"Small-business owners tend to hate accounting because it’s boring. [...] The mistake they make is not thinking about how they can use certain numbers as tools to better manage where their business is headed tomorrow."
- Basics of Accounting Are Vital to Survival for Entrepreneurs, NYTimes 1. Sole proprietorship - *1 owner*, usually small service firms - Not a legal entity - Owner receives all profit and loss 2. Partnership - *Multiple owners*, at least one is a General Partner while others are Limited Partners - Not a legal entity - Owners receive all profit and loss 3. Corporation - Has a board of directors, CEO, CFO, COO, etc. - One or more stock classes - From Initial Public Offering (IPO) or Secondary/Seasoned Equity Offering (SEO) - IPO: When a company first offers stock to investors - Separate legal entity under corporate law - Profit/loss goes to the company Summary: - IASB created IFRS in 2001 + An attempt to standardize accounting rules across countries + Over 100 countries and 49,890 companies using IFRS 0: not used; 1: optional; 2: mandatory - Prescribes nature, function, and boundary of an accounting system - Purpose: To provide financial information that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity > The conceptual framework lays a foundation for resolving big issues - Focused on general purpose financial statements prepared at least annually - Usually quarterly - Semiannually in the UK - Economic resources: what you own - Inventory, buildings, patents, etc. - Claims: claims on the company's assets - Claims by lenders and creditors (debt) - Claims by owners (shareholders) - **Fundamental characteristic** - Is the information material? - Material: Important enough to warrant sharing - Would not disclosing (or incorrectly disclosing) affect users' decisions? > The information is useful - **Fundamental characteristic** - Complete: Includes all necessary information to understand economic phenomenon - Neutral: No bias - Free from error: no errors or omissions > Information is complete, neutral and free from error - **Enhancing characterisic** - Information by the firm can be compared across years - *Not across firms* - If you change the way something is calculated, show the new and the old way > Compare over time for the same firm - **Enhancing characterisic** - All accounting figures can be verified from a paper trail - Receipts - Records of counts - Calculations > Verifiability: Paper trail - **Enhancing characterisic** - Takes time to prepare and verify information - More timely is a tradeoff with other characteristics > Is the information useful when released? - **Enhancing characteristic** - Regardless of how useful the content is, it isn't useful unless users can understand it - Baseline is a *reasonably educated* user - You after you finish this class > Can a *reasonably educated* user use it? - **Assumption** - The basis for our accounting system and many others - Alternative is cash basis - Record when cash changes hands - This will be the focus next week > Record when something happens, not when cash changes hands - **Assumption** - Entity will last long enough to use all assets and pay all liabilities > Assume the company isn't collapsing - Companies paying money to employees and auditors - Theoretical societal loss from leaking of confidential information - Gain from distribution of information - Leads to more informed investments - Better contracts - Better economy > Benefit of accounting to society outweighs its cost - We'll cover each of these at length later - Covered in Session 3: - Income Statement - Changes in Equity - Balance Sheet - Covered in Sessions 10 and 11: - Statement of Cash Flows - Part of the *Statement of Comprehensive Income* - We'll get to this later - Shows net profit or loss for a **period** - Comprised of: - Revenues and gains - Expenses and losses - Shows transactions with owners - Net income flows from the Income Statement to this Statement - Includes outflows from dividends - More formally known as the *Statement of Financial Position* - A snapshot at a **point in time** of a company's: 1. Assets 2. Liabilities 3. Equity - Measures cash receipts and payments - Breaks cash activities into: 1. Operating activities 2. Investing activities 3. Financing activities - Breadtalk 2016 - Samsung 2017Q3 - Wilmar International 2016 - Everything is classified as one of: 1. Assets 2. Liabilities 3. [Shareholders'] Equity - All elemenets of a transaction > Economic resources controlled by an entity which are expected to produce future economic benefits to the entity. - Cash, accounts receivable (A/R) - Inventory, equipment - Factories, machinery - Coffee shop: + Cash + Inventory (coffee beans, food) + Fixed assets (building, espresso machine) > Debit = Increase $\qquad$ Credit = Decrease > Present obligations of the entity which are expected to result in an outflow of economic benefits from the entity. - Accounts payable - Bills outstanding: Wages payable, utilities payable - Debt - Coffee shop: + Bank loan (maybe used to buy the building) + Outstanding utility bill + Bill from coffee supplier > Debit = Decrease $\qquad$ Credit = Increase > The residual interest in the entity's assets after deducting the entity's liabilities and represents shareholder's residual claim to the entity's assets. - Share capital: Amount paid in by owners - Retained earnings: net profit not released as dividends - Revenue: Sales, income - Expenses: costs of doing business - Coffee shop: - The money put in by the founder - Revenue from selling coffee and expenses from paid wages > Debit = Decrease $\qquad$ Credit = Increase Instructions: 1. Get into a group of 3-4 2. Pick any company 3. Determine 3 each of: - Assets - Liabilities - Equity Fill out: - Company: - Assets: 1. 2. 3. - Liabilities: 1. 2. 3. - Shareholders' Equity: 1. 2. 3. $$Assets = Liabilites + Equity$$ - Intuition: 1. All the assets must be owned by someone 2. Liabilities and Equity represent all the claims on assets 3. Assets must equal liabilities plus equity Increase - Receiving assets - Creating assets Decrease - Selling assets - Using assets Increase - Receiving a debt - Payables: like bills - Loans - Recognizing something you owe Decrease - Paying off a debt - Both flow through equity - Income increases equity - Revenue and gains - Expenses decrease equity - Expenses and losses - Share capital - Money paid in by shareholders - SP/LP: money paid in by owners - Corporation: money paid in by stock holders at IPO or SEO - Increases equity - Dividends - Paid to shareholders - Decreases equity - Not an expense! - Retained earnings - Economic contribution of the firm - Previous years' Revenues - Expenses - Dividends - Increases equity $$ \begin{align} Assets &= Liabilities + Equity \\ \\ Equity &= Shares + Retained~Earnings - Dividends \\ &+ Revenues - Expenses \end{align} $$ >- Raising capital: assets ↑ (cash), equity ↑ (share capital) >- Paying an expense early: assets ↑ (prepaid expense), assets ↓ (cash) [no net effect] >- Paying prerecorded wages: assets ↓ (cash), liability ↓ (salaries payable) >- Revenue: asset ↑ (cash), revenue ↑ > - With inventory, add: asset ↓ (inventory), expense ↑ (cost of goods sold) >- Paying debt: assets ↓ (cash), liabilities ↓ > - No change in equity unless there's an interest payment - How would the following transactions affect the expanded accounting equation for a small coffee shop? 1. Sell a latte to a customer. 2. Pay the utility bill. 3. Buy lunch for the supplier's representative. 4. Take a business trip to Guatemala to visit coffee farms. Paid by cash. 5. Take a vacation to Guatemala (not for business). 6. Bought a new coffee maker on credit. 1. Assets ↑ (cash), Equity ↑ (revenue) - Also: Assets ↓ (inventory), Equity ↓ (expense) 2. Assets ↓ (cash), Liabilities ↓ (unpaid utilities) - OR Assets ↓ (cash), Expenses ↑ (Utilities expense) 3. Assets ↓ (cash), Expenses ↑ (misc expense) 4. Assets ↓ (cash), Expenses ↑ (misc expense) 5. None 6. Assets ↑ (equipment), Liabilities ↑ (A/P) 1. Pick a company 2. Come up with 3 transactions the company might have 3. How would each transaction affect the company's accounting equation, and why? - Company: - Transactions: 1. A ↑/↓, L ↑/↓, E ↑/↓ - Explanation: 2. A ↑/↓, L ↑/↓, E ↑/↓ - Explanation: 3. A ↑/↓, L ↑/↓, E ↑/↓ - Explanation: - Post on the eLearn discussion board by the end of the day - Accounting Equation Exercise - *Include all group members names* 1) Recap the reading for this week 2) Read the pages for next week - Bookkeeping (Chapter 2) - Accrual accounting and adjusting entries (Chapter 3) 3) Practice on elearn - Automatic feedback provided - Make sure you have the accounts and accounting equation down! - You'll need to know these next week - Homework 1 due next week - Available on elearn - Submit on elearn - Covers topics from today's session - Bookkeeping (Chapter 2) 1. Analyze transactions 2. Understand how accounting works 3. Record transactions in the journal 4. Construct a trial balance - Accruals and Adjustments (Chapter 3) 1. Relate accrual accounting and cash flows 2. Apply the revenue and matching principals 3. Adjust accounts 4. Prepare a trial balance - 8500 BCE: Shaped clay tokens represent commoditites - 200 BCE: Arabic numerals (except **0**) - 600 CE: **0** developed - 800 CE: 10-digit numerals spread throughout Europe - 1400s CE: First evidence of *double entry* accounting in Italy - 1494 CE Italian monk and scholar Luca Pacioli publishes first text on *double entry* bookkeeping - Summa de Arithmetica, Geometria, Proportioni et Propotionalita *Debits* on the *left* *Credits* on the *right* > Memorize this! > This is double entry accounting *Debits (DR)* - Increase assets - Decrease liabilities - Decrease equity - Decrease revenue - Increase expenses *Credits (CR)* - Decrease assets - Increase liabilities - Increase equity - Increase revenue - Decrease expenses > The side of an account that increases its balance is called the account's *normal balance* > Debits **always** equal credits for a transaction 1. Where do debits go? 2. Where do credits go? 3. What do debits equal? 