1

BBUS 361
INTERMEDIATE ACCOUNTING I
LECTURE NOTES



2
THE ROLE OF ACCOUNTING IN BUSINESS

What is accounting?





Who are the primary users of financial accounting?

Others?






Why do they need this information?






Theoretical value of the firm:












STANDARD SETTING

Why do we need standards?

3

Historical background:



Who sets the standards in the U.S.?





Accounting Standards Codification (ASC)


Example: Accounting for Research and Development

Previously:

Codification:


How are standards set?


Example: Accounting for Employee Stock Options



Advantages: Disadvantages:




How do we know standards are followed?





International Financial Reporting Standards (IFRS)

4
Reasons for global accounting standards:



Difficulties/Drawbacks:



Current Status:










5
CONCEPTUAL FRAMEWORK

Original Framework:

Purpose: To set forth fundamentals on which financial reporting standards are
based.

SFAC #8 Objectives of Financial Reporting

SFAC #8 Qualitative Characteristics of Accounting Information

SFAC #6 Elements of Financial Statements

SFAC #5 & #7 Recognition and Measurement in Financial Statements


Current Conceptual Framework Project:

Purpose: To develop an improved common conceptual framework that provides
a sound foundation for developing future accounting standards (joint project
with IASB)

Eight phases:

Objectives and Qualitative Characteristics
Elements and Recognition
Measurement
Reporting Entity
Presentation and Disclosure



6
Objectives of Financial Reporting (based on revised framework)

Provide useful information to capital providers
-Helps assess amounts, timing and uncertainty about future cash flows
- Clearly portrays the economic resources of an enterprise



Qualitative Characteristics of Accounting Information (based on revised framework)
GRAPHIC 1-7 Hierarchy of Qualitative Characteristics of
Financial Information








Fundamental Characteristics:

Relevance: Capable of making a difference in a decision
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Predictive value

Confirmatory value

Materiality

Faithful Representation: Depicts the economic phenomena it purports to
represent
Completeness

Neutrality (rejection of conservatism)

Free from material error


Enhancing Characteristics:

Comparability


Verifiability


Timeliness


Understandability

8
Key Constraints
Cost Effectiveness





Elements of Financial Statements (based on SFAC #6)

Assets
Liabilities
Equity (or net assets = A L)
Investment by owners
Distributions to owners (dividends)
Comprehensive income
Revenues
Expenses
Gains
Losses


Assets Probable future economic benefit obtained or controlled by a
particular entity as a result of past transactions

Liabilities Probable future sacrifice of economic benefit resulting from a
present obligation of a particular entity as a result of past transactions.

Equity Residual ownership interest (Assets less Liabilities)


Transactions with owners



Comprehensive Income

Comp Inc. = NI + Other Compr. Income


Revenue Expenses + Gains Losses
9

o Revenues:


o Gains:



o Expenses:


o Losses:


10
Recognition and Measurement (based on SFAC #5&7)

Recognition: The process of recording an item in the financial statements

What are the alternatives to recognition?








Criteria for recognition:


Definitions The item meets the definition of an element of financial
statements


Measurability The item has an attribute you can measure

Relevance The attribute is relevant

Reliability The attribute is reliable

Revenue recognition: Realization

Realization principle:
o The earnings process is complete or virtually complete;
o There is reasonable certainty as to the collectability of the asset to be
received.
Expense recognition: Matching


Measurement:
Five different attributes currently used in practice:

1. Historical Cost:

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2. Current Cost:

3. Net realizable value :

4. Present value of future cash flows

5. Fair value:



Which measurement is the most common for recognition?





Why?



Debate over Fair Value Accounting





Evolving GAAP:
Balance sheet approach:

Income statement approach

12
THE ACCOUNTING PROCESS

Review of Accounting Basics

Four Main Financial Statements:

Balance Sheet


Income Statement


Statement of Cash Flows


Statement of Stockholders Equity



Accounting Equation










Relationship among Financial Statements











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Accounting Equation -- Examples
An increase to one side of the equation must result in either:
- Decrease to the side





- Increase to the side




Accounting Cycle
A complete description of the accounting cycle is given in figure 2-3 of
your book (page 56)

Recording Journal Entries
Three components to a journal entry:
14

If debits = credits equation is always balanced
BUTthis does not mean that the journal entry is correct!
Also note:
Revenues increase S/E so an increase in
revenues is a _____
Expenses decrease S/E so an increase in
expense is a _______



15
Top McQueen Espresso Practice Problem

McQueen loves coffee and has decided to open an espresso stand.
She plans to call it Top McQueen Espresso. She enters into several
transactions during June 2005, the first month of operations. For each
transaction described below, write out the appropriate journal entry.

1) McQueen contributes $20,000 to start-up the business.





2) The company takes out a three-year loan from the bank in the
amount of $10,000. [Ignore interest payments for now]





3) The company purchases an espresso machine and cart for
$28,000.






4) The company purchases 100 lbs of coffee beans for $1100. The
purchase was made on account, meaning the amount will be paid
in 30 days.





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5) The company purchases other miscellaneous supplies such as
cups, milk, napkins, etc. continuously throughout the month. Total
supplies purchased during the month were $400. All purchases
were made for cash.






6) The company pays a monthly rental fee for the space on which the
cart is located. The rental fee is $200/month.



7) During the first month of operations, cash sales totaled $4,800.




8) In addition, the company sold pre-paid coffee cards. Customers
can purchase these cards in advance and redeem them at the time
of purchase. Coffee card purchases totaled $400 during the month.






9) Since business was better than expected, McQueen hired a part-
time barista to help out. Wages paid to the part-time barista were
$320.





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Posting -- T-account method
Create T-accounts and post the above journal entries.

















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Adjusting Entries
Some events that need to be recorded are not the result of transactions with
external parties. These events require adjusting entries at the end of the
reporting period.




Adjustments can be classified as:

Prepayments:


Example:

Accruals:

Example:


Prepayment Accrual
Revenues



Expenses





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Example:
1) Prepayments
a. Prepaid expenses
1/18 Paid $30,000 for 3 months rent



1/31 Adjustement




b. Pre-collected revenue

1/10 Collect gift card $500



1/31 $200 yet to redeem

















Alternative approach to record prepayments: to record initial cash directly into
expense or revenue account. The adjusting entry then records the unexpired
prepaid expense (asset) or unearned revenue (liabilities) as of the end of the
period.
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Prepaid Expense Unearned Revenue
Initially



Adjustment




Previous Examples:

2) Prepayments
c. Prepaid expenses
1/18 Paid $30,000 for 3 months rent



1/31 Adjustment




d. Pre-collected revenue

1/10 Collect gift card $500



1/31 $200 yet to redeem
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3) Accruals
a. Accrued expenses

1/15 Wages accrued $400



1/20 Paid wages $400




b. Sales on account

1/15 credit sale of $1000


1/20 collect cash $1000
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Practice Problem (continued):
Analyze the following items and determine if an adjusting entry is necessary.

