Thursday, September 25, 2008

Lecture 3 - Accounting for Inventory

Accounting for Inventory

In the same way we created metrics for Accounts Receivable, we create the same measures of inventory.

Inventory Turnover = Cost of Good Sold / Average Inventory

Cost of Goods Sold (COGS) is the price that the goods cost the company, not the price at which they were sold.

Similarly, Number of Days in Inventory = 365 / Inventory Turnover

In general, you want a high Inventory Turnover. However, there's a trade off in that it may result in low levels of inventory and possibly being out of stock, resulting in dissatisfied customers.

Compare these numbers against the company's historical numbers and against comparable companies in the same industry.

Inventory Systems - Perpetual vs. Periodic

A perpetual inventory system keeps track of every sale and every purchase. You are constantly up-to-date with your inventory.

For each sale, debit A/R (or Cash) and credit sales (a revenue account). Also, debit COGS (an expense account) and credit Merchandise Inventory (an asset account).

A periodic inventory system tracks sales and purchases, but doesn't dynamically update inventory. Inventory is surveyed by an actual, physical count on a periodic basis.

Beginning Inventory + Purchases = Goods available for sale

Goods available for sale - Ending Inventory = Cost of Goods Sold

Note: The year-end adjustment for periodic inventory is not being tested. We're not covering Freight and Returns nor Accounting for Discounts.

Inclusion in Inventory

If you pay for shipping, tariffs, insurance, etc then they are all considered the costs of inventory, i.e. COGS.

Goods in transit are included in your inventory if your terms of sale specify that you're responsible for it - called FOB Shipping Point. Similarly if you have the same agreement with your customers (FOB Shipping), you don't count it in inventory once it has left your shipping dock.

Goods on consignment are goods that are in your physical possession, but are not technically yours. You're holding them for sale for someone else. Consignment goods are not included in your inventory.

Cost Flow Assumptions

We don't easily know the exact cost of each item that is sold. How do we compute COGS under different cost flow assumptions - LIFO, FIFO and Weighted Average CGS?

LIFO and FIFO are accounting assumptions about the cost of inventory, but does not mean that the physical inventory moved in the LIFO or FIFO order.

In a period of rising prices, which technique results in lower net income? LIFO. Because it results in higher COGS.

Changing techniques requires disclosure as well as permission from IRS for tax purposes. You must use the same technique for both tax accounting and financial accounting. Most companies use the FIFO method.

If sales take place after all the purchases (first example), perpetual and periodic techniques are the same.

Weighted average technique is computationally complex when there are sales in between purchases.

FIFO works out the same whether you use the perpetual or periodic technique.

Lecture 3 - Accounting for Accounts Receivable

Accounting for Accounts Receivable

When the sale is made…
Debit A/R
Credit Sales

Then, when the payment comes in…
Debit Cash
Credit A/R

Managerial issues
Accounts Receivable Turnover
Ex: 12,000,000 in sales
Balance in A/R: 1,000,000
Turnover = sales/balance in AR

In our textbook, it says A/R Turnover = Sales/Avg AR balance, where avg AR balance is (starting A/R balance + ending A/R balance)/2

High A/R turnover generally means you’re collecting quickly and is generally good. Looking at turnover trends is also valuable. A problem with high turnover is that sometimes it indicates that the company is requiring customers to pay more quickly, which may make the customers less satisfied and lead to lost sales. Comparison to industry standards is also important.

Another measure of the efficiency of accounts receivable is the Days' Receivables = 365 / A/R Turnover. It indicates how many days it typically takes to collect the receivables.

Getting Cash from Receivables

There are a few ways to get cash from the receivables as quickly as possible.
1. Just wait until the person/firm pays.
2. Take a loan from a bank and use the receivables as collateral
3. Sell the receivables to a third party, called a factor.