4. What do credits equal? 1. Where do debits go? - Left! 2. Where do credits go? - Right! 3. What do debits equal? - Credits! 4. What do credits equal? - Debits! - Assets: Cash, A/R, inventory, equipment, ... - Liabilities: A/P, debt, expenses payable, ... - Equities: Expenses, revenue, capital, ret. earnings, ... - Documented granularly in the *Chart of Accounts* - The paper trail - Establishes amounts - Confirms a traction occurred or was contracted - Allows for analyzing and verifying at the transaction level - Needed for auditing! - Where everything is recorded first - Everything - Every little transaction - Specifies the accounts, values, and document for each transaction - We will skip the docment references in this class - We will be doing journal entries through session 9 - Always *list debits first* > DR = CR for *each entry* 1. Get the in class activity spreadsheet - Session_2_Activity.xlsx 2. We'll go through the first three transactions together - Journal entries 3. Journal the next 11 transactions with your group in the blue tab of the spreadsheet - We'll do the rest of the activity throughout the class - An aggregation of all the accounts - Shows all account balances - Includes details of each account - T-accounts sufficient for this course - Shows all account balances just like the general ledger - Makes sure they add up too! - Use it to verify **DR = CR** - Use it to verify the **accounting equation** - Usually prepared at period end - Can prepare income statement and balance sheet from it > DR = CR for totals - Can't catch: - Unrecorded transactions - Because there's no trace of them - Wrong amounts in balancing transactions in the journal - Everything still balances - Wrong accounts of the same type used in the journal - Everything still balances - $A = L + E$ holds - Let Out of balance amount be: - $OOB = Assets - Liabilities - Equity$ - If OOB / 2 is an integer - DR and CR in a transaction may be flipped - Ex.: Recorded a cash sale as a CR to cash and a DR to revenue - Should be a DR to cash and a CR to revenue - If OOB / 9 is an integer - A slide error happened: - Ex.: Recorded 5,400 instead of 54,000 - A Transposition error happened - Ex.: Recorded 45,000 instead of 54,000 1. Return to the in class activity 2. We'll do the first three as a class 3. Finish the rest of the activity with your group - Do the two green tabs - Records cash only transactions - Used by small companies - $Profit = Cash~in - Cash~out$ PROBLEM - This ignores underlying economic activity - If we make a sale on credit, that doesn't add to profit - If we purchase something on credit, this doesn't lower profit - Records impact of transactions *as they occur* - Required per IAS1, "Presentation of Financial Statements" - Revenue recorded when it is *"more likely than not"* - Expenses recorded as *incurred* - Profit = Revenue - Expenses PROBLEM - Profit may not be indicative of cashflows - This is a concern for lenders - If there's no cash, profit doesn't matter, as the company will go bankrupt - Divides time into *artificial* segments to understand a firm's changes over time + Fiscal year, fiscal quarter + Breadtalk: Jan 1 - Dec 31 + Citigroup: Jan 1 - Dec 31 + Microsoft: Jul 1 - Jun 30 + Walt Disney * 2016: Oct 2 - Oct 1 * 2015: Oct 4 - Oct 1 * 2014: Sept 28 - Oct 3 > Don't focus on this too much for this class - Recognize revenue in the **period** it was earned - May not be when cash is received - Goods revenue recorded when it is *more likely than not* - Service revenue recorded at the percentage complete - If 50% of the work is finished, record 50% of the revenue - If 20% of the work is finished, record 20% of the revenue > This will lead to a lot of tricky accounting, but mostly around period ends - Record revenue when: - Revenue can be measured *reliably* - Economic benefits are *more likely than not* - For goods, you also need: - Transferred *significant risks* to buyer - If we are shipping [FOB destination], wait until they receive it - If they handle shipping [FOB shipping point], wait until picked up for delivery - No continuing managerial involvement (*to an extent*) - Costs incurred from transaction can be measured *reliably* - For services, you also need: - Stage of completion can be measured *reliably* - Cost incurred to date and costs to finish can be measured *reliably* - Match expenses to the revenue within a **period** 1. Identify what expenses were incurred 2. Measure them 3. Match to the revenues - Recognize expenses **only** when an asset is used - Asset purchase $\ne$ expense - Formally, expenses are recognized when: 1) Obligations are incurred, such as on receipt of goods or services have been received 2) Obligations are offset against recognized revenues (matching principle) - 3 ways to match - Directly - When expense is easy to track and tie to an account - Ex.: Inventory - Indirectly (over a period) - When an asset has a long life or is difficult to track - Ex.: Buildings - With acquisition - When usage and acquisition happen at the same time - Ex.: Utilities, rent, labor - Frequently appear as prepaid expenses 1. A sale we are shipping at our expense 2. A sale we are shipping at the buyer's expense 3. Revenue for a week long consulting project paid for up front 4. Electricity usage 5. Building usage (our building) 6. Sale of inventory for revenue 1. A sale we are shipping at our expense - Once the product reaches the buyer 2. A sale we are shipping at the buyer's expense - Once we ship the product 3. Revenue for a week long consulting project paid for up front - Once the project is finished 4. Electricity usage - When billed or at period end (matching principle) 5. Building usage (our building) - At period end (matching principle) 6. Sale of inventory for revenue - At the time the revenue is recognized - The matching principle - Everything needs to match at period end - All day-to-day accounts are ok as is - Do before balance sheet and income statement - Adjustments will go to the trial balance - Why not do this continuously? - Too costly -- some accounts continuously change - Investors only see period-end statements anyway > We'll only do this at period end - Adjustments needed to: - Asset values - Prepaid expenses - Inventory, supplies, etc. - Noncurrent assets - Liabilities - Payables we have yet to recognize - Unearned revenues - Balanced by: - Revenues - Expenses - **All** adjustments affect: - 1 B/S account - Assets - Liabilities - Equity excluding revenues/expenses - 1 I/S account - Revenue or expense - **NEVER** affects cash - *Deferral* + Adjust for prepaid expense (some used) + Adjust for unearned revenue (some may be earned) - *Depreciation* + Some long term assets have been used up - *Accrual* + Record an expense in advance - Adjustment for cash paid or received in advance - Expense or revenue has yet to occur - We *defer* some of it to the next period - Adjustment for allocating the cost of *Property, Plant and Equipment* (PP&E) over its useful life - Record to *accumulated depreciation* - Asset's book value is asset account minus accumulated depreciation - Depreciate to salvage value - What you expect to get when it is used up - Straight line - The same amount every period - If $N$ periods, $S$ salvage value, $H$ historical cost: - $(H-S)/N$ per period - Units of activity - Expense based on units produced - Good if capacity is known and tracked - Declining balance method - More depreciation early on, less later - Accrued expense: debit expense, credit liability - Accrued revenue: debit asset, credit revenue Asset (↑=Dr) Liability (↑=Cr) Expense (↑=Dr) Revenue (↑=Cr) - Homework 1 should be submitted already - Submit on elearn if you haven't - Homework 2 due next week - Looking through real annual reports - Somewhat open ended and will be graded for completion - Look for it on elearn Financial Statements (Ch 4) 1. Appreciate annual reports as a communication tool 2. Understand the presentation of the Statements of: - Financial Position - Comprehensive Income - Changes in Equity Capital (Chapter 10) 1. Learn about the share structure of a corporation 2. Account for changing capital structure and dividends @. Corporate information + Name(s), history, key management/directors, structure + Awards, company description, operating statistics @. Letter to shareholders + Written by CEO @. Management Discussion and Analysis (MD&A) + Management writes this section + Often discuss: * The year's performance * Possible future risks @. Accounting statements + Statement of financial position + Statement of comprehensive income + Statement of changes in equity + Statement of cash flows @. Acknowledgement of responsibility by management @. **Explicit and unreserved** statement of compliance to financial reporting standards. @. Statement notes + Often quite long, substance focused + Discusses important but difficult matters + Cannot rectify inappropriate accounting treatments - If you ever need information about a company's financial standing, the annual and quarterly reports are your primary source. - If you get information elsewhere (Bloomberg, Morningstar, etc.)