment (Tents). To record the acquisition of the new tents.

DATE 1 January 2011

ACCOUNT TITLES Equipment Cash

DR. €375 000

CR. €375 000

Investment in property. To record the disposal of the investment property sold for €115 000.

DATE 31 Dec 2001

ACCOUNT TITLES Cash Investment in property Gain on sale of disposal of investment property

DR. €115 000

CR. €50 000 65 000

2011 Year-end adjusting entries Storage and repair facility. To recognize depreciation expense for the storage and repair facility at yearend. In 2010 the facility was revalued to €148 000 with a residual value of €25 000 resulting in a new depreciable amount of €123 000. Fifteen years remain of the useful life. Depreciation expense is €123 000 ÷ 15 = €8 200.

. .

34

DATE 31 Dec 2011

ACCOUNT TITLES Depreciation expense – Storage and repair facility Accumulated depreciation - Storage and repair facility

DR. €8 200

CR.

€8 200

Old river campsite. To recognize depreciation expense for the original river campsite. This is calculated at €5 600 (€160 000 – 20 000/25 years).

DATE 31 Dec 2011

ACCOUNT TITLES Depreciation expense – river campsite Accumulated depreciation – river campsite

DR. €5 600

CR. €5 600

New Equipment (Tents). To record depreciation of the new tents for 2011 at €70 000 = €375 000 - €25 000 residual value divided by five years useful life.

DATE 1 January 2011

ACCOUNT TITLES Depreciation expense – equipment Accumulated depreciation -- equipment

DR. €70 000

CR. €70 000

New river campsite. To recognize depreciation expense for the new campsite. Depreciation expense would be calculated at €4 000 (€120 000 – 20 000/25 years).

DATE 31 Dec 2010

ACCOUNT TITLES Depreciation expense – new campsite Accumulated depreciation – new campsite

DR. €4 000

CR. €4 000

Vehicles. To recognize depreciation expense for the three vehicles. Depreciation expense for Vehicles #1 and #2 is €42 500 = 85 000 x €0.50 plus the new vehicle which is €38 480 = 74 000 x €0.52 x 74 000.

Totaled these equal €80 980.

DATE 31 Dec 2011

. .

ACCOUNT TITLES Depreciation expense – Vehicles Accumulated depreciation – Vehicles

DR. €80 980

CR. €80 980

35

2011 Revaluation and impairment entries Old river campsite building Building Accumulated depreciation Carrying amount

€160 000 61 600 €98 400

Fair value Less: current carrying amount Revaluation

€190 000 98 400 €91 600

The journal entry to revalue river campsite would be as follows: DATE 31 Dec 2011

ACCOUNT TITLES Building – river campsite Accumulated depreciation – river campsite Revaluation reserve

DR. €30 000 61 600

CR.

€91 600

The statement of financial position would appear as follows at 31 December 2011.

Botswana Wild Tours Statement of Financial Position As at 31 December 2010 € thousands Non-current assets Storage and repair facility Land Buildings Accumulated depreciation – facility

50 000 148 000 (8 200)

189 800

Old river campsite Land Building Accumulated depreciation – campsite

70 000 160 000 (0)

230 000

New river campsite Land Building Accumulated depreciation – campsite

30 000 120 000 (11 667)

138 333

Equipment – new tents Accumulated depreciation – equipment

375 000 (70 000)

305 000

Vehicles . .

36

Cost Accumulated depreciation – vehicles Total non-current assets

. .

525 000 (215 500)

309 500 1 172 633

37

Instructor Manual Chapter 8 Financial Assets and Liabilities . .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

6

Learning Outcome 1 Learning Outcome 2 Learning Outcome 4 Learning Outcome 6 Learning Outcome 7

6 9 10 14 15

Answers to Terminology Practice

16

Answers to Application Exercises

18

Case Analysis

31

. .

2

Errata: In the Botswana Wild Safaris, LLC case on page 498 other current assets at 31 December 2010 should be €126 770. On page 499 other current liabilities at 31 December 2011 should be €451 850.

Lecture Notes Introduction Financial assets and liabilities have become a larger part of corporate accounting over the past few decades. They have also become much more complex, especially with the development of derivativesbased financial instruments. The financial crisis of 2008 with its meltdown of major capital markets was a wake-up call, in my judgment, that more curriculum emphasis is need on financial assets and liabilities.

Chapter 8 was created to address this need.

However, the issue is how much about financial assets and liabilities should be covered in the text book.

I have chosen to emphasize basic accounting issues – accounting for cash and cash equivalents, trade accounts, credit card receivables, notes and bonds. In addition, Chapter 8 discussed the four classifications for financial assets and liabilities – held-for-trading, held-to-maturity, loans and receivables and available-for-sale. Because effective interest rate method is used to account for loans and receivables and held-to-maturity assets, considerable space in Chapter 8 was devoted to an explanation of the appropriate calculations.

You might wish to point out to your classes that he “official” classification of held-for-trading is “a financial asset or liability at fair value through profit or loss”. However, in the end I defaulted to the simpler title – held-for-trading – when discussing this classification in the text.

The next logical step in Chapter 8 would have been to include a discussion on derivatives and more complex financial instruments. However, I decided not to include this in the main text book but rather developed a separate ‘technical note’ which is included in the instructor’s resources. This can be given to students, especially post-graduate students, if you wish to cover that topic.

Chapter Lecture I usually begin the discussion of financial assets and liabilities by giving students an overview of capital markets with an emphasis on the different types of instruments traded – debt, equity, derivatives and so forth. I also present figures on the size of the markets. In more recent years, I have also discussed with them the ‘meltdown’ of global financial markets in 2008 and have question, based on my professional experience, whether corporate managers and boards really understand the transactions they engage in.

As an example, I have recently used two companies, Cathay Pacific airlines and Citic Pacific, that . .

3

engaged in ‘hedging’ transactions but obviously used incorrect financial instruments. This resulted in major losses for both companies that were high profile in the media.

Learning outcome 1 Explain the accounting for cash and cash equivalents A definition of cash equivalents was presented earlier in the text book and therefore does not need to be repeated here. Three short topics are presented. The first is the different ways in which cash can be classified – restricted, compensating balance, bank overdrafts and petty cash. Bank overdrafts are a minor issue but some professional accounting examiners seem to delight in problems that involve cash accounts that are overdrawn.

The second topic is accounting for petty cash. And the last topic is the reconciliation of the cash account to the bank balance. In less developed countries where banks are less sophisticated, it may be necessary to spend some time talking about banks and what a bank statement is.

Learning outcome 2 Explain how financial assets and liabilities are classified In this outcome, my only objective is to help students develop taxonomy of the four classifications of financial assets and liabilities, and the accounting requirement for each. These are best summarized by Figure 8.5. In addition, I have added a category for other financial liabilities. What I emphasize here, is how a particular financial asset or liability is classified which is largely by management action. Thus a bond, for example, could be held-for-trading if the intent is to trade the bond based on price movements versus held-to-maturity if management’s intent is to hold the bond as an investment until it matures.

Learning outcome 3 Apply the effective interest rate method Depending on the prerequisites and the students’ prior classroom experience, some may know discounting technique and some may not. Thus a large shaded box is included within this outcome that provides three basic examples. Learning outcome 3 addresses only how to make effective interest rate calculations.

Learning outcome 4 Explain the accounting for trade accounts In this learning outcome, I addressed both trade accounts receivable and payable since the accounting treatment is basically the same. The major difference, of course, is accounting for uncollectible balances on the receivables side. . .

4

Learning outcome 6 Explain the accounting for notes Again, the outcome for notes covers both notes receivable and notes payable since the accounting is similar but just ‘mirror’ image. The emphasis is on accounting for notes using effective interest method if they are classified as ‘held-to-maturity’ or ‘loans and receivables’ under IFRS. Notes could, of course, be classified as held-for-trading in which case any gain or loss would be recognized in profit or loss. If the note is classified as available-for-sale then any gain or loss would be recognized in comprehensive income.

Learning outcome 7 Explain the accounting for bonds The treatment of bond accounting is similar to that found in many textbooks. This section begins with a discussion of the types of bonds and then the sale of bonds at par, premium and discount.

Learning outcome 8 Evaluate assets and liabilities A discussion of the following liquidity ratios is included in this outcome – working capital, current ratio, acid-test ratio, cash ratio, receivables turnover ratio and average collection period. Solvency ratios include the debt ratio.

ERRATA: Please notice that on page 483 in the top box that the 200 000 at the head of the column should not appear.

. .

5

Answers to Learning Outcome Questions Learning Outcome 1 Explain the accounting for cash and cash equivalents.

On Your Own 1. Define financial asset and financial liability.

Financial assets may be: (a) cash; (b) an equity instrument of another entity; (c) a contractual right to receive cash for financial asset from another entity, or to exchange financial assets or financial liabilities with another entity that are potentially favorable to the entity; or (d) a contract that may be settled in the entity’s own equity instruments and is either a non-derivative for which the entity may receive a variable number of its own equity instruments, or certain types of derivatives.

Financial liabilities are contractual obligations to deliver cash or another financial asset to another entity; or to exchange financial assets or liabilities with another entity that could be unfavorable; or a contract that is settled in the entity’s own equity instruments and is either a non-derivative for which the entity is obligated to receive a variable number of the entity’s own equity instruments, or a derivative to be settled by a fixed amount of cash or a fixed number of the entity’s own equity instruments.

2. What is cash? What is cash equivalent?

Cash includes currency and demand deposits. Cash equivalents include financial investments that are readily convertible to a known amount of cash and which are subject to an insignificant risk of change in value.

3. What is a demand deposit?

A demand deposit is an account from which funds normally held at a commercial bank can be withdrawn without prior notice.

4. What is the time frame applied to determine whether an item is a cash equivalent, current financial instrument or noncurrent financial instrument?

Time Immediate 0-3 months 3-12 months >12 months

Assets Cash Cash equivalent Current financial asset Noncurrent financial asset

Liabilities

Current financial liability Noncurrent financial liability

5. Explain why cash is presented in the statement of financial position as restricted.

Cash would be presented as restricted if it had been set aside by management or the board for a specific purpose such as the need to make a large payment on a debt or a legal settlement. . .

6

6. What is a bank overdraft?

A bank overdraft means that the bank balance is negative.

7. Describe how petty cash is accounted for when the petty cash fund is first created, when the petty cash fund must be replenished and when the petty cash balance is reduced.

When a petty cash fund is established, it is set at a given amount. A check is drawn and cashed to provide the initial cash. When this cash needs to be replenished, a check is drawn for the amount of cash needed to bring the balance in the petty cash fund back to its initial level. If management decides to reduce the amount of the petty cash fund, the amount by which the balance is to be reduced by is deposited back into cash in the bank.

8. What is a voucher? What is an IOU? A voucher is a written record as proof of expenditure or disbursement, such as a cash receipt provided by a restaurant. An IOU is typically a slip of paper or notation that an employee has withdrawn cash but has not returned a voucher.

Learning Outcome Practice 1. Which of the following represents the correct amount in an imprest petty cash fund? d. Notes and coins in the cash box + vouchers + IOUs. 2. A company’s bank reconciliation statement shows outstanding amounts from customers paid of $3800. Cheques outstanding to suppliers were $3500. The cash ledger account has a net debit balance of $25 000. What is the balance on the bank statement? d. $32 300 3. According to Lettice Corporation’s records, the bank account is overdrawn by $2600, yet the balance shown on the bank statement is only $1200 overdrawn. Assuming that no errors have been made by Lettice’s accountants or the bank, what could account for this difference? c. Cheques not yet presented to the bank for payment have been posted to the cash ledger account for $1400.

4. Obake Ltd’s cash ledger account shows a month end debit balance of $13 100. The company’s bank statement, however, shows a different figure. Obake has identified four differences: • Bank charges of $950 have been deducted during the last quarter, but not yet entered in the cash account.

• A cheque for $11 600 paid to a creditor has not been presented to the bank.

• A customer’s cheque for $6820 paid into the bank has not yet been cleared.

• Obake had forgotten that an annual direct debt of $1020 was due, and this has been taken from the account.

What is the balance of Obake’s bank statement at the end of the month? c. $15 910 . .

7

5. Sigma’s bank statement shows an overdrawn balance of $38 600 at 30 June 2010. A check against the company’s cash account revealed the following differences: • Bank charges of $200 have not been entered in the cash account.

• Items recorded on 30 June 2010 but credited by the bank in July $14 700.

• Cheque payment entered in cash account but not presented for payment at 30 June 2010 totalled $27 800.

• A cheque payment to a supplier of $4200 charged to the account in June 2010 was recorded in the cash account as a receipt.

Based on this information, what was the cash account balance before any adjustments? c. $60 300 overdrawn 6. Following is the reconciliation for Tormé Publishing.

Cash Reconciliation Accounting Records Cash balance before reconciliation Customer direct deposit Bank service fee Fee for printed checks Checks returned -- insufficient funds Error in cash disbursement Balance

Bank Statement €289 140 Bank balance before reconciliation 15 000 Deposit in transit (120) Outstanding checks (90) (6 500) (13 050) €284 380 Balance

€297 500 17 880 (31 000)

€284 380

The journal entries are as follows.

Date 31 August 2010

Account titles Cash Trade accounts receivable To record customer direct deposit.

Date 31 August 2010

Account titles

Bank service fees Cash To record customer direct deposit.

Date 31 August 2010

Bank service fees Cash To record customer direct deposit.

. .

DR €15 000

CR €15 000

DR €120

CR €120

Account titles

DR €120

CR €120

8

Date 31 August 2010

Account titles

Printed check fee Cash To record printed check fee.

Date 31 August 2010

Account titles Trade accounts payable Cash To correct error in cash disbursement.

DR €90

CR €90

DR €13 500

CR €13 500

Learning Outcome 2 Explain how financial assets and liabilities are classified.

On Your Own 1. List the four categories of financial assets and liabilities.

1) Financial assets at fair value through profit or loss (held-for-trading) 2) Held-to-maturity investments 3) Loans and receivables 4) Available-for-sale financial assets 2. What are the criteria for including a financial asset or liability as held for trading?

A held for trading financial asset or liability must meet either of the two following criteria: 1) it is classified as held for trading or 2) upon initial recognition it is designated by the entity as at fair value through profit or loss 3. What are the criteria for including a financial asset as held-to-maturity?

Held-to-maturity investments are financial assets with fixed or determinable payments and a fixed maturity that an entity has the positive intention and ability to hold to maturity.

4. What are the criteria for including a financial asset or liability as loans and receivables?

Loans and receivable are financial assets with fixed or determinable payments that are not quoted in an active market.

5. What are the criteria for including a financial asset as available for sale?

Available-for-sale financial assets are designated as available-for-sale or are not classified as a) loans and receivables, b) held-to-maturity securities, or c) financial assets at fair value through profit or loss.

. .

9

6. What categories of financial assets or liabilities are accounted for using fair value through profit or loss?

Only held-for-trading assets are designated as at fair value through profit or loss. Those classified as available-for-sale would have any gain or loss on a change in fair value recognized in other comprehensive income.

7. What categories of financial assets or liabilities are accounted for using the amortized cost using effective interest method?

The following classifications of financial assets and liabilities are accounted for using amortized cost using effective interest rate method: held-to-maturity investments and loans and receivables.

Learning Outcome 4 Explain the accounting for trade accounts.

On Your Own 1. Into what category of financial assets and liabilities are trade receivables and trade payables classified?

Trade payables are classified into loans and receivables. Trade receivables would normally be classified into loans and receivables. However, a trade receivable could be classified into one of the other three categories – held-for-trading, held-to-maturity or available-for-sale.

2. What financial accounting method – fair value through profit or loss or amortized cost using effective interest method – applies to trade receivables and trade payables?

Trade payables would be accounted for as amortized cost using effective interest method. Trade receivables would be accounted for as amortized cost using effective interest method if they are classified as either loans and receivables or held-to-maturity. If a trade receivable is classified as held-for-trading then it would be accounted for at fair value through profit or loss. If a trade receivable is classified as available-for-sale then it would be accounted for by recognizing any gains or losses on changes in fair value in other comprehensive income.

3. What is bankruptcy?

Bankruptcy is a legal procedure that provides protection from creditors while the business is either reorganized or liquidated.

4. What is the allowance method The allowance method estimates the amount of uncollectible amounts based on either the percentage-of-sales or aged receivables methods. This amount is recorded in a contra to trade accounts receivable. Amounts actually written-off are then charged to the allowance account. In this way, the uncollectible expense is matched to the revenue that created that expense. . .

10

Learning Outcome Practice 1. Journal entries for Apex Chemicals for the third quarter: July 2010 Date 31 July 2010

Account titles Trade accounts receivable Sales revenue To record credit sales for July.

DR €1 710 500

€1 710 500

Date 31 July 2010

Account titles DR Uncollectible accounts expense €40 710 Allowance for uncollectible accounts To record the estimated uncollectible amount for July 2010 of €40 710 = €1 710 500 x 2.38%

Date 31 July 2010

Account titles Allowance for uncollectible accounts Trade accounts receivable To record defaults in July 2010.

CR

DR €59 000

CR €40 710

CR €59 000

August 2010 Date 31 August 2010

Account titles Trade accounts receivable Sales revenue To record credit sales for August.

DR €1 655 000

€1 655 000

Date 31 August 2010

Account titles DR Uncollectible accounts expense €39 389 Allowance for uncollectible accounts To record the estimated uncollectible amount for August 2010 of €39 389 = €1 655 000 x 2.38%

Date 31 August 2010

Account titles Allowance for uncollectible accounts Trade accounts receivable To record defaults in August 2010.

. .

CR

DR €27 500

CR €39 389

CR €27 500

11

September 2010 Date 30 September 2010

Account titles Trade accounts receivable Sales revenue To record credit sales for September.

DR €1 670 000

€1 670 000

Date 30 September 2010

Account titles DR Uncollectible accounts expense €39 746 Allowance for uncollectible accounts To record the estimated uncollectible amount for September 2010 of €39 746 = €1 670 000 x 2.38%

Date 30 September 2010

Account titles Allowance for uncollectible accounts Trade accounts receivable To record defaults in September 2010.

CR

DR €26 000

CR €39 746

CR €26 000

On 20 September 2010, the balance in the allowance account assuming all entries are made on the last day of the month would be as follows: €24 522 + €40 710 – €59 000 + €39 389 – €27 500 = €18 121 credit balance

2. The information for SOS Executive Trainers would be: a) The estimated uncollectible amount would be: ($403 600 x 0.78%) + ($446 100 x 2.11%) + ($270 022 x 6.50%) + ($91 000 x 9.85%) = $39 076 b) The journal entry to record the estimate in a) if the allowance account has a beginning debit of $2200.

Date 30 April 2012

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR $41 276

CR €41 276

c) The journal entry to record the estimate in a) if the allowance account has beginning credit balance of $1600.

Date 30 April 2012

. .

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR $37 476

CR €37 476

12

Learning Outcome 4 Explain the accounting for trade accounts Summary: uncollectible accounts On Your Own 1. If Arnbjorg uses the write-off method, the journal entry would be: Date 4 September 2011

Account titles Uncollectible accounts expense Trade accounts receivable

DR 125 000 kroner

CR 125 000 kroner

2. If Arnbjorg uses the allowance method and the beginning balance in the allowance account is 44 000 kroner debit, the entry for the default would be: Date 4 September 2011

Account titles Allowance for uncollectible accounts Trade accounts receivable

DR 125 000 kroner

CR 125 000 kroner

3. The entry would be the same as #2 above. The beginning balance in the allowance account is irrelevant when the default entry is made.

4. The estimate for uncollectible accounts would be 76 110 kroner = 1 770 000 kroner x 4.3%. The entry to record this estimate when the beginning balance in the allowance account is 55 000 kroner debit would be: Date 30 September 2011

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR 76 110 kroner

CR 76 110 kroner

5. The entry would be the same as #4 above. Under the percentage-of-sales method, the beginning balance in the allowance account is not considered in the calculation.

6. The entry to record the estimate under the aged receivables method if the beginning balance in the allowance account is 55 000 kroner debit would be: Date 30 September 2011

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR 77 900 kroner

CR 77 900 kroner

7. The entry to record the estimate under the aged receivables method if the beginning balance in the allowance account is 3000 kroner credit would be: Date 30 September 2011

. .

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR 19 900 kroner

CR 19 900 kroner

13

8. What figure should appear in the statement of income for the year ended 30 June 2011 for these items ? c. $24 000 Learning Outcome 6 Explain the accounting for notes.