10) At month end, McQueen weighed the remaining coffee beans and found
that she had 25 lbs remaining. She also counted her other supplies (cups,
napkins, etc.) and found that she had about $100 worth of supplies
remaining.






11) Interest on the bank loan is 12% payable annually.






12) The espresso machine and cart are expected to last 5 years.






13) By the end of July, $150 worth of cards were redeemed.









Financial Statement Preparation and Closing Entries
23

The financial statements can now be prepared from the ending balances in each T-
account. Recall however that revenues and expenses DO NOT appear on the balance
sheet but do affect the balance sheet through their effect on retained earnings. In order
to prepare the balance sheet, we need to transfer the revenues and expenses to the
retained earnings account. This method of transferring the revenues and expenses to
retained earnings is known as the closing process.

Closing process:
1) Close revenues and expenses to income summary account.
2) Close income summary account to retained earnings.
3) Close dividends to retained earnings.

What does it mean to close an account?






Practice Problem (continued)
Prepare the closing entry for Top McQueen Espresso for the month of June:










Prepare the income statement, balance sheet, and statement of stockholders equity for Top McQueen
Espresso on the following pages.
Top McQueen Espresso
Income Statement
For the month ended June 30, 2001






24













Top McQueen Espresso
Statement of Stockholders Equity
For the month ended June 30, 2001
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Top McQueen Espresso
Balance Sheet
June 30, 2001





























To prepare the cash flow statement, we must return to the Cash T-account and examine
the transactions that affected the account throughout the period. First, classify each
transaction as operating, investing, or financing and then prepare the statement of cash
flows on the next page.
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Top McQueen Espresso
Statement of Cash Flows
For the month ended June 30, 2001

































Notice that Cash from Operation DOES NOT equal Net Income.
27

ACCRUAL VS. CASH FLOWS CONCEPTS
Cash flows from operations is a distinctly different concept from net income
(accrual accounting):

1. Cash Flow Accounting - benefits and efforts are measured in terms of cash
inflows and cash outflows.

2. Accrual Accounting - benefits and efforts are measured in terms of revenues
and expenses. Revenues are inflows of assets (or decreases in liabilities) and
Expenses are outflows of assets (or creation of liabilities). Cash is just one type
of asset!

Very generally:
a) Revenues are recognized when earned.

b) Expenses are recognized when the effort (or resources) is expended to
generate revenue (matching principle)

Examples of differences in timing:

Revenue Examples
Revenue earned before
cash received





Cash received before
revenue earned.










Expense Examples
28
Expense occurs before
cash paid.





Cash paid before
expense occurs









Note that in each case, an asset or liability holds the timing difference between
net income and cash flows from operations.

Which measure is more important?

29
Dechow, P., 1994, Accounting Earnings and Cash Flows as Measures of Firm
Performance: The Role of Accounting Accruals, Journal of Accounting and
Economics 18:3-42

30
Recall that in our Top McQueen Espresso example, Net Income for June did not equal
Cash Flows from Operations. Why?


Lets compare the Net Income and Cash Flows from Operations of Top McQueen
Espresso:

Income Statement Statement of Cash Flows
Revenue Cash collections from Sales
Expenses:
Cost of Goods Sold Cash paid for inventory
Supplies Expense Cash paid for supplies
Rent Expense Cash paid for rent
Wage Expense Cash paid for wages
Interest Expense Cash paid for interest
Depreciation Exp Cash paid for depreciation
NET INCOME Cash flows from operations

Notice:
1) Revenues do not equal Cash Collections from Sales. Why?








2) Cost of Goods Sold (cost of coffee beans used) does not equal cash paid for
inventory. What are the differences?








3) Supplies Expense does not equal Cash Paid for Supplies. What are the
differences?



31




4) Interest Expense does not equal Cash Paid for Interest. What are the
differences?






So, we could reconcile Net Income to CFO as follows:
















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Inferring Journal Entries


Although many different events might affect any given account, there are generally
standard transactions that affect each balance sheet account.

Examples: For each account, think about what will make the account increase and
what will make the account decrease:

Balance Sheet Account Increase Decrease
Accounts Receivable


Interest Receivable


Inventory


Supplies Inventory


Prepaid Insurance


Prepaid Rent


Property, Plant & Equip


Accounts Payable


Wages Payable


Interest Payable


Unearned Revenue



Therefore, if you know the change in a balance sheet account from the beginning
of a period to the end of a period (the net increase or decrease in the account),
AND you know one reason for the change you can infer the other reason for the
change.

Practice Problem:
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Following is selected balance sheet information from Koas Kitty Food, Inc.
for the years ended December 31, 2004 and 2005.

Account 12/31/04 12/31/05
Accounts Receivable 8,500 9,000
Merchandise Inventory 10,100 9,600
Prepaid Rent 2,400 2,000
Accounts Payable 8,900 7,900
Wages Payable 1,900 2,000

In addition, the following information for the year ended 12/31/05 is
provided to you:
Accrual sales $24,500
Cash paid to suppliers for inventory purchased on account 13,700
Rent Expense 3,400
Cash paid for wages 4,700

Using this information, compute the following (NOTE: Assume that
accounts payable relates entirely to merchandise inventory):

a) Cash collected from customers $________________






b) Cash paid for rent expense $________________







c) Cost of goods sold $________________

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d) Wage expense $________________







This inference process is difficult but very useful. We will use it throughout the
quarter and you will see again in BBUS 363 when you cover the Statement of Cash
Flows.

35
INCOME STATEMENT PRESENTATION
Typical Income Statement Format: Multi-step












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Alternative: Single Step Format


























Does it matter?





