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Unit 2 Measurements, Valuation and Disclosure of Investments and Short-Term Items
Unit 2 Measurements, Valuation and Disclosure of Investments and Short-Term Items
Unit 2 Measurements, Valuation and Disclosure of Investments and Short-Term Items
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1. Allowance for Sales Return
A provision for returned goods may be made because of product defects, customer
dissatisfaction, etc. In order to be consistent with the matching principle, estimated sales returns
must be recognized on the same date of the sale of goods.
Entries
On date of Sale of goods Recognition of Sales Returns
Cash/AR XXX Sales Returns XXX
Sales XXX Allowance for Sales Return XXX
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Entries
a. Estimating uncollectible amounts
Bad Debt Expense XXX
AFDA XXX
NOTE
Direct write-off is not acceptable. Occasionally, small firms may use direct write-off method
under the assumption that the difference between it and allowance method is immaterial,
(materiality is an excuse to violate matching principle).
There are 2 methods to measure bad debt expense and AFDA. They are:
1) Percentage of Sales Method (Income Statement Approach)
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1) Percentage of Sales Method (Income Statement Approach)
This method is good to match revenues with expenses. Existing AFDA is ignored.
Bad Debt Expense = Net Sales * %
NOTE
For adjusted AFDA = previous year AFDA + current year AFDA
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Bad Debt Expense 6000 (100,000 * 6%)
Adjusted AFDA = 5000 (6000 - 1000)
NRV = $94000 (100,000 - 6000)
NOTE
For adjusted AFDA = current year AFDA - previous year AFDA
An entity might use balance sheet approach to prepare an aging schedule of AR.
b. Allowance Method
AFDA XXX
AR XXX
NOTE
Bad Debt Expense is not affected when AR are written off or if previously written off account
becomes collectible.
Reconciliation
AR AFDA
Beginning AR Beginning AFDA
+ Credit Sales + Bad Debt Expense during the period
- (cash collected) + Collection of AR written off
- (AR written off) - (AR written off)
Ending AR Ending AFDA
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4. Factoring of Accounts Receivables
Factoring- the transfer of receivables to a third party who assumes the responsibility of
collection. There are 2 types of sale:
1) Without Recourse (sale) - the transferee (credit agency) assumes all the risk. The sale is
final, and the seller (firm) has no liability to the transferee. Receivable is removed from
the firm’s books.
2) With Recourse (secured borrowing) - the transferee (credit agency) transfers the
amount as borrowing (not sale) with collateral (guarantee). Receivables are still in the
firm’s books and the transferred amount is considered a liability.
Credit Sales are common form of factoring. The retailer benefits from prompt cash payment and
avoids bad debt expense and other costs. The credit card firm charges fees.
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2.2 Inventory- Fundamentals
Inventory is the total tangible assets, held for sale in the natural activity of the business. They are
classified as current assets (expected to be realized in cash, sold or consumed during a normal
operating cycle of the business). Long-term assets are either depreciated or retired from use and
are not as inventory.
Retailer VS Manufacturer
1) Retailer’s inventory (trading entity) - are goods purchased to be resold without
modification
The cost of inventory includes all costs incurred in order to bring the asset to the existing
location and ready for use.
The cost of purchased inventory includes costs to purchase the inventory, Imports or taxes,
handling, freight in, insurance etc.
The cost of manufactured inventory (WIP and FG) includes direct materials, direct labor and
manufacturing overhead (conversion costs are DL and MOH)
Entries
Sale on April 1 Purchase on May 1
Cash 4800 Inventory 1200
Sales 4800 Cash 1200
COGS 3000 No Physical Count Required
Inventory 3000 -
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Advantages of Perpetual System
• COGS can be determined at any time without the need for physical count
• Provides better internal control
Disadvantages of Perpetual System
✓ Book-keeping system is expensive and complex
2) Periodic Inventory System- Inventory and COGS are updated at specific intervals,
based on physical count. Used in inexpensive or homogenous items and there is no need
to monitor continuously.