... - They got it from there - Or from someone else who got it there - Contains a lot of other information about companies - Financials - Risks to the company going forward - Legal issues - Corporate strategy - The company's major customers - Good for checking out competitors... - Plenty more! - Full 2016 report here - Web version here > We use **adjusted consolidated segment operating income**, or Adjusted CSOI, and free cash flow as key non-GAAP financial measures. Adjusted CSOI and free cash flow are used in addition to and in conjunction with results presented in accordance with GAAP and should not be relied upon to the exclusion of GAAP financial measures. - End result - Follow up analysis - Name of reporting entity, date ended, currency used, level of rounding + Or individual entity ("Consolidated report for...") - Can group similar accounts together if immaterial + Not disclosing has no impact on F/S users + Cannot offset liabilities with assets, unless allowed * IAS16, IAS18 * Foreign exchange gains and losses - Must be done *at least* yearly (fiscal year) - Usually provide comparative information for past two periods - Also known as a balance sheet - Presents: - Non-current assets (> 1 year in life) - PP&E, Inventories, Intangible assets - Current assets - Cash (and equiv), trade, other financial assets, biological assets, inventory, receivables - Long term (> 1 year until paid off), then current liabilities - Provisions, other financial liabilities - Equity - Non-controlling equity interests, issued capital, reserves - Retained earnings > Presents companies' *stock* of assets, liabilities, and equity 1. Start with an adjusted trial balance 2. List all long term assets and sum 3. List all short term assets and sum 4. List all long term liabilities and sum 5. List all short term liabilities and sum 6. List Retained earnings 7. List capital accounts 8. Sum. 9. Frequently include past year's amounts in a second column - Also known as an Income Statement - Presents: - Revenue - Expenses, categorized by nature or function - Operating expenses - Non operating expenses - Net income - Below or separately it presents: - Gains and Losses - Called other comprehensive income (OCI) > While taxes are always included, you will not be asked to calculate taxes for this course. If no taxes are mentioned, assume they are 0. 1. Start with an adjusted trial balance 2. List revenue 3. List cost of goods sold (COGS) 4. Calculate *gross profit* (revenue - COGS) 5. List other expenses (except interest and taxes) 6. List other revenues (except interest and other holdings) 7. Calculate *operating profit* 8. List other non-tax expenses and incomes - That aren't included above 9. Calculate *income before taxes* 10. List taxes 11. Calculate *net income (loss)* 12. (Optional) start a new page 13. List OCI items (gains and losses) 14. List tax on OCI 15. Calculate *OCI, net of tax* 16. Calculate *total comprehensive income* - OCI, net of tax + net income (loss) 17. Often includes the prior year as well - Reconciles from period start to end - Per IAS 1,must reconcile each equity item separately as well as the total - Shows all transactions with owners - Shows all dividends paid (can be as a note) - This statement often relies on information that is contained outside the adjusted trial balance > You won't be required to construct this statement for exams. 1. List all equity items across the top as columns - Generally includes: share capital, APIC, retained earnings, OCI, total equity 2. Put "balance as of [beginning date]" as the first row 3. List all items that effected 1 of the columns values for the year as the rows - Generally includes: share issuance, treasury share sales, dividends paid, net income 4. Put "balance as of [ending date]" as the last row 5. Fill out all changes 6. Often includes the prior year as well - We'll get back to this... - Sessions 10 and 11 - Chapter 11 - Practice problem on eLearn for Coffee Corp (last week's company) 1. Construct a Statement of Financial Position - Use the adjusted trial balance - Do for both years 2. Construct a Statement of Comprehensive income - Use the adjusted trial balance - Do for both years - Ignore taxes Equity: - Advantages: - No legal obligation to distribute profits - Great for growth - All profit can be reinvested - Disadvantages: - Dilutes existing shareholders' ownership - Decreases the % of the company they own - More expensive - Can only be issued by a corporation Debt: - Advantages - Shareholders maintain ownership - Can be quicker to receive financing - Disadvantages - Often need to pay periodic interest - Requires cash on hand to pay - Solvency risk $\Rightarrow$ bankruptcy Advantages: - Can raise both equity and debt - Continuous life - Ownership is liquid - Limited liability for owners Disadvantages - Separation of ownership and management - Leads to conflicts of interest - Other tax policies apply - More government regulation - Corporate charter stipulates the number of shares - Rare that a company has all such shares issued - Investors hold shares - The company holds treasury shares - Shares the company has bought back - Unissued shares have never been issued - Can issue in an Initial Public Offering (IPO) or Secondary/Seasoned Equity Offering (SEO) - Requires government and exchange approval Voting - For board of directors - For important events Dividends - Right to share in profits (when dividends are declared) Liquidation - Right to share in asset value if company liquidates - After lenders get their share of value Preemption - Right to maintain proportionate ownership - I.e., first claim on new share sales > How shareholders protect themselves Ordinary shares - Standard share type (most common) - Has the four basic shareholder rights - Benefits the most if the company succeeds - Takes on the most risk Preferred shares - Limited/no voting rights - Earns a fixed dividend - Receives dividends before common shares - Receives assets before common shares in liquidation - May have other rights - Varies from company to company - Companies can issue shares from treasury or unissued shares - Factors in issuing shares: 1. Company's current health 2. Company's outlook 3. Expected dividends 4. Economy health 5. Market factors (liquidity) - *Singapore does not allow the par value method* + Still allowed in many countries + The book uses this mostly, so ignore the book on this topic!!! - Simpler treatment in Singapore >Situation: The company issued 1 million ordinary shares at $15 each.
- Separate accounts for par capital and above-par capital >Situation: 1) The company issued 1 million ordinary shares at $15 each with par value of $15.
2) The company issued 1 million ordinary shares at $15 each with par value of $1.
Situation: The company issued 1 million preferred shares at $15 each.
- Common stock that has been repurchased - Reasons for repurchasing: 1. To issues incentive compensation 2. Increase stock price 3. Use in trading 4. Increase EPS 5. Remove a shareholder (defensive) - Retirement removes the shares from share capital entirely >Situation: The company purchased 20,000 shares at $20 each, and then retired them.
>Situation: The company purchased 20,000 shares at $20 each, and then sold them in 2 transactions: 10,000 for $25 each and 10,000 for $15 each.
>Situation: The company purchased 20,000 shares at $20 each, and then sold them in 2 transactions: 10,000 for $15 each and 10,000 for $25 each.
>Situation: The company purchased 20,000 shares at $20 each, and then sold them in 3 transactions: 5,000 for $15 each, 5,000 for $26 each, and 10,000 for $18 each.
- Cash dividends - Final dividend: year end, policy voted on by shareholders - Interim dividends: declared by board of directors - Need to have enough retained earnings on hand to declare the dividend - Need to have enough cash on hand to pay the dividend - Share dividends - Proportional distribution of shares to shareholders - Shifts retained earnings to share capital - Increases number of outstanding shares > Situation: declared $0.10 per share of dividends on Jan 1, with record date of Jan 15 and payment date of Jan 30. 100,000 shares are outstanding. - Shifting of values within equity accounts only > Situation: declared 0.05 shares per share as a share dividend on Jan 1. 100,000 shares are outstanding with a market value of $10 each. - Exchange all common shares at a certain ratio - Such as a 2 for 1 stock split: receive an additional 1 share for every share owned - No accounting effects - No journal entry - Take 5-10 minutes to work on this in groups >Caffeine & Co had 50,000 shares outstanding as of Jan 1, 20X8. The following transactions occurred throughout the year. Prepare the journal entries for each transaction.
