Chapter-1 Development of Accounting Principles and Professional Practice 1.1 The Environment of Financial Accounting and Reporting
1. Definition
accounting is an information system concerned with recording the financial affairs of an organization and providing information about the economic activities and conditions of the organization to its stakeholders to be used as a basis for making economic decisions including investment, credit and taxation
as an information system, it involves the following steps identifying economic activities to be recorded
measuring or expressing effects of economic activities in terms of money analyzing and recording effects of economic activities in books of accounts classifying recorded effects of economic activities in meaningful groups summarizing economic data to prepare financial statements and reports reporting or generating financial statements to provide financial information interpreting financial information contained on financial statements and reports 2. Users of accounting information
two main groups – internal and external users internal users
mainly management personnel of an organization
need very detailed and specific information about activities of an entity need and use accounting information for
o planning future operations
o controlling and evaluating current operations which includes comparing actual performance with budgets
identifying favorable and unfavorable variances investigating causes of variances and
taking necessary actions for better future operations o formulating long-range plans
o making major business decisions such as
investing in or acquiring productive assets e.g. equipment pricing products (goods/services)
choosing which products to emphasize/de-emphasize
allocating scarce resources to competing operations in the best way management accounting
o specialized field of accounting concerned with provision of information for internal uses o provides information via internal company reports
o management accounting reports include detailed information about specific departments, products, territories and the business as a whole
o prepared based on prescriptions from the specific internal user external users
consist of decision makers outside the reporting economic entity are not directly involved in the day-to-day activities of the organization
do not usually have the power to prescribe the format and content of company financial reports include
o current and prospective creditors (e.g. banks, credit suppliers) – to assess ability of the entity to repay its loan including principal and interest
o government agencies – assess the financial activities of an entity for the purposes of taxation and regulation
determine the amount of tax an entity should pay on its earnings enacts laws aimed at
protecting the public from excessive price charges
encouraging business entities to contribute to charitable entities by permitting them to deduct what they contributed in determining taxable income
controlling wages and prices in an attempt to control the economy by reducing the rate of inflation, and etc
o employees and labor unions – need information about an entity’s financial strength and profits before beginning negotiations for a new labor contract (continue/discontinue working with the entity)
o credit rating agencies – establish credit ratings (rikiness of an entity in relation to repayment of credits)
o financial analysts and consultants – to search for promising investment opportunities and accordingly advise their clients
o academic and research institutions – develop theories related to and/or identify possible solutions to entity’s financial and other problems
o customers – assess stability and continuity of the entity, know balances of their accounts with the entity
financial accounting
o specialized field of accounting concerned with provision of information to satisfy the information needs of mainly external users
o but the information can be used by both internal and external users
o for they serve variety of users, financial accounting reports are called general purpose financial statements
o provides information via annual financial statements
o financial statements provide highly summarized information about the affairs of a company as a whole
o general purpose financial statements are prepared based on GAAP, individual users do not have the power to prescribe the format and content of general purpose financial statements
Assignment - Identify and explain at least three areas in which management accounting and financial accounting differ.
3. Environmental factors affecting financial accounting and reporting
financial accounting and reporting are highly affected by various environmental factors and developments including
economic and social developments (e.g. inflation, environmental concern)
political system (e.g. free market – information for decisions concerning investment by individual or institutional investors, ownership of capital and resources by individuals vs command economy – information for national planning, state ownership of capital and resources; accounting and reporting treatment of assets e.g. land)
governmental laws and regulations (e.g. reporting requirements, tax laws and labor laws) professional associations and accounting standard setting bodies (e.g. FASB, AICPA, AAA)
user groups and their information requirements (e.g. investors, creditors, tax and regulator agencies) 1.2 Conceptual Framework for Financial Accounting and Reporting
1. Definition
refers to the theoretical basis/foundation for financial accounting and reporting
2. Contents
the conceptual framework consists of objectives of financial reporting elements of financial statements
qualitative characteristics of accounting information recognition and measurement guidelines
3. Objectives of financial reporting
why are financial statements needed? who needs them? what information do users need? objectives
general
o provide information useful for making various economic decisions including investment and credit
specific – provide information about an entity’s
o economic resources and claims against the economic sources (balance sheet) o financial performance (income statement)
o sources and uses of cash (statement of cash flows)
o changes in owners’ equity (statement of changes in owners) 4. Elements of financial statements
financial statements and reports basic financial statements
o balance sheet o income statement
o statement of changes in owners’ equity o statement of cash flows
supportive reports
o notes to the financial statements o supplementary schedules o auditors’ report
elements of financial statements – items that appear on basic financial statements assets – economic resources with potential to provide future benefits
liabilities – obligations to transfer economic resources
owners’ equity – claims of owners against the economic resources of a company investments by owners – inflows of economic resources from owners
distributions to owners – outflows/transfers of economic resources to owners revenues – inflows of economic resources from delivery of goods/services
expenses – costs of goods/services consumed, sold or exchanged for other goods/services gains – inflows of economic resources from peripheral transactions
losses – outflows of economic resources due to peripheral transactions 5. Qualitative characteristics of accounting information
definition - attributes/characteristics that make accounting information useful components
reliability
o accurate and free from material errors and bias o accounting information is said to be reliable if it