The factored receivable may be sold either with or without recourse. Recourse means that if the factor can't collect the receivable, the seller is responsible for the debt. Selling receivables with recourse sells for more than without recourse, because the factor doesn't bear all the risk.

Another way to get cash is by securitizing the receivables in which they are packaged and then sold on the general market, not to a particular factor.

Accounts Receivable Entries

Direct write-off of uncollectible accounts is not allowed, due to the matching rule. You must use the allowance method which creates adjusting entries to estimate how many accounts will be uncollectible, even though you don't know which (or if) accounts will not be paid.

This is done by crediting the "Allowance for Uncollectible Accounts" account (a contra asset account, like accumulated depreciation) and debiting the uncollectible acounts expense account.

The amount that is creditted is done by estimating, usually based on industry standard or company history.

When, subsequently, an account does go bad, the write-off entry is done by crediting Accounts Receivable and debiting the Allowance for Uncollectible Accounts account.

If you eventually do collect the account, there are two steps:
First debit A/R and credit Allowance for Uncollectible Accounts.
Then, record the cash receipt by debiting Cash and crediting A/R.

Estimating Accounts Receivable Collectibility

First method is based on a percentage of all sales. This estimates the amount to debit to Uncollectible Accounts Expense.

The second method is to prepare an aged receivables schedule of each account and the amount that the account is 1-30 days, 31-60 days, 61-90 days and 90+ days overdue. For each category, assign a percentage that will be considered uncollectible. This estimates the amount to credit to the Allowance for Uncollectible Accounts account.

Lecture 3 - Accounting for Cash

Accounting for Cash

Management issues related to cash management: Management needs to keep track of cash balances for each period, possibly daily or weekly. For each period, plan and track the beginning balance, inflow, outflow and the ending balance. Every firm of any size has this in some form.

A firm may have several cash accounts. For instance, each store may have a separate account. Payroll may be a separate account. All accounts are rolled up together for the Balance Sheet.

Compensating Balance is the minimum balance that a bank requires the company to maintain on deposit. Compensating balances must be disclosed on the balance sheet - in a footnote.

Cash balances may be significantly positive during some times of the year. Companies invest in short-term commercial paper with their excess cash. Commercial paper are notes from other firms. This bypasses the banks and is called disintermediation. Notes with maturing periods of less than 270 days do not need to be registered with the SEC. Commercial paper is unsecured debt, but is preferred over common stock. Get rates for commercial paper here. Commercial paper rarely defaults and is considered very liquid.

How is commercial paper classified on the balance sheet? Since it's so liquid, it's lumped in with cash if it has a maturity of less than 90 days. If it's more than 90 days, it's an investment. Frequently, the balance sheet says "cash or cash equivalents". The equivalents may include commercial paper.

The real market for commercial paper is short-term money market mutual funds. Recently, many money market funds faltered and the government had to step in to rescue them. The problem with money market funds faltering is that they supply funds to the borrowing companies. If the borrowing companies wouldn't be able to secure funds, it would have a major effect on those companies.

Mark McCarthy's audio and video lectures

Mark McCarthy, another Depaul accounting prof, has audio and video lectures available here.

Tuesday, September 23, 2008

XBRL - XML Standard for Financial Reporting

XBRL

XBRL stands for Extensible Business Reporting Language. The idea is to create a standard way of communicating business and financial data in a common format that computers can interpret.

Without XBRL, if you want to compare the financials of several companies, you would typically start by collecting the annual or quarterly reports of those companies. After locating the data that you're looking for, which may be in different places in each of the reports, you would probably re-key the data into a spreadsheet where you could run your analysis.

XBRL eliminates the time and effort required to find the data and rekey it. By providing a standard format for the data, XBRL enables you to import the data straight into your spreadsheet and start analyzing it much more quickly.

XBRL has been gaining a lot of momentum over the past few years. It's been in a pilot program for three years and the SEC has recently proposed a rule that would require all US companies to provide financial information using XBRL within the next three years.