1. On January 30, Caffeine & Co purchased 10,000 shares for \$10 per share. 2. On March 30, Caffeine & Co sold 2,000 treasury shares at \$8 per share. 3. On April 1, Caffeine & Co declared a dividend of \$0.05 per share. The date of record was April 15th, with payment on May 30th. 4. On May 1, Caffeine & Co sold 6,000 treasury shares at \$15 per share. 5. On May 30th, Caffeine & Co paid the previously declared dividend 6. On October 31, Caffeine & Co sold its remaining 2,000 treasury shares at \$8 per share. - To get feedback on the course so far - So I can adjust the course to better fit your needs - Not required, but any response will benefit you > On eLearn under announcements - All feedback is anonymous - Available through Saturday evening 1) Recap the reading for this week 2) Read the pages for next week - Control Systems (Chapter 5) 3) Homework to *turn in by next class* - Available on elearn - Submit on elearn on *your section's elearn page* 4) Practice on elearn - Practice on both F/S and equity - Automatic feedback provided - Closing entries - Accounts are: Revenues, Expenses, *Gains*, *Losses*, Dividends - Depreciation - (Price paid - salvage value) / [life length from purchase] - In homework: (100,000 - 20,000) / 5 = 16,000 - Accrual entries: 1. Bring an expense or revenue forward 2. Create a payable or receivable as well 3. Payable or receivable reversed upon payment - Like the practice quiz you will receive, except 1 hour long - What can be covered: - Everything in the session 1 to 4 slides, except: On the quiz - Par value accounting for equity - Concept names and definitions - Matching principle, periodicity, etc. On the final - Par value accounting for equity > The quiz is to makes sure you have the fundamentals down What you like: 1. In class exercises - \>50% of all responses! 2. The slides and their comprehensiveness 3. Kahoot! 4. Online practices (and the amount of practice in general) 5. Others - Clarity - Lesson pacing - Application What to improve: 1. Too fast - Lessons from starting next week will include 1 or 1/2 of a chapter. - Things will slow down. 2. Small handwriting - **Noted** 3. Others - Need more practice - Slides too detailed - Slides not detailed enough - Homework is too hard - Can't hear at times in back What you need more help with: 1. Identifying accounts 2. Accrual entries 3. Equity transactions Solutions: - Book problems address for 3 - I will post a list of every account we have used, along with their classifications - Also: Class account access to the FASB Codification, which covers this (but in a ton of detail) - Tough accrual and equity questions on the practice quiz - I will post an additional brand new practice for accruals and equity over the weekend Control Systems (Chapter 5) 1. Understand the drivers of fraud 2. Understand how to write off uncollectible A/R 3. Be able to reconcile book and bank cash 4. Be able to identify weaknesses in firms' systems and suggest improvements - Intentional misrepresentation - A cashier pocketing money from cash sales - Managers twisting accounting to reach a goal - Companies telling investors everything is fine when they know it isn't - AAER examples + Apple, Inc. + Backdated stock options + Understated compensation expense + Dell inc.: + Failed to disclose *material information* + "Cookie jar" reserves - Animal Cloning Sciences, Inc. + Used an unlicensed auditor - Am-Pac International + Sold asset at high price to officers; leased it back - Halliburton and Kellogg, Brown & Root, Inc. + "scheme to bribe Nigerian government officials to assist in obtaining multiple contracts worth over $6 billion to build liquefied natural gas production facilities on Bonny Island, Nigeria." - Guilford Mills, Inc. + No accounting controls; false accounting entries + Understated A/P, Overstated earnings - Keppel O&M - \$55M USD bribery in Brazil for contracts - Highly profitable, until fines rolled in - Profit of $351.8M USD - Fines of $422M USD (to US, Brazil, Singapore) [so far] - 6 employees implicated - 1 Keppel lawyer pleaded guilty in USA for drafting bribery contracts - Keppel Club - Employees created 1,280 fake memberships, sold them, and retained all profits - $37.5M from June 1 to August 1, 2014 - Asia Pacific Breweries (Chia Teck Leng) - Forged documents from 1999 to 2003 to obtain $117M from 4 banks - To fund gambling addiction - 42 year jail sentence - Opportunity - A hole in the control system - Exploitable profitably - Rationalization - Resentment of corporation - Poor culture - "Borrowing" - Motivation - Family needs - Maintaining lifestyle - Maintain performance > Need all 3 for fraud to happen - Each part of the company is dependent on other parts - Consider how all parts work together > - Simplest case is a linear assembly line > + Pass the product from one stop to the next until it's done > + Except for... > - Maintenance > - Input selection > - Product mix > - Quality control > - ... > - Where does information flow? - Prevention + Make sure something doesn't go wrong + Ex.: Inspect raw materials before assembly - Detection + Check if something went wrong + Ex.: Check products randomly after assembly - Correction + Something went wrong, so we need to fix it + Ex.: Determine cause of defects, learn from problems - Separation of duties + Different parts of a system handled by different employees * Ex.: Inspection not done by assembly line worker - Monitoring + Check if things are normal * Ex.: Boss stops by every now and then - Limited access + Employees only have access to what they need * Ex.: Line workers can't access inventory records * Ex.: Raw material purchasers can't access salary records - Approvals + Require oversight for some actions * Ex.: Buying from a new vendor may require boss' signature - Collusion + Multiple people can jointly subvert systems - Fatigue + People aren't perfect - Negligence + Not every employee does what they're supposed to > - How would we control car quality? > - Prevention > - Purchase materials from trustworthy suppliers > - Detection > - Point inspections on finished cars > - Correction > - Recalls Objectives: 1. Validity: All recorded transactions ocurred 2. Completeness: All valid transactions have been recorded 3. Valuation: Amounts measured properly 4. Security: Information system protected from unauthorized access or destruction Discussion questions: - What are some risks that threaten these objectives? - How could they be addressed? Documents: - Purchase orders - Invoices for purchases/sales - Checks - Payment records - Petty cash - Small amount set aside for **small** purchases Documents: - Cash deposits, withdrawals - Checks - Electronic checks - EFT, ACH, GIRO, etc. - Bank interest and fees - Nonsufficient funds - Customer's check is rejected - Check writer didn't have enough cash in the bank - The two records come from different sources - We can use this to verify the records! - They likely won't be exactly the same... - Why are the records different? - Time lags - We receive cash and checks first - Called deposits in transit - Bank receives ACH first - Bank knows about fees and interest first - Time lags are shorter with internet banking Cash up: DR cash, CR: - Dividends received: dividend revenue - EFT from customer: A/R - Interest from bank: Interest revenue - Prepayment: unearned revenue Cash down: CR cash, DR: - Charges from the bank: Bank service charges - This is an expense account - Check failed (NSF): receivable the check was for (A/R) - Automatically charged expense: the expense 1. Get the in class activity spreadsheet - Session_4_Activity_Cash.xlsx 2. Do the bank reconciliation 1. Figure out what needs to be reconciled from bank and book 2. Record these in the reconciliation tab 3. Make sure cash reconciles 4. Record the needed journal entries (3) - Case: Hanjin shipping - Read: https://goo.gl/NdxmG6 - Low on cash - Ports didn't think they'd pay them back - *Tons of products stuck in ports...* - Such as the School of Law's writing boards for class rooms when it opened - Shipping rates went up 55% > In other words: unexpected events happen - Companies can go bankrupt, forget to pay, or simply decide to breach contract - Two approaches: Allowance method - Estimate decrease in asset values - *Allowance for ...