Entries
Sale on April 1 Purchase on May 1
Cash 4800 Inventory 1200
Sales 4800 Cash 1200
To get COGS:
No COGS or Inventory Beginning Inventory 1000
+ Purchases 3000
- (Ending Inventory) (3250)
COGS $3000
NOTE
In any case inventory and COGS get the same result
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2. Inventory Period-End Physical Count
In order for the physical count to be accurate, the entity mist eliminate and include the following:
1) Goods in Transit- include inventory help by the entity as legal title (entity bears the risk
of loss in transit)
a. FOB shipping point (FOB Factory)- the buyer is the legal title and must include the
physical count
b. FOB destination- the seller is the legal title and must NOT be included the physical
count
(NOTE- freight in costs are considered when goods arrive under this method)
2) Goods out on consignment- it’s an arrangement between the owner (consignor) and the
sales agent (consignee). These goods are not sold but their ownership is transferred. Only
the consignor records the goods as inventory (consignee never records)
3. Inventory Estimation
In some cases, estimation of inventory is required when exact count is not feasible OR for
interim (temporary) reporting purposes (Ex burned by fire or stolen). We then use Gross Profit
Margin to estimate the inventory.
Gross Profit = Gross Profit Margin % * Sales
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4. Inventory Errors
1) If purchases were not recorded and Ending inventory not included, then COGS and Profit
are not affected, but current assets and liabilities (AP not recorded) are understated
2) If purchases were recorded but ending inventory not included, then COGS is overstated
Profits, inventory, retained earnings and working capital and current ratio are understated.
3) If ending in is overstated (subsequent period), then Profit is overstated and will be offset
by underestimation next year from the overstating of beginning inventory.
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2.3 Inventory- Cost Flow and Subsequent Periods
The purpose of these methods is to calculate the cost of ending inventory and the cost of goods
sold that should be reported in the financial statements.
There are 5 methods to calculate:
1) Specific Method
2) Moving Average
3) Weighted Average
4) First In First Out (FIFO)
5) Last in Last Out (LIFO)
1. Specific Identification
This method requires determining which specific items are sold and therefore reflects the actual
physical flow of goods (Ex- gold, automobiles, cranes). Specific Identification is the most
accurate method as it identifies each item of the inventory, however it requires a detailed record
that may be expensive to keep.
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NOTE
When the inventory is purchased or produced and are identical, specific identification method is
not suitable. So, we have to use average, FIFO or LIFO as they measure periodic income, any
method selected is suitable as long it reflects the clearest periodic income.
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4. FIFO (Periodic and Perpetual)
Under FIFO, the first goods acquired are considered the first sold. The advantage is that it states
ending inventory approximately at current replacement cost. The measurement is same when
periodic or perpetual.
Under Perpetual System, COGS is calculated every time a sale occurs and is from the oldest
units.
Under Periodic System, calculation of Ending Inventory and COGS are made at the end of the
period.
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5. LIFO (Periodic and Perpetual)
This method assumes the newest items of inventory are sold first, so items remaining in the
inventory is the oldest. Under LIFO, the perpetual and periodic may result in different values for
ending inventory and cost of goods sold.
Under Perpetual System, COGS is calculated every time a sale occurs and is from the most
recent purchases.
Under Periodic System, calculation of Ending Inventory and COGS are made at the end of the
period.
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6. Retail Inventory Method
This method estimates ending inventory using Cost to Selling
Price ratio. It’s a very cheap method of estimation. It is used:
a. Interim and annual financial reports GAAP
b. Income Tax Purpose
c. Verifying ending inventory and COGS by an auditor
➢ Under FIFO
Advantage- Ending inventory estimates
the current replacement costs (CRC) &
last-minute purchase has no effect on the
ending inventory.
Disadvantage- Current revenues are being
matched with the previous period costs
➢ Under LIFO
Management can affect the Net Income
with the purchases made at the end of the
period and affecting the COGS.
In the case of fewer units purchased than
sold, the beginning inventory is partially,
or fully liquidated and older costs are matched with current revenues.
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7. Reporting Inventory in the Financial Statement (Ending)
In case of LIFO or Retail, inventory measurements are based on Lower of Cost or Market
(LCM)
In case of FIFO or WA (moving or weighted) inventory is measured by Lower of Cost or Net
Realizable Value (LCNRV)
Whenever there is a loss on write down of inventory in Market or NRV, it should be presented
in COGS if immaterial, contrarily, if the difference is material, it should be presented as a
separate line in Income Statement. Write down of inventory occurs when damage, deterioration,
obsolescence, change in price or demands.
Entry
Loss on inventory write down XXX
Inventory XXX
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Example
s
Under GAAP, reversal of write-downs of inventory is prohibited in subsequent period.
IFRS Difference
Inventory is valued at LCNRV, which is assessed each year. A write-down maybe reversed but
not above the original costs. Write down or reversal is recognized as loss or gain
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2.4 Investments in Equity
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1. Measurement of Equity Securities without Fair Value
There are 4 methods as an alternative if Fair Value is not avaialble:
1) Measurement Alternative
Sometimes the Fair Value method of evaluating investment in equity may not be feasible, so the
entity has an alternative option.
