Financial Accounting

Definition:

• All businesses must have an accounting system that collects and processes financial information about an organization’s business activities
• Reported back to external decision makers at the end of a period
• Negative value are put in parantheses ()
• Includes:
  • Financing Activities: borrowing or paying back money to lenders and receiving additional funds from stockholders or paying them dividends.
    • Equity
    • Liabilities
  • Investing Activities: buying or selling items such as plant and equipment used in the production of beverages.
    • current and non-current asset (available inventory)
  • Operating Activity
• Audit

Financial Statement

Conceptual Framework for Financial Reporting:

• 

Objective:

• To provide financial informationabout the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decision about providing resources to the entity.
  • main capital providers
• Note that supplier is also creditors when purchasing with credit

Assumptions:

1. Economic entity (Separate entity): States that business transactions are separate from the transactions of the owners
2. Going concern: States that businesses are assumed to continue to operate into the foreseeable future (also called the continuity assumption). (atleast 12 months)
3. Monetary unit: States that accounting information should be measured and reported in the national monetary unit without any adjustment for changes in purchasing power.
   • A really good employee is not convertible to money so it is not an asset but what he/she creates for the company is an asset
4. Time period: The long life of a company can be reported in shorter time periods, such as months, quarters, and years.
5. Accrual basis of accounting transactions are recorded in the periods in which the events occur.
   • Cash Basis Accounting vs Accrual Basis Accounting

Principles:

1. Measurement: Applied to measuring different assets and liabilities of the balance sheet.
   • Most balance sheet elements are recorded at their cost (historical cost), which is the cash-equivalent value on the date of the transaction
   • Some countries allow for fair-value to be reported but in VN only historical cost
2. Revenue recognition: Revenues are recognized (1) when the company transfers promised goods or services to customers and (2) in the amount it expects to be entitled to receive.
3. Expense recognition (matching principle): Requires that expenses be recorded in the same time period when incurred in earning revenue
   • only count it as expense when its used to generate revenue not when they are bought
4. Full disclosure:
   • companies should disclose all information that is relevant to their financial statements.
   • includes notes to financial statements: Accounting policies, methods,…

Accounting Transaction:

• Transactions are economic events that require recording in the financial statements.
  • Not all activities represent transactions.
  • Assets, liabilities, or stockholders’ equity items change as a result of some economic event
  • Dual Effect on the accounting equation
• Journal Entry
• An account: record of increases and decreases in a specific asset, libability, equity, revenue or expense item
  • T-Account form
• 
• Recording process:
  • When an event happens
  1. Determine what type of account is involved.
  2. Determine what items increased or decreased and by how much.
  3. Translate the increases and decreases into debits and credits.
• Trial Balance
  • The trial balance is a listing of the ending balance in each account in the general ledger.
  • List accounts in financial statement order (assets, liabilities, stockholders’ equity, revenues and expenses).
  • The purpose of the trial balance is to make sure the debits and credits are equal
• Current ratio $=\frac{\text{Current Assets}}{\text{Current Liabilities}}$
  • We need to compare it with:
    • 1
    • previous ratio
    • industry average
• Net margin ratio:
  • measures the profit generated per dollar of sales (operating revenues).
  • A high ratio as compared to competitors or over time suggests that a company is generating revenues and/or controlling expenses more effectively.
  • compare with:
    • intra-company: previous years’ ratios (at least 2 years)
    • Inter-company: competitors of the same industry, company size
    • development stages
  • Also consider external factors:
    • industry average
    • growth

Adjustments:

• Required for everytime a company prepares financial statements to show:
  • what they should have earned (accrued revenue)
  • what they havent earn (deferred revenue)
  • what they should have paid (accrued expense)
  • what they used but prepaid (deferred expense)
• To rmb:
  • accrual: cash incurred/earned —then⇒ cash paid/received
  • deferred: cash paid/received —then⇒ incurred/earned
• 4 types of adjustments:

  • 	Accruals	Deferral
    revenue	earned, not yet received	deliver good to who paid in advance
    expense	incurred, not yet paid	incurred but prepaid in last period

  • 

  • Deferred revenue: when rev is earned

    • Unearned Revenue: dr
    • Revenue: cr

  • Accrued revenue: when rev is earned

    • Receivable: dr
    • Revenue: cr

  • Deferred expense: when expense is incurred

    • Expense: dr
    • Prepaid expense: cr
      • supplies
      • depreciation for building, machine or equipment (each has different account)
      • other prepaid expenses

  • Expense: when expense is incurred

    • Expense: dr
    • Payvable: cr

Earning per share:

• Reported in Income Statement
• EPS $=\frac{\text{Net Income}}{\text{Average number of shares of common stock outstanding during the period}}$

Total Asset turnover ratio:

• $\text{Total asset turnover ratio}=\frac{\text{Net sales (operating rev)}}{\text{average total asset}}$
  • where avg total asset is average of beginning asset balance and ending asset balance

Closing the book:

• Even though the Balance Sheet account balances carry forward from period to period, the Income Statement account balances DO NOT carry forward.
• Closing entries:
  1. Transfer net income (or loss) to Retained Earnings.
  2. Establish a zero balance in each of the temporary accounts to start the accumulation in the next accounting period.
• Temporary accounts are revenue, expense, gain, and loss accounts

Credit, discount, returns on sales:

• Activities that can affect Net sales revenue:
  1. Credit sale: Allowing consumers to use credit cards to pay for purchases.
  2. Discounts: Providing business customers direct credit and discounts for early payment.
  3. Returns acceptance: Allowing returns from all customers under certain circumstances.