On Your Own

. .

1.

What is a promissory note?

A promissory note is a formal contract entered into by two entities whereby one agrees to pay the other a specified amount of money. Usually notes “bear” interest but notes can also be non-interest bearing.

2.

Who is the issuer of the note?

The issuer – also known as the maker – is the entity which borrows the money.

3.

How do notes receivable and notes payable differ from trade accounts receivable and trade accounts payable, respectively?

Trade accounts are normally not based on formal contracts executed for each transaction. Instead, trade account transactions are based on generally understood terms. A note – or promissory -- is a formal contract to borrow or lend money.

4.

What is the stated rate on a note?

The stated rate is the amount of interest (e.g., 7%) that the issuer will pay to borrow the money. The interest is calculated by multiplying this stated rate times the amount of the note.

5.

Why would the rate used to discount a note be different from the stated rate?

The market interest rate to borrow money may change and can therefore be different from the stated rate.

6.

What is the financial accounting method used for notes receivable and notes payable?

If notes are classified as loans and receivables or held-to maturity, then accounting for the note would be amortized cost using effective interest method. However, if the note is classified as heldfor-trading, then any gain or loss in the fair value of the note would be recognized in profit or loss. If the note is classified as available-for-sale, then any change in fair value would be recognized in other comprehensive income.

14

Learning Outcome 7 Explain the accounting for bonds.

On Your Own 1. Define a bond. How is a bond different from a note?

A bond is a debt instrument in which a borrower, also known as the issuer, promises to repay an amount of money over time plus interest. Bonds are usually used for long-term financing while notes tend to be used for shorter-term financing.

2. Who is the issuer of the bond: the party who owes the money or the creditor?

The issuer of the bond is the party who owes the money – the borrower.

3. What does maturity date mean?

The maturity date is the date on which the issuer must repay the principal on a bond or other financial liability.

4. What is the stated interest rate or nominal interest rate?

The nominal interest rate also known as the stated interest rate is the interest rate paid by the issuer based on the face or stated value.

5. Explain what a callable feature is on a bond When a bond has a callable feature, the issuer has the right to purchase the bond from the investor at a certain call price.

6. Explain the difference between a term bond and an serial bond.

A term bond is a bond on which the principal is due on the maturity date. With a serial bond, the principal is paid in installments over the term of the bond.

7. Explain the difference between a secured bond and an unsecured bond.

Secured bond or debenture bond is backed by a pledge of some asset such as real estate. The investor has a priority claim on the pledged asset in the event of liquidation. An unsecured bond is a bond which is sold on the cognizance of the issuer with no claim against assets.

8. What does it means that a bond is sold at par? At a premium? At a discount?

When a bond is sold at its face value, it is at par. If it sells for an amount above face value, it has sold at a premium. If it sells for an amount below face value, it has sold at a discount.

. .

15

9. If the market rate of interest is above the stated rate of interest on a bond, will a premium or a discount result?

The bond will sell at a discount since the market is offering a higher return than that offered by the bond.

10. How is a premium or a discount on a bond accounted for?

The premium or discount is amortized over the bond’s term using the effective interest method.

Answers to Terminology practice 1. The nominal interest rate or stated interest rate is the amount used to calculate the interest due based on the face value of a note or bond.

2. A bank statement is provided by a bank and shows all activity on the entity’s bank account for some period of time.

3. Restricted cash is a cash amount set aside for a specific purpose.

4. The acid-test ratio divides cash and cash equivalents + trade receivables + marketable securities by current liabilities.

5. Imprest petty cash (also petty cash) refers to cash kept on hand to pay small expenses such as postage, delivery charges, entertainment for clients and other miscellaneous expenses.

6. Loans and receivables are financial assets or liabilities with fixed or determinable payments that are not quoted on an active market.

7. A serial bond is a bond on which the principal is paid in instalments over the term of the bond.

8. Liquidity is the availability of cash in the near future after taking account of financial commitments over this period.

9. The allowance method of accounting for uncollectible accounts records an estimated amount of uncollectible receivables as uncollectible expense when revenue is recognized.

10. The current ratio is calculated by dividing current assets by current liabilities.

11. A promissory note is a debt instrument in which the issuer promises to pay an amount of money over time plus a stated interest rate.

12. A note payable is a formal contract between two entities whereby the issuer agrees to pay a specified amount of money plus interest in exchange for either the loan of money or the purchase of goods or services.

13. A voucher is a written record as proof of an expenditure or disbursement.

14. The percentage of sales method estimates the amount of uncollectible accounts as a proportion of sales for the period.

15. Solvency is the availability of cash over the longer term to meet financial commitments as they come due.

16. To calculate the average collection period, the receivables turnover ratio is divided into 365.

17. A term bond is a bond on which the principal is due on the maturity date.

18. A financial asset is an asset that is cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset. . .

16

19. Held-to-maturity investments are financial assets with fixed or determinable payments and a fixed maturity that an entity has the positive intention and ability to hold to maturity.

20. Bankruptcy is a legal procedure that provides protection from creditors while the business is either reorganized or liquidated.

21. A bank overdraft occurs in situations when a business overdraws the amount of cash it has in its bank account.

22. Net receivables are calculated by subtracting the allowance account for uncollectible accounts from trade accounts receivable.

23. A zero-interest bond is a bond that pays no interest but on which the investor earns a return by purchasing the bond at a discounted price.

24. A discount results when the market price of the bond is below the stated value of the bond.

25. A compensating balance is a minimum cash balance that must be kept on hand at all times as part of a loan agreement with a lender.

26. Available for sale financial assets are financial assets other than cash or cash equivalent that are not classified as (a) loans and receivables, (b) held-to-maturity investments, or (c) financial assets at fair value through profit or loss.

27. Maturity date is the date on which the issuer must repay the principal.

28. A premium results when the market price of a bond is above the stated value of the bond.

29. The debt ratio is calculated by dividing total liabilities by total assets.

30. The receivables turnover ratio is calculated by dividing net credit sales by average receivables.

31. The aged receivables method estimates the amount of uncollectible receivables based on the likelihood of collection for the time the amounts have been outstanding.

32. A financial liability is a liability that is a contractual obligation to deliver cash or another financial asset, or a contract that will be settled in the entity’s own equity instruments.

33. Term is the repayment period for a note or bond.

34. A callable bond grants the issuer the right to purchase the bonds from investors, at a certain price.

35. A financial asset or liability at fair value through profit or loss is a financial asset or financial liability that is either classified as held for trading or on initial recognition is designated as at fair value through profit and loss.

36. A secured bond is backed by a pledge of some asset such as real estate on which the investor has a priority claim in the event of liquidation.

37. The cash ratio divides cash and cash equivalents + marketable securities by current liabilities.

38. The issuer is the party who must repay the amount owed on a note.

. .

17

Answers to Application Exercises 1. The set up for the financial calculator for annual installments would be as follows.

N 3

I/Y 8

PMT ?

PV -43 000

FV 0

Each annual payment would be €16 685.44.

2. The set up on the calculator for monthly installments would be as follows.

N 36

I/Y 0.6667

PMT ?

PV -43 000

FV 0

Each annual payment would be €1 347.47.

3. The journal entries for Premier Financial Ltd would be as follows. i.

The entry to record the purchase:

Date 1 January 2009

Account titles

DR £574 701

Equipment Cash Note payable To record purchase of equipment.

CR £130 000 424 701

The discounted amount for the note is calculated at £424 701 as follows.

N 3 ii.

I/Y 9.0

PMT 0

PV ?

FV £550 000

The entries to record year end adjusting entries.

Date 31 December 2009

Account titles Interest expense Note payable

DR £38 223

CR £38 223

Outstanding balance for note £424 701 x 9% = £38 223 Balance of note payable on 31 December 2009 £424 701 + £38 223 = £462 924

Date

. .

Account titles

DR

CR

18

31 December 2010

Interest expense Note payable

£41 663 £41 663

Outstanding balance for note £462 924 x 9% = £41 663 Balance of note payable on 31 December 2010 £462 924 + £41 663 = £504 587

Date 31 December 2011

Account titles

DR £45 413

Interest expense Note payable

CR £45 413

Outstanding balance for note £504 587 x 9% = £45 413 Balance of note payable on 31 December 2011 £504 587 + £45 413 = £550 000 iii.

The journal entry for the payment of the note.

Date 31 December 2011

Account titles

DR £550 000

Note payable Cash

CR £550 000

4. The amortization schedule for Premier Financial Ltd under the interest-only payment loan would be amortized as follows.

Beginning balance

Date

Interest accrued

Interest payment 0

Ending balance

1-Jan-09

£

550 000

0

£ 550 000

30-Jun-09

£

550 000

£

19 250

£

19 250

£ 550 000

31-Dec-09

£

550 000

£

19 250

£

19 250

£ 550 000

30-Jun-10

£

550 000

£

19 250

£

19 250

£ 550 000

31-Dec-10

£

550 000

£

19 250

£

19 250

£ 550 000

30-Jun-11

£

550 000

£

19 250

£

19 250

£ 550 000

31-Dec-11

£

550 000

£

19 250

£

19 250

£ 550 000

a. The entry to record the purchase: Date 1 January 2009

Account titles

Equipment Cash Note payable To record purchase of equipment.

DR £680 000

CR £130 000 550 000

b. The journal entries for 30 June and 31 December are as follows. . .

19

Date 30 June 2009

Date 31 December 2009

Date 30 June 2010

Date 31 December 2010

Date 30 June 2011

Date 31 December 2011

Account titles

DR £19 250

Interest expense Cash

CR £19 250

Account titles

DR £19 250

Interest expense Cash

CR £19 250

Account titles

DR £19 250

Interest expense Cash

CR £19 250

Account titles

DR £19 250

Interest expense Cash

CR £19 250

Account titles

DR £19 250

Interest expense Cash

CR £19 250

Account titles

DR £19 250

Interest expense Cash

CR £19 250

c. The journal entry for the payment of the note.

Date 31 December 2011

Account titles

DR £550 000

Note payable Cash

CR £550 000

5. The semi-annual payment on the note is calculated at £103 217.51 as follows.

N 6 . .

I/Y 3.5

PMT ?

PV -550 000

FV £0

20

The amortization schedule is as follows:

Date 1-Jan-09 30-Jun-09

Beginning balance £ 550 000 £ 550 000

Interest accrued 0 £ 19 250

Interest payment 0 £ 103 218

31-Dec-09 30-Jun-10 31-Dec-10 30-Jun-11 31-Dec-11

£ £ £ £ £

£ £ £ £ £

£ £ £ £ £

466 032 379 126 289 178 196 082 99 727

16 311 13 269 10 121 6 863 3 490

103 218 103 218 103 218 103 218 103 218

Amortization Amount 0 83 968 86 907 89 949 93 077 96 355 99 727

Ending balance £ 550 000 £ 466 032 £ 379 126 £ 289 178 £ 196 082 £ 99 727 £ 0

a. The entry to record the purchase: Date 1 January 2009

Account titles

Equipment Cash Note payable To record purchase of equipment.

DR £680 000

CR £130 000 550 000

b. The entries to record year end adjusting entries.

Date 30 June 2009

Date 31 December 2009

Date 30 June 2010

Date 31 December 2010

. .

Account titles Interest expense Note payable Cash

CR

£103 218

Account titles Interest expense Note payable Cash

DR £16 311 86 907

CR

£103 218

Account titles Interest expense Note payable Cash

DR £13 269 89 949

CR

£103 218

Account titles Interest expense Note payable

DR £19 250 83 968

DR £10 121 93 077

CR

21

Cash Date 30 June 2011

£103 218 Account titles

DR £6 863 96 355

Interest expense Note payable Cash

Date 31 December 2011

CR

£103 218

Account titles

DR £3 490 99 727

Interest expense Note payable Cash

CR

£103 218

c. The journal entry for the payment of the note.

Date 31 December 2011

Account titles

DR £550 000

Note payable Cash

CR £550 000

6. Ren Motor calculates the effective interest rate at 4.6669% as follows.

N 40

I/Y ?

PMT 4 500 000

PV -97 000 000

FV £100 000 000

The amortization schedule is shown below through 30 June 2012 when the bonds were retired.

Beginning balance

Date

. .

1-Jan-09

¥

97,000,000

30-Jun-09

¥

97,000,000

31-Dec-09

¥

30-Jun-10

¥

31-Dec-10

Effective interest rate

Interest expense

Interest paid

Amortized amount

Unamortized discount

Ending balance

¥

-

¥

3,000,000

¥97,000,000

¥

-

4.6669%

¥

4,526,893

¥ 4,500,000

¥

26,893

¥

2,973,107

¥97,026,893

97,026,893

4.6669%

¥

4,528,148

¥ 4,500,000

¥

28,148

¥

2,944,959

¥97,055,041

97,055,041

4.6669%

¥

4,529,462

¥ 4,500,000

¥

29,462

¥

2,915,497

¥97,084,503

¥

97,084,503

4.6669%

¥

4,530,837

¥ 4,500,000

¥

30,837

¥

2,884,661

¥97,115,339

30-Jun-11

¥

97,115,339

4.6669%

¥

4,532,276

¥ 4,500,000

¥

32,276

¥

2,852,385

¥97,147,615

31-Dec-11

¥

97,147,615

4.6669%

¥

4,533,782

¥ 4,500,000

¥

33,782

¥

2,818,603

¥97,181,397

30-Jun-12

¥

97,181,397

4.6669%

¥

4,535,359

¥ 4,500,000

¥

35,359

¥

2,783,244

¥97,216,756

22

The journal entry to record the issuance of the bonds is as follows.

Date 1 January 2009

Account titles Cash Discount on bonds Bonds payable

DR ¥97 000 000 3 000 000

CR

¥100 000 000

The journal entries to record interest accrual and payment semi-annually.

Date 30 June 2009

Date 31 December 2009

Date 30 June 2010

Date 31 December 2010

Date 30 June 2011

Date 31 December 2011

. .

Account titles Bond interest expense Discount on bonds Cash

DR ¥4 526 893

Account titles Bond interest expense Discount on bonds Cash

DR ¥4 528 148

Account titles Bond interest expense Discount on bonds Cash

DR ¥4 529 462

Account titles Bond interest expense Discount on bonds Cash

DR ¥4 530 837

Account titles Bond interest expense Discount on bonds Cash

DR ¥4 532 276

Account titles Bond interest expense Discount on bonds Cash

DR ¥4 533 782

CR ¥26 893 4 500 000

CR ¥28 148 4 500 000

CR ¥29 462 4 500 000

CR ¥30 837 4 500 000

CR ¥32 276 4 500 000

CR ¥33 782 4 500 000

23

Date 30 June 2012

Account titles Bond interest expense Discount on bonds Cash

DR ¥4 535 359

CR ¥35 359 4 500 000

The journal entry to retire the bonds would be as follows.

Date 30 June 2012

Account titles Bonds payable Loss on retirement of bonds payable Cash

DR ¥100 000 000 1 000 000

CR

¥101 000 000

7. Following are the calculations and journal entries for Restaurant Concepts Inc. bonds. i.

The sale price of the bonds would be calculated as follows.

The bonds paid $1 400 000 interest annually = $20 000 000 x 7% The market yield was 6.5%.

Sale price of bonds = $1 400 000 ÷ .065 = $21 538 462.

The effective interest rate would be calculated as follows.

N 5

i/Y ?

PMT $1 400 000

PV -$21 538 462

FV $20 000 000

Solving for i/Y, the effective interest rate is 5.2128%.

The amortization schedule would be as follows.

Date

. .

Beginning balance

Effective interest rate .

1-Jan-08

$

21 538 462

31-Dec-08

$

21 538 462

31-Dec-09

$

31-Dec-10

Interest expense

Amortized amount

Interest paid

$

-

5.2128%

$

1 122 757

21 261 219

5.2128%

$

$

20 969 524

5.2128%

31-Dec-11

$

20 662 623

31-Dec-12

$

20 339 724

Unamortized discount

Ending balance

$

-

$

1 538 462

$

21 538 462

$ 1 400 000

$

(277 243)

$

1 261 219

$

21 261 219

1 108 305

$ 1 400 000

$

(291 695)

$

969 524

$

20 969 524

$

1 093 099

$ 1 400 000

$

(306 901)

$

662 623

$

20 662 623

5.2128%

$

1 077 101

$ 1 400 000

$

(322 899)

$

339 724

$

20 339 724

5.2128%

$

1 060 269

$ 1 400 000

$

(339 724)*

$

0

$

20 000 000

24

*rounded ii.

The journal entry to issue the bonds would be as follows.

Date 1 January 2008

iii.

DR $21 538 462

CR $1 538 462 20 000 000

The journal entries on the interest payment dates would be as follows.

Date 31 December 2008

Date 31 December 2009

Date 31 December 2010

Date 31 December 2011

Date 31 December 2012

. .

Account titles Cash Premium on bonds Bonds payable

Account titles Bond interest expense Premium on bonds Cash

DR $1 122 757 277 243

Account titles Bond interest expense Premium on bonds Cash

DR $1 108 355 291 695

Account titles Bond interest expense Premium on bonds Cash

DR $1 093 099 306 901

Account titles Bond interest expense Premium on bonds Cash

DR $1 077 101 322 899

Account titles Bond interest expense Premium on bonds Cash

DR $1 060 269 339 724

CR

$1 400 000

CR

$1 400 000

CR

$1 400 000

CR

$1 400 000

CR

$1 400 000

25

iv.

The journal entry for the repayment of the principal amount would be as follows.

Date 31 December 2012

Account titles

DR $20 000 000

Bonds payable Cash

CR $20 000 000

8. Following are the calculations and journal entries for Restaurant Concepts Inc. bonds. a. The sale price of the bonds would be calculated as follows.

The bonds paid $1 400 000 interest annually = $20 000 000 x 7% The market yield was 7.75%.

Sale price of bonds = $1 400 000 ÷ .0775 = $18 064 516.

The effective interest rate would be calculated as follows.

N 5

i/Y ?

PMT $1 400 000

PV -$18 064 516

FV $20 000 000

Solving for i/Y, the effective interest rate is 9.5218%.

The amortization schedule would be as follows.

Date

Beginning balance

Effective interest rate .

1-Jan-08

$

18 064 516

31-Dec-08

$

18 064 516

31-Dec-09

$

31-Dec-10

Interest expense

Amortized amount

Unamortized discount

Ending balance

$

-

$ (1 935 484)

$

18 064 516

Interest paid

$

-

9.5218%

$

1 720 067

$ 1 400 000

$

320 067

$ (1 615 417)

$

18 384 583

18 384 583

9.5218%

$

1 750 543

$ 1 400 000

$

350 543

$ (1 264 874)

$

18 735 126

$

18 735 126

9.5218%

$

1 783 921

$ 1 400 000

$

383 921

$

(880 952)

$

19 119 048

31-Dec-11

$

19 119 048

9.5218%

$

1 820 477

$ 1 400 000

$

420 477

$

(460 475)

$

19 539 525

31-Dec-12

$

19 539 525

9.5218%

$

1 860 514

$ 1 400 000

$

460 475*

$

0

$

20 000 000

DR $18 064 516 1 935 484

CR

*rounded. b. The journal entry to issue the bonds would be as follows.

Date 1 January 2008

. .

Account titles Cash Discount on bonds

26

Bonds payable

$20 000 000

c. The journal entries on the interest payment dates would be as follows.

Date 31 December 2008

Date 31 December 2009

Date 31 December 2010

Date 31 December 2011

Date 31 December 2012

Account titles Bond interest expense Discount on bonds Cash

DR $1 720 067

Account titles Bond interest expense Discount on bonds Cash

DR $1 750 543

Account titles Bond interest expense Discount on bonds Cash

DR $1 783 921

Account titles Bond interest expense Discount on bonds Cash

DR $1 820 477

Account titles Bond interest expense Discount on bonds Cash

DR $1 860 514

CR $320 067 1 400 000

CR $350 543 1 400 000

CR $383 921 1 400 000

CR $420 477 1 400 000

CR $460 475 1 400 000

d. The journal entry for the repayment of the principal amount would be as follows.

Date 31 December 2012

Account titles Bonds payable Cash

DR $20 000 000

CR $20 000 000

9. Following are the adjustments required at 31 March 2010.

. .

27

i.

Electricity charges for February and March must be accrued even though an invoice has not been received for $4 580 = $6 870 x 2/3. The adjusting entry would be as follows.

Date 31 March 2010

ii.