Valuation Implications:



Types of irregular items:

1. Economic events
(millions, except per share data)

2004

2003

2002

Sales

$ 45,682

$ 40,928

$ 36,519

Net credit card revenues

1,157

1,097

891

Total revenues

46,839

42,025

37,410

Cost of sales

31,445

28,389

25,498

Selling, general and administrative expense

9,797

8,657

7,505

Credit card expense

737

722

629

Depreciation and amortization

1,259

1,098

967

Earnings from continuing operations before interest expense and
income taxes

3,601

3,159

2,811

Net interest expense

570

556

584

Earnings from continuing operations before income taxes

3,031

2,603

2,227

Provision for income taxes

1,146

984

851

Earnings from continuing operations

$ 1,885

$ 1,619

$ 1,376

Earnings from discontinued operations, net of $46, $116 and $152
tax

$ 75

$ 190

$ 247

Gain on disposal of discontinued operations, net of $761 tax

$ 1,238

$

$

Net earnings

$ 3,198

$ 1,809

$ 1,623

Basic earnings per share

Continuing operations

$ 2.09

$ 1.78

$ 1.52

Discontinued operations

$ 0.08

$ 0.21

$ 0.27

Gain from discontinued operations

$ 1.37

$

$

Basic earnings per share

$ 3.54

$ 1.99

$ 1.79

Diluted earnings per share

Continuing operations

$ 2.07

$ 1.76

$ 1.51

Discontinued operations

$ 0.08

$ 0.21

$ 0.27

Gain from discontinued operations

$ 1.36

$

$

Diluted earnings per share

$ 3.51

$ 1.97

$ 1.78

Weighted average common shares outstanding:

Basic

903.8

911.0

908.0

Diluted

912.1

919.2

914.3


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a. Discontinued operations (SFAS #144, ASC 205-20): Component of a
company 1) that has or will be eliminated from the operations of the company and
2) that the company will not have any significant continuing involvement in after
disposal


Proposed changes:
(based on Exposure draft of a new ASU) : Component of a company 1) that has
been disposed or 2) is classified as held for sale, and represents one of the
following:
1) An operating segment

2) A business


Why does it matter?




Two components:
- When the component has been sold:
1) Income/Loss from operation of discontinued segment from the beginning of the
reporting period to the disposal date,
2) Gain or loss on disposal of discontinued segment

- When the component is considered held for sale:
If decision has been made in the current period to discontinue operation but
not yet discontinued (eg by sale) need to
1. separately report the income/loss on this operation
2. if FV of assets < book value, recognize the expected loss on sale (an
impairment loss)
But if FV > book value, do NOT recognize the gain til actually sell the
operations.

Example: Company disposes of a segment that had operating losses for the year of
$40,000 and that resulted in loss of $10,000 on disposal. Tax rate is 40% and
income from continuing operations is $200,000.
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Example of discontinued operations from Target Corp 10-K
CONSOLIDATED RESULTS OF OPERATIONS

(millions, except per share data) 2004 2003 2002
Sales $ 45,682 $ 40,928 $ 36,519
Net credit card revenues 1,157 1,097 891
Total revenues 46,839 42,025 37,410
Cost of sales 31,445 28,389 25,498
Selling, general and administrative expense 9,797 8,657 7,505
Credit card expense 737 722 629
Depreciation and amortization 1,259 1,098 967
Earnings from continuing operations before interest
expense and income taxes 3,601 3,159 2,811
Net interest expense 570 556 584
Earnings from continuing operations before income taxes 3,031 2,603 2,227
Provision for income taxes 1,146 984 851
Earnings from continuing operations $ 1,885 $ 1,619 $ 1,376
Earnings from discontinued operations, net of $46, $116
and $152 tax $ 75 $ 190 $ 247
Gain on disposal of discontinued operations, net of $761 tax $ 1,238 $ $
Net earnings $ 3,198 $ 1,809 $ 1,623
Basic earnings per share
Continuing operations $ 2.09 $ 1.78 $ 1.52
Discontinued operations $ 0.08 $ 0.21 $ 0.27
Gain from discontinued operations $ 1.37 $ $
Basic earnings per share $ 3.54 $ 1.99 $ 1.79
Diluted earnings per share
Continuing operations $ 2.07 $ 1.76 $ 1.51
Discontinued operations $ 0.08 $ 0.21 $ 0.27
Gain from discontinued operations $ 1.36 $ $
Diluted earnings per share $ 3.51 $ 1.97 $ 1.78
Weighted average common shares outstanding:
Basic 903.8 911.0 908.0
Diluted 912.1 919.2 914.3

See Notes to Consolidated Financial Statements throughout pages 28-37.

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b. Extraordinary items: Income items that are unusual and infrequent






c. Other unusual/irregular items: Income items that are unusual or infrequent
(but not both)



Restructuring charges

- Recognize when incurred not necessarily paid.
- Fair value the liability
a. Based on expected termination/severance payments to employees
b. Are estimates. So could be too high or low

Are they part of permanent earnings?


40





Pro forma earnings
- Street earnings: managers (and analysts) exclude items from earnings

Some people refer to as excluding the bad stuff:

41



42
1. Turns out pro forma earnings are more highly correlated with stock returns
than reported earnings meaning (in an efficient capital market) .
2. SOX Section 401. If firms report pro forma in a press release or elsewhere,
they must reconcile to reported earnings











What are managers incentives for reporting these items?


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How should irregular or unusual economic events be reported?

Options:
1. Combined with other revenue and/or expense line items



2. Include as a separate line item in the income statement

And include in calculation of income from continuing operations



And exclude from calculation of income from continuing operations


3. By-pass net income and record directly to retained earnings



Why is this important?

44
Example: Coca-Cola Enterprises

Examine the following Statement of Income and excerpts from the Notes to the
Consolidated Financial Statements (next page).

Did CCE have any unusual or irregular items during 2005?



45





46
Practice Problem
Shepard Industries is a manufacturer of medical devices. During 2004, several unusual
events occurred at Shepard Industries:

The company sold a subsidiary, Shepard Financing, that provided financing to
customers to assist them in purchasing some of the more expensive items in the
companys product line. The company no longer offers financing directly but
provides customers with referrals to financing companies that provide such services.
Prior to the sale, Shepard Financing incurred a loss of $200,000. The sale of the
subsidiary resulted in a gain of $50,000.

The company incurred damage to one of their production facilities in Arizona,
resulting from a tornado. Tornados are highly unusual occurrences in the area. The
damage sustained to the buildings, equipment, and inventory totaled $80,000

Due to poor performance, the company announced a restructuring plan to reorganize
its business units and streamline production. The restructuring plan included layoffs
of 2,000 personnel and the disposal of non-productive assets and inventory from
underperforming product lines. The cost of the restructuring was $130,000.

Excluding these items, the company had revenues of $1,000,000, Cost of Goods Sold
of $600,000, and Selling, General and Administrative Expenses of $180,000.

The companys income tax rate is 30%.

The company has (and always had) 100,000 shares of common stock outstanding and
no preferred stock.

Prepare an income statement for Shepard Industries for the year ended December 31,
2004, in good form (space available on next page).
47
Shepard Industries
Statement of Income
For the Year Ended 12/31/2004
48

2. Accounting related (SFAS #154, effective from January 1, 2006)
a. Corrections of errors: Error in financial statement resulting from mistake,
misapplication of GAAP or misuse of facts






b. Changes in accounting principles:
- A change from one allowable method under GAAP to another
(voluntary change)
Ex:



- or as a result of a rule change (mandatory change)





c. Changes in accounting estimates: Normal, recurring corrections/
adjustments to estimates in the financial statements









Earnings Per Share
is the amount of income earned expressed on a per share basis.