accurately represents the financial performance and position – representational faithfulness is objective/verifiable – can be proved by examining evidence underlying the information is neutral – free from bias, prepared without any intention to influence (persuade/mislead)
relevancy
o make a difference in decision
o decision with and without the information should not be the same o affect/influence the decision making process
o accounting information is said to be relevant if it
is timely – available at the right time/before decision is made
helps users evaluate past, present and future events – predictive value helps users to confirm or correct expectations – feedback value understandability
o the information must be understandable/comprehensible to users o be prepared in such a way that users can understand and use it o a linkage between accounting information and its users
o depends on
preparer’s skills and abilities to communicate information user’s ability to comprehend that information
comparability
o must enable users to compare events (e.g. performance) of a company overtime – inter period comparison
with other similar companies at the same time – intercompany comparison
intercompany comparison is very difficult due to application of different operating and accounting policies
o helps users to detect and explain similarities and differences among companies and evaluate the performance of each over time
o especially, helps users to easily identify weaknesses and/or strengths of a company due to changes in accounting and reporting methods, procedures, policies, etc (detect income manipulation)
o comparability needs
consistency in using accounting and reporting methods, procedures, policies overtime full disclosure of uses of and changes in accounting and reporting methods, procedures,
policies constraints
o considerations that affect provision of accounting information possessing the required qualities discussed earlier
o include
cost-benefit – cost of preparing and reporting accounting information should not exceed the expected benefit (e.g. steady supply of goods/services, better performance) from having and using the information
materiality – items considered to be insignificant to affect decision should be treated in the most economic and convenient ways
conservatisms – when faced with dilemma as to the selection of accounting and reporting methods, go for the one that understate net assets and net income
industry practice – peculiar nature of some industries and business concerns sometimes requires departure from what would normally be considered good accounting practice or GAAP
6. Recognition and Measurement Guidelines
when and at what amount to record and report an element recognition
o it meets the definition of an element
o sufficient evidence for the existence of the item is availability
o the item can be measured in monetary terms with sufficient reliability for some items (e.g. uncollectibles) an estimate will be necessary
use of reasonable estimates is a normal part of the accounting and reporting process provided that the estimates are reasonably reliable and prudent
stages of recognition
o initial recognition – when recording the items in the books of accounts
o subsequent remeasurement or revaluation – due to change as to the value or usefulness of the item
o derecognition – removing an element from books of accounts Measurement
at what amount to record and report an item the amount is usually expressed in monetary terms
measurement basis or recording and reporting methods include
o historical cost – initial amount of cash or cash equivalent given up (e.g. all plant assets and inventory)
o current/replacement cost – the current cash or cash equivalent needed to replace the item (e.g. inventory)
o current market value – cash or cash equivalent obtainable by selling or needed to liquidate the item (e.g. short-term investment)
o net realizable value – liquidating value of the item net of other liquidating costs or the maximum cash or cash equivalent obtainable from disposing the item (e.g. inventory and accounts receivable)
o present value – the value today of the item (e.g. long-term receivables and payables) 1.3 Generally Accepted Accounting Principles (GAAP)
1. Definition
also called conventions, standards, postulates, assumptions
general guidelines for recording transactions and preparing financial statements to provide information useful for decision making
unlike principles of natural sciences, are not universally accepted and static
highly affected by the social, political, economic and cultural conditions in a nation include accounting and reporting methods, procedures and policies
sources
USA – FASB, AICPA, APB, SEC IASC – IASB
UK – ASB 2. Components - include
a) Accrual concept
transactions and other events should be recognized when they occur rather than when related cash is received or paid
b) Accounting/business entity
each business entity exists separate from and independent of its owner/s or any other business entity under the same owner/s
thus, each business entity must keep its own financial records and prepare its own financial statement
discuss accounting entity (corporation, partnership and soleproprietorship) versus legal entity (corporation)
c) Going concern/continuity
the life of a business entity is indeterminate
an economic entity will continue operating in a profitable business in the foreseeable future unless substantial evidence to the contrary exists
affect classification and valuation of assets and liabilities discuss going concern versus quitting concern
d) Monetary principle
national currency (e.g. birr, dollar) is used as a unit of measure for recording and reporting effects of economic activities
the unit of measurement is assumed to be stable – no change in purchasing power of money over time
financial statements may be supported by notes showing effects on A, L, C, R, E, L and G of changes in purchasing power of money
e) Accounting period/periodicity
the indeterminant life of a business organization can be divided into smaller but equal time periods called accounting periods
accounting period may be a month, a quarter, a semiannual or a year needed to prepare timely information for decision making
set of financial statements must be prepared at least once in a year fiscal year – an accounting period consisting of 12 months
interim financial statements – statements prepared covering less than one year period of time discuss calendar year versus business cycle
f) Historical cost
historical cost – initial amount of cash or cash equivalent received or paid in exchange for an item elements are recorded and reported at their respective historical costs
the historical cost is retained until the item is consumed, sold or liquidated and removed from records
reasons for use of historical cost o objectivity/reliability
o determined based on negotiation between seller and buyer g) Revenue recognition
revenue is recorded and reported one
o earned – when the earning process is complete or substantially complete i.e. when the seller totally or substantially accomplished what it must do in order to claim money or any other resources from the buyer
o realized – when the seller received cash or cash equivalent
o or realizable – when the item is readily convertible into a definite amount of cash or near cash (for example, when the item can be sold at a quoted price on an active market)
h) Matching principle
all costs and expenses incurred to generate revenue must be deducted from (matched against) the revenue which they supported for its recognition in a given period
help to accurately determine income/loss i) Disclosure principle
financial statements and reports must contain all information necessary to the users of such statements and reports
means of disclosure
o main parts of the financial statements/reports – to disclose elements