Here's a link to the SEC press release.
The AICPA Center for Audit Quality has an XBRL resource page - which is odd, because auditors are not required to sign off on the XBRL data in a financial statement.
The XBRL Consortium has a home page.
An article in the Houston Chronicle about XBRL.

Monday, September 22, 2008

Crosson videos on YouTube

Susan Crosson

Susan Crosson is co-author of Managerial Accounting with Belverd Needles. She also teaches Financial Accounting at Sante Fe College in Gainesville, Florida. She's got a slew of videos up on YouTube where she teaches Financial Accounting in 5 minute segments. They're a good, quick review.

Click here for a chapter-by-chapter list of her vids.

Thursday, September 18, 2008

Lecture 2 - Accrual Accounting (cont.)

Accrual Accounting (continued)

Cash flows can be determined from examining the accrual data.

Prepaid expenses
Accrued expenses
Accrued revenues
Prepaid revenues

Adjusted Trial Balance

Accountants use a worksheet to work with the adjustments and then record them in the ledger accounts.

Then the books for the period are closed and a post-closing trial balance is calculated. The numbers from the post-closing trial balance feed the preparation of the financial statements. Sometimes the financial statements are made from the adjusted trial balance.

Closing Entries

Assets, liabilities and owners' equity (balance sheet accounts, aka permanent or "real accounts") are never zeroed out. They carry over.
Revenue and expenses (temporary or "nominal accounts") start at zero each period.
Dividends restart at zero each period even those it's an equity account.

Revenue accounts typically have credit balances, so debit them and balance that debit with a credit in a special account called Income Summary.

Expense accounts typically have debit balances, so credit them and balance it with a debit to Income Summary.

Dividends always have a debit balance, so credit the account and balance it with a debit to Retained Earnings.

This new account, Income Summary, has expenses on the left side and revenues on the right side. The balance is the Net Income. We need to zero out this account also. If it's a credit (right-hand, revenue) balance, zero it with a debit and balance that debit with a credit to Retained Earnings. If it's a debit (left-hand, expense) balance, zero it with a credit and balance it with a debit to Retained Earnings.

Then the Post-Closing Trial Balance is generated. The difference between the P-C Trial Balance and the Adjusted Trial Balance is that the P-C Trial Balance has all revenue, expense and dividend accounts zeroed out.

Lecture 2 - Accrual Accounting

Accrual Accounting

It would be nice if we could just take the balances from the Trial Balance and transfer them to the financial statements. Unfortunately, it's not so simple. There are some prepaid/unpaid expenses and

We need to make adjustments for these issues before we close out the books for the accounting period.

Assumption: Investors are primarily concerned with income. Therefore the income statement is much more important and exact than the balance sheet. Ex: the balance sheet assumes the value of an asset (real estate) at purchase price, even though it may have increased in value since the purchase. However, the income statement is very precise and must only contain income that actually pertains to the reporting period.

Going Concern Assumption: The business will continue to exist into the indefinite future.

Conventions of periodic reporting and revenue recognition: report revenues in the year in which they are "earned".

Revenues for goods are generally recognized at the date of sale. Service revenues are usually recognized when the service is performed and they are billable. (There are more details and exceptions for specific goods and services.)

Expenses are recognized in the same period as the revenues to which they relate are recognized. Again, there are details and exceptions for some expenses, such as R&D which is expensed as incurred.

So now the expanded accounting cycle is:
...
Trial Balance
Adjustments
Adjusted Trial Balance
...

Adjusting Entries

Adjusting entries adjust transactions between the balance sheet (assets, liabilities) and the income statement (revenues, expenses). There are 4 possible combinations.

Revenue Earned but Not Recorded (Revenue, Asset)
Ex: Accrued interest that hasn't been paid yet. Debit the Interest Receivable account (asset) and credit the Interest Revenue account (revenue).