Account titles Utilities expense Trade accounts payable

DR $4 580

$4 580

The rent payment would have been recorded as prepaid rent. This must be reclassified to expense for three months (January, February and March). Monthly rent would be $4 750 = $28 500 ÷ 6 and for three months the amount would be $14 250 = $4750 x 3. The adjusting entry would be as follows.

Date 31 March 2010

Account titles Rent expense Rent payable

DR $14 250

No entry required.

iv.

The entry to write off the uncollectible balance would be as follows.

Date 31 March 2010

DR

CR $660 $660

Based on the aged receivables, the allowance for doubtful debts balance should be $9 067 = [$27 200 x 20%] + [$4836 x 75%]. The existing balance is $7240 = $7900 - $660.

Therefore, the adjusting entry for $1827 = $9067 – $7240 would be as follows.

Date 31 March 2010

vi.

Account titles Allowance for doubtful debts Trade accounts receivable

CR $14 250

iii.

v.

CR

Account titles Uncollectible accounts expense Allowance for doubtful debts

DR $1827

CR $1827

Depreciation would be recorded for $17 920 = $89 600 x 20%.

Date 31 March 2010

Account titles Depreciation expense Accumulated depreciation

DR $17 920

CR $17 920

The corrected financial statement would be as follows. . .

28

Corrected Statement of Financial Position as at 31 March 2010 Noncurrent assts Equipment at cost $ 175 000 Accumulated depreciation (103 320) $71 680 Current assets Inventories 42 339 Trade accounts receivable 147 584 Bank account 6 280 196 203 $ 267 883 Equity $162 493 Current liabilities 105 390 $267 883

10. Following are the answers for your industrial machinery client. a. A bad debt (or uncollectible debt) has defaulted and cannot be collected. It is therefore written off. Doubtful debts are estimates usually based on the company’s past experience with bad debts. b. The allowance for bad debts would be calculated as [$18 700 x 6%] + [$9722 x 50%] = $1122 + $4861 = $5983 The charge to the statement of income would be $1467 = $5983 - $4516.

The net trade accounts receivable would be reported at $59 030 = $65 013 - $5983 before the write off or $59 030 = $61 439 - $2409 after the write off. c. The rule is lower of cost and net realizable value – inventories should be valued at the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

. .

29

d. The value of the closing inventories would be calculated as follows.

Type of machine Cost a. Expected sales value b. Expenses of sale Net realizable value (a-b) Lower of cost or net realizable value

Picking Machine $5 980 5 500 200 5 300 $5 300

Industrial Press $11 670 14 900 475 14 425 $11 670

Forklift Truck $3 926 4 200 720 3 480 $3 480

11. Following are the answers for Wilson. a. Wilson’s cash ledger account including correcting entries would be as follows.

DR Beginning balance - overdrawn Correct check 958602 4 May bank charges Insufficient funds check Cancellation of cheque 956784 Ending balance after corrections - overdraw

CR $113

$90 428 320 625 $146

b. The bank reconciliation would be as follows.

Cash Reconciliation 31 May 2011 Accounting Records Cash balance before reconciliation Correct cheque 958602 4 May bank charges Insufficient funds cheque Cancellation of cheque 956784 True balance

($113) 90 (428) (320) 625 ($146)

Bank Statement Bank balance before reconciliation Erroneous interest Deposit in transit Outstanding cheques

$228 (220) 850 (1004)

Balance

($146)

c. The final accounts should report cash as $146 overdrawn.

. .

30

Case analysis Botswana Wild Safaris, LLC Trade accounts receivable The first part of the case deals with trade accounts receivable and uncollectible accounts.

In 2009, the estimate of uncollectible accounts would €24 000 = €800 000 x 3%. Since this is the first year that Washford established an allowance for uncollectible accounts, the journal entry would be as follows.

Date 31 December 2009

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR €24 000

CR €24 000

During 2009, Botswana Wild Safaris had a write off of €13 000. The journal entry would be as follows.

Date 31 December 2009

Account titles Allowance for uncollectible accounts Trade accounts receivable

DR €13 000

CR €13 000

This leaves a balance in the allowance for uncollectible accounts of €11 000 = €24 000 - €13 000.

In 2010, the estimate of uncollectible accounts would €33 300 = €1 110 000 x 3%. The journal entry would be as follows.

Date 31 December 2010

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR €22 300

CR €22 300

During 2009, Botswana Wild Safaris had a write off of €14 000. The journal entry would be as follows.

Date 31 December 2010

Account titles Allowance for uncollectible accounts Trade accounts receivable

DR €14 000

CR €14 000

This leaves a balance in the allowance for uncollectible accounts of €19 300.

In 2011, the estimate of uncollectible accounts would €43 800 = €1 460 000 x 3%. The journal entry would be as follows.

. .

31

Date 31 December 2011

Account titles Uncollectible accounts expense Allowance for uncollectible accounts

DR €43 800

CR €43 800

During 2011, Botswana Wild Safaris had a write off of €37 000. The journal entry would be as follows.

Date 31 December 2011

Account titles Allowance for uncollectible accounts Trade accounts receivable

DR €37 000

CR €37 000

This leaves a balance in the allowance for uncollectible accounts of €26 100.

Notes payable The accounting for the existing note would be as follows. Interest expense would be recorded as follows when paid at the end of 2009.

Date 31 December 2009

Account titles Interest expense Trade accounts receivable

DR €99 000

CR €99 000

The existing note is then retired.

Date 31 December 2009

Account titles

DR €1 110 000

Note payable Cash

CR €1 110 000

The new note would be recorded as follows.

Date 31 December 2009

Account titles

DR €200 000

Cash Note payable

CR €200 000

The following schedule shows the amortization of the note over its two year life.

Beginning balance

Date

Interest accrued

Interest payment

Ending balance

31-Dec-09

€

200,000

€

-

€

-

€

200,000

31-Dec-10

€

200,000

€

18,000

€

-

€

218,000

31-Dec-09

€

218,000

€

19,620

€

-

€

237,620

The adjusting entry for the new note on 31 December 2010 would be as follows.

Date

. .

Account titles

DR

CR

32

31 December 2010

Interest expense Note payable

€18 000 €18 000

The adjusting entry for the new note on 31 December 2011 would be as follows.

Date 31 December 2011

Account titles Interest expense Note payable

DR €19 620

CR €19 620

The journal entry to record repayment of the new note would be as follows.

Date 31 December 2011

Account titles Note payable Cash

DR €237 620

CR €237 620

Private bond The private bond placement would be recorded as follows.

Date 31 December 2009

Account titles Cash Bonds payable

DR €700 000

CR €700 000

The interest payment for 2010 would be as follows.

Date 31 December 2010

Account titles Bond interest expense Cash

DR €45 500

CR €45 500

The interest payment for 2011 would be as follows.

Date 31 December 2011

Account titles Bond interest expense Cash

DR €45 500

CR €45 500

The statement of financial position for current assets, current liabilities and non-current liabilities would appear as follows at 31 December 2009.

Botswana Wild Tours Statement of Financial Position As at 31 December 2009 . .

33

€ thousands Current assets Cash Trade accounts receivable Less: Allowance for uncollectible accounts Prepaid expenses Other current assets

214 200 424 000 (11 000) 35 000 45 000

707 200

Current liabilities Trade accounts payable Accrued liabilities Other current liabilities

128 200 25 000 10 000

163 200

Noncurrent liabilities Bond payable Note payable (due 31 December 2012)

700 000 200 000

900 000

The statement of financial position for current assets, current liabilities and non-current liabilities would appear as follows at 31 December 2010.

Botswana Wild Tours Statement of Financial Position As at 31 December 2010 € thousands Current assets Cash Trade accounts receivable Less: Allowance for uncollectible accounts Prepaid expenses Other current assets

807 000 365 000 (19 300) 70 000 80 000

1 302 700

Current liabilities Trade accounts payable Accrued liabilities Other current liabilities

330 000 10 000 15 000

355 000

Noncurrent liabilities Bond payable Note payable (due 31 December 2012)

700 000 200 000

900 000

. .

34

The statement of financial position for current assets, current liabilities and non-current liabilities would appear as follows at 31 December 2011.

Botswana Wild Tours Statement of Financial Position As at 31 December 2011 € thousands Current assets Cash Trade accounts receivable Less: Allowance for uncollectible accounts Prepaid expenses Other current assets Current liabilities Trade accounts payable Note payable (due 31 December 20 Accrued liabilities Other current liabilities Noncurrent liabilities Bond payable

. .

1 160 500 410 000 (26 100) 80 000 88 000

1 712 400

270 000 200 000 5 000 15 000

490 000

700 000

35

Instructor Manual Chapter 9 Equity

. .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

4

Learning Outcome 1 Learning Outcome 2 Learning Outcome 3 Learning Outcome 5

4 4 7 8

Answers to Terminology Practice

9

Answers to Application Exercises

11

Case Analysis

14

. .

2

Lecture Notes Introduction The two major goals of this chapter are to 1) introduce terminology related to contributed capital and 2) illustrate the basic accounting for contributed capital including dividends.

Learning Outcome 3 When introducing the terminology and procedures related to dividends, I try to make the process more interesting to students by putting into the context of a board meeting. That seems to take some of the ‘dryness’ away from just defining declaration date, date of record and payment date.

Students almost always ask why a board declares a scrip dividend or share split as opposed to a cash dividend. I put the emphasis in my lecture on the difference between the two by focusing on the mechanics – a scrip dividend reclassifies retained earnings into contributed capital and a share split is not recorded. The scrip dividend therefore ‘gives’ the shareholders something but it does not change their proportional ownership. A scrip dividend is therefore often a communication from the board that the company is doing well and some distribution of retained earnings is warranted, but the company wants to retain cash.

In the past, a share split has been explained as a means of making the share price more accessible to a larger number of potential investors. I still use this explanation but also remind students that most shares are now bought and sold by institutional investors who make such large purchase that they do not care about the size of the individual share price. I then explain that share splits are still commonly used, but that they are means of expressing optimism about the company’s growth.

However, I also explain that the choice between a share dividend and a share split can have tax consequences in some jurisdictions, so other considerations come into play. In any event, I remind them that from an accounting perspective, a technical difference exists – scrip dividends are a reclassification of retained earnings into contributed capital and split dividends are not.

. .

3

Answers to Learning Outcome Questions Learning Outcome 1 Explain the difference between ordinary shares and preference shares.

On Your Own 1. Name the two major types of share capital.

The two major types of share capital are ordinary shares and preference shares.

2. What is the difference between ordinary shares and preference shares?

Ordinary shares are equity instruments that are subordinate to all other classes of equity instruments. Ordinary shares have voting rights. Preference shares also have a stated dividend however this dividend is not normally a legally obligation of the limited liability company until it is declared by the board of directors.

3. Do ordinary shares or preference shares have priority if the business is liquidated?

Preference shares therefore have priority over ordinary shares in the event of liquidation. Creditors have priority over all shareholders, preferred or ordinary.

Learning Outcome 2 Define authorized share capital, issued shares, investment in own shares and outstanding shares.

On Your Own 1. What are authorized shares?

Authorized shares are the number of shares that a limited liability company is given permission to issue by the jurisdictional authority.

2. What is the nominal value or par value of a share? What is the real value?

Nominal value refers to the total amount of stated legal value of the shares. Nominal value per share is the total authorized share capital amount divided by the number of shares, sometimes referred to as par value. The real value is the market price of the shares.

3. What is a charter? What are examples of common provisions found in a charter?

A charter is an internal document, sometimes filed with the government authority under which the limited liability company was registered, that determines how the business will be governed.

. .

4

4. What is an issued share? How is an issued share different from an authorized share?

An issued share is one that is owned by an investor or shareholder. Issues shares are a subset of authorized shares. A share-based entity may not issue more shares than authorized without seeking government approval to increase the number of authorized shares.

5. To what does the term ‘member’ refer?

A member is an owner of shares. Members are also referred to as shareholders and stockholders.

6. What is the register of members?

The register of members, also referred to as the shareholder register, is the official list of shareholders at any point in time.

7. What is the purpose of the general shareholders’ meeting?

General shareholders’ meetings, also referred to as annual meetings, provide members with an opportunity to hear management’s views on business developments and financial results, ask questions and raise concerns. The board of directors is also elected at the general shareholders’ meeting and other issues may be voted on by members depending on the requirements set out by the charter.

8. Explain what a share premium account is.

A share premium account includes any amount received by the limited liability company in exchange for the share over the share’s nominal or par value. The share premium account is part of contributed capital in equity.

9. What is a share-based payment? Give examples of the different forms a share-based payment can take.

A share-based payment is payment for goods and services with shares. A common example is when employees are issued shares as part of their compensation.

10. Why would a company invest in its own shares? How is investment in own shares accounted for?

A company may purchase its own shares in preparation to grant those shares to an executive or other employee as compensation, or because the shares are a good investment. Investment in own shares are accounted for in a separate contra account as part of equity. Investments in own share are not accounted for as assets.

11. What are outstanding shares?

Outstanding shares are issued shares less the entity’s investment in own shares.

. .

5

Learning Outcome Practice 1. A company has 10 000 shares issued, the maximum number it is permitted to issue, and 1000 investment in own shares. Nominal value is €1.50 per share. Real value has always been €7 per share. What is the outstanding number of shares? b. 9000 2. A company has 10 000 shares issued, the maximum number it is permitted to issue, and 1000 investment in own shares. Nominal value is €1.50 per share. Real value has always been €7 per share. What is the authorized number of shares? c. 10 000 3. A company has 10 000 shares issued, the maximum number it is permitted to issue, and 1000 investment in own shares. Nominal value is €1.50 per share. Real value has always been €7 per share. What is the amount of authorized share capital? a. €15 000 4. A company has 10 000 shares issued, the maximum number it is permitted to issue, and 1000 investment in own shares. Nominal value is €1.50 per share. Real value has always been €7 per share. What is the amount of issued share capital? a. €15 000 5. A company has 10 000 shares issued, the maximum number it is permitted to issue, and 1000 investment in own shares. Nominal value is €1.50 per share. Real value has always been €7 per share. What is the amount of share premium? b. €60 000 6. A limited liability company issued 50 000 ordinary shares with a nominal value of $0.25 each at a premium of $0.50 per share. The cash received was correctly recorded, but the full amount was credited to the ordinary share capital. Which of the following journal entries is needed to correct this error?

Debit Credit b. Share capital account $25 000 Share premium account $25 000

. .

6

Learning Outcome 3 Explain the accounting for cash dividends, scrip issues and share splits.

On Your Own 1. What are the three dates which boards of directors must consider when making dividend distributions?

The three dates are the 1) declaration date, 2) date of record and 3) payment date.

2. When does a dividend become a legal obligation of the business?

A dividend becomes a legal obligation on the date on which the board of directors declares the dividend – the declaration date.

3. What is the importance of the date of record?

The date of record determines who will receive the dividend. The dividend is paid to members listed on the membership register on the date of record.

4. What is the difference between a dividend on ordinary shares and a preference dividend?

The amount of dividend on ordinary shares depends on the amount determined by the board of directors. The preference dividend is stated as part of the terms of a preference share. However, a preference dividend does not become a legal obligation of the business entity until it is declared by the board of directors.

5. What is a cumulative versus non-cumulative preference dividend?

A cumulative preference dividend means that if the dividend was not declared and paid in the past, it must be paid along with current preference dividends before any dividend distribution can be made to ordinary shareholders. A non-cumulative preference dividend in arrears would not be paid in the current period if dividends are declared by the board of directors, however the current preference dividend must be paid before the ordinary shareholders receive a dividend.

6. When is a dividend in arrears?

A dividend in arrears refers to a preference dividend that has not been declared by the board of directors and which remains undeclared and therefore unpaid.

7. What is the difference between a participating and non-participating dividend?

A participating preference dividend means that preference shareholders would participate in dividend distributions over and above the stated preference dividend. If preference shareholders receive only the preference dividend, then the shares are non-participating.

. .

7

8. What is a scrip issue? What is the accounting for a scrip issue?

A scrip issue, also referred to as a share dividend, means that additional shares are issued to members in some proportion to their current shareholdings. A scrip issue is accounted for by reclassifying a portion of retained earnings to contributed capital.

9. What is a share split? What is the accounting for a share split?

A share split is an increase in the number of shares based on a ratio that is determined by the board of directors (e.g., 2:1). No journal entry is recorded for a share split though notations are made for legal purposes that the shares have split and that the nominal value per share has been adjusted for the split. For example, if shares with a nominal value of €6 per share split 3:1, the nominal value would be adjusted to €2 per share.

10. Explain the difference between a scrip issue and a share split? If, for example, two shares are granted for each share currently owned, would this be a scrip issue or a share split?

A scrip issue reclassifies an amount from retained earnings to contributed capital while a share split does not. If two shares are given for each existing share, this could be a scrip issue or a share split depending on how the board of directors chooses to restructure the transaction.

Learning Outcome 5 Calculate equity-related ratios used to evaluate financial position.

On Your Own 1. How is the dividend yield ratio calculated? What does the dividend yield ratio tell an investor?

Which type of investor would be more interested in the dividend yield ratio – an investor for income or capital appreciation?

The dividend yield ratio is calculated by dividing the annual dividend by share price. This tells the investor what his or her return is based on the market value of the share. An investor for income would be more interested in the dividend yield ratio as a means of determining how much income will be received for the amount invested. Capital appreciation investors will be more interested in the market price of the shares, not whether or how much dividend is paid.

2. How are earnings per share calculated? What do earnings per share tell an investor?

Earnings per share is calculated by dividing profit less preference dividends by average ordinary shares outstanding. Earnings per share tells an investor how much profit can be attributed to each ordinary share outstanding.

3. Why are preference dividends subtracted from profit in the numerator of the earnings per share calculation?

The earnings per share pertain only to ordinary shareholders. Thus, preference dividends are treated similarly to interest on debt because they are stated. Preference shareholders are entitled only to . .

8

the stated preference dividend and do not otherwise have access to the retained earnings of the business entity.

4. What is dilution? What causes dilution? How are diluted earnings per share calculated? What do diluted earnings per share tell an investor that earnings per share do not?

Dilution refers to the conversion of debt and preference shares into ordinary shares, if the debt instrument or preference share has a conversion feature. If converted, the number of ordinary shares would increase thus ‘diluting’ earnings. Thus the diluted earnings per share ratio tells an investor the amount of earnings per share assuming that all possible conversions have occurred.

5. How is the book value to share ratio calculated?

Book value per share is calculated by subtracting preference shares amount from equity and then dividing by ordinary shares outstanding.

6. What does the debt to equity ratio measure? How is this ratio calculated?

The debt to equity ratio measure the amount of debt the business entity has compared to total equity. Debt to equity is calculated by dividing total liabilities by total equity.

7. Why can we say that there is no good or bad ratio when we look at that ratio in isolation?

Ratios are most useful when they are used to compare a business entity’s financial information over time or to compare to the ratios of competitors or the industry. A ratio for a business entity when examined by itself usually does not provide much information.

Answers to Terminology practice 1.

2.

3.

4.

A pre-emptive right gives shareholders the right of first refusal on new share issuances.

Authorized share capital is the total amount of shares that a limited liability company can issue.

The price earnings ratio (PE ratio) is calculated by dividing share price by earnings per share.

Participating performance shares give preference shareholders the right to receive a share of dividends beyond the preference dividend.

5. The date that determines which shareholders will be paid a dividend is the date of record.

6. When the number of treasury shares is subtracted from issued shares the result is outstanding shares.

7. A share premium is the difference between the amount recorded when shares are issued over their nominal value.

8. The Dividend yield ratio is calculated by dividing the annual dividend by share price.

9. Earnings per share (EPS) are calculated by dividing profit less preference dividends by the average ordinary shares outstanding.

10. Shareholders are also referred to as members.

11. The register of members or shareholder register is an official listing of all current shareholders. . .

9

12. A preference dividend is stated but is not a legal obligation of the business entity until declared by the board of directors.

13. Ordinary shares are also referred to as common shares and common stock.

14. A dividend becomes a legal obligation of the business entity on the declaration date.

15. Capital appreciation refers to increases in share value.

16. The cumulative preference dividend feature gives preference shareholders the right to receive dividends in arrears.

17. The debt to equity is calculated by dividing total liabilities by total equity.

18. The charter is an internal document that determines how a share-based business will be governed.

19. Investment in own shares, also known as treasury shares, are when a company invests in its own shares.

20. The annual gathering of members is referred to as the general shareholders’ meeting or annual meeting.

21. The total authorized value for share capital is the nominal value.

22. A scrip issue or bonus issue refers to a dividend distribution, which is given as additional shares issued to members in proportion to their current shareholdings.