o notes/supplementary schedules – to disclose contingencies, accounting methods and procedures, details of major elements of the financial statements/reports, events subsequent to the balance sheet date, etc
o parenthesis – to disclose current information about some elements e.g. market values of short-term investments or current cost of inventories
j) Consistency
accounting and reporting methods/procedures must be used uniformly from period to period, from year to year
previously adopted accounting and reporting methods/procedures should remain unchanged unless otherwise a new method/procedure is identified to better fairly and accurately account for and report on the financial affairs of the entity
change is not prohibited but if there is any change, disclose
o nature of the change (e.g. from direct write off of uncollectible to allowance)
o reasons (e.g. allowance method timely matches losses from uncollectible with revenues (especially, credit sales) which are the causes for the losses)
o effect of the change on elements of the financial statements/reports (e.g. income/assets will decrease/increase by certain amount compared to the use of direct write of method)
purposes
o enables users to easily identify changes in financial performance/position of an entity due to changes in accounting/reporting methods, policies, etc
o makes easy comparison of financial performance/position of an entity over time or comparison among different entities
o prevents income manipulation due to changes in accounting/reporting methods/procedures k) Materiality
elements that are not significant enough (both in amount and nature) to influence decisions should be treated in the most economic and convenient manner rather than in strict accordance with accounting theory
materiality depends on
o nature of the item (e.g. related party transactions (selling to/purchasing from an entity where managers of the company have some interest)
o relative size (amount) of the item l) Conservatism/prudence
when alternative accounting/reporting methods/procedures are equally possible, select the one that is least likely to overstate assets and income in the current period
means of resolving uncertainties
but priority should be given to other principles 1.4 Cash Flows and Income Measurement
1. Cash flows and revenues/expenses cash inflows versus revenues/gains
collection of cash from investors (additional investment), creditors (loans) or advance payments by customers (unearned revenues) are not revenues
cash outflows versus expenses/losses
cash payments for dividends, purchase of assets (e.g. machinery) or cash loans to other entities are not expenses
2. Income measurement methods a) Introduction
modified cash/accrual basis accrual basis cash basis b) Accrual basis
revenues are recognized when earned and realized regardless of when related cash is received expenses are recognized when goods/services are used/sold regardless of when related cash is paid net income
Revenues earned $xxx
Less: Expenses incurred (xxx)
Net income/loss $xxx
c) Cash basis
revenues are recognized only when collected in cash expenses are recognized only when paid in cash net income
Revenues collected in cash $xxx Less: Expenses paid in cash (xxx)
Net income/loss $xxx
expenses exclude payments for dividends and repayment of principals of loans d) Modified cash/accrual basis
cash and accrual bases are two extremes
modified is a mixture of accrual and cash bases of accounting e.g. some items may be recognized on accrual while other on cash basis
when modified is applied to a merchandising business
revenues from sales of inventory are recognized on accrual basis revenues from all other sources are recognized on cash basis e.g. rent cost of goods sold are recognized on accrual basis (or at the time of sale)
depreciation and amortization are recognized on accrual basis (based on allocation of costs plant and intangible assets over their respective useful lives)
all other expenses are recognized on cash basis e.g. supplies and rent when modified is applied to a service giving enterprise
revenues and accrued expenses are recognized on cash basis
depreciation, amortization and prepaid items are recognized on accrual basis 3. Converting cash-basis financial statements to accrual-basis
in some cases it may be needed to convert cash basis amounts of elements of the financial statements into their accrual basis counterparts
the following table helps converting cash basis figures into accrual basis ones
Cash basis Adjustments Accrual basis
cash collection from customers
+ accounts receivable-ending
= sales revenue - accounts receivable-beginning
cash collection from other income (e.g. rent)
+ unearned rent-beginning
= rent income - unearned rent-ending
+ rent receivable-ending - rent receivable-beginning
cash payments to inventory suppliers
+ accounts payable-ending
= cost of goods sold - accounts payable-beginning
+ inventory-beginning - inventory-ending cash payments for operating
expenses (e.g. supplies, rent,
salary)
- accrued items-beginning + accrued items-ending
cash payments for tangible and intangible long-term operational assets (e.g. buildings and franchise)
C, EL, Method and SV = Depreciation/amortization expenses
Example-1.1
ABC Share Company was established in 2000. The company uses cash basis of accounting to account and report on its financial affairs. At present the company is required to prepare accrual based financial statements to apply for a bank loan. Examination of its financial records indicates that $195,000 cash was collected from customers and a total of $206,000 cash was paid for various items. Cash balances as of January 1, 2003 and December 31, 2003 were $120,000 and $109,000, respectively. Based on physical inventory, the company's merchandise inventory balances as of January 1, 2003 and December 31, 2003 were determined to be $80,000 and $107,200, respectively. As of December 31, 2003, customers owed the company $104,300 and the company owed inventory suppliers and employees $105,100 and $15,000, respectively. As of January 1, 2003, amount owed by customers total $95,000 while amounts owed to inventory suppliers and utility companies total $120,000 and $200, respectively. The cost of supplies on hand as of January 1, 2003 and December 31, 2003 was determined to be $500, and $800, respectively. Examination of the company's check book indicates that during 2003, the company;
i) paid $154,000 to inventory suppliers and $30,000 for operating expenses. Included in the payment for operating expenses was $5,000 cash paid on January 1 for a 2-year rent on office building.
ii) paid $9,000 for acquisition of office machine on January 1. The company uses straight line depreciation method and the economic life and salvage value of the machine were estimated to be 5 years and $1,000, respectively.
iii) paid $13,000 cash dividends.
Required: Prepare income statement for the year ended December 31, 2003 using each of the following bases of accounting: a) cash b) accrual and c) modified-accrual
Example-1.2 (assignment)
Since its establishment, Jan 8, 2000, ABC Share Co keeps cash based accounting records of its financial affairs. In 2002, the company is required to prepare and submit accrual based set of financial statements as part of its application for a bank loan. Besides, major shareholders have been asking the company to adopt an accounting system which produces fair and timely financial information. You are called to help the company in preparing the required types of financial statements. Your preliminary examination of the financial records of the company revealed the following financial information as of Dec 31, 2001, end of the previous fiscal year.