Credit sales:

• Incurs credit card discount, fee by credit card provider:
  • Net sale (reported on income statement) = Sale revenue - Credit card discount

Sale discounts to businesses:

• Companies may offer a sales discount as an early payment incentive
  • format: discount percentage / nb of days in discount period, net / max credit period
  • ex: 2/10, n/30 (two ten, net thirty) meaning if amount is paid within 10 days → discount 2% for maximum of 30 days
• → buyers usually take the discount as the discount typically higher than interest of banks

Sale returns and allowances:

• Customers have a right to return unsatisfactory or damaged merchandise and receive:
  • receive a refund → Sales return
  • adjustment to their bill, store credits, giftcards → Sales allowance
• Cost of goods sold related to the returned sale would also be reduced as inventory is added

		dr	cr
When good sold	Cash	x
	Sale revenue		x
	Cost of good sold	x
	Inventory		x
accept return of half	Sale return and allowance	x/2
	Sale revenue		x/2
	Inventory	x/2
	Cost of good sold		x/2
give store credits for half	Sale return and allowance	x/2
	store credits		x/2

Reporting net sales

• Companies record credit card discounts, sales discounts, and sales returns and allowances separately to allow management to monitor the magnitude of these transactions.
  • Sales revenue $6,000
  • Less:
    • Credit card discounts (a contra-revenue) $90
    • Sales discounts (a contra-revenue) $20
    • Sales returns and allowances (a contra-revenue) $500
  • Net sales (the first line of the income statement) $5,390

Types of receivable:

• account receivable vs note receivable
  • account receivable: created by a credit sale on an open account (no interest within due date)
  • note receivable: created as a written promise to pay principle and interest
• trade receivable vs non-trade receivable:
  • trade receivable: created in business operation when a credit sale of merchandise or service occurs, related to revenue
  • Nontrade receivables: arise from transactions other than the normal sale of merchandise or services, related to gain

Bad debts:

• Subsidiary Account: a separate receivable account for each customer for 1 account receivable. The amount on the balance sheet represents the total of these individual customer accounts.
• Bad debts result from credit customers who will not pay the amount they owe, regardless of collection efforts
  • Bad debt expense is a part of General and Administrative expense in Income Statement

Allowance method

• to measure bad debt expense. The allowance method is based on estimates of the expected amount of bad debts with two steps:
  1. Make end-of-period Adjusting Entry to record bad debt expense.
     • Debit bad debt expense (+E, -SE)
     • Credit allowance for doubtful accounts (+XA, -A)
  2. Write off specific accounts determined to be uncollectible during the period.
     • Debit allowance for doubtful accounts (-XA, +A)
     • Credit Account receivable (-A)
• Notice that this journal entry did not affect any income statement accounts. It also did not change the net book value of accounts receivable

Bad debt recoveries:

• When a company receives a payment on an account that has already been written off as expense
• Reverse to put the receivable back on the books and record cash
  • Un-write-off
    • Debit Account receivable
    • Credit allowance for doubtful accounts
  • Receive cash from receivable
    • Debit cash
    • Credit account receivable

Estimating bad debts:

• bad debt expense amount recorded in the end-of-period adjusting entry often is estimated based on either:
  1. A percentage of total credit sales for the period
     • Simple
     • Estimate bad debit loss rate based on past periods
     • Bad debt expense = credit sales (total receivable) * bad debt loss rate
     • This amount would be directly recorded as Bad Debt Expense (and an increase in Allowance for Doubtful Accounts) in the current year.
  2. An aging of accounts receivable.
     • Estiate uncollectible accounts based on age brackets of each account receivable
     • example: not due yet = 2%, up to 90 days = 12%, over 90 days = 30%
     • Sum the amount * rate of each bracket to get total estimated bad debts

Receivable turnover ratio:

• measures how many times average trade receivables are recorded and collected for the year.
• $\text{Receivable turnover}=\frac{\text{Net Sales}}{\text{Average Net trade accounts receivable}}=\frac{\text{Net Sales}}{(\text{Begin + end net trade accounts receivable})/2}$

Inventory management:

Primary goals:

• To have sufficient quantities of high- quality inventory available to serve customers’ needs
• To minimize the costs of carrying inventory (production, storage, obsolescence, and financing)
• DIfferent type of business have different inventory:
  • for merchandisers:
    • merchandise
  • for manufacturers:
    • raw materials
    • work in process
    • finished good

Costs included in inventory purchases:

• Total inventory cost of an item=
  • (+) Invoice price
  • (+) Fright-in (fee charged to deliver to company warehouse) (opposite to fright out)
  • (+) Inspection cost
  • (+) Preparation
  • (-) Purchase returns and allowances (as in Sale returns and allowances)
  • (-) Purchase discount (as in Sale discounts to businesses)
• Company cease accumulating purchase costs when raw materials are ready to use or when the merchandise is ready to be shipped
  • cost incurred after that is then selling, general and administrative expense