Cost – (Impairment) +/- change in Observable price
If the entity chose to apply the alternative option, it must re-assess each year the Fair Value if it
is determined or not. Once the Fair Value is determined, the investment is measured at the Fair
Value through the Net Income.
2) Impairment Test
A qualitative assessment may consider impairment indicators (Ex deterioration, asset quality,
earnings, and credit ratings). An investment is impaired if the Fair Value is lower than the
Carrying Amount. In case of impairment indicators, the entity must perform quantitative test.
Impairment Loss = Carrying Amount – Estimated Fair Value
IFRS Difference
Investment in equity securities must value by Fair Value through Income Statement (under
GAAP), however the IFRS also allows the investor to measure Securities (that are available for
sale and held to maturity) under Fair Value presented at the Other Comprehensive Income. The
only condition is that if the entity records the unrealized gain or loss under Other Comprehensive
Income, it can never be reclassified into the Income Statement unless if sold.
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2.5 Equity Method for Investment
It is presumed to exist if the investor has between 20% and 50% of the investees voting interest
(shares of common stock). This investment enables the investor to influence the investee by the
equity method (assuming no FVO (fair value option))
The equity investment is initially recognized with the cost. This method allows the investor to
recognize a share of the investee’s earnings or losses.
Entries
In Case of Earning
Investment in X Co. XXX
Revenue-share in X Co XXX
In Case of Loss
Loss-share in X Co XXX
Investment in X Co XXX
Dividends from the investee are treated as return on investment (ROI), they have no effect on the
investors Net Income. (Acts as a bank account, decreases as dividends are received)
Entry
When dividends are distributed
Cash / Dividends Receivables XXX
Investment in X Co XXX
If the investor for some reason is assumed to exercise significant influence (due to decrease in
ownership), this ceases his account for investment
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2.6 Investment in Debt Securities
A debt security is a creditor’s relation to the issuer. There are a few forms of these stocks
including common debts, mandatory redeemable preferred stock, redeemable preferred stock at
the investor’s option and mortgage obligations. Leases, option, financial future contract and
forward contracts are not debts.
✓ Statement of Cash Flow- it depends on the trading security (Trading Security and
Financial Assets valued under Fair Value)
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2. Available for Sale Securities- Fair Value through OCI
Recorded at cost at the initial acquisition. Purchased and there is an intent to keep it OR sell it in
the short-term. In the balance sheet, the value is re-measured at Fair Value. Unrealized
gains/losses (net of tax) are reported at the Other Comprehensive Statement OCI.
Entry (acquisition)
Available for Sale Security XXX
Cash XXX
✓ Balance Sheet- valued at Fair Value (current or non-current assets) (in equity section
unrealized gains/losses are reported at the accumulated OCI as the real OCI account is
close)
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3. Held to Maturity Securities (Amortized Cost)
An investment is classified as held to maturity if the holder has the positive intent and the
ability to hold the security until the maturity date. The security cannot be classified in this form
if the holder has the intent to sell it before maturity date for cash supply or avoid interest risk.
If the sale was done before maturity date it can still be considered as held to maturity security
if:
1) The sale was done near the maturity/call option (within 3 months)
2) Sale is after the collection of 85% of the principal invested.
Held to maturity is reported at amortized cost in balance sheet.
Entry
Held to Maturity Security XXX
Premium XXX
Cash XXX
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4. Impairment of Debt Securities
Unrealized changes in Fair Value are recognized as earnings in the Income Statement if they
present permanent declines. The amortized cost differs from fair value by:
Costs +/- Net unrealized gain/loss
If a decrease in Fair Value below the amortized cost of held to maturity securities or available for
sale securities, then the cost must be written down to the fair value as the new cost. The realized
loss is included in the Income Statement if:
1) The new cost doesn’t affect the recoveries by the fair value
Prior changes in fair value of available for sale securities are included in OCI except temporary
changes
IFRS Difference
Classification and measurement of the investment in debt securities depend on:
1) Investor’s business model for managing
2) The nature of cash flows
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2.7 Business Combination and Consolidated Financial
Statements
A business combination (acquisition) happens when the acquirer obtains control (more than 51%
of the business) of one or more business
a. Control (controlling financial interest) - the direct or indirect ability to select the
directions of management and policies of the investee. Control exceeds 50% of the voting
interests (shares of common stock)
b. Parent- entity that controls more than one subsidiary
c. Subsidiary- the entity that is held by the parent
Measurement Principle- the identifiable assets acquired, liabilities assumed and NCI in the
subsidiary are recognized separately from the goodwill and must be measured by Fair Value on
the acquisition date
Non-Controlling Interest (NCI) - the portion of equity (net assets) in a subsidiary. It must be
also reported by Fair Value on the acquisition date, reported in the consolidated Balance Sheet
separately from the parent’s equity, known as minority interest. In case the parent holds all the
outstanding shares, there is no NCI or minority interest recognized.