Debit Credit
Cash……… $8,100
Accounts Receivable……….. 12,600
Inventory……… 16,800
Supplies……….. 3,600
Equipment………... 36,000
Accounts Payable……… $14,300
Income Tax Payable……… 4,000
Paid-in-capital……...……….. 58,800
Totals……….. $77,100 $77,100
common stock and $13,800 in retained earnings. The company is subject to 40% income tax due within four months after the end of each fiscal year. It is now Dec 31, end of 2002. The company's checkbook shows a balance of $72,300 which includes cash receipts from customers of $212,100 and cash payments of $147,900. Examination of the cash payments shows that
a) $91,800 was paid to inventory suppliers
b) $38,100 was paid for operating expenses including $16,000 paid on Jan 1, 2002 for two years' rent and $4,000 income tax, and
c) $18,000 was paid for dividends On Dec 31, 2002
d) customers owed the company $17,700
e) the company owed inventory suppliers and employees $21,000 and $2,700, respectively f)cost of merchandise inventory and supplies were $18,900 and $2,400, respectively Required: Using the
1) accrual basis 2) cash basisand
3) modified accrual basis of accounting
a) determine for the year ended Dec 31, 2002 i) sales (8 marks)
ii) cost of goods sold (16 marks) iii) operating expenses (14 marks)
iv) income tax expense, (1 mark)
b) prepare income statement and balance sheet (9 marks)
c) Prepare entries needed to correct any error you discovered in the course of examining the financial records of the company. Towards this end, you may use existing accounts or create any new account if necessary. (2 marks)
CHAPTER-2 SUMMARY OF THE ACCOUNTING PROCESS 2.1 Introduction
1. Definition
accounting is an information system concerned with the process of business transactions to provide information useful for decision making
consists of steps collectively called the accounting cycle 2. Accounting process
consists of three phases recording
summarizing
preparation of financial statements and year-end entries 2.2 The Recording Phase
1. Identifying recordable events a) events
economic activities that bring monetary changes in the elements of the financial statements -monetary principle
divided into
external - exchanges of resources between the entity and other external parties such as suppliers and customers e.g. purchases and sales of goods/services
internal - economic activities occurring within the entity which do not affect external party e.g. consumption of prepaid items
b) source documents
business papers which provide complete information about events evidencing their occurrence -objectivity (objective evidence) principle
the basis for journalizing transactions
proper design and preparation of source documents is an important element of internal control system
2. Journalizing a) journal
book of original entry
used to initially record transactions chronologically two types
i) general - used to record any transactions if special journals are not maintained ii) special
used to record voluminous, same and frequently occurring transactions
facilitate the process of recording and posting transactions and minimize related costs include
sales journal - used to record credit sales of goods/services
cash receipts journal - used to record collection of cash from any sources
cash payments journal(check register) - used to record payments of cash for any purposes b) journalizing
process of recording effects of transactions on the elements of financial statements using the double entry accounting system
system of recording the dual effects called debits and credits of a transaction requires recording of equal dollar amounts of debits and credits
differentiate between double entry and single entry accounting systems and identify the advantages and disadvantages of each if any
rules of debits and credits
Debit credit
Assets increases decreases
Liabilities decreases increases
Owners'equity
Dividends/withdrawals increases decreases
Retainedearnings decreases increases
Capitalstock decreases increases
Incomesummary decreases increases
Revenues/gains decreases increases
Expenses/losses increases decreases
importance of journalizing
ensure that dual effects of each transaction are recorded
have historical records of dual effects of each transaction in the same place provide detailed analysis of transactions
3. Posting a) account
business document used to categorize and collect in one place effects of business transactions on a specific asset, liability, owners' equity, revenue, gain, expense and loss account
three classifications
nominal/temporary - accounts whose balances must be transferred to the real accounts at the end of each period
real/permanent - accounts whose balances are carried forward from period to period mixed - accounts whose balances are partly real and partly nominal
b) chart of accounts
list of account names and related identification numbers (codes) shows all accounts a company uses to record effects of transactions c) ledger
collection of accounts
a folder containing company accounts two types
general - containing accounts that appear on financial statements called controlling accounts e.g. accounts receivable, buildings, accounts payable, sales etc
subsidiary - containing accounts showing details of controlling accounts e.g. customers and suppliers accounts
subsidiary accounts may be maintained for any controlling accounts
subsidiary accounts are useful to get detailed information for follow-up and control purposes d) posting
process of transferring debit and credit entries from the journals to accounts in the ledger
2.3 The Summarizing Phase 1. Introduction
the summarizing phases consists of steps aimed at collecting and arranging data need for preparation of financial statements and year-end entries
usually done through the help of worksheet 2. Worksheet
working paper/schedule used to summarize and arrange date needed for preparation of financial statements
adjusting and closing entries
prepared using pencil, helps to minimize errors
depending upon the nature and type of business, it may have four (unadjusted trial balance, adjustments, income statement and balance sheet) or more major columns
items 3 to 6 below show the steps in the preparation of worksheet 3. Unadjusted trial balance
the fist step in the preparation of worksheet
prepared by copying accounts having non-zero balances from the general ledger made to check equality of debit and credit totals in the general ledger
but having total debits equal to total credits does not imply that the accounting process if free of error for there are some errors which do not affect the equality of the two totals of the trial balance e.g. failure to record a transaction or recording equal but erroneous debits and credits
4. Adjustments a) definition
second step in the preparation of worksheet
refers to updating account balances by recording events which were not recorded in the journalizing process
b) purpose
record unrecorded events thus
determine accurate balances of accounts
determine net income/loss by matching revenues earned with expenses incurred and costs expired c) GAAP
GAAP that justify the need for adjustment of accounts revenue recognition principle
accrual concept periodicity principle matching principle
d) Items requiring adjustments i) deferral
including prepaid expenses (assets) and unearned revenues (liabilities)
adjustment required to record the expired/unexpired costs and unearned/earned revenues ii) accruals
including accrued expenses (liabilities) and accrued revenues (assets)
adjustment required to record expenses incurred but not paid and revenues earned but not collected
iii) estimated items
including depreciation/amortization and uncollectible account expenses
adjustments required to record expired costs of plant/intangible assets and losses from uncollectible accounts
iv) merchandise inventory
to adjust inventory account for inventory shortage or overage - perpetual inventory system 5. Adjusted trial balance
the third step in the preparation of worksheet