Expenses Incurred but Not Recorded (Expense, Liability)
Ex: Utility expenses are incurred this period but the bill may not be received until next period.
Debit the Utilities Expense (expense) account and credit the Utilities Payable account (liability).

Expenses Recorded but Not Incurred (Expense, Asset)
Ex: Prepaid rent or insurance.
Original prepayment is recorded as a debit to prepaid rent account (expense) and credit to cash.
Adjustment is made by debiting rent expense account and crediting prepaid expense

Depreciation of a special case. It's usually impossible to match the expense of the machine to the revenue that it generates. Rather, we depreciate it over time. This is analogous to a prepaid expense.

The original purchase of the asset is recorded by debiting the depreciable asset account and crediting cash.
Then the depreciation adjustment is made by debiting the depreciation expense account and crediting the accumulated depreciation account. The accumulated depreciation is a special "contra" asset account. It is unusual among asset accounts in that it has a credit balance.

Revenues Recorded but Not Earned (Revenue, Liability)
Ex: Revenues received for prepaid magazine subscriptions.
The original transaction is recorded as a debit to cash (asset) and a credit to unearned revenue (liability).
The adjustment is a debit to unearned revenue (liability) and a credit to a revenue account (revenue).

Lecture 2 - The Accounting Cycle (cont.)

The Accounting Cycle (continued)
In the standard accounting cycle, transactions are first recorded in journals in a uniform, systematic way and then (after transactions are checked for accuracy) they are transferred to the actual accounts.

The standard form of a journal entry has both debits and credits, which must equal each other. Debits are listed first, followed by credits. Credits are traditionally indented. Explanations are typically appended to the end of the journal entry.

The process of moving transactions from journal entries to the general ledger is called "posting".

Additional Terms

The Chart of Accounts is a listing of all the accounts the company uses in its General Ledger. Usually the listing is in the following order:
  1. Assets
  2. Liabilities
  3. Owners' Equity
  4. Revenues
  5. Expenses
A Trial Balance is a listing of the accounts and their respective balances. Typical balances are:
  • Assets - Debit
  • Liabilities - Credit
  • Owners' Equity - Credit
  • Revenues - Credit
  • Expenses - Debit

Monday, September 15, 2008

Recent Financial Accounting News

Note: My intention in my posts that are not lecture notes is to bring attention to news items that relate directly to the lectures or may be of general interest to the class. Enjoy!

Transition to IFRS


There have been several news items recently involving the transition from US GAAP to IFRS.

A July 28, 2008 interview with Conrad Hewitt, chief accountant at SEC.

In the interview, Hewitt says he "lifted" the transition roadmap which he inherited when he took office. By "lifted", I assume he means "trashed". He then says that the commission will redo the roadmap this summer (before Sept 21) and it will likely consist of a transition period, during which US companies can optionally use IFRS, followed by a full transition, at which point US companies must use IFRS. This phased-in approach is similar to the way SOX404 and XBRL were adopted as standards. Hewitt anticipates the transition to IFRS to be slower than the transition to XBRL.

Hewitt raises some practical concerns such as whether IFRS is being taught in universities and tested on the CPA exam. He also raises the issue of whether US companies are ready to train their staff and change their systems to use IFRS. He has spoken with the 6 largest accounting firms and they reported that they are retraining their staffs on IFRS.

The Rush to International Accounting

Accounting Convergence Goal Reset to 2011

PwC Releases IFRS Guides

PCAOB

Appeals Court Rules PCAOB is Constitutional

In last week's class, we learned about the role that PCAOB plays in setting auditing standards. It turns out that the Free Enterprise Fund and a small auditing firm filed suit claiming that the establishment of PCAOB violates the principle of separation of powers and is therefore unconstitutional. FEF claimed that since PCAOB officers are not appointed directly by the President, they therefore are "unaccountable and divorced from presidential control to a degree not previously countenanced in our constitutional structure."