23. Book value per share is calculated by dividing equity less preference shares by ordinary shares outstanding.

24. Dilution is the effect that conversion of all convertible financial instruments has on earnings per share. The result is diluted earnings per share.

25. Debt is subordinate to preference shares which are subordinate to ordinary shares.

26. When the board of directors does not declare a preference dividend, then that dividend is in arrears.

27. A debt instrument or preference share can be exchanged for an ordinary share if it has a convertible feature.

28. A share split occurs when the board of directors divides shares into a multiple (for example, two shares for each currently authorized share).

. .

10

Answers to Application Exercises 1. Following are comments on each proposal: i.

Making a bonus issue of one ordinary share for every two held, in order to raise $500 000 for the company.

This proposal has tow flaws. First, Ambia has already issued its authorized limit and cannot issue additional shares without raising the number of authorized shares. Second, a bonus issue does not raise money since it is only a reclassification of retained earnings into contributed capital.

ii.

Paying a dividend of 10 cents per share.

The board will be generally unable to do this since the dividend would total $100 000 and Ambia has only $50 000 in retained earnings. Thus, the company would be distributing part of its contributed capital.

iii. Increasing the revaluation reserve to $300 0000 by revaluing goodwill from $800 000 to $1 100 000.

This option is not possible since goodwill is created only by the purchase of another business entity for more than its carrying amount. Goodwill is not revalued though it can be impaired.

2. Sailbird’s dividend distribution schedule would be as follows: Total dividends for 2009 Preference dividends to be paid for 2007 -- noncumulative Preference dividends to be paid for 2008 – noncumulative Preference dividends to be paid for 2009 – current Amount available to ordinary shareholders for 2009

$50 000 0 0 (2 400) $47 600

3. Sailbird’s dividend distribution schedule would be as follows: Total dividends for 2009 Preference dividends to be paid for 2007 -- cumulative Preference dividends to be paid for 2008 – noncumulative Preference dividends to be paid for 2009 – current Amount available to ordinary shareholders for 2009

. .

$50 000 (2 400) (2 400) (2 400) $42 800

11

4. Jerome Highland Corporation’s equity section would appear as follows: Ordinary shares, £1 par, authorized 200 000 shares Ordinary share premium Retained earnings Investment in own shares Total equity

£200 000 420 000 194 000 (4 600) £809 400

5. The journal entries would be as follows: Date 30 April 2009

Date 30 November 2009

Date 15 December 2009

Account titles Cash Ordinary shares, $12 par Ordinary share premium

DR $600 000

Account titles

DR $9 000

Dividend Dividend payable

CR $360 000 240 000

CR $9 000

Account titles Dividend payable Cash

DR $9 000

CR $9 000

6. The journal entries would be as follows: Date 30 April 2009

Date 30 November 2009

Date 15 December 2009

Account titles Cash Ordinary shares

DR $600 000

CR $600 000

Account titles Dividend Dividend payable

DR $9 000

CR $9 000

Account titles Dividend payable Cash

DR $9 000

CR $9 000

7. The journal entries would be as follows: Date 30 April 2009

. .

Account titles Cash Ordinary shares

DR $600 000

CR $600 000

12

Date 1 October 2009

Date 30 November 2009

Date 15 December 2009

Account titles Investment in own shares Cash

DR $110 000

Account titles

DR $7 500

Dividend Dividend payable

CR $110 000

CR $7 500

Account titles Dividend payable Cash

DR $7 500

CR $7 500

8. The answers to the questions are as follows: a) How many treasury shares does the company have?

1000 = £25 000 ÷ £2.50 b) How many unissued shares does the company have?

40 000 = 120 000 authorized – (£80 000 ÷ £1 par) c) How many outstanding shares does the company have?

79 000 = (£80 000 ÷ £1 par) – 1000 treasury shares d) How many authorized shares does the company have?

120 000 as given in schedule e) How many issued shares does the company have?

80 000 = (£80 000 ÷ £1 par)

. .

13

Case analysis Botswana Wild Safaris, LLC Continued from Chapters 7 and 8 The journal entry to record the issuance of the additional shares is: Date 1 January 2010

Account titles Cash Ordinary shares, no par

DR €200 000

CR €200 000

The journal entry to record the dividend in 2010 is: Date 30 June 2010

Account titles

DR €50 000

Dividend Cash

CR €50 000

The journal entry to record the purchase of the treasury shares is: Date 1 January 2011

Account titles

DR €300 000

Treasury shares Cash

CR €300 000

The journal entry to record the dividend in 2011 is: Date 30 June 2011

Account titles

DR €50 000

Dividend Cash

CR €50 000

The statement of financial position would appear as follows at 31 December 2009.

Botswana Wild Tours Statement of Financial Position As at 31 December 2009 € thousands Non-current assets Storage and repair facility Land Buildings Accumulated depreciation – facility

50 000 125 000 (36 000)

139 000

Old river campsite Land Building Accumulated depreciation – campsite

40 000 160 000 (50 400)

149 600

. .

14

New river campsite Land Building Accumulated depreciation – campsite

30 000 120 000 (3 667)

116 333

Equipment - tents Accumulated impairment loss Accumulated depreciation – equipment

350 000 (145 000) (205 000)

0

Vehicles Cost Accumulated depreciation – vehicles

510 000 53 000

457 000

Intangible assets – software

9 500

Investment in property Total non-current assets Current assets Cash Trade accounts receivable Less: Allowance for uncollectible accounts Prepaid expenses Other current assets Total current assets TOTAL ASSETS

50 000 921 433

214 200 424 000 (11 000) 35 000 45 000 707 200 1 628 633

Current liabilities Trade accounts payable Accrued liabilities Other current liabilities

128 200 25 000 10 000

163 200

Noncurrent liabilities Bond payable Note payable (due 31 December 2012)

700 000 200 000

900 000

Equity Ordinary shares, 50 000 issued Retained earnings* TOTAL LIABILITIES AND EQUITY

300 000 265 433

565 433 1 628 633

*This is the amount retained earnings must be since no other information is available.

. .

15

The statement of financial position would appear as follows at 31 December 2010.

Botswana Wild Tours Statement of Financial Position As at 31 December 2010 € thousands Non-current assets Storage and repair facility Land Buildings Accumulated depreciation – facility

50 000 148 000 (0)

198 000

Old river campsite Land Building Accumulated depreciation – campsite

70 000 160 000 (56 000)

174 000

New river campsite Land Building Accumulated depreciation – campsite

30 000 120 000 (7 667)

112 333

Equipment - tents Accumulated impairment loss Accumulated depreciation – equipment

350 000 (145 000) (205 000)

0

Vehicles Cost Accumulated depreciation – vehicles

525 000 (134 520)

390 480

Investment in property Total non-current assets Current assets Cash Trade accounts receivable Less: Allowance for uncollectible accounts Prepaid expenses Other current assets Total current assets TOTAL ASSETS Current liabilities Trade accounts payable . .

50 000 924 813

807 000 365 000 (19 300) 70 000 126 770 1 349 470 2 274 283

330 000

16

Accrued liabilities Other current liabilities

10 000 15 000

355 000

Noncurrent liabilities Bond payable Note payable (due 31 December 2012)

700 000 200 000

900 000

Equity Ordinary shares, 50 000 issued Retained earnings TOTAL LIABILITIES AND EQUITY

500 000 472 513

972 513 2 227 513

The statement of financial position would appear as follows at 31 December 2011.

Botswana Wild Tours Statement of Financial Position As at 31 December 2011 € thousands Non-current assets Storage and repair facility Land Buildings Accumulated depreciation – facility

50 000 148 000 (8 200)

189 800

Old river campsite Land Building Accumulated depreciation – campsite

70 000 160 000 (0)

230 000

New river campsite Land Building Accumulated depreciation – campsite

30 000 120 000 (11 667)

138 333

Equipment – new tents Accumulated depreciation – equipment

375 000 (70 000)

305 000

Vehicles Cost Accumulated depreciation – vehicles Total non-current assets Current assets Cash Trade accounts receivable . .

525 000 (215 500)

309 500 1 172 633

1 160 500 410 000

17

Less: Allowance for uncollectible accounts Prepaid expenses Other current assets Total current assets TOTAL ASSETS Current liabilities Trade accounts payable Note payable (due 31 December 20 Accrued liabilities Other current liabilities

(26 100) 80 000 88 000 1 712 400 2 885 033

270 000 200 000 5 000 15 000

Noncurrent liabilities Bond payable Equity Ordinary shares, 50 000 issued Less: Treasury shares Retained earnings* TOTAL LIABILITIES AND EQUITY

. .

490 000

700 000

500 000 (300 000) 1 495 033

1 695 033 2 885 033

18

Instructor Manual Chapter 10 Equity Changes

. .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

4

Learning Outcome 2 Learning Outcome 3 Learning Outcome 5 Learning Outcome 7

4 4 6 6

Answers to Terminology Practice

7

Answers to Comprehensive Application Problems

8

Case Analysis

18

. .

2

Lecture Notes Introduction This chapter outlines the basic components of equity including ordinary shares, preference shares, retained earnings and revaluation reserves created by other comprehensive income. Because laws related to the creation of limited liability companies vary from country to country and even within a country (e.g., the United States) only a general discussion is possible. I tell students that laws may vary in their own countries but that the underlying concepts are similar. Also, some developing countries in particular have a small or no public equities market, so you may need to provide a background lecture on capital markets and how they function.

I also find that students find this material somewhat dry. On page 533-4, I’ve include a case for Brik’s restaurants. This company generates a large amount of cash and management uses it to repurchase stock. This reduces the shares outstanding, increases the earnings per share and presumably causes the share price to increase. Students find this manipulation interesting. Plus it provides students with some idea of the flexibility of decision-making with respect to equity.

. .

3

Answers to Learning Outcome Questions Learning Outcome 2 Describe the statement of comprehensive income.

On Your Own 1. What are the two choices management has for presenting total comprehensive income?

Management can present a single statement of comprehensive income which includes both profit and loss and other comprehensive income. Or management can choose to present two statements.

The first is the statement of income which includes profit or loss. The second is the statement of comprehensive income which begins with profit or loss and then presents other comprehensive income.

Learning Outcome 3 Explain how revenue is recognized.

On Your Own 1. What the two major components of total comprehensive income?

The two major components of total comprehensive income are profit or loss and other comprehensive income.

2. What is the difference between income and profit or loss?

Profit or loss is equal to revenues less expenses. Income refers to increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

3. Define revenue. What is the difference between revenue and income?

Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of the entity. Income is a broader term that includes but is not limited to revenue.

A revaluation of an asset can result in income for the entity, for example.

4. What are royalties?

Royalties are charges for the use of long-term assets such as patents, trademarks, copyrights and software.

5. When is revenue recognized for the sale of goods? For rendering of services? For interest, royalties and dividends? How is revenue measured?

Revenue for goods is recognized when the following criteria are met: 1) the ownership is transferred to the buyer, 2) the business no longer has control over the goods sold, 3) the amount of revenues . .

4

and the costs associated with that revenue can be reliably measured, 4) it is probable that the economic benefits of the sale will flow to the entity.

Revenue for services is recognized based on how complete the services are. In addition, the amount of revenue, associated costs and stage of completion must be able to be reliably measured and the economic benefits from the service revenue transaction must flow to the business entity.

Revenue for interest, royalties and dividends is based on when the business is entitled to the economic benefits and when they can be reliably measured.

6. What is FOB shipping point? What is FOB destination?

FOB shipping point means that the buyer assumes ownership and responsibility for the goods when the seller turns them over to the carrier or shipping company. FOB destination means that the buyer assumes ownership and thus responsibility when the carrier delivers the goods to the buyer.

7. Why is revenue such as critical issue for accounting?

The recognition of revenue in the appropriate accounting period is a critical issue because it affects profit or loss for the period.

Learning Outcome Practice 1. How much revenue should Lanzhou recognise? b. €72 000 2. Which of the following conditions does not have to be met in order for revenue to be recognized for goods? d. The costs associated with the revenue must have already been incurred.

3. When should revenue be recognized by the seller in Paris? a. 12 November 2009 4. When should revenue be recognized by the seller in Paris? b. 14 November 2009 5. Which of the following conditions does not have to be met in order for revenue to be recognized for services? b. Services must be substantially complete.

6. How much dividend revenue should Roldo recognize in 2010? b. €250 000

. .

5

Learning Outcome 5 Explain why gains and losses are included in other comprehensive income.

On Your Own 1. Which of the following statements is correct? d.

A gain has been both recognized and realized 2. Which is correct? b.

The company has recognized but not realized a gain Learning Outcome 7 Explain how equity changes are evaluated.

ON YOUR OWN Learning Outcome Review 1. How is the times interest earned ratio calculated? What does the time interest earned ratio measure?

The times interest earned ratio is calculated by dividing profit + interest expense + tax expense by interest expense. The times interest earned ratio measure the number of times the amount of interest paid is “covered” by profit before interest and taxes. The higher the ration, the better able the company is to service the interest it must pay on debt.

2. How is the gross profit ratio calculated? What does the gross profit margin ratio measure?

The gross profit margin is calculated by dividing gross margin by net sales. The gross profit margin measures the amount contributed to profit before operating expenses, interest and taxes are deducted. When comparing two companies, for example, the company with a lower cost of goods sold would have the higher gross profit margin.

3. How is the profit margin ratio calculated? What does the profit margin ratio measure?

Profit margin is calculated by dividing profit (or loss) by net sales. At a given level of sales, the profit margin ratio measures how much profit or loss was generated. A higher profit margin ratio is more desirable.

4. What is the difference between the gross profit ratio and the profit margin ratio?

The gross profit ratio takes only the cost of sales or cost of goods sold into consideration. The profit margin ratio takes all expenses into consideration.

5. How is the return on assets calculated? What does return on assets measure?

Return on assets is calculated by dividing profit (or loss) by average total assets. Return on assets tells users how successful management was earning a return (profit) on the assets that were at their disposal. . .

6

6. How is return on investments calculated? What does return on investments measure?

Return on investment is calculated by dividing profit + interest expense (1 – tax rate) by average non-current liabilities plus equity. Return on investment tells the user how much before interest profit (net of taxes) was earned on the total amount invested including non-current assets and equity – the total amount investors have in the business.

Answers to Terminology Practice 1. Royalties are charges for the use of long-term assets such as patents, trademarks and software.

2. The gross profit ratio is calculated by dividing gross profit by net sales.

3. Realizable value is the amount of cash or cash equivalent that could currently be obtained by selling an asset in an orderly disposal.

4. Total comprehensive income is the total of profit or loss and other comprehensive income.

5. The times interest earned ratio is calculated by dividing profit + interest expense + tax expense by interest expense.

6. Interest income is payment received for earnings on amounts owed to the business entity.

7. A value added tax is a tax assessed on the value of goods and services at each stage of distribution.

8. FOB shipping point and FOB destination refer to the point which the buyer assumes responsibility for the goods being shipped.

9. Dividend income is the income received from profit distributions from a company owned by the business entity.

10. Realization occurs when a transaction has been completed or consummated.

11. The profit margin ratio is calculated by dividing profit by net sales.

12. A sales tax is a tax levied on the final sales price of goods or services.

13. Return on assets is calculated by dividing profit by average total assets.

14. Return on investment is calculated by dividing average noncurrent liabilities plus equity into profits plus after tax interest expense.

. .

7

Answers to Comprehensive Application Problems 1. The corrected statement of income for Gareth Carson Corporation follows.

Gareth Carson Corporation Statement of Income For the year ended 30 April 2011 Revenue Cost of goods sold Purchases Add: Carriage and delivery Less: Purchase discounts Returns inwards (purchase allowances) Cost of goods available Less: Ending inventory – see Note 1 Gross profit Operating expenses Wages – see Note 3 Rent – see Note 2 Electricity Telephone Other expenses Carriage and delivery Total operating expenses Profit

$97 600 $46 840 1 428 (2 423) (954) 44 891 6 259

38 632 58 968

31 580 12 000 4 800 2 750 839 418 52 387 $6 581

Note 1 – The damaged goods would be valued at lower of cost and net realizable value. Net realizable value is $1 445 = $1 820 - $375. The amount for the undamaged goods is $4 814 = $6 378 - $1 564. Thus, the ending inventory would be $6 259 = $4 814 + $1 445.

Note 2 – The last payment of $3 000 should be classified as prepaid rent. Thus, the amount of rent expense would be $12 000 = $15 000 – $3 000.

2. The corrected statement of income for Airn Enterprises Ltd. follows.

Airn Enterprises Ltd. Statement of Income For the year ended 30 June 2010 Revenue Cost of goods sold Purchases Cost of goods available Less: Ending inventory . .

$517 200 $334 600 334 600 63 200

8

Gross profit Operating expenses Wages Depreciation on shop fittings Depreciation on new motor van Rent and general expenses Total operating expenses Operating profit Gain on sale of motor van Profit

271 400 74 000 4 500 4 400 55 300 138 200 133 200 500 $133 700

1) Revenue is calculated by adding $418 200 in cash receipts banked plus $95 100 in cash receipts that were used to pay expenses in cash (see Note 1) plus the increase in trade receivables of $3 900.

2) Purchases are calculated by adding purchases paid in cash for $13 700 (see Note 1) plus $316 300 from the accounting of cash transactions plus the $4 600 increase in trade payables.

3) Rent and general expenses are calculated by adding $7 400 for expenses paid in cash, $47 400 from the accounting of cash transactions plus $500 for the increase in the amount owing for rent and general expenses.

3. Following are the calculations for Rampion as of 31 December 2010.

Part a.

Profit before adjustments Inventory adjustment $36 000 – (40% x $36,000) Uncollectible accounts expense – see Note Profit after adjustments

$684 000 (21 600) (10 400) $652 000

Part b.

Inventory before adjustment Adjustment for inventory sold after reporting date Inventory after adjustment

$116 800 21 600 $138 400

Trade receivables Allowance after adjustments – see Note Net receivables

$248 000 12 400 $235 600

Note – The beginning balance in the allowance account of $10 000 is reduced to $2 000 with the $8 000 write off. Then it is increased to $12 400 based on the 5% of $248 000 in trade receivables. Thus, the allowance account must be increased by $10 400 = $12 400 - $2 000 which would be recognized in expense for the period. . .

9

4. Sondaw LLC a. Following is the statement of income and statement of financial position.

Sondaw LLC Statement of Income For the year ended 31 May 2009 $000 Revenue Cost of sales Beginning inventories Purchases Discounts received Depreciation expense – see schedule below General expenses Heating and lighting Wages and salaries Cost of goods available Less: Ending inventory Gross profit Administrative expenses Marketing and advertising expenses Uncollectible accounts expense Depreciation expense – see schedule below General expenses Heating and lighting Wages and salaries Distribution costs Depreciation expense – see schedule below General expenses Heating and lighting Wages and salaries Operating profit Interest expense Income tax expense Profit

. .

5 876 $1 200 2 200 (150) 217 60 45 300 $3 872 800

242 58 75 300 18 50

75 240 27 150

3 072 2 804

743

492 $1 569 30 250 $1 289

10

The schedule to calculate and allocate depreciation expense follows.

Total depreciation expense Allocations Cost of sales Distribution costs Administrative expenses

Building $250

Motor Vehicles $25

Property and equipment $92

Totals $367

125 50 75

25 -

92 -

217 75 75

General expenses $600

Heating & lighting $90

Wages and salaries $500

60 240 300

45 27 18

300 150 50

The schedule to calculate and allocate other expenses follows.

Total expense Allocations Cost of sales Distribution costs Administrative expenses

Totals $1 190 405 417 368

Total wages = $490 000 + $10 000 accrual (see item iii).

Sondaw LLC Statement of Financial Position 31 May 2009 $000 Assets Non-current assets Building at cost Accumulated depreciation -- building Plant and equipment at cost Accumulated depreciation – plant and equipment Motor vehicles at cost Accumulated depreciation – motor vehicles Total noncurrent assets Current assets Cash in bank Trade receivables Allowance for uncollectible accounts Prepaid marketing and advertising expenses . .