prepared by determined adjusted accounts balances which is the sum/difference of their respective amounts in the unadjusted trial balance and adjustment columns
helps to check whether the adjustment and account balance determination steps are done correctly on the worksheet
6. Completing the worksheet
the last step in the preparation of worksheet
involves transferring adjusted account balances to the manufacturing column
income statement column retained earnings column
balance sheet column of the worksheet
2.4 Preparation of Financial Statements and year-end entries 1. Preparation of financial statements
means of providing financial information useful for decision making include
statements of goods manufactured income statement
statement of retained earnings statement of cash flows balance sheet
notes to the financial statements auditor's report
two types
annual - covering one year
interim - covering less than one year period of time such as monthly and quarterly reports 2. Preparation of year-end procedures
a) journalizing and posting adjusting entries - to update account balances in the ledgers
b) journalizing and posting closing entries - to remove balances of temporary accounts and transfer their balance to the owners' equity account thus update its balance
c) preparation of post-closing trial balance - check equality of debit and credit totals of real accounts d) journalizing and posting reversing
i) definition
exact reverses of adjusting entries involving the same accounts and amounts made at the beginning of the next accounting period
help to comply with company policies of recording deferrals and simplify recording of transactions related to adjustments in the next accounting period
ii) adjustments requiring reversing entries adjustments for
prepayments initially recorded as expenses advance collections initially recorded as revenues accrued expenses and revenues
iii) adjustments not requiring reversing entries adjustments for
prepayments initially recorded as assets
advance collections initially recorded as liabilities estimated items
3. Journalizing and posting correcting entries
entries made to correct errors made during any steps in the accounting process types of errors
mathematical mistakes oversight
misuse of facts
incorrect classification items not considered as errors
changing from one accounting method to another one
changes in estimated items such as economic life and salvage values of plant assets, percentage of uncollectible accounts and percentage of completion
means of discovering errors preparation of trial balances
reconciling general ledger accounts with their respective subsidiary ledger accounts internal and external audits
chance
correcting entries may affect temporary accounts if the errors are discovered in the year made and accounts are not closed for that year
Chapter-3 Revenue an Expense Recognition Income measurement and reporting 3.1 Revenue recognition
1. Definition o see chapter-1 o revenues are
inflows or enhancements of assets
settlements of liabilities (e.g. deliver of goods/services - customer advance payments) any combination of the above events
o sources of revenue (e.g. merchandising business) major - sales of goods
secondary - interest, rent, royalty, dividends, commission, etc 2. Revenue recognition principle
o guideline as to when and at what amount to recognize revenue o revenue is recognized when
i) earned
when the earning process is completed or virtually (nearly) completed
when the enterprise performed what is expected from it to claim cash/other assets from it customers eg.
sale a product and transfer risks and rewards associated with it perform service
permit others to use assets ii) realized
goods/services are converted in to cash or other assets
realizable – goods/services can readily be converted into cash or other assets, eg. precious metals and farm products with immediate marketability at quoted prices
Example 3-1
On January 1, 2003, ABC Brokers entered into a contract to sell residential house of its customer. The contract entitled the company to receive 10% commission on the selling price of the residential house. The commission is to be paid one month after the sell of the residential house. On March 3, 2003, the company sold the house for Birr100,000 and collected the commission on April 2, 2003.
Required:
a) When is the commission revenue earned? Realized? b) When shall the company recognize it? 3. Revenue Recognition Methods
o point of sale (delivery) o before delivery
percentage of completion completed contract
o after delivery installment cost recovery a) Point of sales
o revenue is recognized when
assets are used by customers rent/royalties as time passes interest income
o conditions
price should be fixed or reasonably determinable
buyer has paid or obliged to pay without any precondition eg. resale, theft or damage future returns and uncollectibles can be reasonably estimated
Example 3-2
Refer to example 3-1 above. When shall the company recognize the commission revenue under the point of sale method? And what will be the journal entry?
b) Before delivery (during production)
o applied on revenue generating activities which require several years to complete such as long-term contracts including construction of multi-storyed buildings, macro dams and bridges, highways and aircrafts
o applying point of sale in these cases provides less relevant information
distorts income does not accurately reflect current period performance o two methods
percentage of completion completed contract i) Percentage of completion
o revenue is recognized based on the amount of work completed (done) in each year o measurement of work done
input measures costs incurred
labor/machine hours worked quantity of materials consumed
output measures tones produced
storey of a building completed miles of a high way completed
o conditions
dependable estimates of progress towards completion
consideration receivable is reasonably measurable and collectible (receipt is reasonably assured) performance consists of execution of more than one acts
steps (using the cost-to-cost method of estimating work done)
estimate the remaining cost required to complete the contract determine percentage of completion (work done) to date
Percentage = Cost incurred to date
Complete total cost to complete the contract
Total cost to complete = cost incurred to date + estimated cost
the contract to complete the contract
determine current year revenue as shown below
Revenue to date (contract price x percentage complete)….. $xxx Less: total revenue recognized in previous years………….. (xxx)
Current year revenue………... $xxx
the following journal entries are made to record construction and other related transactions to record construction costs incurred
Construction in process……….…………... xx
Cash/Accounts payable/other accounts… xx
Note: Construction in progress is an inventory account and is recoded and reported at its NRV (accumulated cost + accumulated profit)
to record process billings
Accounts receivable……….. xx
Partial billing………. xx
Note: Partial billing represents amount of money the construction company claimed from (billed) the customer for work done and is a contra construction in progress account
excess of construction in progress over partial billings represents unbilled portion and is reported as current asset
excess of partial billings over construction in progress represents unearned revenue and is reported as current liability
to record collection
Cash……….. xx
Accounts receivable……….. xx
to record revenue and related construction costs (similar to cost of goods sold in the case of merchandising business)
Construction costs (for cost incurred)..………. xx Construction in process (for gross profit)……. xx
Construction revenue……….. xx
to record other expenses (e.g. administrative expenses) Salary/supplies/rent/other expenses………. xx
Cash/salary payable/supplies/other accounts… xx to record final completion of the construction
Partial billings……… xx
Construction progress……… xx