The court ruled in favor of PCAOB. The WebCPA article characterizes the suit as a rogue act and not supported by major accounting firms and organizations, although the court's ruling was not unanimous.

You can download a PDF of the complete decision here.

See also Michael Cohn's commentary on how a Supreme Court appeal may look "Given the tenuous nature of some of the Supreme Court's close decisions in the last term and some of the justices' predilections, some of them may welcome the opportunity to place a stricter interpretation on the appointments clause and thereby strengthen the president's powers, depending on who the next president is, of course."

Thursday, September 11, 2008

Lecture 1 - Accounting Standards, Management & Auditor Responsibilities

Accounting Standards
In the US, accounting standards are set by the FASB, by permission of the SEC (who has statutory authority and has delegated it to FASB). Their rules are known as GAAP - generally accepted accounting principles. Committees of the AICPA sets rules on more minor or industry-specific issues. "Industry practice" also sets accounting rules.

To be listed on US exchanges, foreign companies must abide by FASB standards. Many other countries follow IASB rules, known as IFRS (International Financial Reporting Standards). In the late 90s, the EU required listed companies to use IASB rules. Basic structure of statements and rules are the same between FASB and IASB, but they differ in the details.

SEC was traditionally against adopting IASB rules in the US. It would reduce their level of control. However, according to a recent announcement, they will be transitioning from FASB to IASB rules within the next few years.

The Public Company Accounting Oversight Board sets auditing standards. They were created by the Sarbanes-Oxley Act and they report to the SEC.

Setting Accounting Standards
Accounting standards focus on three areas: Recognition, Valuation, Classification

Recognition - When are events recorded on the books? What types of events need to be recorded?
Valuation - In the US, we value assets at cost. Other countries revalue if the price changes.
Classification - The breakdown of assets, liabilities, equity and other categories on financial statements.

Responsibilities of Management
  • Management of the firm is responsible for the preparation of the financial statements.
  • Management of the firm is responsible for the internal controls over financial reporting.
  • Auditors perform tests to support an opinion on the quality of internal control and an opinion that the financial statements "fairly present" the company's financial position and results of operations.
Review by auditors is a condition for being listed on US exchanges. An IPO requires 3 years of audited financial statements. Lenders (banks) may also require them.

The Accounting Cycle
There's a process between the original recording of the transaction and the final appearance on the financial statement. This is known as the Accounting Cycle.

The cycle looks like this:
Journal - General Ledger - Trial Balance - Worksheet - Financial Statement

General Ledger contains different accounts for each category of assets and liabilities. Accounts are used to accumulate amounts from similar transactions and to act as the basic storage units for accounting data. An account is the sheet on which individual transactions affecting a particular item are "posted".

T Accounts - A representation of the way that account transactions are divided between debits (left side) and credits (right side).

Asset accounts - the left side represents an increase in the account.
Liability and Owners' Equity accounts - the right side represents an increase in the account.

When entering corresponding asset/liability pairs in corresponding accounts, note the relationship with numbers.

Lecture1 - Uses of Financial Statements

Financial Statements

Financial statements are directed primarily towards investors and creditors. Outsiders to the firm.

Insiders to the firm use managerial accounting which may overlap with financial accounting but is a separate topic.

Government and labor are also interested in financial statements. Gov't for taxes and oversight. Labor to make sure they're being paid in accordance with the profit level that the company is earning.

A side note: Depaul faculty and staff used to receive the school's annual financial statements. They noticed that operating funds were transferred to the endowment. Usually it's the opposite. Faculty and staff raised the issue and it was dealt with.

Financial annual reports are available from http://www.annualreports.com/. SEC also has the info at edgar.sec.com. (EDGAR = Electronic Data-Gathering, Analysis, and Retrieval) It's not packaged very nicely though.

Another good, free site is finance.yahoo.com. Search/filtering capabilities are excellent.

Earnings.com informs you of key events (dividends, stock splits, etc) on a daily basis.