* - Contra asset - *Bad debt expense* Direct write-off method - Write-off when the loss is guaranteed - Violates the matching principal > We'll use the allowance method 1. Determine an *allowance schedule* - This will be given to you - Tells you the estimated non-payment rates 2. Categorize receivables by rate 3. Multiply through to get estimated uncollectable portion per account 4. Sum all estimates to get the total Allowance 5. *Adjust* allowance account to match new allowance amount - Adjustment = Ending balance - book balance - Suppose we have the following allowance schedule and accounts receivables outstanding at year end - What should our allowance be? - What about GC Corp? + The auditor issued a going concern opinion + High chance of bankruptcy + Let's update the allowance schedule for that: - *Bankruptcy follows the direct write-off method* - We record it when it happens - Use up some of the allowance (DR), decrease our A/R (CR) - If the firm recovers, we reverse this transaction - Example: PGUS goes bankrupt. During bankruptcy they pay us \$300, and we expect no further payments from them. 1. Get the in class activity spreadsheet - Session_4_Activity_AR.xlsx 2. Complete the activity in groups of 3-4 1. Use the allowance schedule to determine the amount of uncollectible A/R and record the adjustment to the journal and T-account 2. Record A/R related journal entries, record to T-account 3. Use the allowance schedule to determine the amount of uncollectible A/R and record the adjustment to the journal and T-account 1) ***Quiz 1*** 2) Read the pages for next week - Chapter 6 (Inventory) * Just 6 pages 3) No homework 4) Practice on elearn - Covers bank reconciliation and A/R - Automatic feedback provided - 7.5\% of overall grade - 1 hour to complete - When finished, revise or turn in at the front - 15 minute break after - Class will resume after the break - Grades are on eLearn - We'll have more practice with annual reports later in the course - Week 12: Using these reports to understand companies' activities *Starting part 2 of the course* - Deep dive into transactions Inventory (Chapter 6) 1. Understand the nature of inventory operations 2. Record inventory transactions 3. Determine inventory and COGS value > Inventories are assets, held for sale in the ordinary course of business, or in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services. (FRS2-6) > Unsold inventory is an asset > Sold inventory is converted to COGS (expense) - Why hold inventory? + Supply can be erratic + No inventory could mean missed sales + Can buy more in low cost periods - Low costs from shipping, production, purchasing, etc. - Drawbacks of inventory + Cost of holding - Warehousing, electricity, ... + Liquidity -- Cash tied up as inventory + Inventory obsolescence + Adverse price changes - Buy low, sell lower - Service firms 1. Have little to no inventory - Merchandisers 1. Get inventory items 2. Sell them at a higher price - Than inventory cost + overhead - Manufacturers 1. Get *raw materials* 2. Transform raw materials into *finished goods* 3. Sell them at a higher price - Than raw materials + transformation + overhead 1. Inventories recorded at cost of purchase - Will need a price and quantity 2. Add any conversion costs (manufacturing) 3. Add delivery fees 4. Subtract any discounts received 5. Make sure the above is lower than the selling price - If it's not, decrease the value to selling price - Like with treasury stock and retained earnings, the decrease in value can be reversed later > The above works for individual items, but we'll need a way to track items purchased and used. - Usually barcode based. - Allows efficient tracking - Record two entries per transaction - DR Cash or A/R (↑), CR Revenue (↑) - DR COGS (↑), CR Inventory (↓) - Relies on counts for data - Simpler, but less efficient - One entry to record revenue - DR Cash or A/R (↑), CR Revenue (↑) - Adjusting entry at end of year - DR COGS (↑), CR Inventory (↓) > Not practical for businesses needing close tracking of inventory - Buying on cash or A/P - Paying full amount - If there are shipping costs to *receive* the inventory, we add those to the inventory value itself - Debit inventory - Credit cash - Sometimes inventory needs to be returned - Wrong or faulty/broken items - To record: - Directly credit the inventory account for the amount returned - OR: Credit "Purchase returns," a contra-asset to inventory - Debit... - A/P if not yet paid - Cash if paid and receiving cash now - A/R if paid and receiving credit now or cash later - Sometimes companies offer discounts for paying early - Standard format for discounts: - Ex.: 2/10, n/30 = - Get a 2% discount if paid in 10 days - Pay the full amount by 30 days. - Record discount as a decrease in inventory - Remember: we record assets at cost paid for them - Can also record to a "purchase discounts" contra-asset > Situation: Purchase inventory on account for $100 with 2/10 n/30 terms Practice question (3 entries): 1. Purchased $200 of inventory on account with 10/5, n/45 terms - Also paid $20 in shipping to DHL on delivery 2. $50 of inventory was damaged, which we returned 3. Paid payable 3 days after receiving inventory - Selling for cash or A/R - Receiving full amount - Recognize revenue when earned - Recall from lesson 2: Revenue recognition principle - FOB shipping point: record when given to shipping company - FOB destination: Record when customer receives goods - Since we will need to pay shipping, we will have a *Delivery expense* account, an operating expense - Sometimes our sales are returned - Wrong or faulty/broken items - To record: - Debit *sales returns and allowances* for the amount returned - A contra-equity to revenue - Credit... - A/R if not yet paid - Cash if paid and returning cash now - A/P if paid and giving credit now or returning cash later - We use the same discount terminology here - Record any discount as a debit to *Sales discount* - Another contra-equity to revenue > Situation: Sold inventory of $50 for $100 on account with 2/10 n/30 terms Practice question (3 entries): 1. Sold \$155 of inventory for \$300 on account with 10/5, n/45 terms - Also paid $20 in shipping to DHL for delivery 2. $50 of goods were damaged, which were returned to us 3. Customer Paid receivable 3 days after receiving goods - At the end of the day, we need our inventory to be priced below *what we can make from it* - Call this amount *net realizable value* (NRV) > NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale. [IAS 2.6] - If Inventory < NRV - Do nothing, unless we previously wrote it down - If Inventory > NRV - Need to *write down* to NRV - Need to write down your inventory value + If book value of inventory > *lower of cost or NRV* > Situation: Inventory is valued at $1,500, but NRV is $1,000 - Can be reversed if the value goes back up - Only up to the amount originally written down - Credit *gain* when reversing - Using *Inventory writedown* is **always** correct - Using *COGS* for inventory writedowns is fine for small adjustments - Usually when writing down by $<5\%$ of inventory - Can use COGS for small theft - Do not use COGS for major price drops > Wrong in some parts of the book. Use the slides here! > When in doubt, use *Inventory writedown*. - When you have a fixed margin, you can use this to determine COGS - Fixed margin means that COGS = constant % of sales - Allows you to avoid counting inventory >- Example: > - Coffee corp always sells bags of beans at a 25% markup. Revenue from selling bags of beans for the year was \$10,000. What was the COGS for selling bags of beans? > - $Gross\ Margin = 1 - \frac{1}{1+25\%} = 20\%$ > - $COGS \% = 1 - Margin = 80\%$ > - $COGS = Sales \times COGS \% = \$10,000 \times 80\% = \$8,000$ > Situation: Coffee Corp sells all of their products using fixed margins. Determine the COGS for each product below, using the given revenues. 1. \$50,000 worth of lattes were sold with a fixed gross margin of 70\% 2. \$9,000 worth of travel mugs were sold at a 50\% mark-up 3. \$1,000 worth of espresso cups were sold, comprising 50 cups each sold with $8 profit (all cups cost the same) > Situation: Coffee Corp sells all of their products using fixed margins. Determine the COGS for each product below, using the given revenues. 