5 000 (2 250) 700 (332) 160 (85)

$2 750 368 75 3 193

50 400 (20) 6

11

Inventories Total current assets TOTAL ASSETS

800 1 236 $4 429

Equity $1 ordinary shares Retained earnings ($280 + $1 289) Total Equity Liabilities 5% loan note Trade payables Wages payable Taxes payable Total liabilities Total liabilities and equity

1 500 1 569 $3 069

600 500 10 250 1 360 $4 429

b. Depreciation systematically allocates the depreciable cost of a noncurrent asset over its useful life. The rationale of depreciation is that the cost of the asset must be matched to the revenue it generates. IFRS allows management to choose any method of depreciating an asset as long as it reflects the pattern of economic benefits generated by the asset. However, as a practical matter, assets are usually depreciated using either the straight-line, diminishing balance or units-of-production methods discussed in Chapter 7.

5. The adjusted statement of financial position for Shuswap follows.

Shuswap Statement of Financial Position 31 December 2009 $000 Assets Non-current assets Land and Building Plant and equipment Total noncurrent assets Current assets Cash at bank Trade receivables – net allowance Inventories Total assets TOTAL ASSETS . .

12 000 11 650 23 650 6 700 2 494 3 000

12 194 35 844

12

Equity Capital and reserves Issued share capital (ordinary shares 50 cents each) Share premium Retained earnings Revaluation reserve Total Equity

13 000 2 400 12 450 4 000 31 850

Noncurrent liabilities Loan notes (redeemable 2010) Current liabilities Trade payables Total liabilities and equity

2 000 1 994 35 844

6. The statement of income and statement of financial position for Adnett follow.

Adnett, LLC Statement of Income For the year ended 31 May 2011 $000 Revenue Returns inwards Net sales Cost of sales Beginning inventories ($515 + $35 acquisition) Purchases Returns outwards Carriage inwards Depreciation expense -- plant Depreciation expense – building Heating and lighting Wages and salaries Cost of goods available Ending inventory Gross profit Operating expenses Administrative expenses Discounts allowed and received ($70 - $80) General administrative expenses Depreciation expense – building Impairment of goodwill Heating and lighting . .

3 500 (15) 3 485

550 2 170 (17) 105 200 13 108 146 3 275 (560)

2 715 770

(10) 60 13 17 108

13

Wages and salaries Distribution costs Depreciation expense – building Heating and lighting Wages and salaries Director’s remuneration Operating expenses Operating profit Interest expense Tax expense Profit

73 26 54 73

261

153 60 296 306 58 70 178

The schedule to calculate and allocate depreciation expense follows.

Total depreciation expense 5% x $1 040 Allocations Cost of sales Distribution costs Administrative expenses

Building $52

13 26 13

The schedule to calculate and allocate other expenses follows.

Total expense Allocations Cost of sales Distribution costs Administrative expenses

Heating & lighting $270

Wages and salaries $292

108 54 108

146 73 73

Goodwill would be recorded as an asset and written down when impaired.

Adnett, LLC Statement of Financial Position 31 May 2011 $000 Assets Non-current assets . .

14

Buildings at cost Accumulated depreciation – building ($160 + $52) Plant at cost Accumulated depreciation – plant Land at cost Goodwill Total noncurrent assets Current assets Cash in bank Trade receivables Allowance for uncollectible accounts Inventories Total current assets TOTAL ASSETS

1 040 (212) 1 200 (600)

828 600 345 68 1 841

147 700 (30) 560 1 387 3 228

Equity $1 ordinary shares ($800 + $100 + $180) Share premium account ($200 + $20 - $180 scrip issue) Retained earnings ($115 - $35 transfer + $178 profit) General reserve ($35 + $35 transfer from profits) Total Equity

1 080 40 258 70 1 448

Liabilities 10% loan notes Trade payables Wages and salaries payable Taxes payable Interest payable Total liabilities Total liabilities and equity

580 1 030 42 70 58 1 780 3 228

7. Following is the statement of changes in equity for Yeung, LLC. Yeung, LLC Statement of Changes in Equity For the year ended 30 June 2011 $m Share capital

Balance at 1 July 2010 Error correction for inventory Share capital issue

. .

Share premium

100

140

100

180

Revaluation reserve

Accumulated profits

60

120 (6)

Totals

420 (6) 280

15

Sale of land Profit adjusted for inventory Dividends Balance at 30 June 2011

(60)

200

320

-

34 (8) 140

(60) 34 (8) 660

8. The statement of income and statement of financial position for Tonson, LLC follow.

Tonson, LLC Statement of Income For the year ended 31 October 2011 $000 Revenue Returns inwards Net sales Cost of sales Beginning inventories Purchases Discounts received Cost of goods available Ending inventory Gross profit Operating expenses Wages and salaries Insurance expense General expenses Energy expenses Marketing expenses Bad debt expense Property expenses Telephone expenses Loss on inventory write down Depreciation expense – building Depreciation expense – motor vehicles Depreciation expense – furniture and equipment Operating expenses Operating profit Interest expense Tax expense Profit

. .

5 780 (95) 5 685

325 3 570 (50) 3 845 250

3 595 2 090

715 75 60 66 45 155 100 80 25 75 32 240 1 668 422 33 150 239

16

Tonson, LLC Statement of Financial Position 31 October 2011 $000 Assets Non-current assets Buildings – revalued Accumulated depreciation Motor vehicles Accumulated depreciation Furniture and equipment Accumulated depreciation – furniture and equipment Land at cost Total noncurrent assets Current assets Cash Trade receivables Allowance for uncollectible accounts Prepaid marketing Inventories Total current assets TOTAL ASSETS Equity $1 ordinary shares Share premium account Retained earnings ($315 + $239 profit) Revaluation reserve Total Equity Liabilities 7% loan notes Overdrawn bank Trade payables Wages and salaries payable Taxes payable Total liabilities Total liabilities and equity

. .

1 800 240 (112) 1 200 (660)

1 800 128 540 740 3 208

15 900 (45) 5 250 1 125 4 333

1 980 20 554 735 3 289

470 94 290 40 150 1 044 4 333

17

Case Analysis Botswana Wild Safaris, LLC Continued from Chapters 7, 8 and 9 The statements of comprehensive income and statement of changes in equity for 2009 are as follows.

Botswana Wild Safaris, LLC Statement of Comprehensive Income For the Year Ended 31 December 2009 € (euros) Revenue Less: Expenses Uncollectible accounts expense Maintenance expense Depreciation expense Storage and repair facility Old river campsite New campsite Equipment Vehicles Amortization expense – software Interest expense Total expenses Operating profit Loss on impairment of equipment Gain on investment in property Profit or loss Other comprehensive income TOTAL COMPREHENSIVE INCOME

. .

800 000 550 000 24 000 1 800 4 000 5 600 3 667 65 000 36 000

114 267 9 500 99 000 798 567 1 433 (145 000) 15 000 (128 567) 0 (128 567)

18

Botswana Wild Safaris, LLC Statement of Changes in Equity For the Year Ended 31 December 2009 € (Euros) Retained earnings

Share capital Balance 1 January 2009

Revaluation account

Total

300 000

295 000

Profit of loss

-

(128 567)

Dividends

-

0

0

0

300 000

166 433

0

466 433

Balance 31 December 2009

0

595 000 (128 567)

The statements of comprehensive income and statement of changes in equity for 2010 are as follows.

Botswana Wild Safaris, LLC Statement of Comprehensive Income For the Year Ended 31 December 2010 € (Euros) Revenue Less: Expenses Uncollectible accounts expense Depreciation expense Storage and repair facility Old river campsite New campsite Vehicles Amortization expense – software Interest expense (€18 000 + €45 500) Total expenses Profit or loss Other comprehensive income Revaluation of storage and repair facility Revaluation of river campsite land TOTAL COMPREHENSIVE INCOME

. .

1 100 000 600 000 22 300 4 000 5 600 4 000 81 250

94 850 9 500 63 500 790 150 309 850 63 000 30 000 402 850

19

Botswana Wild Safaris, LLC Statement of Changes in Equity For the Year Ended 31 December 2010 € (Euros) Retained earnings

Share capital

Revaluation account

Total

Balance 1 January 2010

300 000

166 433

0

466 433

Issuance of shares

200 000

-

-

200 000

Profit of loss

-

309 850

-

309 850

Revaluations

-

-

93 000

93 000

Dividends

-

(50 000)

0

(50 000)

500 000

426 283

93 000

1 019 283

Balance 31 December 2009

The statements of comprehensive income and statement of changes in equity for 2011 are as follows.

Botswana Wild Safaris, LLC Statement of Comprehensive Income For the Year Ended 31 December 2011 € (Euros) Revenue Less: Expenses Uncollectible accounts expense Depreciation expense Storage and repair facility Old river campsite Equipment New campsite Vehicles Interest expense (€19 620 + €45 500) Total expenses Operating income Gain on disposal of investment property Profit or loss Other comprehensive income Revaluation of river campsite TOTAL COMPREHENSIVE INCOME . .

1 460 000 750 000 43 800 8 200 5 600 70 000 4 000 80 980 65 120

233 900 1 027 700 432 300 65 000 497 300 91 600 588 900

20

Botswana Wild Safaris, LLC Statement of Changes in Equity For the Year Ended 31 December 2010 € (Euros) Retained earnings

Share capital

Revaluation account

Total

Balance 1 January 2009

500 000

426 283

Treasury shares acquired

(300 000)

-

(300 000)

Profit of loss

-

497 300

497 300

Revaluations

-

-

91 600

91 600

Dividends

-

(50 000)

0

(50 000)

200 000

873 583

184 600

1 258 183

Balance 31 December 2009

. .

93 000

1 019 283

21

Instructor Manual Chapter 10 Cash Flows

. .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

4

Learning Outcome 1 Learning Outcome 3 Learning Outcome 4 Learning Outcome 5

4 4 6 7

Answers to Terminology Practice

8

Answers to Application Problems

9

Case Analysis

18

. .

2

Lecture Notes Introduction The centerpiece of this chapter is the construction of the statement of cash flows under both the indirect and direct method. Though the IASB favors the direct method, as pointed out in the chapter, the vast majority of companies use the indirect method.

. .

3

Answers to Learning Outcome Questions Learning Outcome 1 Describe how cash flows relate to business life cycle phases On Your Own 1. What are the four phases of the business life cycle?

The four phases of the business life cycle are start-up, growth, expansion and maturity.

2. How does each phase of the business life cycle typically affect cash flows from operating activities, investing activities and financing activities?

Activity

Growth Phase

Operating activities Investing activities

Start-Up Phase Use Use

Use Use

Expansion Phase Source Use

Financing activities

Source

Source

Source

Maturity Phase Source Source or use Source or use

Learning Outcome 3 Explain the sources and uses of cash and cash equivalents On Your Own 1. What are operating activities as reported on the statement of cash flows? What are investing activities? What are financing activities?

Operating activities relate to the principal revenue producing activities of the entity, and other activities that are not investing or financing activities.

Investing activities relate to the acquisition and disposal of long-term assets and other instruments not included in cash equivalents.

Financing activities relate to changes in the size and composition of the contributed equity and borrowings of the entity.

2. What are examples of operating activities? What are examples of investing activities? What are examples of financing activities?

Operating activities – Sources could include cash receipts from the sale of goods and services, royalties, fees, commissions and other revenue. Uses could include cash payments to suppliers for goods and services, and employees.

. .

4

Investing activities – Sources could include cash receipts from the sale of property, plant and equipment or intangible and other assets, and from the sale of equity or debt instruments of other businesses. Uses could include cash payments to acquire property, plant and equipment or intangible or other assets and to acquire equity or debt instruments of other businesses.

Financing activities – Sources could include proceeds from the sale of the business’s shares and from short-term and long-term borrowings. Uses could include cash payments to acquire the business’s own shares and repayments of amounts borrowed.

3. What is the difference between an investing activity and a financing activity?

An investing activity relates to the acquisition and disposal of long-term assets and other investments not included in cash while financing activities relate to changes in the business’s borrowings and equity.

4. Why are movements between cash and cash equivalents excluded from the statement of cash flows?

Movements between cash and cash equivalents is that the investment of excess cash into cash equivalents and the conversion of cash equivalents into cash is part of a business’s normal cash management activities. They are therefore not regarded as a source or use of cash.

5. What is the rule of thumb in terms of the number of months for classifying an investment as a cash equivalent? If an investment has a maturity that does not meet this rule-of-thumb test, then how is it classified?

Normally cash equivalents have a maturity within three months of the date of acquisition.

Otherwise, the investment would be treated as an investing activity.

6. What the two major exceptions for not reporting cash flows on a net basis? Why do you think that cash flows are generally not reported on a net cash basis?

Cash flows arising from the following operating, investing or financing activities may be reported on a net basis: a. cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the entity; and b. cash receipts and payments for items in which the turnover is quick, the amounts are large, and the maturities are short.

7. What options are available to report interest and dividends in the statement of cash flows?

Interest and dividends are usually included as part of operating activities however they can also be classified as financing activities 8. What are examples of noncash transactions?

Examples of noncash transactions include the acquisition of assets assuming a related liability, the acquisition of another company by issuing additional shares in the business, and the conversion debt to equity.

Learning Outcome Practice 1. Borrowing a loan from a bank would be classified as which of the following? c. Financing activity . .

5

2. Cash used to purchase equipment would be classified as which of the following? b. Investing activity 3. Cash payments to acquire the business’s own shares would be classified as which of the following? c. Financing activity 4. Cash flows from acquisitions and disposals of subsidiaries and other businesses would be classified as which of the following? b. Investing activity 5. Cash inflows and outflows related to income taxes would be classified as which of the following? a. Operating activity 6. Cash receipts from commissions earned would be classified as which of the following? a. Operating activity 7. Cash repayments of amounts borrowed would be classified as which of the following? b. Financing activity 8. Cash receipts from the sale of property, plant and equipment, intangible and other assets would be classified as which of the following? b. Investing activity 9. Cash payments to employees would be classified as which of the following? a. Operating activity Learning Outcome 4 Construct a statement of cash flows using the indirect and direct methods On Your Own 1. What are two methods for calculating the operating activities section of the statement of cash flows?

The two methods are the direct method and the indirect method.

2. What is the approach used by the direct method? What is the approach used by the indirect method?

The direct method reports gross cash receipts and gross cash payments by major class. The indirect method begins with profit or loss and then makes the adjustments necessary to convert to cash flows.

3. What three types of adjustments are made to profit or loss in the operating activities section under the indirect methods?

Three adjustments are made to profit or loss under the indirect methods: 1. effects of noncash transactions 2. deferrals or accruals of past and future operating cash receipts or payments 3. items of income or expense associated with investing or financing cash flows. . .

6

Learning Outcome Practice 1. Which of the following would increase the amount of cash generated by operating activities under the indirect method? i. Trade receivables increase by €120 000 during the period ii. Trade payables increase by €80 000 during the period. iii. Inventories increase by €200 000 during the period b. ii only 2. By how much does cash generated by operating activities under the indirect method increase or decrease when the effects of all the following items are considered? i. Trade receivables increase by €120 000 during the period ii. Trade payables increase by €80 000 during the period iii. Inventories increase by €200 000 during the period b. €240 000 decrease 3. By how much does cash generated by operating activities under the indirect method increase or decrease when the effects of all the following items are considered? i. Loss on a sale of equipment for €14 000 during the period ii. Trade receivables decrease by €8 000 during the period iii. Depreciation for the period was €43 000 b. €65 000 increase Learning Outcome 5 Calculate cash flow related ratios On Your Own 1. How is the current cash debt coverage ratio calculated? Is this a liquidity, solvency or profitability ratio?

The current cash debt coverage ratio is calculated: Current cash debt coverage ratio =

Cash from operating activities Average current liabilities

The cash debt coverage ratio measures liquidity.

2. How is the cash debt coverage ratio calculated? Is this a liquidity, solvency or profitability ratio?

The cash debt coverage ratio is calculated: Cash debt coverage ratio =

Cash from operating activities Average total liabilities

The cash coverage ratio measures solvency.

3. How is free cash flow calculated? Is this a liquidity, solvency or profitability measure? . .

7

Free cash flow is calculated: Free cash flow =

Cash provided from operating activities

-

Capital expenditures

-

Cash dividends

Free cash flow measure solvency.

4. How is operating cash flow per share calculated? Is this a liquidity, solvency or profitability measure?

Operating cash flow is calculated: Operating cash flow per share =

Cash from operating activities Ordinary shares outstanding

Operating cash flows is a profitability measure.

Answers to Terminology Practice 1. The cash debt coverage ratio is calculated by dividing cash from operating activities by average total liabilities 2. In the maturity phase of the business life cycle, a business has reached the point where its infrastructure is fully developed, even though it may replace and upgrade assets and invest in new products and services as market-place opportunities evolve 3. When the direct method of calculating cash flows from operating activities is used, major classes of gross receipts and gross cash payments are disclosed 4. In the expansion phase of the business life cycle, a business has usually established a presence in the market place and may have a positive cash flow from operating activities 5. The current cash debt coverage ratio is calculated by dividing cash from operating activities by average current liabilities 6. A business life cycle describes the typical evolution of a business and has four phases: start-up, growth, expansion and maturity 7. In the growth phase of the business life cycle, a business is beginning to produce and market a product or service 8. Free cash flow is calculated by subtracting capital expenditures and cash dividends from cash provided from operating activities 9. In the start-up phase of the business life cycle, a business is just beginning operations and costs typically exceed revenue 10. When the indirect method of calculating cash flows from operating activities is used, profit or loss is adjusted for the effects of transactions of a noncash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income and expense associated with investing or financing cash flows 11. Operating cash flow per share is calculated by dividing cash from operating activities by ordinary shares outstanding

. .

8

Answer to Application Exercises 1. The amounts for missing items are as follows.

Cash balance at beginning of reporting period Net cash provided by (used by) operating activities Net cash provided by (used by) investing activities Net cash provided by (used by) financing activities Cash balance at end of reporting period

$18 100 ($3 900) $9 210 $15 000

2. Cash from sales is calculated as follows.

Sales for year ended 31 December 2009 40% sold cash Increase in trade accounts receivable Cash from sales

¥300 700 000 120 280 000 (119 000 000) ¥1 280 000

3. Cash paid to suppliers is calculated as follows.

Cost of goods sold 2010 Increase in inventories Decrease in trade accounts payable Cash paid to suppliers

£1 350 000 55 000 50 000 £1 455 000

4. Interest expense paid is calculated as follows.

Financing expenses as reported Increase in interest payable Cash paid for interest during the year

€230 000 (25 000) €205 000

5. Cash paid for 2009 operating expenses is calculated as follows.

Operating expenses for 2009 Less: Non-cash depreciation expense Decrease in prepaid expenses Increase in liabilities Cash paid for 2009 operating expenses

$2 500 000 (310 000) (110 000) (35 000) $2 045 000

6. Cash generated from operating activities is calculated as follows.

Profit for the year ended 31 December 2009 Add: Non-cash depreciation expense Add: Non-cash amortization expense Decrease in trade accounts receivable Increase in trade accounts payable Cash generated from operating activities . .

€400 000 22 000 1 370 2 500 (2 000) €423 870

9

7. The ratios would be computed as follows.

. .

Current cash debt coverage ratio

=

Cash from operating activities Average current liabilities

Current cash debt coverage ratio

=

£135 000 (£20 000 + 18 000) ÷ 2

Current cash debt coverage ratio

=

7.12

Cash debt coverage ratio

=

Cash from operating activities Average total liabilities

Cash debt coverage ratio

=

£135 000 (£130 000 + 113 000) ÷ 2

Cash debt coverage ratio

=

1.11

Free cash flow

=

Cash provided from operating activities

-

Capital expenditures

Free cash flow

=

£135 000

-

£30 000

-

£14 000

£91 000

=

£135 000

-

£30 000

-

£14 000

Operating cash flow per share

=

Cash from operating activities Ordinary shares outstanding

Operating cash flow per share

=

£135 000 20 000

£6.75

=

£135 000 20 000

-

Cash dividends

10

8. The classification of items is as follows.

Operating Activity Source Use Cash outflows for acquisitions of subsidiaries and other businesses Cash receipts from the payment of advances

Investing Activity Source Use X

X

Cash proceeds from short-term and long-term borrowings Cash repayments of amounts borrowed

X X

Cash loans to other parties.

Cash inflows from the disposal of subsidiaries and other businesses.

Cash receipts from the sale of property, plant and equipment, intangible and other assets.

Cash payments to acquire equity or debt investments of other businesses.

Cash payments to suppliers for goods and services.

Cash outflows for investments in financial assets and liabilities.

Cash payments to acquire the business’s own shares.