The Accounting Equation

Assets = Liabilities + Owners' Equity
  • This equation underlies the preparation of the balance sheet.
  • Basis for the "double entry" system
The Balance Sheet

Balance of assets, liabilities and owners' equity at a specified point in time.
Business assets and liabilities are kept separate from those of the owners.

Assets
Resources owned by the entity.

Is a very talented employee (for instance, a major league baseball player) under contract for 5 years an asset that would go on the balance sheet? It's an asset, but it doesn't go on the balance sheet. By convention, human resources are not on the balance sheet as an asset.

Goodwill is a complex topic and is not covered in this course.

Assets can be categorized as monetary (liquid), non-monetary (designated in monetary terms, but not as liquid) and non-physical.

Some facts about the firm (e.g. president is ill) may be important, but they do not appear on the balance sheet at all.

Liabilities
Commitments requiring future resources, usually cash.
Some liabilities are satisfied in other ways. For instance, if you receive payment for a prepaid subscription. This incurs a liability that is satisfied by delivering the product.

Owners' Equity
In a way, it's a residual: the difference between assets and liabilities. However, we don't calculate it like that.
Two components: Contributed capital (what investors have put into the business) and retained earnings (profit that the company has made but not returned to the stockholders).

The Double Entry Bookkeeping System
Analyze how accounting events affect the accounting equation.
  1. Issue stock for $100k - Asset ($100k cash) and Equity increase.
  2. Buy car for $20k - No change - Just a transfer from one type of asset (cash) to another (vehicles).
  3. Purchase truck for $10k to be paid in the future - Assets (vehicles) and Liabilities (amount owed) both increase.
  4. Pay for the truck - Assets (cash) and liability (amount owed) both decrease.
  5. Sell services for $15k in cash - Assets (cash) and Equity (retained earnings) both increase by $15k.
  6. Sell services for $25k to be received in the future - Assets (accounts receivable) and Equity (retained earnings) by $25k.
  7. Collect the $25k - No change - Cash increases, accounts receivable decreases. Both are offsetting assets.
  8. Pay rent of $5k - Both Assets (cash) and Equity (retained earnings) decreases by $5k.
  9. Pay dividend of $7k - Both Assets (cash) and Equity (dividends) decrease by $7k.

Financial Statements

Balance Sheet
Implements the accounting equation A = L + OE at a given point in time.

Statement of Retained Earnings
Beginning Balance (from last year's balance sheet)
+Net Income
-Dividends
=Ending Balance (should match this year's balance sheet)

Income Statement
Record all items of revenue and all expenses to compute a net income. That net income is used in the statement of retained earnings, so it must be prepared first.

Statement of Cash Flows
This is complex. It'll be covered in the last class. For now: It focuses on the change in cash over the year. When looking at the statement of cash flows, analysts and others focus on where the cash came from: operating activities, investing activities, financing activities (borrowing).

Lecture 1 - Introduction to ACC 500

Introduction to ACC 500

Use Blackboard to get course information.

Answers to all textbook questions are available on-line. The link is on Blackboard. Note that solutions are in spreadsheets that may have multiple tabs.

The textbook has a web site with sample questions for each chapter.

Quizzes are not collected. Answers are given in class only, not on-line.

Current events in accounting will also be covered in class.

Assignments are primarily short exercise; not many longer problems. The assignments are not collected. They won't be discussed in class unless there's a particular question about the assignment.

Grading scheme is not strict and somewhat subjective. It tends to be on the lenient side. Midterm grade will be a raw score and a preliminary letter grade, based solely on the midterm.

Some weeks' lectures may have more material than others.

Financial Accounting - Pre-lecture 1

Welcome to my notes on Financial Accounting - ACC 500 with Professor Mark Sullivan at DePaul University, Fall 2008.

Textbook is Financial Accounting by Needles and Powers.

Syllabus is posted on Blackboard.

Room: Depaul Center 8208