1. \$50,000 worth of lattes were sold with a fixed gross margin of 70\% 2. \$9,000 worth of travel mugs were sold at a 50\% mark-up 3. \$1,000 worth of demitasse (espresso cups) were sold, comprising 50 cups each sold with $8 profit (all cups cost the same) Solution >1. $COGS = \$50,000 \times (1-70\%) = \$15,000$ >2. $COGS = \$9,000 \times \frac{1}{1+ 50\%} = \$6,000$ >3. $COGS = \$1,000 - 50\times \$8 = \$600$ 1. FIFO + **F**irst **I**n, **F**irst **O**ut 2. LIFO + **L**ast **I**n, **F**irst **O**ut 3. Average cost + Value / number of items 4. Specific identification + One-to-one tracking > LIFO *is not allowed under IFRS* -- but you need to know it > First three only require minimal tracking, and are used when you have multiple orders of the same thing - Only used with expensive items - Too costly to track individual items otherwise - Examples - Cars - Luxury goods - Real estate > Record COGS with revenue - **F**irst **I**n, **F**irst **O**ut - Assumes you sell items in the order you received them - Ex.: You buy 5 bags of coffee beans for \$10 each, and then another 5 at \$12 each. You sell 3 bags and then 4 bags. - The first 3: - $3 \times 10 = \$30$ - The next 4: - $2 \times 10 + 2\times 12 = \$44$ - COGS: \$74 for 7 bags - **L**ast **I**n, **F**irst **O**ut - Assumes you sell the most recent items first - Ex.: You buy 5 bags of coffee beans for \$10 each, and then another 5 at \$12 each. You sell 3 bags and then 4 bags. - The first 3: - $3 \times 12 = \$36$ - The next 4: - $2 \times 12 + 2 \times 10 = \$44$ - COGS: \$80 for 7 bags $$ \begin{equation*} Price = \frac{P_1 \times N_1 + P_2\times N_2 + \cdots}{N_1 + N_2 + \cdots} \end{equation*} $$ - Assumes you sell a mix - Weighted average - $P_i$: price per item for order $i$ - $N_i$: number of items in order $i$ - Ex.: You buy 5 bags of coffee beans for \$10 each, and then another 5 at \$12 each. You sell 3 bags and then 4 bags. - Avg cost: $\frac{5\times 10+5\times 12}{5+5}=\$11$ - COGS: $7\times \$11 = \$77$ Perpetual 1. Calculate COGS for sales up to first purchase 2. Add in first purchase 3. Calculate COGS for sales up to next purchase 4. Add in next purchase 5. Repeat 3 and 4 until done Periodic 1. Write out all your inventory for the period 2. Determine what was sold - Profit depends on method choice! + FIFO typically leads to higher net income + Real effect: taxes depend on net income! + Use LIFO to minimize taxes? - Choice can affect important ratios used in debt contracting - Changing methods is allowed, but you need to report using **both** then - From our enhancing characteristic of *comparability* - Reliability - FIFO leaves the most recent purchases in inventory, so the balance sheet numbers are more reliable - LIFO puts the most recent purchases in COGS, so the income statement numbers are more reliable - Average cost is between the two > Started with 10 bags of coffee beans at \$10 each. Then: 1) purchased 5 bags at \$12 each; 2) Sold 7 bags; 3) Bought 10 bags at \$8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS. > Started with 10 bags of coffee beans at \$10 each. Then: 1) purchased 5 bags at \$12 each; 2) Sold 7 bags; 3) Bought 10 bags at \$8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS. > Started with 10 bags of coffee beans at \$10 each. Then: 1) purchased 5 bags at \$12 each; 2) Sold 7 bags; 3) Bought 10 bags at \$8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS. > Started with 10 bags of coffee beans at \$10 each. Then: 1) purchased 5 bags at \$12 each; 2) Sold 7 bags; 3) Bought 10 bags at \$8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS. > Started with 10 bags of coffee beans at \$10 each. Then: 1) purchased 5 bags at \$12 each; 2) Sold 7 bags; 3) Bought 10 bags at \$8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS. > Started with 10 bags of coffee beans at \$10 each. Then: 1) purchased 5 bags at \$12 each; 2) Sold 7 bags; 3) Bought 10 bags at \$8 each; 4) Sold 4 bags; 5) Sold 4 bags. Determine COGS. - Inventory goes to the balance sheet - Almost always a current asset - Slow moving inventories can be non-current assets - Purchase discounts decrease inventory - COGS is an expense $\Rightarrow$ goes to income statement - Sales returns and allowance, sales discount affect income statement - Decrease net revenue - Inventory write-downs decrease net income - Reversals are gains $\Rightarrow$ increase OCI > Situation: Coffee Corp started the year with 100 coffee cups for sale, each originally purchased at $8. Determine the cost of goods sold under each inventory system given the transactions on the right. - FIFO, Perpetual - LIFO, Perpetual - Average cost, Perpetual - FIFO, Periodic - LIFO, Periodic - Average cost, Periodic 1. Sold 40 cups 2. Purchased 60 cups, $10 each 3. Sold 90 cups 4. Purchased 90 cups, $12 each 5. Sold 80 cups 1. FIFO, Perpetual: \$2,000 - Remaining: 40 @ \$12 2. LIFO, Perpetual: \$2,120 - Remaining: 10 @ \$12, 30 @ \$8 3. Average cost, Perpetual: \$2,030 - Remaining: 40 @ \$11.25 4. FIFO, Periodic: \$2,000 - Remaining: 40 @ \$12 5. LIFO, Periodic: \$2,160 - Remaining: 40 @ $8 6. Average cost, Periodic: \$2,083.20 - Remaining: 40 @ \$9.92 1) Read the pages for next week - Chapter 7 (PP&E, Intangibles) 2) No homework 3) Practice on eLearn: Journal entries #2 - Focus on inventory - Automatic feedback provided - Will be posted over the weekend - Take a few days off of studying :) 1) Read the pages for next session if you have time 2) Check elearn announcements tomorrow at 3:30 for details - There will be slides to read - Examples to solve - A quick knowledge check on elearn as a quiz - Take the quiz -- it will count for extra participation 3) Join the webex class at 3:30pm on Saturday. - Details will be on elearn under announcements - Attendance will count for full participation 4) Practices: - Session 5's will be posted over the weekend - Session 6's will be posted next week - Come up and get your exam when called - Answer key/rubric is on eLearn (as of the start of class) - We'll go over each question in class - Average score: 79.6\% (B+) - Median score: 81\% - Question 1: 89\% - Question 2: 91\% - Question 3: 68\% - Question 4: 67\% PP\&E, Intangibles (Chapter 7) 1. Understand which assets qualify as PP&E and Intangibles 2. Account for acquisition and depreciation of PP\&E 3. Understand additional issues related to PP&E 4. Account for intangibles - Long term investments - Construction in Progress + Incomplete skyscrapers + Incomplete manufacturing plants + Incomplete complicated machinery * Tungsten cathode, LPP Fusion, 1.25 years - *Property, Plant, and Equipment*, PP\&E - Leasehold Land - 99 year ownership - Central Boulevard white site - S$2.57B - Freehold land - Permanent ownership - The Peak @ Cairnhill II - Natural Resources - San Ardo Oil Field - *Property, Plant, and Equipment*, PP\&E - Buildings - Land improvements - Furniture and Fixtures - Equipment - Machinery - Vehicles - *Intangibles* + Patents + Internally developed software + Trademarks and names + M\&A value (goodwill) - Not accounted for intangibles - Reputation - Own brand name - Management quality > PP&E has useful life or extends useful life, whereas expenses do not extend useful life but merely maintain or restore working order. [IAS 16] - Include as an asset: - Anything with useful life - Anything *extending* useful life - Expense: - Maintenance - Maintenance doesn't extend useful life, it just keeps useful life where it should be - Include: - Purchase price at historical cost - Net of discounts - Duties and *non-refundable* taxes - Employee benefits - For setting up the PP\&E, such as insurance - Purchase commissions - Site preparation - Delivery and handling - Installation and/or assembly - Testing expenses - Net of test good proceeds - Fees incurred - What don't we include? - Opening ceremonies - No useful life after - Advertising a new product - A direct expense for operations, not the PP\&E - Business costs due to dealing with customers - Operating costs - Admin/overhead costs - Operating costs What is the asset value of the following: 1. \$10,000 of land with a \$1,000 stamp duty (tax) and a \$300 opening party 2. A $5,000 machine, where testing cost \$1,000 but created \$500 of useful inventory. 1. \$10,000 of land with a \$1,000 stamp duty (tax) and a \$300 opening party - Answer: \$11,000 - Purchase cost is included - Taxes are including (unless refundable) - Opening ceremonies are excluded 2. A $5,000 machine, where testing cost \$1,000 but created \$500 of useful inventory. - \$5,500 - Purchase cost is included - Testing costs are included - Inventory created during testing is subtracted - Often, companies purchasing groups of assets - Firesales or deals with other companies - We call this basket purchasing 1. Determine the market value of each asset 2. Allocate a percent of market value to each asset 3. Allocate basket price by percentages to assets - Record journal entries as usual > Situation: Bought Machinery (MV: $8,000), Land (MV: $10,000), and Equipment (MV: $2,000) for $10,000 in one cash purchase Determine the value of each item in the following basket purchase for $90,000 cash: 1. A service van worth $30,000 2. A small tract of land worth $50,000 3. A large amount of inventory worth $20,000 - Standard repairs are an expense - They don't increase useful life - They maintain it - Repairs that increase useful life should be capitalized - Add the repair cost to asset value - Recognize usage of assets over time - Even though we still have the asset, it's lost value - Not as new - Charge to income statement as *depreciation expense* - Recognize on balance sheet as *accumulated depreciation* - Contra asset - Matching principal + We used the asset to generate revenue, so we need to match asset usage (expense) to this revenue How much does 1 year affect the value of the following? 