Note: When the project is completed, the balance of partial billing is equal to that of the construction in progress account
Example 3-3
On February 2, 2002, ABC Construction Company entered into a contract to build a dam over the coming three years. The contract price is Birr1,000,000 and the company estimated that the project will cost it in total Birr800,000. The company’s fiscal year ends on December 31. Below is additional information related to the contract:
2002 2003 2004
Current year progress billing………. 250,000 370,000 380,000
Current year cash collection.………. 200,000 400,000 370,000 Administrative expenses……… 75,000 75,000 75,000 Required: Using the percentage of completion revenue recognition method, determine
a) revenue, gross profit and net income for each year of construction b) prepare all the necessary journal entries
ii) Completed contract method
o revenue is recognized when the contract is completed o conditions
short term contract taking less than a year
when the percentage of completion method is not applicable or conditions for application of percentage of completion are not met
o limitations
provides less relevant information about the construction
distorts earnings does not accurately reflect current period (year) performance
o costs and expenses which are not traceable to (associated with) the construction e.g. administrative expenses are reported as expenses in each year resulting in a loss until completion of the contract o the following journal entries are made to record construction and other related transactions
to record construction costs incurred
Construction in process……….………….. xx
Cash/Accounts payable/other accounts… xx Note: Construction in progress is an inventory account and is recoded and reported at cost under the completed contact method (note the difference with percentage of completion method) to record process billings Accounts receivable……….. xx
Partial billing………. xx
Note: Partial billing represents the amount of money the construction company claimed (billed the customer) for work done and is a contra construction in progress account excess of construction in progress over partial billings represents unbilled portion and is reported as current asset excess of partial billings over construction in progress represents unearned revenue and is reported as current liability to record collection Cash……….. xx
Accounts receivable……….. xx
to record other expenses (e.g. administrative expenses) Salary/supplies/rent/other expenses………. xx
Cash/salary payable/supplies/other accounts… xx to record final completion of the construction Construction cost……… xx
Construction in progress……….. xx
Partial billings……….. xx
Construction revenue……… xx
Note: Under the completed contract method both construction costs and revenues are recognized only when the project is completed. Note also the difference in journal
entries especially at the time of completion. Example 3-4
a) revenue, gross profit and net income for each year of construction b) prepare all the necessary journal entries
iii) Comparison of the percentage of completion and completed contract methods
Percentage of completion Completed contract Reliability of information………… Less (estimates) More (actual)
Relevancy of information………… More (timely) Less (late) iv) Special Problems
o revision/change in estimated total cost to complete the contract
treated prospectively (does not affect amounts of revenue recorded in previous years o change in customer orders that affect the contract price and cost of construction
e.g. change in design, location/training place and courses to be covered treated prospectively (affect current year and future periods)
o gross loss in current year on profitable contract (only under percentage of completion)
Construction costs (cost incurred)………. xx
Construction in progress (gross loss)……… xx
Conduction revenue………... xx
Example 3-5 Refer to example 3-4 above. The estimated cost to complete the contract as of December 31, 2003 is determined to be Birr490,000 instead of Birr300,000. Required: Using the percentage of completion method, determine a) revenue, gross profit and net income for the year ended December 31, 2003 b) prepare all the necessary journal entries o anticipated loss on contract - if the contract is expected to be completed at loss completed contract loss = total estimated cost less contract price entry Loss on long-term contract……… xx
Allowance for loss on contract…….. xx
percentage of completion Construction cost………... xx
Construction in progress……… xx
Construction revenue……… xx
Allowance for loss on contract………... xx Example 3-6
Refer to example 3-4 above. The estimated cost to complete the contract as of December 31, 2003 is determined to be Birr600,000 instead of Birr300,000.
Required: Using the percentage of completion and completed contract (if appropriate) methods, determine
a) revenue, gross profit/loss and net income/loss for the year ended Dec 31, 2003 b) prepare all the necessary journal entries
c) After Delivery Methods
o revenue is recognized when cash is collected
o applied when the collectability of the receivables (sales prices) is highly uncertain or uncollectibles cannot be reasonably estimated
o revenue is recognized in the form of gross profit in proportion to the amount of cash collected in each year
o applied on installment sales i.e. long term credit sales where in there is a down payment (usually small amount)
remaining amount is payable regularly
title is retained till final settlement (to protect non-payment) o steps
record installment sales, cost of installment sales and collection on installment sales in the normal manner (as usual) but separately identified from normal (regular) credit sales
to record sales
Installment receivable-2003………. xx Cost of installment sales……….. xx
Installment sales……….. xx
Merchandise inventory/other account……. xx to record collection
Cash……….. xxx
Installment receivable-2003……….. xx Installment receivable-2002……….. xx By the end of the accounting period
remove installment sales and cost of installment sales and record deferred (unrealized) gross profit for the difference
Installment sales……….………. xx
Cost of installment sales……….. xx
Deferred gross profit-2003...……….. xx computer gross profit rate on current year installment sales
Gross profit = Gross profit-2003
Rate-2003 Installment sales-2003 determine and record current year realized gross profit
Realized gross = Cash collected from X Gross profit
from sales of 2003 sales of 2003 rate-2003 Example 3-7
ABC Share Company sales its inventory items both on normal credit and installment bases. Below is information related to the sales transactions for the years 2002 and 2003:
2002 2003
Other sales…………..………. Birr1,400,000 Birr2,000,000 Cost of normal sales……… 800,000 1,200,000 Installment sales………. 800,000 900,000 Cost of installment sales………. 280,000 594,000 Current year cash collection from
installment sales of 2003………. -- 420,000 installment sales of 2002………. 200,000 400,000 Operating and other administrative expenses.. 450,000 530,000 Required: Using the installment methods, determine
a) realized gross profit from installment sales for each year b) prepare income statement for each year
c) prepare all the necessary journal entries o Special problems
interest charges
interest is accounted for separately accrued interest is recorded as follows
Interest receivable……….. xx
Deferred interest income……… xx
when cash is collected, first recognize interest income as follows
Cash………..……….. xx
Deferred interest income……….………… xx
Interest receivable.……….. xx
Interest income………....………… xx
realized gross profit is calculated on total collection less interest income Example 3-8
On January 1, 2003, ABC Share Co sold a product costing $16,160 for $24,860 payable in three annual installments of $10,000 starting December 31, 2003. Yearly installment payment includes 10% interest on unpaid balance at the beginning of each year. The company uses the installment method of accounting for this transaction and its fiscal year ends December 31.