In the income statement, firms must disclose:
EPS for
(a) income before any separately reported items,
(b) each separately reported item
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(3) net income

Basic EPS = (Net Income Preferred Dividends) / # of common stocks
outstanding.


($ in thousands, except per share data) 2010
Loss from continuing operations before
extraordinary item $ (77,962)
Loss from discontinued operations, net of tax _
Extraordinary item, net of tax --
Net loss $ (77,962)

Basic earnings (loss) per share
Loss from continuing operations before
extraordinary item $ (.67)
Loss from discontinued operations --
Extraordinary item --
Net loss $ (.67)



50
COMPREHENSIVE INCOME (SFAS #30)
All changes in equity except those resulting from investments by or distributions to
owners

Comprehensive income = NI +Other Comprehensive Income (OCI)



Common items in OCI:




Impetus for this standard:




Presentation:


1. Separate statement



2. Combined statement






Accumulated Other Comprehensive Income (Accumulated OCI)
- Reported in balance sheet

51

52


53
BALANCE SHEET AND DISCLOSURES

Purpose:



Typical Format:


54
What are assets?
Assets
Classified how:


Operating cycle: define







Limitations:








Classifications:
Cash and Cash Equivalents

Example: Dell (from the text)
55
Note 1Description of Business and Summary of Significant Accounting Policies
Cash and Cash Equivalents
All highly liquid investments, including credit card receivables, due from banks,
with original maturities of three months or less at date of purchase are carried
at cost and are considered to be cash equivalents. All other investments not
considered to be cash equivalents are separately categorized as investments.

Short-term investments :
temporary investment or short-term marketable securities. The company
has the intend and ability to sell within a year or operating cycle.
o

PROPERTY, PLANT, AND EQUIPMENT.

What are liabilities?
probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events.

Shareholders Equity
Residual ownership interest (assets less liabilities)
56

Other Important Disclosures/Elements of Financial Statements:

Notes to the financial statements


Summary of Significant Accounting Polices pp 56-66 (11 pages!!)

Subsequent Events

What are they?


Walmart: 14. Subsequent Events (in part) On March 5, 2009, the Company's
Board of Directors approved an increase in the annual dividends for fiscal
2010 to $1.09 per share. The annual dividend will be paid in four quarterly
installments on April 6, 2009, June 1, 2009, September 8, 2009, and January
4, 2010, to holders of record on March 13, May 15, August 14, and December
11, 2009, respectively. On March 27, 2009, the Company issued and sold
$1.0 billion of 5.625% Notes Due 2034 at an issue price equal to 98.981% of
the notes' aggregate principal amount.

Related Party transactions
What are they?

Why disclose?

Note M: Related Party Transactions (in part)On May 16, 2008, we completed
two transactions relating to our corporate aircraft. First, we sold our
Bombardier Global Express airplane for approximately $46,787,000 in cash
57
(a net after-tax cash benefit of approximately $29,000,000) to an unrelated
third party. This resulted in a gain on sale of asset of approximately
$16,000,000 in the second quarter of fiscal 2008. Second, we entered into an
Aircraft Lease Agreement (the Lease Agreement) with a limited liability
company (the LLC) owned by W. Howard Lester, our Chief Executive
Officer and Chairman of the Board of Directors, for use of a Bombardier
Global 5000 owned by the LLC. These transactions were approved by our
Board of Directors.

Management Discussion and Analysis


Auditors Report
External auditor attest to the fairness of the financial statements


1. Unqualified :

2. Qualified:

3. Adverse
4. Disclaimer
Compensation of directors and top executives

58
FINANCIAL STATEMENT ANALYSIS

General principles:

Scaling: Numbers need to be scaled to be economically meaningful

o Common size financial statements

I/S: Express all line items as a % of

B/S: Express all line items as a % of

o Ratios Divide line items in economically meaningful way


Benchmarks: Need to compare to something to be useful





Common ratios:
Liquidity: Ability to pay debts as they come due in the short-term

Current ratio: CA/ CL



Quick Ratio:


Solvency: Ability to pay debts when they come due in the long-term

Debt to equity:



Times interest earned:


59


Activity: Effectiveness of asset use

Receivables turnover




Inventory turnover




Asset turnover




Profitability: Ability to generate wealth in the long-term

Profit margin



Return on Assets (ROA)



Return on Equity (ROE)
ROE = Profit Margin Asset turnover (1+Leverage)







Example: Nordstrom vs. Costco
60
Nordstrom and Costco are both retailing giants but they have very different
business models.

Which ratios discussed above, would you expect to differ between the two
companies?




The following are selected data from Nordstrom and Costco for 2003:

Nordstrom Costco
Sales 6,491,673 42,545,552
COGS 4,213,955 37,235,383
Net Income 242,841 721,000
Receivables 594,900 556,090
Inventory 901,623 3,339,428
Current Assets 2,455,430 5,711,538
Total Assets 4,465,688 12,709,383
Current Liabilities 1,049,549 4,528,802
Shareholders Equity 1,634,009 6,554,980



Were your intuitions correct?

61
REVENUE RECOGNITION

Issue: What amount of revenue should a company report in a given period?

General Principle: Revenue is recognized when it is both:

Earned


Realized or realizable



How easy is this to apply?


Start of End of Sale/ Start of End of
Production Production delivery Cash Cash
of Asset Collection Collection

Examples:

Merchandise sales at Nordstrom?



Upfront activation fees associated with cellular service?



Sale of an iphone?
-

Why is applying principle difficult?

-
Why is it important?



62
Excerpt from Kravet, T. and T. Shevlin, 2010 Accounting Restatements and
Information Risk, Review of Accounting Studies 15:264-294



63

Staff Accounting Bulletin (SAB) 104 (previously 101):

Reason behind the issuance of SAB 101


Is this GAAP?