1. Smart phone 2. Car 3. Textbook 4. Fiction book 1. Straight line + We've seen this one already! + $Depr = \frac{Cost-Salvage}{\#Periods}$ 2. Units of activity + $Depr = (Cost-Salvage) \frac{Units~Used}{Total~Units}$ 3. Double declining balance + $P = 2/\#Periods$ + $Depr = (Book - Accum~Depr) \cdot P$ > Note: *Never go below salvage value*. Stop depreciating when you hit salvage value - *Salvage value* is also known as *residual value* > The depreciation method used shall reflect the pattern in which the asset's future economic benefits are expected to be consumed by an entity. [FRS 16:60] - Expect variation in methods used, as different firms may argue different usage patterns for the same assets > The method must be used consistently from period to period. [FRS 16:61, 62] - You generally can't change methods during the life of an asset $Depr = \frac{Cost-Salvage}{\#Periods}$ - Constant over time - Same amount per year - Partial years: multiply by the $Months\ used/12$ - Will end up at salvage value after $\#Periods$ periods > You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is straight-line depreciation in years 1 and 2? > You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is straight-line depreciation in years 1 and 2? $Depr = (Cost-Salvage) \frac{Units\ Used}{Total\ Units}$ - Constant per unit produced - Same amount per unit, but units vary by year - Partial years: no change - Will end up at salvage value after the total number of units are produced > You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is units of production depreciation in years 1 and 2? Usage will be 10%, 30%, 40%, 10%, and 10% for each year. > You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is units of production depreciation in years 1 and 2? Usage will be 10%, 30%, 40%, 10%, and 10% for each year. $Depr = (Cost - Acc\ Depr)\times P$, $P=\frac{2}{\#Periods}$ - More depreciation early, less later - Partial years: multiply by the $Months\ used/12$ - Can hit salvage value early -- stop depreciating at this point $Depr = (Cost - Acc\ Depr)\times P$, $P=\frac{2}{\#Periods}$ Steps for calculation: 1. Determine the percentage to deduct each period, $P=\frac{2}{\#Periods}$ 2. Determine net asset value, $NAV = Historical~Cost-Accum~Depr$ 3. Determine the maximum depreciation, $max=NAV \cdot P$ 4. If not the last period: - Check if $NAV-max \ge salvage$ - If it is, depreciation is $max$ - If it is not, depreciation is $NAV - salvage$ 5. If the last period: - Take $NAV - salvage$ as your depreciation > You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is double declining balance depreciation in years 1 and 2? > You have a $100k asset which you will use for 5 years, with $25,000 salvage value. What is double declining balance depreciation in years 1 and 2? > Situation: You have a $100k asset which you will use for 5 years, with \$0 salvage value. Determine depreciation using the 3 methods. Usage will be 10%, 30%, 50%, 10%, and 10% for each year. > Situation: You have a $100k asset which you will use for 5 years, with *\$25,000* salvage value. Determine depreciation using the 3 methods. Usage will be 10%, 30%, 50%, 10%, and 10% for each year. - Depletion + Just like *units of activity* depreciation + Different name as resources are *depleted* when mined + Meaning the amount of resources left has decreased - Useful life is an *estimate* - Salvage value is an *estimate* - Depreciation method is a *choice* - 0 **net** asset value $\ne$ unusable + **net** asset value means asset value minus its accumulated depreciation + Don't record any more depreciation though - Depreciation method affects your taxes! - This makes double-declining balance look more enticing - Partial years + Straight-line and DDB: Multiply yearly depreciation by $Months\ used/12$ + Units of production: No change needed, as fewer units produced controls for this - Many things change over time + This includes the accuracy of your depreciation assumptions + Length of time, salvage value + Increased life from maintenance is an example - Use new assumptions going forward > Situation: Bought an asset on September 31st for \$10,000, with useful life of 7 years and \$3,000 of salvage value. What is depreciation under straight line and DDB for the asset as of December 31st of the same year? - Months passed: 3 months - Oct, Nov, Dec - Straight-line - Full year is: $\frac{10,000-3,000}{7}=1,000$ - Partial year is: $1,000 \times \frac{3}{12} = 250$ - DDB - Full year is: $(10,000 - 0)\times \frac{2}{7} = 2,857.14$ - Partial year is: $2,857.14\times \frac{3}{12} = 714.29$ - *Retirement* $=$ throwing the asset out - Adjust the PP&E value to include partial depreciation (if any) - Same as usual depreciation methods - Record retirement: Asset at 0 net asset value (NAV) - No gain or loss here Asset at $>0$ net asset value - Debit *loss on asset retirement* - Sale is like retirement, but you are receiving some cash instead of nothing. - Adjust the PP&E value to include partial depreciation (if any) - Same as usual depreciation methods - Record a sale: Loss (NAV $>$ Cash) - Debit *loss on asset sale* Gain (NAV $<$ Cash) - Credit *gain on asset sale* - Exchange is the same as a sale, but with non-cash settlement - Ex.: Exchange machinery for a car - Adjust the PP&E value to include partial depreciation (if any) - Same as usual depreciation methods - Record an exchange: Loss (NAV $>$ Asset received) - Debit *loss on asset sale* Gain (NAV $<$ Asset received) - Credit *gain on asset sale* > Situation: A machine bought for \$10,000 has \$4,000 of accumulated depreciation, but the firm no longer needs the asset. Record the following possible outcomes: 1) Disposal of the machinery; 2) Sale for \$4,000 cash; 3) Exchange for an \$8,000 Warehouse 1. Get the in class activity spreadsheet - Session_6_Activity_Depr.xlsx 2. Calculate depreciation for the assets listed in the file using each method - Literally "not perceptible by touch" + Things you can't hold, but still have value - Patents - Copyrights - Franchise rights - Licenses - Trademarks - Goodwill (i.e. excess acquisition price) - Most cited: US4683202A + Filed 25/10/1985 + 8,252 citations + Most recently on 21/07/2016 by Argos Therapeutics > The present invention is directed to a process for amplifying any desired specific nucleic acid sequence contained in a nucleic acid or mixture thereof. The process comprises treating separate complementary strands of the nucleic acid with a molar excess of two oligonucleotide primers, and extending the primers to form complementary primer extension products which act as templates for synthesizing the desired nucleic acid sequence. The steps of the reaction may be carried out stepwise or simultaneously and can be repeated as often as desired. - Nortel patent sale + Over 6,000 patents + Consortium of Microsoft, Apple, Sony, RIM (Blackberry), EMC, Ericsson + **\$4.5B** - Merck Lawsuit against Gilead + Over patent infringement + Hepatitis C drug + **\$2.54B*** jury verdict + 10% of all revenue - © or "rights reserved" - McDonalds operated by Lionhorn Pte Ltd - Software licenses - Can be for a period or infinite - Periodic licenses treated as a prepaid expense - Infinite licenses treated as an asset - Unless the license usefulness is clearly limited - ™ or ® - The amount paid for a company in an acquisition above its **updated** book value - If price < **updated** book value, negative goodwill - Microsoft bought LinkedIn - $25B price - LinkedIn had about $4B book value - Note: LinkedIn's assets were worth more than their book value - *As much as \$17B was goodwill* - If internally generated - Legal costs for titles can be capitalized (registration costs) - Added to asset account - Generation costs are expensed - Exception: Development after Research can be capitalized under IFRS (IAS 38) - If purchased - Record at cost > Why do we have this difference? It's because purchases have more *reliable* values. - Goodwill comes from acquiring other firms - We record new book values for each asset acquired - We use the *net asset value* of each asset for this - To calculate goodwill: 1. Start with the purchase price of the firm 2. Subtract the *net asset values* of all assets 3. Add back all liabilities 4. What's left is goodwill > Situation: Coffee Corp bought a rival coffeeshop for \$100,000. The coffee shop has book values of assets and liabilities of \$80,000 and \$40,000, respectively. We estimate NAV to be $90,000. What is goodwill? - Goodwill is \$100,000 - \$90,000 + \$40,000 = \$50,000 - We ignore the old book value of assets - It isn't a physical item, so it doesn't depreciate - It *can* lose value over time. Solution: - For infinitely lived items: - Revalue when doing financial statements - If market value is lower, we *impair* the value - For finitely lived items: - Amortize the value - Works like straight line depreciation with 0 salvage value - Check impairment as well - Debit *Impairment expense* - Directly record decrease to the asset (Credit) - We can impair PP&E as well 1. We bought a competitor for \$800: \$400 of machinery and \$400 of goodwill (for their R&D). 2. We realized that the R&D we paid extra for had no value. 