Flow of inventory costs:

• 
• For merchandise:
  • Purchase: debit inventory, credit cash
  • Sale: debit COGS, credit inventory
  • → COGS during a period = Beginning Inventory + Purchase during period - Ending Inventory
• For manufacturer:
  • Purcase: debit raw material inventory, credit cash
  • Process: debit WIP inventory, credit raw material inven, credit direct labor incurred, factory overhead incurred
  • Finished process: debit finished goods inventory, credit WIP inventory
  • Sale: debit COGS, credit finished goods inventory

Perpetual vs Periodic Inventory system:

Feature	Perpetual Inventory System	Periodic Inventory System
Def	Purchase transactions are recorded directly in an inventory account	Purchase transactions are not recorded at time of transactionD
Real-time Inventory Tracking	Yes	No
Physical Inventory Count	Less frequent	More frequent
Cost of Goods Sold (COGS) Calculation	Calculated with each sale	Calculated at the end of the accounting period
Inventory Valuation Methods	Can use various methods (FIFO, LIFO, Average Cost)	Can use various methods (FIFO, LIFO, Average Cost)
Complexity	More complex	Less complex
Cost	More expensive to implement and maintain	Less expensive to implement and maintain
Control over Inventory	Better control	Less control

Inventory costing methods:

• Problem: for many identical products of same type, it is bought and sold at different time and price → we need a way to determine how much a product cost when sold
  • Total dolloar amount of good available = Ending Inventory + Cost of Goods Sold

1. Specific Identification: each specific product have different price
   • Only work for small business
2. FIFO (First in, first out): costs are based on products that been to the inventory first
   • 
3. LIFO (Last in first out): costs are based on products that been to the inventory last
4. Average cost: average cost of a product is updated in every new purchase

Lower of Cost or Net Realizable Value, LCNVR principle:

• Net realizable value (NRV) = sale price less costs to sell
• Inventory value is the lower of purchase cost or NRV
  • due to some cases, products must be sold less than value when bought
    • particular importance for high-tech companies (products no longer best) and seasonal goods (example: winter clothes)
  • To prevent overstatement of inventory value on the balance sheet
  • based on conservatism constraint (better to undervalue)
• if NRV < Purchase cost, write-down (purchase cost - NRV) is recorded
  • debit COGS
  • credit Inventory value

Inventory Turnover:

• $\text{Inventory Turnover}=\frac{\text{COGS}}{\text{Average Inventory}}$
• $\text{Avg days to sell inventory}=\frac{\text{365}}{\text{Inventory Turnover}}$

Reporting Property, plant & equipment:

Long lived productive assets and fixed asset turnover ratio

• Tangible vs intangible asset:
  • tangible: Physical; land, building, equipments, natural resources,…
  • intangible: No physical; patents, copyrights, franchises, lisences, trademark,…
• $\text{Fixed asset turnover ratio}=\frac{\text{Net sales (or operating revenues)}}{\text{Average net fixed assets}}$
  • Net fixed assets = total fixed assets - accumulated depreciation
  • measures the sales dollars generated by each dollar of fixed asset used.
  • Higher number suggest more effective management
    • but downtrend can show that more money is being used to expand the company

Acquisition and improvement

• Acquisition cost of a productive item (capitalize an asset) =
  • (+) Purchase price
  • (+) Sale taxes
    • in Vietnam, its VAT
  • (+) Legal fees
  • (+) Transportation costs
  • (+) Installation and preparation costs
  • doesnt include financing charges but include interest on debt incurred during the construction period is an exception because it is considered part of the cost to bring the asset to its intended operational state.
• Repair, maintainance vs Improvement as expenditure
  • Hiding expense as capitalization decrease expense → more net income and more asset

Repair, maintainance	Improvements
value of asset stays the same	increase value
maintain the productivity	increase productive life, capacity or efficient
usually cheaper	expensive and occured infrequently
Count as expense	as capitalization

• Net book value = cost (acquisition + improvement) - depreciation

Cost allocation:

• Adjusting for depreciation:
  • debit depreciation expense
  • credit accumulated depreciation
• Methods to calculate depreciation expense
  • Depreciation expense is calculated with acquisition cost, estimated useful life and estimated residual value
  1. Straight-line: depreciation each year $=\frac{\text{cost - residual}}{\text{useful life}}$
  2. Units-of-production
  3. Declining balance

Asset imparement:

• Capitalized assets are expected to help generate atleast acquisition cost
• if not (net book value > estimated future cash flows), it is impared.
• Then impairment = Netbook value - Fair value (market price)

Disposal of PPE

• Sells the asset, write-off accumulated depreciation
  • if its more than netbook value, record the difference as gain
    • debit cash
    • debit accumulated depreciation
    • credit gain on sale asset
    • credit asset value
  • if less than NBV, record as loss
    • debit cash
    • debit accumulated depreciation
    • debit loss on sale
    • credit asset value