Income tax refunds.

Cash receipts from the sale of goods and services, royalties, fees, commissions and other revenue.

Cash receipts from the sale of equity or debt investments of other businesses.

Cash proceeds from the sale of the business’s shares.

Cash payments to employees.

Cash payments to acquire property, plant and equipment, intangible and other assets.

Income tax payments.

Cash inflows for investment in financial assets and liabilities.

. .

Financing Activity Source Use

X X X X X X X X X

X X X X X X

11

9. The statement of cash flows for Nobrie using indirect method is as follows.

Nobrie Statement of cash flows for the year ended 31 May 2009 000 Cash flows from operating activities Profit $31 881 Adjustments for: Depreciation 5 862 Increase in inventories (866) Increase in trade accounts receivable (5 684) Decrease in bank overdraft (1 440) Decrease in trade accounts payable (3 625) Increase in taxation (payable) 666 Profit on sale of equipment (1 540) Cash provided by operating activities

$25 254

Cash flows from investing activities Purchase of property, plant and equipment – see note below Sale of property, plant and equipment Cash used by investing activities

(24 995)

Cash flows from financing activities Increase in share capital Payments on noncurrent loan note Cash provided by financing activities Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

($28 048) 3 053

$7 450 (6 244) 1 206 1 465 2 224 $3 689

For the purchase of property, plant and equipment: Nobrie ended 2009 with $144 844 000 in noncurrent assets. However, $8 272 000 of this increase was due to the increase in the revaluation reserve (no other noncurrent asset was available to revalue). A revaluation of an asset would be a noncash event. Thus, the difference is $136 752 000.

At the beginning of the year, Nobrie reported $114 785 000. But during the year the company had disposed of an asset for $3 053 000 and a profit of $1 540 000. The carrying value was therefore $1 513 000 which is the difference. But what was the cost of the asset that had been disposed of?

To calculate that, depreciation expense is subtracted from the ending accumulated depreciation balance to give $21 571 000 = $27 433 000 - $5 862 000. The difference between this amount and the accumulated depreciation balance at the beginning of the year is $4 748 000 = $21 571 000 - $26 319 000. This difference was the amount of accumulated depreciation for the asset that the company disposed of. . .

12

Adding the carrying value of $1 513 000 and the accumulated depreciation of $4 748 000 is equal to $6 261 000 which was the cost of the asset the company sold. This amount is deducted from the beginning cost of property, plant and equipment to give $108 424 000. Therefore, the cost of newly acquired property, plant and equipment was $28 048 000 = $136 572 000 - $108 524 000.

10. The statement of cash flows for Sioux LLC using indirect method is as follows.

Sioux LLC Statement of cash flows for the year ended 31 December 2010 $ 000 Cash flows from operating activities Profit Adjustments for: Depreciation Decrease in inventories Increase in receivables Increase in payables Increase in income tax Profit on sale of equipment Cash provided by operating activities

1 650 1 250 400 (900) 500 100 (150) 2 850

Cash flows from investing activities Purchase of property, plant and equipment – see note below Sale of property, plant and equipment Cash used by investing activities

(3 300) 500

Cash flows from financing activities Payment of cash dividend Proceeds from increase in loan notes Cash provided by financing activities

(750) 1 000

(2 800)

Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

250 300 100 400

For the purchase of property, plant and equipment: Sioux ended 2010 with $11 000 000 in noncurrent assets. However, $500 000 of this increase was due to the increase in the revaluation reserve related to land. Thus, the difference is $10 500 000.

At the beginning of the year, Sioux reported $8 000 000 in noncurrent assets. But during the year the company had disposed of an asset which cost $800 000 leaving a net of $7 200 000 in assets. When this is subtracted from the $10 500 000, then the company must have acquired $3 300 000 in new assets. . .

13

To calculate depreciation expense, accumulated depreciation for the asset disposed of is calculated at $450 000 = $800 000 cost less net book value of $350 000. This is subtracted from the beginning accumulated depreciation to give $4 350 000. Thus depreciation expense is $1 250 000 = $5 600 000 - $4 350 000.

11. The statement of cash flows for Snowdrop using indirect method is as follows.

Snowdrop Statement of cash flows for the year ended 31 May 2011 $ 000 Cash flows from operating activities Profit Adjustments for: Increase in inventories Increase in receivables Increase in payables Increase in income tax Increase in bank overdraft Loss on sale of equipment Cash used by operating activities

$852 (80) (30) 85 35 58 20 940

Cash flows from investing activities Purchase of property, plant and equipment Sale of property, plant and equipment Cash used by investing activities

(2 100) 180

Cash flows from financing activities Increase in share capital Payment of cash dividend Payment of loan note Cash provided by financing activities

1 280 (270) (100)

Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

(1 920)

910 (70) 170 100

Comment: Cash flow from operations is positive. The company appears to be increasing equity and reinvesting that into additional property, plant and equipment.

. .

14

12. The statement of cash flows for H. Marathon using indirect method is as follows.

H. Marathon Statement of cash flows for the year ended 31 October 2011 $000 Cash flows from operating activities Profit 8 319 Adjustments for: Depreciation 6 784 Decrease in inventories 3 015 Decrease in receivables 3 232 Decrease in payables (270) Increase in taxation payable 175 Decrease in bank overdraft (973) Gain on sale of equipment (1 806) Cash provided by operating activities

18 476

Cash flows from investing activities Purchase of property, plant and equipment Sale of property, plant and equipment Cash used by investing activities

(7 671) 5 667 (2 004)

Cash flows from financing activities Increase in share capital Payment of cash dividend Payment of loan note Cash provided by financing activities

4 231 (3 697) (16 889)

Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

. .

(16 355) 117 3 036 3 153

15

13. The statement of cash flows for Granada using indirect method is as follows.

Granada Statement of cash flows for the year ended 31 December 2010 $000 Cash flows from operating activities Profit Adjustments for: Depreciation Increase in inventories Decrease in receivables Increase in payables Increase in income tax Decrease in bank overdraft Gain on sale of equipment Cash provided by operating activities Cash flows from investing activities Purchase of property, plant and equipment Sale of property, plant and equipment Cash used by investing activities Cash flows from financing activities Increase in share capital Payment of cash dividend Payment of loan note Cash provided by financing activities Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

. .

670 310 (200) 200 100 100 (140) (20) 1 020

(1 500) 80 (1 420)

480 (250) 200 430 30 50 80

16

14. The statement of cash flows for Joyce LLC using indirect method is as follows.

Joyce LLC Statement of cash flows for the year ended 31 October 2011 $000 Cash flows from operating activities Profit Adjustments for: Increase in inventories Increase in receivables Decrease in payables Increase in tax payable Increase in bank overdraft Cash used by operating activities

(4 900) (8 900) (2 100) 2 000 1 300 1 400

Cash flows from investing activities Purchase of property, plant and equipment Cash used by investing activities

(6 000)

Cash flows from financing activities Increase in share capital Payment of cash dividend Increase of loan note Cash provided by financing activities

2 000 (4 000) 2 000

Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

. .

14 000

(6 000)

(4 600) 4 600 -

17

Case Analysis Botswana Wild Safaris, LLC Continued from Chapters 7, 8, 9 and 10

The statement of cash flows for 2010 would be: Botswana Wild Tours, LLC Statement of Cash Flows For the year ended 31 December 2010 € thousands Cash flows from operating activities Profit Adjustments for: Depreciation Software amortization Uncollectible accounts expense Decrease in trade accounts receivable Increase in prepaid expenses Increase in other current assets Increase in trade accounts payable Decrease in accrued liabilities Increase in other current liabilities Cash from operating activities

102 140 9 500 8 300 60 000 (35 000) (35 000) 201 800 (15 000) 5 000

Cash flows from investing activities Purchase of new vehicles Cash used by investing activities

(151 000)

Cash flows from financing activities Increase in share capital Note payable Payment of cash dividend Cash provided by financing activities

200 000 18 000 (50 000)

Net change in cash Cash at the beginning of 2010 Cash at the end of 2010

. .

302 560

301 740 604 300

(151 000)

168 000 621 300 197 200 818 500

18

The statement of cash flows for 2011 would be: Botswana Wild Tours, LLC Statement of Cash Flows For the year ended 31 December 2011 € thousands Cash flows from operating activities Profit Adjustments for: Depreciation Uncollectible accounts expense Increase in trade accounts receivable Increase in prepaid expenses Increase in other current assets Decrease in trade accounts payable Decrease in accrued liabilities Gain on disposal of investment property Cash from operating activities

188 760 6 800 (22 000) (10 000) (8 000) (60 000) (5 000) (65 000) 25 560

Cash flows from investing activities Purchase of equipment Sale of investment property Cash used by investing activities

(375 000) 115 000

Cash flows from financing activities Purchase of treasury shares Note payable Payment of cash dividend Cash provided by financing activities

(300 000) 19 620 (50 000)

Net change in cash Cash at the beginning of 2011 Cash at the end of 2011

. .

437 320

(260 000)

(330 380) (127 500) 818 500 691 000

19

Instructor Manual Chapter 12 Comparability and Consistency

. .

1

Lecture Notes

3

Answers to Review Questions

3

Answers to Terminology Practice

4

Answers to Application Exercises

5

. .

2

Lecture Notes Introduction In this chapter, I tried to raise awareness of the importance of investment professionals in evaluating financial statements. I also wanted to emphasize the role of institutional investors. Thus, the beginning of the chapter is devoted to a discussion of these groups and the roles they play.

In addition, I find that students are very interested to learn that accounting practices are not always accepted at face value. Investors and others often have views about the usefulness of accounting information. Therefore, the introduction (pages 633-4) briefly reviews survey findings related to income measurement, historical cost versus revaluation to fair value and cash flows.

Following that are discussions of horizontal analysis, vertical analysis and ratio analysis. The chapter was constructed around actual data from the airlines.

Answers to Review Questions 1. A company may choose to finance its activities mainly by equity capital, with low borrowings (low gearing) or by relying on high borrowings with relatively low equity capital (high gearing). Required: Explain why a highly geared company is generally more risky from an investor’s point of view than a company with low gearing.

High gearing means the company has a large amount of debt on which it must pay interest. Also, the debt must be repaid on the agreed-upon schedule. If the business experiences a downturn causing cash flow to decline, then the company may have difficulty making payments. In the extreme, this could lead to a default on the debt.

2. Ratio analysis in general can be useful in comparing the performance of two companies, but it has its limitations. Required: State and briefly explain three factors that can cause accounting ratios to be misleading when used for such a comparison.

1) If a company has multiple lines of business, ratio analysis will be less helpful than if comparing companies with a single business line 2) Ratios can be used meaningfully only when comparing businesses in the same industry or to industry averages and are not meaningful between companies in different industries 3) Ratios do not tell the entire story. On the last point, ratios may show that liquidity is decreasing but this does not tell us why management is doing this or whether decreased liquidity is desirable.

. .

3

Answers to Terminology Practice 1. Horizontal analysis can be performed using either the base period analysis or period-to-period analysis.

2. Trend analysis attempts to identify patterns in information over time.

3. The period-to-period analysis to horizontal analysis compares amounts for a line item in the current period with the amount for the same line item in the previous period.

4. Horizontal analysis compares amounts on each line item on the statement of financial position and the statement of comprehensive income over time.

5. Investment professionals include financial analysts, advisers and others who evaluate the financial position and performance of companies and offer opinions and advice about whether to invest in the companies’ debt and equity securities.

6. Vertical analysis divides each line item on the statement of financial position by total assets and each line item on the statement of comprehensive income by revenue to calculate a percentage.

7. The base period analysis to horizontal analysis compares amounts for a line item in the current period to an amount for the same line item in a base period.

8. Common size analysis converts financial amounts to ratios, which makes the information comparable for an entity over time and between entities.

9. Institutional investors are organizations that pool significant sums of money to invest in debt and equity securities.

. .

4

Answers to Application Exercises 1. The ratios for F. Raser are as follows. i.

Return on assets

Return on assets =

Profit Average total assets

Return on assets =

$10 000 $225 000

Return on assets =

4.4%

Note: Information is not available to calculate average total assets so the total assets for the current period would be used. ii.

Gross profit ratio =

Gross profit Net sales

=

$60 000 $160 000

Gross profit ratio =

37.5%

Gross profit ratio

Gross profit ratio

iii.

. .

Profit margin ratio Profit margin ratio =

Profit Net sales

Profit margin ratio =

$10 000 $160 000

Profit margin ratio =

6.25%

5

iv.

Acid-test ratio

Acid-test = ratio

Cash and cash equivalents + trade receivables + marketable securities Current liabilities

Acid-test = ratio

$5 000 + $25 000 + 0 $45 000

Acid-test = ratio

0.667

v.

Receivables collection period

Receivables turnover ratio =

Net credit sales Average receivables

Note: Net credit sales is not available, so sales would be used in the denominator. Also the previous period’s trade receivables balance is not available so the trade receivables balance for the current period would be used.

. .

Receivables turnover ratio =

$160 000 $25 000

Receivables turnover ratio =

6.4

Average collection period =

365 6.4

Average collection period =

57.0

6

vi.

Earnings per share Earnings per share =

Profit less preference dividends Ordinary shares outstanding

Earnings per share =

$10 000 - $0 100 000

Earnings per share =

10.0 per share

b. Report on Financial Performance F. Raser seems to be deteriorating in all respects except for the gross profit ratio which is increasing. This means that the company is reducing its cost of sales as a percentage of revenue.

However the profit margin ratio is declining as is the earnings per share which suggest that either distribution and administrative costs, finance costs or tax expense – or some combination of these – are increasing. All profitability measures have declined below industry average. In addition, the company’s return on assets has declined dramatically over the three years and is significantly below the industry average.

Also worrisome is the fact that the company’s liquidity has declined and is now substantially below industry average. Part of the problem appears to be trade receivables since the average days to collect accounts have increased significantly and that number is well above the industry average. Thus, we can conclude that profitability has decreased though not because of cost of sales and the company has become less liquid.

2. a. The ratios for Aber and Cromby follow. i.

Gross profit ratio

Gross profit ratio

=

Gross profit Net sales

Aber’s gross profit ratio

Gross profit ratio . .

=

$1 100 000 $5 500 000

7

Gross profit ratio =

20.0%

Cromby’s gross profit ratio

Gross profit ratio

=

Gross profit ratio =

ii.

$2 160 000 $7 200 000 30.0%

Return on assets

Return on assets =

Profit Average total assets

Aber’s return on assets Return on assets =

$275 000 $4 405 000

Return on assets =

6.2%

Cromby’s return on asset Return on assets =

Return on assets =

iii.

3.6%

Earnings per share Earnings per share =

. .

$280 000 $7 750 000

Profit less preference dividends Ordinary shares outstanding

8

Aber’s earnings per share Earnings per share =

$275 000 - $0 3 000 000

Earnings per share =

9.2 per share

Cromby’s earnings per share Earnings per share =

$280 000 - $0 7 000 000

Earnings per share =

4.0 per share

b. On gross profit ratio, Cromby is doing significantly better than Aber. However, both return on assets and earnings per share Aber is outperforming Cromby. This suggests that operating expenses for Cromby are higher than Aber’s more than offsetting the superior performance of the gross profit ratio. c. Ratios can only point to possible issues that management may need to address. For example, Aber’s management needs to examine its cost of sales to determine why it is high compared to Cromby. And Cromby’s management must determine why operating, interest or tax expenses or so high when compared to Aber. However, ratios cannot determine exactly what the underlying problems are or for that matter whether a problem exists.

3. Binky and Smokey calculations are as follows.

a. Ratio calculations i.

Profitability ratios

Gross profit ratio

Gross profit ratio

=

Gross profit Net sales

Binky’s gross profit ratio . .

9

=

$129 000 $284 000

Gross profit ratio =

45.4%

Gross profit ratio

Smokey’s gross profit ratio =

$154 000 $305 000

Gross profit ratio =

50.5%

Gross profit ratio

Profit margin ratio Profit margin ratio =

Profit Net sales

Binky’s profit margin ratio Profit margin ratio =

$61 000 $284 000

Profit margin ratio =

21.5%

Smokey’s profit margin ratio Profit margin ratio =

$47 000 $305 000

Profit margin ratio =

15.4%

Return on assets ratio Return on assets =

. .

Profit Average total assets

10

Binky’s return on assets Return on assets =

$61 000 $446 000

Return on assets =

13.7%

Smokey’s return on asset Return on assets =

$47 000 $802 000

Return on assets =

5.9%

ii. Liquidity ratios Current ratio Current ratio

=

Current assets Current liabilities

Binky’s current ratio Current ratio

=

$201 000 $200 000

Current ratio

=

1.0

Smokey’s current ratio Current ratio

=

$383 000 $325 000

Current ratio

=

1.2

Acid-test ratio Acid-test ratio

. .

=

Cash and cash equivalents + trade receivables + marketable securities Current liabilities

11

Binky’s acid-test ratio Acid-test ratio

=

Acid-test ratio

=

$64 000 + $46 000 + $0 $188 000

0.59

Smokey’s acid-test ratio Acid-test ratio

=

Acid-test ratio

=

$15 000 + $75 000 + $0 $325 000

0.28

Average or receivables collection period (first the receivables turnover ratio must be calculated)

Receivables turnover ratio =

Net credit sales Average receivables

Binky’s receivables turnover ratio

Receivables turnover ratio =

$284 000 $46 000

Receivables turnover ratio =

6.2

Average collection period =

365 6.2

Average collection period =

58.9

Smokey’s receivables turnover ratio

Receivables turnover ratio = . .

$305 000 $75 000

12

Receivables turnover ratio =

4.1

Average collection period =

365 4.1

Average collection period =

89.0

b. Smokey’s gross profit margin exceeds Binky’s which means that cost of sales as a percentage of revenue is lower. However, Binky’s profitability as measured by both the profit margin ratio and return on assets is higher than Smokey’s. This means that operating expenses, interest and taxes taken together are lower.

Smokey’s current ratio is higher than Binky’s but its near term liquidity as measured by the acid-test ratio is significantly lower. This suggests that Smokey may have a short-term cash crunch. One reason may be that the average collection period for receivables is higher than Binky’s. Perhaps management should focus on improving receivables collections or at least investigate why the average collection period is so much higher than Binky’s.

4. a. Hadrian’s profit before interest and taxes would be calculated as follows.

Retained earnings 2009 Dividends Subtotal Retained earnings 2008 Profit after profit and taxes Taxation Interest Profit before interest and taxes

$314 000 100 000 $414 000 130 000 $284 000 80 000 6 000 $370 000

c. Hadrian’s statement of cash flows follows.

Hadrian LLC Statement of cash flows for the year ended 31 May 2009 $000 Cash flows from operating activities Profit $284 000 Adjustments for: Depreciation 132 000 . .

13

Increase in inventories Increase in receivables Decrease in payables Increase in income tax Profit on sale of equipment Cash provided by operating activities

(110 000) (120 000) (30 000) 20 000 (20 000)

156 000

Cash flows from investing activities Purchase of property, plant and equipment Sale of property, plant and equipment Cash used by investing activities

(580 000) 100 000

(480 000)

Cash flows from financing activities Share issuance Payment of cash dividend Payment of loan note Cash provided by financing activities

550 000 (100 000) (60 000) 390 000

Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

(66 000) 70 000 4 000

c. Ratio calculations follow.

Return on assets

Return on assets =

Profit Average total assets

Return on assets =

$284 000 [($1 950 000 + $2 614 000) ÷ 2]

Return on assets =

12.5%

Acid-test ratio

Acid-test ratio

. .

=

Cash and cash equivalents + trade receivables + marketable securities Current liabilities

14

Acid-test ratio

=

Acid-test ratio

=

$4 000 + $270 000 + 0 $200 000

1.37

Dividend yield

Dividend yield =

Annual dividend Share price

Dividend yield =

$0.225 per share $3.75

Dividend yield =

6.0%

Current ratio

Current ratio

=

Current assets Current liabilities

Current ratio =

$614 000 $200 000

Current ratio =

3.1

5. a. The statement of cash flows for Renada follows.

Renada LLC Statement of cash flows for the year ended 31 October 2009 $000 Cash flows from operating activities . .