According to SAB 104, revenue is realized or realizable and earned when the
following criteria are met:

Persuasive evidence of an arrangement exists

Delivery has occurred or services has been rendered


1) Bill-and-hold arrangements
- Facts: Company A receives purchase orders for products it manufactures. At
the end of its fiscal quarters, customers may not yet be ready to take delivery
of the products for various reasons. These reasons may include, but are not
limited to, a lack of available space for inventory, having more than sufficient
inventory in their distribution channel, or delays in customers' production
schedules.
- Question:
o May Company A recognize revenue for the sale of its products once it
has completed manufacturing if it segregates the inventory of the
products in its own warehouse from its own products?
o May Company A recognize revenue for the sale if it ships the products to
a third-party warehouse but (1) Company A retains title to the product
and (2) payment by the customer is dependent upon ultimate delivery to
a customer-specified site?
- The Commission has set forth criteria to be met in order to recognize
revenue when delivery has not occurred. These include:
1. The risks of ownership must have passed to the buyer;
2. The customer must have made a fixed commitment to purchase the goods,
preferably in written documentation;
3. The buyer, not the seller, must request that the transaction be on a bill and
hold basis. The buyer must have a substantial business purpose for ordering
the goods on a bill and hold basis;
64
4. There must be a fixed schedule for delivery of the goods. The date for
delivery must be reasonable and must be consistent with the buyer's
business purpose (e.g., storage periods are customary in the industry);
5. The seller must not have retained any specific performance obligations such
that the earning process is not complete;
6. The ordered goods must have been segregated from the seller's inventory and
not be subject to being used to fill other orders; and
7. The equipment [product] must be complete and ready for shipment.

2) Customer acceptance provisions
- Installation, (by whom), working to specifications
3) Subsequent performance obligations
Inconsequential?
4) License fee revenue
Delivery begins when license term begins
5) Nonrefundable upfront fees

o A registrant sells a lifetime membership in a health club. After paying a
nonrefundable "initiation fee," the customer is permitted to use the health
club indefinitely, so long as the customer also pays an additional usage fee
each month. The monthly usage fees collected from all customers are
adequate to cover the operating costs of the health club.
A registrant requires a customer to pay a nonrefundable "activation fee"
when entering into an arrangement to provide telecommunications services.
The terms of the arrangement require the customer to pay a monthly usage
fee that is adequate to recover the registrant's operating costs. The costs
incurred to activate the telecommunications service are nominal.
- Unless the up-front fee is in exchange for products delivered or services
performed that represent the culmination of a separate earnings process, the
deferral of revenue is appropriate.
- In the situations described above, the staff does not view the activities
completed by the registrants (i.e., selling the membership, signing the
contract, enrolling the customer, activating telecommunications services or
providing initial set-up services) as discrete earnings events.

The sellers price to the buyer is fixed or determinable



Collectibility is reasonably assured
65



66
Revenue Recognition after Delivery (i.e., during cash collection)
If the collection of cash on a sale is not reasonably assured, the sale does not meet
the realized or realizable criteria to recognize revenue. In this case, revenue (and
the associated expense i.e., COGS) is recognized over the period in which cash is
collected.

Two methods:
Installment method

o Record receivable, inventory reduction and deferred profit




o Compute average gross margin on sales for the year





o Recognize a portion of gross profit based on cash collected: gross
profit % $ collected


Cost recovery method

o Same as above except recognize gross profit once cash received to
date exceeds cost of sales

67
Practice Problem
George Company sells washing machines and has a very lenient credit policy. As a
result, the company has no basis for estimating uncollectible accounts. The
company began operations in 2003. In the first two years of operations the
company had:

2003 2004
Installment Sales $250,000
(Sale A)
$260,000
(Sale B)
Cost of Installment Sales 150,000 169,000
Cash Collections:
On Installment Sales A 75,000 100,000
On Installments Sales B 150,000

Prepare the appropriate journal entries assuming the company uses the installment
method:
2003 2004












What if the company uses the cost recovery method?







Revenue Recognition before Delivery - Contract Accounting (ARB 45, ASC 605-35)
When would recognition before delivery be a concern?


68

Two methods:
Percentage-of-completion method

-


Completed-Contract method



Simple Example
Seattle Grace Construction Company (SGCC) enters into a contract to build a new
building for Addison Company. The contract price is $2,500,000, expected costs
are $2,000,000, and the construction is expected to last 2 years. Cost incurred on
the project are $1,200,000 in year 1 and $800,000 in year 2.

What percent of the project is completed at the end of year 1? How much of the
revenue should be recorded in year 1 and year 2?



Percentage Completion Completed Contract
Year 1 Year 2 Year 1 Year 2
Revenues
Expenses
Net Income

Which provides better information?








Use percentage-of-completion when:
69
1. Estimates of progress toward completion, revenues, and costs are reasonably
dependable.
2. Contract specifies enforceable rights regarding goods or services to be
provided and received by the parties, the consideration to be exchanged, and
the manner and terms of settlement
3. The buyer can be expected to satisfy all obligations under the contract
4. The contractor (seller) can be expected to perform the contractual
obligations.


Accounting using Percentage-of-Completion Method

JE to record costs incurred on the project:



JE to record Revenue/COGS:







Progress Billings: Contractually agreed-upon amounts that the contractor (seller) is
allowed to bill the buyer at set intervals. Only the amounts billed can be
recorded in Accounts Receivable. Revenue earned in excess of amounts billed are
kept in the Contracts in Progress (i.e., Inventory) account.


JE to record progress billings:




Why use a contra-account?




Contracts in Progress Billings on CIP A/R
70








71
Simple Example (cont)
Assume all construction costs are paid in cash, that the progress billings made by
SGCC to Addison are $1,250,000 in years 1 and 2, and Addison pays that amount in
each of the two years What journal entries would the company record if the
company uses the percentage of completion method?

Year 1 Year 2
















Net impact on Financial Statements?

Assets = Liabilities + S/E










Changes in estimates:
The total estimated costs of the project could change over time. This is treated as a
change in estimate and is treated prospectively that is, no changes are made to
prior net income but changes are made going forward.

72
Thus, calculations of revenues and expenses should be based on cumulative amounts
less amounts recorded in prior periods.

Revenue recorded in CY = Revenue earned to date Revenue recorded in PY



Expense recorded = Expense to date Expense recorded in PY



Practice Problem
On July 1, 2003, Scranton Construction contracted to build an office building for
Scott Industries for a total contract price of $1,900,000. The building was
completed on December 31, 2005. Additional data were:

2003 2004 2005
Contract costs incurred during the year $450,000 210,000 900,000
Estimated costs to complete as of 12/31 1,050,000 990,000 0
Billings to Scott Industries 300,000 700,000 900,000
Collections from Scott Industries 300,000 700,000 900,000


73

Compute the amount of revenue and expenses that should be recorded in each year.















74

Prepare the journal entries that would be recorded in each of the three years

2003 2004 2005
















What amounts would be reflected on the companys financial statements?

2003 2004 2005
Balance Sheet:







Income Statement:




EXCEPTION: If a change in the estimate of total costs will result in the contact
becoming unprofitable, the company must recognize in the current period the
entire expected loss which includes reversing any gross profit recorded in the
prior period.

75
Revenue recorded =



Expense recorded =



76
Practice Problem (cont)
Suppose that the estimated cost to complete as of December 31, 2004 were
$1,340,000 and the estimated cost turns out to be correct:

2003 2004 2005
Contract costs incurred during the year $450,000 210,000 1,340,000
Estimated costs to complete as of 12/31 1,050,000 1,340,000 0
Billings to Scott Industries 300,000 700,000 900,000
Collections from Scott Industries 300,000 600,000 1,000,000

Compute the amount of revenue and expenses that should be recorded in each year.