Required:
a) Determine the amount of Realized Gross Profit in each of the years 2003 and 2004
b) Prepare all journal entries including adjusting and closing needed to handle transactions of each year
Defaults and repossessions
occurs when the buyer fails to make further payments on the installment sale and the seller repossesses the item sold
accounting
record the item repossessed at its NRV=Resale price - any reselling costs (e.g. remodeling, repair, reconditioning)
remove the unpaid installment receivable and its related deferred gross profit determine and record any loss or gain on repossession
Gain/loss:
Net realizable value………. xxx Less: unrecovered cost:
Installment receivable………….. xx Less: Deferred gross profit…….. (xx)
Unrecovered cost……….. (xx) Gain (loss)………. xxx
journal entry
Repossessed inventory……….. xx Deferred gross profit….……….………… xx Loss on repossession……….. xx
Installment receivable……….. xx Gain on repossession………...………… xx Example 3-9
On January 1, 2003, ABC Share Co sold a product costing $14,000 for $20,000 to a customer called Altawari. Terms of payment require $2,000 down payment and $500 regular payments at the end of each month starting January 31, 2003. After making 16 monthly payments of $500, Altawari defaulted and the company repossessed the item having a net realizable value of $5,000 at the time of repossession, August 5, 2004. The company uses the installment method of accounting for this transaction and its fiscal year ends December 31.
Required:
a) Determine the amount of Realized Gross Profit in each of the years 2003 and 2004
ii) Cost recovery method
o revenue is recognized in the form of gross profit starting form the period in which collection exceeds cost of sale i.e. after cost is fully recovered
o steps
record sales, cost of sales and collection in the normal manner
at the end of the accounting period remove sales and cost of sales and record deferred gross profit
record realized gross profit after cost is fully recovered or starting from the period where in which collection starts to exceed cost
Example 3-10
In 2002, ABC Share Co sold a plot of land for $90,000. The land had a recorded cost of $60,000. Because of the speculative nature of the usefulness of the land, the company uses the cost recovery method of accounting for revenues from sale of the land. Cash collections in 2002, 2003 and 2004 were $25,000, $45,000 and $20,000, respectively. Fiscal year ends December 31.
Required:
a) Determine the amount of Realized Gross Profit in each of the years 2002, 2003 and 2004
b) Prepare all journal entries including adjusting and closing needed to handle transactions of each year
o Special problem Interest charges
accrued interest is recorded as follows
Interest receivable……….. xx
Deferred interest income……… xx
when cost is fully recovered, recognize first interest income and then gross profit 3. Revenue Recognition Methods for Long-term Service Contracts
o specific performance method - similar to point of sale for merchandising businesses
o completed performance method - similar to completed contract method for long-term construction contracts
o proportional performance method - similar to percentage of completion method for long-term construction contracts
o cash basis
3.2 Recognition of Gains 1. Definition
o gains refer to net increases in owner equity from incidental transactions which do not relate to the main operations of the company e.g. gain from selling an old plant asset
2. Recognition principle
o gains are recognized when realized 3.3 Recognition of expenses
1. Definition
o outflows of assets e.g. payment of cash for current period rent, sales of merchandise inventory o consumption of assets e.g. supplies, fuel
o incurrence of liabilities e.g. accrued salary, rent, interest o any combination of the above events
2. Classification
o natural – reflecting the kind of resources consumed
e.g. cost of goods sold, depreciation, supplies, salaries, interest, etc o functional – reflecting areas of responsibility where the expenses are incurred
e.g. selling, administration, production 3. Recognition principles
accrual principle matching principle
periodicity materiality 4. Recognition methods
o three expense recognition methods
a) association of causes and effect - expenses are recognized in the period in which the related revenues (i.e. the causes) are recognized
expenses to be recognized under this method include cost of goods sold
delivery expenses sales commission uncollectible expenses
b) systematic and rational allocation - costs are recognized as expenses based on a systematic and rational allocation among periods in which benefits are received or the costs appear to expire
expenses to be recognized under this method include prepaid assets
costs of plant and intangible assets
c) immediate recognition - costs are expensed as incurred
if there is no direct relationship between the costs and revenues earned
when no future benefit is expected from the expenditure incurred currently or in previous period
expenses to be recognized under this method include administrative expenses
research and development costs 5. Expense Recognition in Service Enterprises
o initial direct costs - recognized in the period in which the related revenues are recognized commission and legal fees
document progressing
o direct costs - recognized in the same way as initial direct costs
labor and material expenditures directly related with the service performed o indirect costs - recognized as soon as incurred
all expenditures not directly related with the service performed or not classified in any of the above classes e.g. administrative costs
3.4 Recognition of Losses 1. Definition
o net decreases in owners' equity from incidental transactions o non-productive expenditures or expired costs
2. Recognition principle
o recognized as soon as the transaction (event ) resulting them occurred o examples include
obsolete/worthless assets
destruction of assets by casualty such as fire, flood
decline in market value of inventory, short-term investments, etc 3.5 Income Measurement and Reporting
1. Net income/loss
o net income/loss is the net increase/decrease in owners' equity resulting from operating activities of an enterprise
o measured using the accrual based transactional approach but two approaches capital maintenance approach
Capital-ending………. xx Add: withdrawal……….. xx Less: capital-beginning……… xx
transactional approach Net income/loss:
Revenues………. xx
Gains………..……….. xx
Total revenues and gains……….. xxx
Costs and expenses………... xx
Losses……… xx
Total costs, expenses and losses………… (xxx)
Net income (loss)……… xxx
o only life-time income/loss accurately measures financial performance of a company Life-time income/loss:
Proceeds from liquidation………. xxx Add: total drawings (dividends)……… xxx Less: total investment……… (xxx)