15

Profit Adjustments for: Depreciation Increase in inventories Increase in receivables Increase in payables Increase in income tax Loss on sale of equipment Cash provided by operating activities

$160 000 300 000 (1 000 000) (530 000) 80 000 50 000 50 000

(890 000)

Cash flows from investing activities Purchase of property, plant and equipment Sale of property, plant and equipment Cash used by investing activities

(880 000) 30 000

(850 000)

Cash flows from financing activities Share issuance Increase in loan notes Cash provided by financing activities

500 000 1 100 000 1 600 000

Net change in cash Cash at the beginning of 2009 Cash at the end of 2009

(140 000) 140 000 -

b. The two ratio calculations are as follows.

Days in inventory for 2009

. .

Inventories turnover ratio

=

Cost of goods sold Average inventories

Average inventories

=

Beginning inventories + ending inventories 2

Average inventories

=

$600 000 + $1 600 000 2

Average inventories

=

$1 100 000

Inventories turnover ratio

=

$7 200 000 $1 100 000

16

Inventories turnover ratio

=

Days in inventory

=

Days in inventory

=

6.55

365 6.55 55.7

Average collection period for 2009

. .

Average receivables

=

Beginning receivables + ending receivables 2

Average receivables

=

$1 270 000 + $1 800 000 2

Average receivables

=

$1 535 000

Receivables turnover ratio =

Net credit sales Average receivables

Receivables turnover ratio =

$9 000 000 $1 535 000

Receivables turnover ratio =

5.9

Average collection period =

365 5.9

Average collection period =

61.9

17

6. Ratios for Reactive for the year ended 31 March 2010 follow. All amounts are in millions.

Return on assets

Return on assets =

$150 $1 160

Return on assets =

12.9%

Gross profit ratio

=

Gross profit Net sales

=

$550 $4 000

Gross profit ratio =

13.8%

Gross profit ratio

Gross profit ratio

Profit margin ratio Profit margin ratio =

Profit Net sales

Profit margin ratio =

$150 $4 000

Profit margin ratio =

3.8%

Current ratio Current ratio =

. .

Current assets Current liabilities

18

=

$610 $480

Current ratio =

1.3

Current ratio

Days in inventory

Inventories turnover ratio

=

Cost of goods sold Average inventories

Inventories turnover ratio

=

$3 450 $250

Note: The current year’s inventory was used to calculate the inventory turnover ratio since the previous year’s inventory figure is not available.

Inventories turnover ratio

=

Days in inventory

=

Days in inventory

=

13.8

365 13.8

26.5

Average collection period

. .

Receivables turnover ratio =

Net credit sales Average receivables

Receivables turnover ratio =

$3 000 $360

Receivables turnover ratio =

8.3

19

Average collection period =

365 8.3

Average collection period =

44.0

Dividend yield

Dividend yield =

Annual dividend Share price

Dividend yield =

$0.225 per share $3.75

Dividend yield =

6.0%

Earnings per share Earnings per share =

Profit less preference dividends Ordinary shares outstanding

Earnings per share =

$150 - $0 400

Earnings per share =

$0.375 per share

b. When comparing the ratios between the two years, Reactive’s profitability has declined in terms of gross margin ratio and profit margin ratio. Most notable is the fact that the return on assets had declined substantially. Interestingly, the average days in inventory has declined substantially. One possibility is that the company’s inventory decreased causing older, higher costs to be allocated to cost of goods sold. This would cause the gross profit margin to decrease and the overall profit margin to decrease and could account for the decline in the return on assets. Also liquidity has declined as measured by the current ratio. Receivables do not appear to be a factor since the ratio was approximately the same in both periods.

. .

20

7. (a) The ratios for Egriff follow.

Gross profit ratio

Gross profit ratio

=

Gross profit Net sales

=

$4 600 000 $20 000 000

2008

Gross profit ratio

Gross profit ratio =

23.0%

Gross profit ratio =

$4 950 000 $26 000 000

Gross profit ratio =

19.0%

2009

Profit margin ratio Profit margin ratio =

Profit Net sales

2008 Profit margin ratio =

$2 140 000 $20 000 000

Profit margin ratio =

10.7%

2009 Profit margin ratio =

. .

$2 180 000 $26 000 000

21

Profit margin ratio =

8.4%

Return on assets

Return on assets =

Profit Average total assets

Return on assets =

$2 140 000 $14 320 000

2008

Note: Total assets for the current period are used for 2008 and 2009 since an amount for total assets in 2007 is not available (needed to calculate total assets for 2008).

Return on assets =

14.9%

Return on assets =

$2 180 000 $19 000 000

Return on assets =

11.5%

2009

Inventories turnover ratio

Inventories turnover

=

Cost of goods sold Average inventories

Inventories turnover

=

$15 400 000 $6 000 000

2008

Note: Inventories for the current period are used for 2008 and 2009 since an amount for total assets in 2007 is not available (needed to calculate total assets for 2008).

. .

22

Inventories turnover

=

2.6

Inventories turnover

=

$21 050 000 $6 700 000

Inventories turnover

=

3.1

2009

Acid-test ratio Acid-test ratio =

Cash and cash equivalents + trade receivables + marketable securities Current liabilities

2008 Acid-test = ratio

$120 000 + $4 400 000 + 0 $3 200 000

Acid-test = ratio

1.4

2009 Acid-test = ratio

$960 000 + $6 740 000 + 0 $4 200 000

Acid-test = ratio

1.8

Average collection period

Receivables turnover ratio =

Net credit sales Average receivables

2008 $20 000 000 . .

23

Receivables turnover ratio =

$4 400 000

Note: Receivables for the current period are used for 2008 and 2009 since an amount for total assets in 2007 is not available (needed to calculate total assets for 2008).

Receivables turnover ratio =

4.5

Receivables collection period =

365 4.5

Receivables collection period =

81.1

2009

Receivables turnover ratio =

$26 000 000 $6 740 000

Receivables turnover ratio =

3.9

Receivables collection period =

365 3.9

Receivables collection period =

93.6

(b) Comment on the success of the business expansion as indicated by the ratios you have calculated in part (a).

The ratios suggest that the business’s performance has deteriorated somewhat. Though revenue increased from $20 million to $26 million during 2009 both the gross profit and the profit margins declined. Also the return on assets decreased. Another problems is the increase in inventory as measured by the inventory turnover ratio while at the same time the receivables collection period has increased somewhat. On the other hand, the acid-test ratio shows that liquidity has improved somewhat. (c) Briefly explain the factors that Egriff should consider in deciding whether to raise finance by issuing loan notes rather than issuing more shares.

The most important factor is whether Egriff can service the interest charged on the borrowings and repay the amounts that come due. We do not know why profitability and return on assets have declined. And . .

24

the situation liquidity is mixed – the acid-test ratio has improved while the receivables collection period has deteriorated, for example. Thus, if money is borrowed through loan notes, Egriff’s management may want to put additional effort into improving liquidity by reducing inventories and increasing receivables collections.

8. (a) Ratio calculations for Tressven follow.

Dividend per share

Dividend per share =

Dividends Shares outstanding

Dividend per share =

$10 000 000 50 000 000

Dividend per share =

20 cents per share

Dividend yield

Dividend yield =

Annual dividend Share price

Dividend yield =

20 cents per share $1.50

Dividend yield =

13.3%

Earnings per share

. .

Earnings per share =

Profit less preference dividends Ordinary shares outstanding

Earnings per share =

$11 150 000 - $0 50 000 000

25

Earnings per share =

$0.223 per share

Price earnings ratio Share price Earnings per share

Price earnings ratio =

Price earnings ratio =

$1.50 $0.223

Price earnings ratio =

6.7

Debt-to-equity ratio Debt-to-equity ratio =

Total liabilities Total equity

Debt-to-equity ratio =

$2 480 000 $32 250 000

Debt-to-equity ratio =

7.7%

(b) Analyze the financial performance of Tressven compared to Hilladay.

From an investor’s perspective, the earnings per share are slightly higher for Trevessen and the dividend per share is twice as much. Trevessen has about half the debt-to-equity as Hilladay and thus this may be increasing the profits per share. However, the price-earnings ratio of Trevessen is about half of Hilladay’s. This could reflect a lack of confidence in the Trevessen. But it could also mean that Trevessen is an interesting investment opportunity.

. .

26

Dairy Farm International Holdings Limited Analyzing an Annual Report

2006

2005

0.87 0.39 $312.2 million 2.61 45.34

0.82 0.35 $352.3 million 1.66 41.91

Solvency/leverage Total debt to total assets6 Total debt to total capital7 Long-term debt to equity Operating cash flow to debt

0.85 2.19 1.54 0.17

0.87 2.53 1.80 0.22

Asset management Capital assets turnover8 Total assets turnover9

9.58 2.43

10.25 3.33

Profitability Gross margin Operating profit margin Net profit margin Return on total assets

$1 571.0 million 0.05 0.04 0.11

$1 414.5 million 0.05 0.04 0.11

Return to investors Earnings per share10 Price earnings ratio11 Dividend yield

$15.70 basic; $15.66 diluted See footnote 11 See footnote 11

$15.34 basic; $15.25 diluted See footnote 11 See footnote 11

Liquidity Current ratio1 Acid-test ratio2 Cash flow from operations 3 Average receivables collection period4 Average number of days in inventory5

1

Consolidated Balance Sheet See Notes 12 and 13 in Dairy International 2006 Annual Report for details on current assets. The numerator includes bank balances (Note 13) and trade debtors (Note 12). No marketable securities are identified.

3 Consolidated Cash Flow Statement 4 See Note 12 – Trade debtors for trade account receivable 5 Consolidated Balance Sheet (see “Stocks) and Consolidated Profit and Loss Account 6 2006 non-current debt is $497.7 million and 2005 is $404.4 million.

7 Total debt divided by total non-current debt plus equity (shareholders’ funds not including minority interest).

8 Sales divided by tangible assets.

9 Sales divided by total assets.

10 As reported on the Consolidated Profit and Loss Account.

11 Since both the price earnings ratio and dividend yield depend on the market price of Dairy Farm’s shares, students can go to http://dairyfarmgroup.com (Shareholder Information tab, then the Stock Quote tab to retrieve the current share price. See Note 23 for dividend information.

2

. .

27

Common-Size Balance Sheet (Vertical Analysis) 2006

2005

Current assets Cash and investments Accounts receivable Inventory (Stocks) Other current assets Total current assets

456.5 45.1 472.1 161.3 1135 .0

21.5% 2.1% 22.2% 7.6% 53.4%

389.1 28.8 423.8 132.8 974.5

21.2% 1.6% 23.1% 7.3% 53.2%

Fixed assets Intangible assets Other fixed assets Total assets

266.1 725.5 2126.6

12.5% 34.1% 100.0%

226.8 631.3 1832.6

12.4% 34.4% 100.0%

Current liabilities Accounts payable12 Short-term debt13 Other current liabilities Total current liabilities

843.9 47.0 409.5 1300.4

39.7% 2.2% 19.3% 61.2%

789.7 35.9 359.5 1185.1

43.1% 2.0% 19.6% 64.7%

Long-term debt Deferred income taxes Other liabilities Total liabilities

41.3 456.6 1798.3

1.9% 21.5% 84.6%

34.9 369.5 1589.5

1.9% 20.1% 86.7%

Shareholders’ equity Minority interests Total shareholders’ equity Total liabilities and shareholders’ equity

324.0 4.3 328.3 2126.6

15.2% 0.2% 15.4% 100.0%

224.1 19.0 243.1 1832.6

12.2% 1.1% 13.3% 100.0%

12 13

. .

See Note 15.

See Note 16.

28

Common-Size Statement of incomes

Sales Cost of sales Gross margin Other operating income Subtotal Costs and expenses Selling, general and administrative expenses Total operating expenses Operating income Interest expense ( net financing charges) Other income (associates and joint ventures) Income before taxes Income taxes Net earnings Gains (losses) from discontinued operations Profit attributable to equity holders Minority interests Dividends paid14

14

. .

2006 5175.0 100.0% (3604.0) (69.6%) 1571.0 30.4% 13.7 0.2% 1584.7 30.6%

2005 4749.4 100.0% (3334.9) (70.2%) 1414.5 29.8% 32.0 0.7% 1446.5 30.5%

(1350.9) (1350.9) 233.8 (6.0) 27.7 255.5 (44.5) 211.0 0 210.8 0.2

(26.1%) (26.1%) 4.5% (0.1%) 0.5% 4.9% (0.9%) 4.0% -4.0% --

(1214.0) (1214.0) 232.5 (9.4) 28.5 251.6 (45.0) 206.6 0 205.3 1.3

(25.6%) (25.6%) 4.9% (0.2%) 0.6% 5.3% 0.9% 4.4% -4.3% --

118.1

2.3%

435.3

9.2%

See Note 23.

29

Instructor Manual Chapter 13 Assurance Systems . .

1

Lecture Notes

3

Answers to Learning Outcomes Questions

4

Learning Outcome 2 Learning Outcome 3 Learning Outcome 4 Learning Outcome 5 Learning Outcome 6 Learning Outcome 7

4 6 7 9 10 11

Answers to Review Questions

13

Answers to Terminology Practice

16

Answers to Application Cases

18

Case Analysis

1

. .

2

Lecture Notes Introduction The last chapter addresses five assurance systems – 1) corporate governance, 2) risk management, 3) internal control, 4) internal auditing and 5) independent auditing. After students have been through the entire process of understanding what financial statements are, the process that generates them and the evaluation of the results, it seemed appropriate to ask ‘how do you know you can rely on these financial statements’? The purpose of Chapter 13 is to answer this question.

. .

3

Answers to Learning Outcome Questions Learning Outcome 2 Explain corporate governance and how an effective board should be structured and function.

On Your Own 1. What is an assurance system? What are the five assurance systems?

Assurance systems refer to the five systems that give users assurances that the financial statements present and true and fair view of financial position, performance and changes; that the assets entrusted to management are safeguarded; whether management is recognizing and responding appropriately to risk; and whether the business is being measured in an efficient and effective manner. The five assurance systems 1) corporate governance, 2) risk management, 3) internal control, 4) internal auditing and 5) independent auditing.

2. Define corporate governance. Who is ultimately responsible for corporate governance?

Corporate governance includes organization culture, policies and procedures that determine how the entity is directed, administered and controlled. The board of directors is ultimately responsible for the system of corporate governance.

3. What is risk management?

Risk management refers to processes that identify, assess, manage and control potential events or situations to provide reasonable assurance that the organization’s objectives will be met.

4. Define internal control.

Internal control is the system of policies and procedures within the business that facilitates efficient and effective operations that allow the company to respond to significant risks; safeguard assets; ensure the quality of internal and external reporting; and monitor compliance with laws, regulations, and internal business policies.

5. What is the difference between an internal audit and an independent audit?

Internal audits use a systematic and disciplined approach to evaluate and review the effectiveness of risk management, the internal control system and corporate governance processes. Independent audits, on the other hand, are carried out by external, audit specialists who perform test and other procedures to enable them to express an opinion about whether the financial statements have been prepared in all material respects in accordance with applicable accounting standards.

6. What is a fiduciary? What is a principal?

. .

4

A fiduciary represents the interests of principals (owners of the business), which is the highest standard of care under law. Essentially, the fiduciary must put the principal’s interests ahead of his or her own.

7. Explain the difference between an inside director and a nonexecutive director.

Inside directors also hold a position as an executive or manger within the entity in addition to being on its board of directors. A nonexecutive director is not part of the entity’s executive or management team.

8. Why are nonexecutive directors thought to add strength to the board of directors?

Nonexecutive directors add strength because they: 1) are independent of the entity’s management, 2) they are presumably more willing to voice dissenting opinions about management actions and 3) they have skills that may otherwise be absent from the board.

9. Describe the difference between a unitary board and a multilevel board.

With unitary boards, all directors serve on the same board. Entities with multilevel boards have more than board; usually one board represents the interests of shareholders and employees while the second board focuses on management concerns.

According to the Combined Code on Corporate Governance: 10. How should the duties of the chairman and the chief executive officer be structures?

The roles of chairman and chief executive officer should be served by two individuals with a clear division of responsibilities.

11. How should the board be balanced to achieve independence?

The board should be balanced with respect to executive and nonexecutive directors. The board should not be too large to be unwieldy but at the same time should be large enough to ensure that needed experience and skills are represented. Committee memberships should be refreshed periodically to ensure that one person does not dominate a committee. And committee meetings should be attended only by the chairman and members unless others are specifically invited.

12. How should appoints to the board be made?

Appointments should be made based on merit and using objective criteria for selection. In addition, care should be taken to ensure that directors have time available to devote to the job.

13. What responsibilities does the chairman have with respect to providing information and professional development opportunities to the board?

. .

5

The chairman should be responsible to ensure that directors receive accurate, timely and clear information. In addition, the chairman should ensure that directors continually update their skills, knowledge and familiarity with the company.

. .

6

14. What performance evaluations should be made of the board?

Evaluations should ensure that directors continue to contribute effectively and demonstrate commitment to the role.

15. How should remuneration of board members be handled?

The remuneration committee should judge where to position their company’s compensation of directors relative to other companies. This may involve the use of consultants who specialize in director compensation.

16. What should the board’s response be for financial reporting, internal control and dialogues with shareholders and institutional investors?

Directors should maintain sufficient contact with shareholders to ensure that they understand their issues and concerns.

17. What are the main committees common to most boards? What are their functions?

The main committees common to boards include: ▪ Audit committee -- responsible for accounting and financial reporting ▪ Nominations committee – identifies candidates to serve on the board and advises the board about directors who may need to be removed ▪ Remuneration committee – concerns itself with compensation for the board and top management ▪ Risk management committee – oversees issues related to the entity’s risk management practices

Learning Outcome 3 Define risk management and explain how risk management provides assurances for financial statements.

On Your Own 1. Define risk. What are examples of risks experienced in global businesses?

Risk is the possibility of an event occurring that will have an impact on the achievement of objectives as measured in terms of impact and likelihood. Risk can be financial such as the inability of the company to raise required capital in an illiquid capital markets (as was the case in the 2008 global financial ‘meltdown’); operational such as a hurricane or typhoon that causes production to cease for a period of time; or political such as the passage of punitive laws created by a host government in a country where facilities are located.

. .

7

2. What is adequate control over risk?

Adequate control over risk means that there is reasonable assurance that the business’s risk is managed effectively, and that the business’s goals and objectives are achieved efficiently and effectively.

3. What is residual risk? What is risk appetite? What is risk tolerance?

Residual risk refers to any risk that remains once actions have been taken to reduce the likelihood of an adverse event.

Risk appetite refers to a broader statement about the level of tolerance for risk within an entity.

Risk tolerance refers to specific levels of acceptable risk around specific objectives.

4. What are examples of uncertainty as related to the financial statements?

Any risk that has the potential to impact financial position or performance would create uncertainty for the financial statements. This could include operational complexities, government intervention, actions by competitors, and the ability to borrow and repay debt.

Learning Outcome 4 Define internal control and explain the principles and limitations of internal control.

On Your Own 1. What are the five general principles of internal control?

The five general principles of internal control are: 1) Assignment of responsibility 2) Segregation of duties 3) Documentation 4) Physical controls 5) Independent verification 2. List the eight components for describing and analyzing internal control systems based on COSO’s Enterprise Risk Management – Integrated Framework.

The eight components (see Figure 13.10) are: 1) Internal environment 2) Objective setting 3) Event identification 4) Risk assessment 5) Risk response 6) Monitoring 7) Information and communication . .

8

8) Control activities 3. According to the Turnbull Guidance, which companies derive the most benefit from application of the Guidance?

The companies that have derived the most benefit from application of the Guidance were those whose boards saw embedded risk management and internal control as an integral part of running the business.

4. What is the control environment?

The control environment includes control activities, information and communications processes and ongoing monitoring of the effectiveness of the internal control system.

5. According to the Turnbull Guidance, what should be contained in the annual statement made by the board?

In the annual statement, the board should review changes in significant risks since the last annual statement including the ability of the business to respond. Also the board should disclose the scope and quality of management’s ongoing monitoring of risk and the internal control system, including the internal audit function as well as the frequency and extent of communication of monitoring results; the incidence of internal control failings and weaknesses; and the effectiveness of the company’s public reporting process.

6. What are the limitations of internal control?

Limitations of internal control include: 1) Cost versus benefit 2) Errors in judgment 3) Management interference 4) Employee collusion 5) Malfunctions of the internal control system.

Learning Outcome 5 Define internal auditing and explain its role in providing assurance for financial statements.

ON YOUR OWN Learning Outcome Review 1. Define internal auditing.

Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve the organization’s operations. It helps an organization to accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes. . .