2003 2004 2005
77

IFRS
IAS 11 governs accounting for long-term construction contracts.

Primary difference: Completed-contract vs. Zero-Profit methods




78
Multiple-deliverables (EITF 00-21, ASC 605-25)


Examples:



What are managers incentives with respect to accounting for multiple-deliverable
items?



Originally, in arrangement with multiple deliverables, delivered item could be
considered separate unit of accounting only if all the following conditions were
met:

1) Delivered item has value to customer on stand-alone basis
2) There is objective evidence of fair value of undelivered item
3) If general right of return exists, delivery/performance of undelivered item
considered probable and substantially under control of vendor

Recent changes:




Allocation of amounts (consideration) received should be based on relative selling
prices, using:

Vendor-specific objective evidence
Third-party evidence
Best estimate of selling price

BUT: Limited to amount that is NOT contingent upon delivery of additional item


Example: CellularCo. (from EITF 00-21)
CellularCo runs a promotion in which new customers who sign a two-year contract
receive a free phone. The contract requires the customer to pay a cancellation fee of
$300 if the customer cancels the contract. There is a on-time activation fee of $50 and
a monthly fee of $40 for the ongoing service. The same monthly fee is charged by
79
CellularCo regardless of whether a free phone is provided. The phone costs CelluarCo
$100. Further, assume that CellularCo frequently sells the phone separately for $120.
CellularCo is not required to refund any portion of the fees paid for any reason.
CellularCo is sufficiently capitalized, experienced and profitably business and has no
reason to believe that the two-year service requirement will not be met. CellularCo is
considering whether 1) the phone and 2) the phone service (that is, the airtime) are
separable deliverables in the arrangement. The activation fee is simply considered
additional arrangement consideration to be allocated. The phone and activation are
delivered first, followed by the phone service (which is provided over the two-year period
of the arrangement).

1) Are these separate units of accounting? Why or why not?








2) If yes, how should the total consideration be divided between the two units?






80
Example of disclosure on revenue recognition for multiple elements (from the 10-K
of Cellco Partnership, d/b/a Verizon Wireless, Notes to Consolidated Financial
Statements):
Revenue Recognition
The Partnership earns revenue by providing access to the network (access revenue) and for usage of the
network (airtime/usage revenue), which includes roaming and long distance revenue. In general, access
revenue is billed one month in advance and is recognized when earned; the unearned portion is
classified in advance billings. Airtime/usage revenue, roaming revenue and long distance revenue are
recognized when service is rendered and included in unbilled revenue until billed. Equipment sales
revenue associated with the sale of wireless handsets and accessories is recognized when the products
are delivered to and accepted by the customer, as this is considered to be a separate earnings process
from the sale of wireless services. Effective July 1, 2003, the Partnership adopted the provisions under
Emerging Issues Task Force (EITF) Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables. Prior to the adoption, customer activation fees, along with the related costs up to but not
exceeding the activation fees, were deferred and amortized over the customer relationship period.
Subsequent to the adoption of EITF 00-21, customer activation fees are recognized as part of equipment
revenue. The existing deferred balances, prior to the effective date, will continue to be amortized in the
statement of operations.
The Partnerships revenue recognition policies are in accordance with the Securities and Exchange
Commissions (SEC) Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial
Statements, SAB No. 104, Revenue Recognition, and EITF Issue No. 00-21.



IFRS
IAS 18 is the main standard related to revenue recognition and has similar
requirements to SAB 104

BUT: more principles based vs. rules-based

81
Revenue Recognition Exposure Draft (November 2011)
Purpose:




Core Principle: Recognize revenue to depict the transfer of goods or services to customers in
an amount that reflects the consideration received (or expected to be received)
Requirements:
Identify contracts with customers

Consider substance over form

Examples:


Identify separate performance obligations in the contract

Bundled goods: Separate performance obligation if good/service is distinct



Determine transaction price

amount of consideration expected to be entitled



Allocate transaction price to separate performance obligations

Based on relative standalone selling price basis

What if not sold separately?
- Expected cost + margin approach
- Expected market assessments approach

Recognize revenue when the entity satisfies each performance obligation
When customer obtains control of good or service

82
CASH AND EQUIVALENTS

Cash


Cash equivalents
short-term, highly liquid investments that are:
easily converted into a known amount of cash.
close to maturity. no longer than three months from date of purchase
not sensitive to interest rate changes.


Cash and Cash equivalents usually combined and reported as the most liquid
current asset.

Restricted cash
cash that has been set aside for a particular use and is not available for paying
current liabilities.

Compensating Balance
is some specified minimum amount that must be maintained on deposit with a
bank that has made a loan to the company.


RECEIVABLES
Two main types of receivables:

Accounts receivable short-term, oral promises to pay for goods or services
sold

Notes receivable short or long-term, written promises to pay a certain sum
of money on specified future date(s)

Accounts Receivable
Two main accounting issues:

83
1) Recognition (initial valuation) record account receivable at face vaue less
any trade discount and possibly and cash discount




2) Subsequent valuation record account receivable (net) at net realizable
value, using an allowance for returns and/or an allowance for uncollectibles
as necessary.









Sales Discounts
Offered to encourage prompt payment.

Example of terminology: 2/10, n/30














Gross method (most common): Sales recorded at gross amount, discounts taken
are recorded in a contra-revenue account called Sales discounts


2 /10, n/ 30
# of days
discount is
available

Otherwise, net
(or all) is due

Credit
period

Discount
percent
84
Simple Example: ABC Company sells a widget to XYZ company for $5,000 on
terms 2/10, n/30.

At time of sale:





If paid in 10 days:





Net method: Sales recorded at net amount, discounts NOT taken, recorded as
additional income (perhaps as Interest Income).

At time of sale:




When discount period expires:





What is the cost of offering cash discounts?


In our simple example, what does the company earn if it doesnt offer a discount?






What does it earn if it does offer the discount (suppose annual interest is 10%)?

85





Valuation
Accounts receivable should be recorded at net realizable value the net amount
the company expects to receive in cash. Requires determination of whether
accounts will be collected.


How do we know which accounts wont be collected?
-- Wait until specific accounts are known to be uncollectible (direct write-
off method).



-- Estimate amount of accounts receivables that will ultimately not be
collected and record amount in the period in which revenue is generated
(allowance method).