Life-time income/loss………. xxx
2. Income statement
o refers to a report that shows the results of an entity 's operating activities for a given period of time
o content – it is divided in to the following sections and subsections i) Income/loss from continuing operations (net of tax)
sales, cost of sales and gross profit
operating expenses, other income and expenses, losses and gains income tax on income from continuing operations
ii) Income/loss from discontinued operations (net of tax) Income/loss (net of tax) from discontinued operations
gain/loss (net of tax) from liquidation of assets/liabilities of discontinued operations
discontinued operation refer to major operation of a company that is liquidated for various reasons
for example, a company may have three major operation i.e. transportation, publication and mining
if the mining wing is closed/liquidated, it financial performance until the time of liquidation will be reported under the income/loss from discontinued operations
closing a sales outlet does not amount to a discontinued operation
Separately disclosing income from continuing and discontinued operations is necessary to easily compare the financial performance of the company over time
to easily predict future performance of the company iii) Extraordinary gains/losses (net of tax)
extraordinary gains/losses refer to gains/losses arising from transactions which are unusual/abnormal - highly unrelated to the activities of a company
infrequent - not expected to happen in the foreseeable future
examples include losses from earth quake and flood which are unusual and infrequent in the Ethiopian case
iv) Cumulative effect of changes in accounting principles (net of tax)
change in accounting principles refer to any change in method/procedure of recording and reporting elements of the financial statements e.g. change from FIFO to LIFO, straight line to unit of production
v) Net income/loss
vi) Earnings per share(EPS) used to
measure profitability
for simple capital structure i.e. with common shares only EPS = Net Income
Outstanding # of common shares o format
i) single-step
simple to prepare
avoids classification problems
Revenues and gains……….. xxx
Costs, expenses and losses………... (xxx)
Net income (loss)……….. xxx
Earnings per share………. x
ii) Multiple-step
shows detailed information
contains sections, sub-sections and grand and intermediate balances
separates results achieved through normal operations from subordinate or non-operating activities
below are major sections
Income/loss from continuing operations (net of tax)……….. xxx Income/loss from discontinued operations (net of tax)……….. xxx Extraordinary gains/losses (net of tax)………. xxx Cumulative effect of changes in accounting principles (net of tax)….. xxx
Net income/loss……….. xxx
Earnings per share (EPS)……… xxx
iii) Condensed
contains only major categories and grand total of the multiple-step form 3.6 Statements of retained earnings
1. Definition
o retained earnings refers to earnings accumulated overtime which are not distributed to owners 2. Statement of retained earnings
o shows changes in retained earnings over a period of time usually one year
Retained earnings – beginning……… xxx
Add/less: prior period adjustments (e.g. correction of prior period errors)… xx Adjusted retained earnings………. xxx Add/less): net income/loss………. xx
Less: dividends……… (xx)
Retained earnings – ending………. xxx 3.7 Combined statement of income and retained earnings
o combines both the income statement and statement of retained earnings in one statement Income/loss from continuing operations (net of tax)……….. xxx Income/loss from discontinued operations (net of tax)……….. xxx Extraordinary gains/losses (net of tax)………. xxx Cumulative effect of changes in accounting principles (net of tax)….. xxx
Net income/loss……….. xxx
Add: Adjusted retained earnings-beginning
Retained earnings – beginning………… xxx Add/less: prior period adjustments...… xx
Adjusted retained earnings………. xxx
Less: dividends………... (xx)
Chapter-4 Balance Sheet and Statement of Cash Flows 4.1 Balance Sheet
4.1.1 Meaning, purpose and limitation 1. Definition
presents the financial position of an entity on given time
shows the resources of an enterprise and claims against these resources 2. Purpose
to provide information about
nature and amount of investment in enterprise resources type and amount of obligations
type and amount of owners' equity
to provide information that serves as bases for determining and evaluating capital structure assessing liquidity
▪ current ratio (CA/CL), net working capital (CA-CL), debt-to-equity ratio assessing financial flexibility
▪ ability to use financial resources to adapt to unexpected needs
▪ ability to take advantage of unexpected new investment opportunities
▪ ability to survive crisis 3. Limitation
does not provide information about the current fair value of resources, thus value of the entity -historical cost principle
does not report on non-financial resources critical to the success of an entity e.g. human resource, reputation, quality of goods/services
4.1.2 Content and format 1. Elements and classification
three elements: assets, liabilities and owners' equity
i) assets - resources controlled by an entity with the potential to provide future services
a) current assets - cash and other assets expected to be collected, sold or consumed within a year or operating cycle whichever is longer
operating cycle - time needed to acquire and pay for resources, convert resources into goods/services, sell the goods/services and collect related cash (for most businesses operating cycle is less than one year)
examples - cash, receivables, prepaid items, investments, inventories
b) noncurrent assets - assets not expected to be collected, sold or consumed within a year or operating cycle
long-term investment - assets held for collection, sale or speculation purposes including long-term receivable, land and building acquired for speculation, investments in debt and equity securities, sinking fund and cash surrender value of life insurance policy
property, plant and equipment - fixed tangible assets acquired for use in the operations including land, building, equipment, furniture and fixtures, vehicles
natural resources - long-term inventories of natural resources to be extracted for use or sell including mineral and gas deposits
intangible assets - fixed assets lacking physical existence acquired for use in the operations including trade license, mark and name, franchise, copyright, goodwill, organizational costs c) other assets - all assets that cannot be conveniently classified in any of the above classes of
assets including idle fixed assets waiting disposition, deferred charges (e.g. long-term prepayments, machinery rearrangement costs and bond issue costs) and long-term receivables from company officers and employees