3. We realized we overpaid for the machinery by \$200. > Note: Technically this account is called "impairment loss," but it is an expense account despite having loss in the name. Either will be fine for this course. - Amortization is like depreciation for intangibles - Debit Amortization expense - Credit accumulated amortization - Always use straight-line with 0 salvage value - Example: 1. Bought a patent for $100 cash. It has 5 years of life. 2. Recorded amortization after 1 year. 3. Recorded amortization after another year. - Determining the life of intangibles - Often, this is based on a country's laws - Copyright duration is set by each country - Trademark law determines trademark life - Mergers will be infinitely lived, but are often impaired 1. Get the in class activity spreadsheet - Session_6_Activity_JE.xlsx 2. This file contains some trickier journal entries - Reading + Chapter 9 (Liabilities) + Tricky subject, reading highly recommended + We'll spend 2 weeks on liabilities - Homework 3: Valuation + Due by February 23rd - An extra bit of time for the holiday - Extra practice available + Focused on PP&E + Automatic feedback, as usual - Come up and get your exam when called - Answer key/rubric is on eLearn (as of the start of class) - We'll go over each question in class - Average score: 79.6\% (B+) - Median score: 81\% - Question 1: 89\% - Question 2: 91\% - Question 3: 68\% - Question 4: 67\% Liabilities (Chapter 9) 1. Account for current liabilities 2. Account for contingent liabilities 3. Become familiar with "time value of money" - We'll need this for Bonds next session > Obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. (FRS 37:10) - Current liability: Something you owe within the span of one year (the current accounting term) - Non-Current liability: Something you owe after the current accounting term + Accounts payable + Unearned revenue + Salaries payable + Taxes payable + Notes payable + Interest payable + ________ payable + Estimated liabilities + Provision for Warranty repairs + Liabilities Contingent - Also known as GST - Generally paid quarterly - Can pay monthly as well - Retailers collect this from customers to pass to tax authorities (IRAS) - Notes payable is a small, short-term loan - Similar to A/P, but: + More formal + Has a stated interest rate - Can be provided by any party + Banks + Suppliers > This is included in Chapter 5 in the book - Creditor: the lender - Debtor: the party that owes money - Term: length of time of the note - Maturity date: when the note is due - Principal: amount of money borrowed - We'll record this at the start - Interest: additional payments for borrowing - We'll record these as they occur - Or when doing adjusting entries - Maturity value: amount owed at maturity - Interest is usually all paid at the end - The interest rate will be given as the *annual* rate > Received a $2,000 note payable with 9% interest due in 3 months payable to our supplier. > Gave $2,000 with 9% interest due in 3 months payable to our customer as a note receivable. - We consider any payment owed in the coming fiscal year as a current liability - This includes payments on long term debt - We shift these payments to short term debt when we do our balance sheet - Call it "current portion of long term debt" > Coffee Co. gives $1,000 to Latte Inc. on November 1st, 20X8 as a note with 6% interest over 6 months. Record the journal entries for *both companies*, i.e., the note receivable and the note payable. Assume December 31st is both companies' fiscal year end. >- Hints: > - Money changes hands on November 1 > - Interest accrues on December 31 > - The note is paid back on April 30th - Manufacturers need to factor in liabilities from warranties - Estimate this *provision for warranty repairs* at year end - Contingent liabilities are not presently liabilities, but could become liabilities in the future. - Listed in the financial statement notes, but not journalized - To note all 3 must be true: 1. Must depend on a future outcome of past events 2. May, *but probably will not*, require an outflow of resources 3. Must not have a sufficiently reliable estimate of the amount owed. > Contingent liabilities are obligations you might or might not have - If chance of owing is very low - Ignore - If chance is reasonably possible - *Contingent liability* $\Rightarrow$ Make a note to your financial statements, but don't include it in the statements themselves - If a sufficiently reliable estimation can be made - This is a *real liability* $\Rightarrow$ Include it in your adjusting entries - Not as a contingent liability - Ex.: - Provision for warranty repairs - Fill out the survey - G5: https://goo.gl/gipfUx - G6: https://goo.gl/MK9P5K - G7: https://goo.gl/P7MMbh - G8: https://goo.gl/927d9Q - Select your name - Select up to 2 classmates you'd like to work with - Groups will be determined at random - Uses a custom, game theory based algorithm to ensure fairness while optimizing to your preferences based on simulation > The bottom line: If you both pick each other, it's much more likely you'll be in the same group - Fill out the survey - G5: https://goo.gl/gipfUx - G6: https://goo.gl/MK9P5K - G7: https://goo.gl/P7MMbh - G8: https://goo.gl/927d9Q - Present a topic of your choice from a list of 15+ topics covering (example below): - JV, M&A, International business, Current issues in IFRS, Fraud > Your deliverable will be a 15 minute presentation, graded on content (70%) and presentation delivery (30%). >- Everyone should have 1 card >- If you give me the card during the next break, I'll give you 1 chocolate >- If you give me the card at the end of class, I'll give you 2 chocolates >- Which do you prefer? >- What if it was 2 now and 1 later? >- What if it was 1 now and 1 later? >- How many chocolates would you need later to not take one now? (Decimals are fine) >- We'll do 1 now or 2 later This section is based on: Corporate finance: An Introduction Ivo Welch Pearson: Boston, MA. 2009. > It's a good finance textbook! - No taxes - No transaction costs - Can find buyers/sellers costlessly - Can deliver costlessly - Everyone has identical beliefs - Many buyers and sellers (liquid) > We'll use these assumptions in this class 1. You can earn interest on \$1 today, so it's worth more than $1 tomorrow. 2. Inflation means that \$1 tomorrow can buy less than \$1 today. 3. \$1 today gives me the option to spend today or tomorrow, but \$1 tomorrow can only be spent tomorrow. If that option is valuable to me, \$1 today is worth more than \$1 tomorrow. > All three of these are equivalent: a dollar today is worth more than a dollar tomorrow - When we talk about returns, we'll talk about *compounded* returns - If \$1 today is \$1.10 next year... - then \$1.00 in two years is \$1.21, not \$1.20 - Return scales with capital - More explicitly: if the interest rate, $r$ is 10%, and the principal, $P_0$ is \$1, then: - Tomorrow $P_0$ is worth $P_1=P_0\cdot (1+r) = 1\cdot 1.10 = 1.10$ - Flipping the equation implies: $P_0 = \frac{P_1}{(1+r)} = \frac{1.10}{1.1} = 1$ - What is $1 worth in two years? Three years? ... - $P_2 = \left(1\cdot 1.1\right)\cdot 1.1 = 1.21$ - $P_3 = \left(\left(1\cdot 1.1\right)\cdot 1.1\right)\cdot 1.1 = 1.331$ - $\ldots$ - $P_{50} = \left(\ldots \left(1\cdot 1.1\right)\cdot 1.1\ldots\right)\cdot 1.1 \approx 106.72$ - $\ldots$ - $P_n = P_0\cdot (1+r)^n$ - What is the current value of \$1 in two years? Three years? ... - $P_0'' = \left(1/1.1\right)/1.1 = 0.83$ - $P_0''' = \left(\left(1/1.1\right)/1.1\right)/1.1 = 0.75$ - $\ldots$ - $P_0^{(50)} = \left(\ldots\left(1/ 1.1\right)/ 1.1\ldots\right)/ 1.1 \approx 0.0085$ - $\ldots$ - $P_0^{(n)} = \frac{P_n}{(1+r)^n}$ 1. What is \$10 worth in 20 years, if the interest rate is 5\%? 2. What is \$10 received 20 years from now worth today, if the interest rate is 5\%? Answers: >1. $10\times (1+0.05)^{20}=\$26.53$ >2. $\frac{10}{(1+0.05)^{20}}=\$3.76$ - What we just did! - Determine the price *today* of some future (expected) cashflows - Numerator is the future cash flow, $CF$ - Denominator is the *discount factor*, $R$ - That is, we discount cash flows by the return to get today's value $$ NPV_0 = \frac{CF}{R} $$ - What if there are multiple cash flows? > $NPV_0 = \sum_{i=0}^{n} \frac{CF_i}{R_i}$ > NPV at time 0 (today) is the sum of all discounted cash flows - The discount factor is the amount of *cumulated* return or interest you would expect to receive between two period of time. - We often assume a fixed discount rate for each year of $1+r$ - Let $R_i$ denote the discount factor from time $0$ to time $i$ - $R_1=1+r$ - $R_2=(1+r)\cdot(1+r)$ - $R_3=(1+r)\cdot(1+r)\cdot(1+r)$ - $\ldots$ - $R_n=(1+r)^n$ - A project costs \$500 today, and is expected to pay out the following: - \$100 in one year - \$600 in two years. - If the interest rate is 10\%, what is the NPV of the project?