9

2. What are assurance services?

Assurance services are objective examinations of evidence to provide an assessment on risk management, control or governance processes within a business, including financial, performance, compliance, system security and due diligence engagements.

3. What are consulting services?

Consulting services advise business units on adding value and improving governance, risk management and control processes.

Learning Outcome Practice 1. To whom is the internal auditor primarily responsible? a. The directors of the company

Learning Outcome 6 Define independent auditing and explain its role in providing assurance for financial statements.

On Your Own 1. Who conducts independent audits?

Independent audits are conducted by outside service firms of independent auditors sometimes referred to as registered auditors, external auditors or public accountants. Qualified individuals can also conduct audits. In many nations, independent auditors must be licensed.

2. What is the difference between an internal audit and an independent audit?

Internal audits use a systematic and disciplined approach to evaluate and review the effectiveness of risk management, the internal control system and corporate governance processes. Independent audits, on the other hand, are carried out by external, audit specialists who perform test and other procedures to enable them to express an opinion about whether the financial statements have been prepared in all material respects in accordance with applicable accounting standards.

3. What are the general requirements to become an independent auditor?

General requirements may include having attained some level of education, passing papers or examinations, experience and in some cases evidence of social and ethical responsibility.

4. What does an independent auditor do?

An independent auditor provides a professional opinion about whether the financial statements provide a true and fair view of the business’s financial position and performance in accordance with applicable accounting standards. This is done by evaluating the entity’s system of internal control and reviewing accounting policies and procedures. Then the auditor conducts tests to determine . .

10

whether transactions have been processed and reported in accordance with standards, policies and procedures.

5. What are the four types of opinions that an independent auditor can give?

An independent auditor can typically give one of four opinions depending on the results of the independent audit: 1) an unqualified opinion, 2) a qualified opinion, 3) an adverse opinion, or 4) a disclaimer of opinion.

Learning Outcome 7 Explain why fraud auditing and forensic accounting have become part of independent auditing.

ON YOUR OWN Learning Outcome Review 1. Define fraud.

Fraud is a false representation intentionally made in order to gain a material advantage.

2. What three conditions are normally present when fraud is committed?

First, the perpetrator is under some pressure or has an incentive to commit fraud. Second, the opportunity is present. Third, individuals are able to rationalize the fraud.

3. What is the term for a person who commits fraud?

The person who commits fraud is referred to as the perpetrator.

4. What two types of misstatement could occur in financial statements?

1) Fraudulent financial reporting 2) Misappropriation of assets 5. What is the auditor’s responsibility in terms of discovery of fraud?

The purpose of an independent audit is not to discover fraud. However, auditors are encouraged to exercise professional skepticism and evaluate the likelihood of fraud.

6. What are the three general categories of fraud prevention?

1) Creating and maintaining a culture of honesty and high ethics 2) Evaluating the risk of fraud and implementing the processes, procedures and controls needed to mitigate risks and reduce the opportunities for fraud 3) Developing an appropriate oversight process

. .

11

7. What steps can a business take to create a culture of honesty and high ethics?

Steps to create a culture of honesty and high ethics include: 1) setting the appropriate tone at the top, 2) training, 3) confirming the commitment to honesty and high ethics and 4) reacting to incidents or suspected fraud.

8. What steps can a business take to evaluate antifraud processes and controls?

Antifraud processes and controls can be evaluated by: 1) identifying and measuring fraud risks, 2) taking steps to mitigate identified risks, 3) implementing and monitoring appropriate preventative and detective Internal controls and other deterrent measures.

9. What steps can a business take to develop an appropriate oversight process?

Steps that can be taken to develop an appropriate oversight process include: 1) creating an audit committee within the board if none exists, 2) implementing and monitoring by management, 3) training of employees and 4) confirming the commitment to the entity’s code of ethics.

. .

12

Answers to Review Questions 1. Explain why assurance systems are regarded as part of the overall financial accounting reporting system.

Assurance systems give users assurances of the following: that the financial statements provide a true and fair view of the entity’s financial position and performance; that the assets entrusted to management are being safeguarded; whether management is recognizing and responding appropriately to risks faced by the business; and whether the business is being managed in an efficient and effective manner.

2. What are the five assurance systems?

The five assurance systems are: 1) Corporate governance 2) Risk management 3) Internal control 4) Internal audits 5) Independent audits.

3. Why is the board of directors important in providing assurance to shareholders and other users?

What is the responsibility of the board?

The board of directors serves as fiduciaries of the shareholders. The board has three responsibilities: 1) Shaping the strategy of the business 2) Monitoring management 3) Ensuring accountability.

4. What are the consequences if the board fails to perform its fiduciary duties?

If boards fail to perform their fiduciary duties appropriately then the interests of the shareholders are not served.

5. If risk is not managed appropriately, why would that cast doubts on the reliability of the financial statements?

If risk is inappropriately managed, then that may prevent the entity from achieving its objectives and therefore compromise the financial position or performance of the business.

6. What would be your concerns about a company that has not nonexecutive directors on the board?

The lack of nonexecutive directors would create several concerns: 1) that management would not have the benefit of a view independent of their own judgment, 2) the board would be weaker because there would be fewer dissenting opinions about management decisions and 3) the board would lack skills and experience that nonexecutive directors could contribute.

. .

13

7. Which do you think would be more effective at corporate governance – a unitary or multilevel board? Explain the reasons for your answer.

Students could argue this either way – that unitary boards are more effective or multilevel boards are more effective. Unitary boards have the advantage that all directors meet together and therefore there is no disagreement between boards (although there could certainly be disagreement between individual directors). Multilevel boards separate duties so that each board can focus on its particular concern – one may represent the interests of shareholders and employees while the other focuses only on management issues.

8. Why do you think the use of committees like the audit committee, nominations committee, remuneration committee and risk management committee is an effective way for boards to get their work done?

Boards accomplish much of their work in committees. Without these committees, all issues would have to be dealt with by the entire board which would be inefficient. However, committees can resolve many minor issues bringing only major concerns to the entire board.

9. Why is potential collusion between employees a problem? How do the various principles of internal control contribute to preventing collusion?

Collusion is a problem because it has the potential to by-pass the system of internal controls. The principles of internal control ensure that someone is responsible for each activity within the business (assignment of responsibility), that critical responsibilities are carried out by different individuals (segregation of duties), that responsibilities are documented (documentation), that assets included information are physically protected (physical controls) and that activities are independently verified (independent verification).

10. Describe the eight factors in the integrated framework for Enterprise Risk Management from the Treadway Commission.

1) Internal environment – This sets the tone in an organization for how risk is viewed including management’s risk management philosophy and risk appetite, integrity and ethical values.

2) Objective setting – This is the process of setting objectives consistent with the businesses’ mission and risk appetite.

3) Event identification – This involves the identification of events that may affect achievement of the business’s objectives including distinguishing between those events that represent opportunities and those which pose risks.

4) Risk assessment – This includes the identification and analysis of risks including their likelihood.

5) Risk response – Management selects a response to specific risks which could include avoidance, acceptance, reduction or risk sharing. The response should be aligned with the entity’s risk tolerance and risk appetite.

6) Monitoring – This is the ongoing process of assessing the quality of the business and internal control system’s performance, and reporting the results to the appropriate parties. . .

14

7) Information and communication – Effective communication includes reports on operational, financial and compliance-related activities that make it possible to operate and control the business.

8) Control activities – These include policies and procedures to ensure that management directives are carried out as intended.

11. What are the similarities and differences between the Treadway Commission’s Enterprise Risk Management Framework and the Turnbull Guidance?

Both the Treadway Commission’s Enterprise Risk Management Integrated Framework and the Turnbull Guidance focus on the importance of risk management and internal control being “embedded” as an integral part of running the business. This includes the identification of risks against specific organizational objectives. The Turnbull Guidance has taken a principles-based approach. The Enterprise Risk Management Integrated Framework has taken provided a framework (shown in Figure 13.10).

12. What are the limitations of internal control? How do you think these limitations can be overcome?

Limitations of internal control include: 1) Cost versus benefit 2) Errors in judgment 3) Management interference 4) Employee collusion 5) Malfunctions of the internal control system.

13. Compare and contrast the purposes, activities and objectives of an internal audit versus an independent audit.

Internal audits use a systematic and disciplined approach to evaluate and review the effectiveness of risk management, the internal control system and corporate governance processes. Independent audits, on the other hand, are carried out by external, audit specialists who perform test and other procedures to enable them to express an opinion about whether the financial statements have been prepared in all material respects in accordance with applicable accounting standards.

14. What opinions can be given by an independent auditor?

An independent auditor can typically give one of four opinions depending on the results of the independent audit: 1) An unqualified opinion 2) A qualified opinion 3) An adverse opinion 4) A disclaimer of opinion.

. .

15

15. Why do accountants confine their concern about fraud to fraudulent financial reporting and misappropriation of assets that cause the financial statements not to conform to applicable accounting standards?

The objective of accountants when they perform the duties of an independent auditor is provide an opinion about whether the financial statements present a true and fair view of the financial position and performance of the business entity. Fraudulent financial reporting and misappropriation of assets would have an impact on the financial statements. Other forms of fraud do not affect the financial statements and therefore are of no direct concern.

Answers to Terminology Practice 1. A fiduciary represents the principals (owners) of a business.

2. Risk management refers to the processes that identify, assess, manage and control potential events or situations, to provide reasonable assurance regarding the achievement of the organization’s objectives.

3. A unitary board means that both inside directors and nonexecutive directors serve on a single board that discharges all board obligations.

4. Residual risk is the risk that remains once actions have been taken to reduce the likelihood of an adverse event.

5. An audit committee is a committee of the board, usually comprised of nonexecutive directors who oversee financial reporting and both the external and internal auditors.

6. An inside director holds a position as an executive or manager within the business as well as being a member of the board.

7. Assurance services are objective examinations of evidence to provide an assessment on risk management, control or governance processes within the business, including financial, performance, compliance, system security and due diligence engagements.

8. Internal control is the system of policies and procedures within the business that facilitates efficient and effective operations that allow a company to respond to significant risks; safeguards assets; ensures the quality of internal and external reporting; and monitors compliance with laws, regulations and internal business policies.

9. Risk is the possibility of an event occurring that will have an impact on the achievement of objectives and measured in terms of impact and likelihood.

10. A perpetrator is a party who commits fraud.

11. An internal audit is a systematic and disciplined approach to evaluate and review the effectiveness of risk management, the internal control system and corporate governance processes.

12. Corporate governance includes the organizational culture, policies and procedures that determine how an entity is directed, administered and controlled, as overseen by the business’s board of directors.

13. Risk tolerance refers to levels of acceptable risk around specific objectives.

14. Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization to accomplish its . .

16

objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes.

15. Consulting services involve advising business units on adding value and improving governance, risk management and control processes.

16. Misappropriation of assets is the effect of a theft of a business’s assets that causes the financial statements not to conform to applicable accounting standards.

17. An audit engagement is conducted by external accounting and auditing specialists who perform tests and other procedures on the business to enable them to express an opinion about whether the financial statements of the business have been prepared, in all material respects, in accordance with applicable accounting standards.

18. Adequate control over risk means that there is reasonable assurance that the business’s risk is managed efficiently.

19. A multilevel board means that more than one board exists within the business.

20. Independent auditors, also known as registered auditors or external auditors are professionally qualified individuals or firms who can perform independent audits and render an opinion regarding the financial statements.

21. Fraudulent financial reporting involves misstatement or omission of amounts or disclosures that cause financial statements not to conform to applicable accounting standards.

22. A nonexecutive serves on the board of directors but is not an executive or manager of the business entity.

23. A nominations committee is a committee of the board that advises the board about candidates for the board, removal of existing directors and conducts performance evaluations of board members.

24. Risk appetite is the level of tolerance for risk within an entity 25. An audit report is the formal report to the board of directors that contains the opinion of the independent auditors about whether the financial statements, in all material respects, present a true and fair view of the financial results of the business in accordance with applicable accounting standards.

26. Engagement provide advice to business units on adding value and improving governance, risk management and control processes.

27. Compliance refers to an engagement that evaluates whether the business is conforming to policies, plans, procedures, laws, regulations, controls and other requirements.

. .

17

Answers to Application Cases 1. Chemco’s proposed acquisition of JPX Industries, LLC a. Evaluate JPX’s corporate governance arrangements and explain why they are likely to be considered inadequate by the Chemco board.

Very little about JPX’s corporate governance practices are acceptable by modern international standards. It might be helpful to point out to students that many family-owned businesses are often dominated by the family members, so this is a common situation throughout all nations in the world including developed nations.

Specifically, the following features of JPX’s corporate governance are inadequate: 1) The family dominates the board though no information is available in the case which tells us whether family members have professional business training, 2) the boards have no nonexecutive directors who would bring outside experience and skills, 3) senior managers have little input into the boards’ deliberations and 4) the boards do not use committees and thus are likely to be inefficient. b. Manprit suggested that the acquisition of JPX might expose Chemco to a number of risks.

Illustrating from the case as required, identify the risks that Chemco might incur in acquiring JPX and explain how risk can be assessed.

The primary risks from the case include: 1) the lack of transparency in board deliberations due to family domination, 2) risk is increased by exposure to foreign markets where Chemco has less experience and is thus somewhat reliant on JPX family owners, 3) the risk of combining Chemco and JPX since they have different cultures and structures, 4) JPX is located in countries which have few corporate governance requirements. With respect to item #3, companies often experience major problems when trying to combine different cultures and structures, so this is a common problem in business. With respect to item #4, countries with few corporate governance regulations and less transparency often have major corruption problems. This would expose the combined company to the whims of corrupt officials who demand bribes and create complications.

The major point to be gleaned here is that there are several risks associated with this proposed combination. These risks could adversely affect financial position and performance. They should therefore be carefully considered before moving ahead.

To assess risk, the obvious solution would be to follow the eight steps outlined in the Treadway Commission’s Enterprise Risk Management – Integrated Framework (see Figure 13.10). c. Construct the case for JPX adopting a unitary board structure after the proposed acquisition.

Your answer should include an explanation of the advantages of unitary boards and a convincing case for the JPX board changing to a unitary structure. . .

18

Over the past few years, unitary boards have become under increasing criticism. However, their strength is that they combine all directors into a single forum and thus there is no difference of positions between multiple boards. The strongest argument for JPX going to a single board structure is that it would then be consistent with Chemco. Also, if Chemco acquired JPX or most of its shares, then Chemco may need only the single board to represent its interests at JPX (this assumes that JPX remains an independent entity with its own board). Thus a unitary board would be more efficient. d. Explain the role of nonexecutive directors (NEDs) and assess the specific contributions that NEDs could make to improve the governance of the JPX board.

NEDs would provide outside experience and skills. This would help balance the insular family dominated board now in existence. In addition, NEDs would presumably challenge thinking by current board members and management.

2. Frank Finn’s Compensation a. Explain the role of a remunerations committee and how the cross-directorship might undermine these roles at ABC Co. Remunerations committees typically deal with compensation of the board and top management.

A cross-directorship in this case means that while Mr. Ng served on the board of ABC, Frank Finn served on the board of DEF Co. That means that Mr. Ng would have some ability to influence Frank Finn on DEF Co. decisions and thus “reward” this behavior by supporting increased compensation for Finn at ABC since Mr. Ng was the chairman of ABC’s remuneration committee.

Thus, ABC may be paying more than necessary for Frank Finn’s services. b. Swanland Investments believed Mr. Finn’s remunerations package to be ‘poorly aligned’ to its interests. With reference to the different components of a director’s remuneration package, explain how Mr. Finn’s remuneration might be more aligned to shareholders’ interests at ABC Co. The primary responsibility of a sales director is to increase sales. Thus Finn’s compensation could depend more directly on the amount of revenue or profit generated reducing the salaried portion of his compensation. c. Evaluate the proposal from Hanoi House that both Mr. Ng and Mr. Finn be required to resign from their respective nonexecutive positions.

While the case presents no specific evidence of wrongdoing, the appearance of wrongdoing and lack of independence can be just as damaging as the actual wrongdoing. Thus there is a strong argument for asking one or both individuals to resign. The major issue is for the board to eliminate the conflict of interest from the cross-directorship.

. .

19

3. FF Co.’s Internal Control System a. Describe how the internal control systems at FF Co. differ from a ‘sound’ system of internal control, such as that set out in the Turnbull guidance.

First, the Turnbull guidance notes that boards of directors are responsible for the systems of internal controls and should regularly seek assurances that the internal control system is functioning effectively. In this case, the “incident” demonstrated that FF Co.’s internal control system was not sound because Miss Osula’s superior failed to report her concerns about the fire hazard.

Indeed, the system of internal control also failed because the material was not in compliance with the international fire safety standards. An effective system of internal control should have identified this fault and sought corrective action. An even more disturbing issue is that the material was mislabeled as being compliant with the international standard. If the company knew this was not the case, then it would have been fraud. In any event, this discrepancy should have been caught and corrected by the system of internal control. b. Explain, with reference to FF as appropriate, the ethical responsibilities of a professional accountant as an employee and as a professional.

A professional accountant is bound by any code of ethics at FF Co. as well as the code of ethics of any professional organizations the accountant belongs to. Thus, even if FF Co.’s code of ethics does not address an issue, the professional code of ethics may.

4. Sentosa House and Eastern Products a. Explain what an ‘agency cost’ is and discuss the problems that might increase agency costs for Sentosa House in the case of Eastern Products.

Agency costs arise when the board of directors fail to oversee the business entity in a manner which are consistent with the interests of the shareholders. In this case, several factors suggest that the board may be deviating from the shareholders’ interests: 1) the use of increasingly risk strategies, 2) failing to comply with stock market requirements related to the number of nonexecutive directors and 3) the disbanding of the risk committee at a time when risk is increasing. b. Describe, with reference to the case, the conditions under which it might be appropriate for an institutional investor or intervene in a company whose shares it holds.

Whether institutional or not, investors have certain rights that they should exercise in their own interest. Institutional investors, however, tend to have more power because their shareholdings are typically larger and companies who must obtain capital do not want to risk alienating institutional investor. However, no investor should attempt to ‘micro-manage’ the board.

. .

20

Nonetheless, if evidence is available that the board is not effectively discharging as fiduciary, then the institutional investor, on behalf of its constituents, needs to step in and make its concerns known and intervene if necessary. c. Evaluate the contribution that a risk committee made up of nonexecutive directors could make to Sonia’s confidence in the management of Eastern Products.

A risk committee’s contributions can include the following: 1) Recommending changes in risk management strategy and policy 2) Providing leadership in risk assessment and monitoring 3) Assessing the effectiveness of risk management systems 4) Reviewing reports on emerging risks and providing early warning on significant new risks to the full board 5) Reviewing internal control and internal audit effectiveness in relation to the entity’s risk profile. d. Assess the opinion given to Sonia that because Eastern Products was listed in a principles-based jurisdiction, compliance with the stock market’s rules was ‘not compulsory’.

Being located in a principles-based jurisdiction has nothing to do with the stock market’s compliance rules. The objective of principles-based standards is not to provide gaps which allow management to avoid adequate disclosure but rather provide them with the flexibility to adapt their reporting to local standards.

5. Franks & Fisher’s Internal Control and Audit Function a. Explain, with reference to the case, the factors that are typically considered when deciding to establish internal audit in an organization.

The system of internal control comprises the policies and procedures within the business that facilitate efficient and effective operations that allow the company to respond to significant risk; safeguard assets; ensure the quality of internal and external reporting; and monitor compliance with laws, regulations and internal business policies. Any evidence that problems exist in any of these areas would raise the question of whether an internal audit function is needed. b. Construct the argument in favor of appointing the new internal auditor from outside the company rather than promoting internally.

The danger of promoting internally is that the new internal audit director may be responsible for auditing operations that he or she once managed. This creates a potential conflict of interest.

Another major argument for hiring from outside is to bring in experienced person who can effectively establish the new internal audit function.

. .

21

c. Critically evaluate Mr. Kuma’s belief that the internal auditor should report to him as finance director.

The internal audit director should report to the audit committee of the board of directors. Again, a conflict of interest would be created if the internal audit director reported to Mr. Kuma since internal audits may address areas for which Mr. Kuma is responsible. d. Define ‘objectivity’ and describe characteristics that might demonstrate an internal auditor’s professional objectivity.

In Chapter 2, a definition of objectivity was given from the Hong Kong Institute of Certified Public Accountants (HKICPA): Objectivity – A professional accountant should not allow bias, conflict of interest or undue influence on others to override professional or business judgments.

. .

22