Accounting under Allowance Method:
JE to record estimate of uncollectible accounts each period as bad debt expense:





JE to record specific accounts determined to be uncollectible:




-
Two basic methods for estimating bad debt expense:

1) Percentage of sales method:



86

2) Percentage of receivables method





Practice Problem
The following information is taken from the balance sheet of Mickey Company at
12/31/2004:

Accounts Receivable (net of allow. for doubtful accts of $10,000) $90,000





The following events occurred during 2005. Prepare the journal entries for each
event:

1) Sold $1,000,000 on account




2) Collected $800,000 on A/R




3) Identified $20,000 of specific accounts which are deemed uncollectible



4) Estimated bad debt expense
a. using the percentage of sales method (2.5%)




Compute the balances in each account at year end:
87

A/R Allow. for DA Bad Debt Exp.










b. Now assume the company estimates bad debt expense using the percentage of
receivable method. An aging schedule of Accounts Receivable at 12/31/2005 is as
follows (with estimated % of uncollectible for each group):

Current $130,000 2%
1-30 days 70,000 5%
31-75 days 30,000 10%
75+days 50,000 30%
280,000








Under the two methods:

%age of Sales Aging
Accounts Receivable Balance
Allowance for Doubtful Accts
Net Receivable
Bad Debt Expense


Why is bad debt expense and allowance balances different under these two
methods?

88






Advantages/Disadvantages:

% of Sales




% of Receivables




Recoveries Accounts that have been written off the books that are subsequently
collected. Recoveries are accounted for by 1) reversing the write-off entry, 2)
recording the collected cash.







89
Notes Receivable
Notes receivable should be recorded at the present value of the cash expected to be
collected.

Cash Flows:

Principles: amount to be received at the maturity
Interest : periodic interest payment

Definition: written promises that will receive certain sum(s) of money at specified
future date(s).

Short term :
Long term :

Interest Bearing Notes

Recognition:
Record the face amount and recognize interest revenue when it is earned;

EX: On October 1, 2012, McQueen Company sold car parts and accepted a $5,000,
90-day, 12% note from Mater Corp. Interest is payable at maturity. Mater paid all
amounts due on December 31, 2012. Record the necessary journal entries.

1) First Scenario: McQueens FYE is 12/31

10/1/12




12/31/12



2) Second Scenario: McQueens FYE is 10/31

10/1/12


90




10/31/12






12/31/12







Non-Interest Bearing Notes

Recognition: using a discount account (essentially the same method as long-term
notes)


EX:
On October 1, 2012, McQueen Company sold car parts and accepted a $5,000, 90-
day, non-interest-bearing note from Mater Corp. Mater paid all amounts due on
December 31, 2012. Record the necessary journal entries.


1) First Scenario: McQueens FYE is 12/31

10/1/12






12/31/12
91






2) Second Scenario: McQueens FYE is 10/31

10/1/12




10/31/12





12/31/12





What is the effective rate?

Subsequent Valuation of Notes Receivable

Using an allowance account for uncollectibles : provisions for loan loss
More important for long-term notes receivable
92
Financing with Accounts Receivables
Companies will sometimes transfer their receivables to another party.

Secured Borrowing Borrowing money and using receivables as collateral

o Pledging



o Assigning






Practice Problem:
On December 31, 2009, ABC Company assigns $100,000 of its
accounts receivable to a finance company and signs a promissory
note. The finance company advances 80% of the accounts
receivable assigned less a finance fee of 1.6% of the accounts
receivable assigned. Interest on the note at 12% is payable
monthly.
93
December 31, 2009










During January 2010, ABC recorded cash collections of $58,000
and sales discounts (ABC uses the gross method) of $2,000
related to the assigned accounts receivable. At the end of
January, ABC remitted the cash for the assigned accounts
receivable collected plus accrued interest to the finance company.

January 2010






January 31, 2010










94
Selling Receivable Transferring rights to collect receivables to a third party in
exchange for cash

o Without recourse purchaser bears risk of uncollectibility




o With recourse seller bears the risk of uncollectibility



Why do firms do this?




Which would managers prefer?





Criteria for classification as sale (SFAS #140, ASC 860-10-40):

1. Transferred asset is isolated from transferor (beyond reach of transferors
creditors)

2. Transferees can pledge or exchange the transferred asset

3. Transferor does not have effective control of asset through repurchase
agreement




95
Practice Problem

On December 31, 2009, B Company sells $100,000 of accounts
receivable to a factor. B receives cash equal to 90% of the
factored accounts receivable. The factor retains the remaining
10% to cover its factoring fee (5% of the factored accounts
receivable) and to provide a cushion against potential sales
returns. B estimates that the fair value of the last 10% of
receivables to be collected is $9,000 and that $3,000 of the
factored accounts receivable will be uncollectible.

Without Recourse With Recourse







96
INVENTORY
Items held for sale in the ordinary course of business. Three issues related to
inventory: 1) Control,
2) acquisition/Production, 3) Cost Flow Assumption

Control
Why are accurate, up-to-date records of inventory important?

-



Perpetual inventory system tracks purchases and sales as they occur




Periodic inventory system inventory physically counted periodically






What effect do errors in inventory counts have on the financial statements?




Recall: Beginning Inventory + Purchases COGS = Ending Inventory



Balance Sheet Income Statement
This Period This period Next period

Overstated Inventory



Understated Inventory

97


Acquisition/Production of Inventory
1) Items to include

Consigned goods


Goods in Transit

FOB Shipping point vs. FOB destination



Buyback arrangements



2) Cost to attach
General rule: All costs associated with manufacture, acquisition, storage or
preparation.


Merchandising Company:


Manufacturing Company:




Cash Discounts
Gross method: Record in inventory at gross amount, reduce inventory if
discounts taken



Net method: Record in inventory at net amount, record Discounts Lost
as other expense
98



99
Cost Flow Assumption
Question: How do we allocate the total cost of goods available for sale (beginning
inventory + purchases) between COGS and ending inventory?

Beginning Inventory + Purchases = COGS + Ending Inventory

Four possibilities:
1) Specific ID: Specifically identify which items were sold and which are
remaining.

2) FIFO Assume items are sold in the order they are purchased.

COGS: First items purchased (oldest items) are the first items sold
(FIFO)

End. Inv.: Last items purchased (newest items) stay in ending inv. (LISH)

3) LIFO Assume most recent items purchased are sold first.

COGS: Last items purchased are the first items sold (LIFO)

End Inv: First items purchased stay in ending inv. (FISH)


4) Weighted Average: Items sold are valued at the weighted average cost of the
goods available for sale
COGAS/total no. of units available for sale


IMPORTANT POINT: The method chosen need not represent the actual movement
of inventory!! It is simply a method of assigning $ values to inventory items.

A company may use any of the above methods under either a periodic or a
perpetual inventory system. The difference between, for example, LIFO periodic
and LIFO perpetual, is in what you consider "available for sale" at the time of each
sale.