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Goodwill- recognized only in business combinations, it’s an intangible asset that is expected to
have future economic benefit to the firm from the acquired asset. Goodwill has indefinite
(unlimited) life and presented under non-current assets, so it must not be amortized in the
subsequent period but instead must be tested for impairment. Internally generated goodwill
must not be recognized in the financial statement.
Acquisition related costs- such as consulting fees, finder, general and administrative costs,
professional fees must be expensed as incurred. Costs for security are accounted for as:
Consolidated Procedures
The following steps must be performed when preparing the consolidated financial statements
1) All assets, liabilities, revenues, expenses, gains, losses and OCI items of a subsidiary is
added to the parent.
2) The Net Income/Loss of a subsidiary is presented separately in the non-controlling
interest (NCI)
3) All equity amounts of the subsidiary are eliminated
4) No investment from parent to subsidiary is presented in the Statement (current assets and
liabilities)
5) Goodwill is recognized at acquisition date as an intangible asset
6) The NCI is separately reported in a single line in the equity section. It must be adjusted
for the proportion of 1) Subsidiary Net Income/Loss 2) Dividends Declared (decrease) by
the subsidiary 3) OCI items recognized by the subsidiary
7) Intra-entity (items between parent and subsidiary (internal)) balances, transactions,
income and expenses must be fully eliminated
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2.8 Other Expenses and Liabilities
1. Purchase Commitment
A commitment to acquire goods in the future is not recorded
at the agreement time, however, they are recognized when the
inventory is received. A loss is recognized by the firm if the
contract is non-cancellable if the market price is lower than
the commitment (contract) price. (Ex- take or pay contract
that requires the party to purchase a specific amount of goods,
otherwise pay a penalty)
Expected loss on purchase commitments are measured as
inventory loss when the goods are recognized and disclosed
separately. The main reason for the current loss recognition is
a decrease (not increase) in the future economic benefits.
Entry (buyer)
Predicted Future Loss
Unrealized Hold Loss XXX
Liability-purchase commitment XXX
The nature of the terms of the contract must be disclosed in
the notes of the financial statements.
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2. Warranty Liability
A warranty liability is a written agreement of the integrity (well-being) of a product or service.
The seller agrees to repair, replace or refund for additional services.
There are 2 types/approaches of warranty:
1) Inseparable/Expense Warranty- under this method, if the probable amount can be
reasonably estimated a liability for the warranty cost is recognized when the revenue
related is recognized. This is matching principle. The entire liability (expense) must be
recognized on the date when the product was sold.
Entries
Possible/Predicted Warranty
Warranty Expense XXX
Warranty Liability XXX
Actual Warranty
Warranty Liability XXX
Warranty Expense (if) XXX
Cash/Parts/Inventory XXX
2) Separable/Sales Warranty- occurs when the warranty is sold separately from the
product, the revenue is deferred (postpone) and is recognized over straight line basis,
depending on the contract terms.
Entry
When customer pays for the warranty
Cash XXX
Deferred Warranty Liability XXX
Costs are postponed and recognized only when they are directly related to the sale of the
warranty. Expenses in fulfilling the contracts should be expensed as period costs when incurred.
Entry
When Earned
Deferred Warranty Liability XXX
Warranty Revenue XXX
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3. Contingencies- Recognition and Reporting
A contingency is an existing condition involving uncertainty as to a possible gain/loss that will
be resolved in the future and may occur or not. A contingency maybe:
1) Probable- likely to occur 80%-100%
2) Reasonably Possible- a chance more than remotely to occur 50%
3) Remote- slight chance of occurring 1%-5%
Disclosure in the nature of the accrued amount and range of loss might be better to be presented
to prevent misleading information.
If at least one condition is not met but the probability of loss is reasonably possible, the nature of
the contingency (uncertainty) must be disclosed.
Loss contingency with remote possibility are not normally disclosed.
Gains on contingencies are recognized only when earned, and the gain must be disclosed
adequate in the notes (ex-award for damage).
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