For this class, we will assume a periodic inventory method for all computations of
COGS.

Practice Problem:
100
The following information relates to the Sunny Valley Corporation for the month of
October:

Date Description Units Cost Total
Beginning 300 10
October 5 Purchase 220 11
October 12 Sale 260
October 22 Purchase 150 12
October 25 Sale 80
TOTAL

Compute COGS and ending inventory assuming the company uses the FIFO cost
flow assumption:






Compute COGS and ending inventory assuming the company uses the LIFO cost
flow assumption:






Compute COGS and ending inventory assuming the company uses the Weighted
Average cost flow assumption:






Notice that under each method COGS + EI = COGAS. Why?

FIFO LIFO WA
COGS
Ending Inv.
101
COGAS



Which method provides the most current cost in Ending Inventory?



Which method provides the most current cost in COGS?



If prices rising: COGS
LIFO
COGS
FIFO

NI
LIFO
NI
FIFO

EI
LIFO
EI
FIFO


If prices falling COGS
LIFO
COGS
FIFO

NI
LIFO
NI
FIFO

EI
LIFO
EI
FIFO


These relations are true as long as the number of units purchased exceeds the
number of units sold.

LIFO Liquidations
If the number of units sold exceeds the number of units purchased, the company
has essentially sold some of the beginning inventory units (which may have very
old costs attached to them). This is called liquidating LIFO layers.

Practice Problem (cont)
Continue the Sunny Valley Corporation example. Suppose in the following year,
the company has the following purchases and sales:

Units Cost Total
Purchases 200 13 2,600
Sales 400

What is COGS under LIFO?


102




What is COGS under FIFO?





103
LIFO reserve
The difference between EI valued on a LIFO basis and EI valued on a FIFO basis is
often referred to as the LIFO reserve. The LIFO reserve is a contra-account to
Inventory.

Companies often maintain records on a FIFO basis and at the end of each period
compute EI on a LIFO basis and adjust the reserve accordingly.

Practice Problem
McCoy Industries is a manufacturer of small office equipment. The company
values its inventories under the LIFO method. At 12/31/2004, the company reported
the following:

Inventories (net of LIFO reserve of 25,000) 125,000

During 2005, the company purchased $825,000 of inventory and determined COGS
using FIFO to be $800,000. At 12/31/2005, inventories using LIFO would be valued
at $140,000. Record the journal entry to adjust the LIFO reserve









FIFO or LIFO?
Arguments in favor of LIFO Arguments in favor of FIFO






IFRS
IAS 2 governs accounting for inventory.

Primary Difference: NO LIFO!


104
Dollar Value LIFO
Using the LIFO method discussed previously can be problematic because of 1)
record-keeping and 2) LIFO liquidations.




An alternative is Dollar-value LIFO (DVL), which applies LIFO procedures to pools
of similar goods based on dollars rather than units. Ending inventory is compared
to beginning inventory, both measured in dollars adjusted for inflation.

Recall: Under unit LIFO,
If units purchased > units sold
(or units EI > units BI) LIFO layer added
If units purchased < units sold
(or units EI < units BI) LIFO layer liquidated

Under DVL,
If $ purchased > $ sold
(or $ EI >$ BI) LIFO layer added
If $ purchased < $ sold
(or $ EI < $ BI) LIFO layer liquidated

But, if tracking inventory in $s and not units:
Inventory in $ = inventory in units x cost/unit

Inventory in $ could be due to in units or in cost/unit
Inventory in $ could be due to in units or in cost/unit

Therefore, to determine if LIFO layers are added or liquidated, we need to adjust
the inventory in $s to take away the effect of changes in cost/unit (i.e., price
level changes).

How do we do that?
1. Compute price change from base year prices (price index) for the pool of
inventory

105
Price index a measure of the change in prices from a base
year (the first year dollar value LIFO is adopted in this case) to the
current year.


Price index = Ending inventory quantities x current end-of-year costs
Ending inventory quantities x base end-of-year costs

(Mostly is given)

2. Divide the inventory value for the pool (based on current prices) by price
index



The difference between the beginning inventory at base year prices and the ending
inventory at base year prices indicates whether a layer has been added or taken
away:

If EI
BASE$
> BI
BASE$
LIFO layer added
add LIFO layer at current year cost (multiply layer at base year prices and
multiply by price index)



If EI
BASE$
< BI
BASE$
LIFO layer liquidated
remove most recent layers added
106
Practice Problem
On January 1, 2000, Deoxys Inc. changed from FIFO to dollar value LIFO. At that date, its
beginning FIFO inventory was $100,000. The following information relates to the
companys inventory for the years ended 12/31/2000 through 12/31/2003:

Year-ended Ending inventory at
current costs (or FIFO)

Year-end price index
12/31/2000 $124,800 1.2
12/31/2001 169,500 1.5
12/31/2002 144,200 1.4
12/31/2003 140,400 1.3

Compute ending inventory on a dollar value LIFO basis for each year:
















107
If the company purchased $500,000 of goods during 2000, what would COGS be
under FIFO and under LIFO?

108
INVENTORY ADDITIONAL ISSUES

Lower of Cost or Market (LCM) rule
GAAP requires that inventories be reported at the lower of cost or market

What is Cost?

What is Market?



Under GAAP, market is defined as replacement cost (RC), except:

If RC > Net Realizable Value (NRV), use NRV


If RC < NRV less normal profit margin, use NRV less normal profit margin




Note that the rule is asymmetric inventory is reduced if market falls below cost but is
NOT written up if market rises above cost.

The LCM rule can be applied to products individually or to groups of products. What is
the advantage of grouping products?




Journal entry to record write-down:

What impact does the companys choice of cost flow assumption have on the probability
of an inventory write-down?



Practice Problem
The following data relate to Zubat Inc. for the five different items it sells to its customers.
Determine the appropriate market value for each of the five products.

Product Product Product Product Product
109
A B C D E
Historical Cost $1,000 $2,000 $1,500 $1,125 $800
Replacement Cost 550 1,300 675 1,000 900
Estimated selling price 850 1800 1,200 1,875 1,400
Estimated costs of disposal 250 600 300 375 240
Normal Profit Margin 90 180 120 200 140
Market

What value should be reported for ending inventory if the company applies the LCM, to
individual products? Prepare any necessary journal entries to adjust inventory to LCM.











What is the value of ending inventory if the company applies LCM to the entire inventory?
Prepare any necessary adjusting journal entries.



110
IFRS
Another difference between US GAAP and IAS 2 relates to LCM. Under IAS 2 market is
always defined as NRV.

How would that change our previous analysis?




Also, write-downs can be subsequently reversed if market value increases BUT only up to
the amount of the original write-down.
o