Ministry of Higher Education and Scientific ResearchWarith alanbiyaa UniversityCollege of Administration and EconomicsDepartment of Accounting

Accounting in English

Preparation:

Eman Jawad Ahmed

2019

Chapter one

Accounting For Property, Plant and Equipment

Definition of fixed assets: Fixed assets are assets that are held by a firm for use in the production Or supply of

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goods and service and not intended for With the ordinary course of business. Classification of fixed assets: Fixed assets also referred to as long -term assets or long-lived assets are often divided in to tangible and intangible categories.

Tangible assets: are fixed assets that have a physical existence and can be seen and felt مرئي) ,(وملم%%وس include land, buildings, equipment and vehicles.

Intangible assets: are fixed assets that haven't a physical existence, they represent legal rights or economic benefits. Trademarks and goodwill etc. Examples of intangible assets.

Nature Resources: are fixed assets which must be depletion during a specific period, for example the Mines of gold , iron etc.

Cost of a fixed assets: The cost of a fixed asset represents the sum of all costs necessary to use the assets prepared for intended use(االستعمال المرتقب ).

Exercise(1): Machine was purchased for IQD 3000000 cash, IQD 100000 was paid as charges of wage and installation IQD 300000, the Estimated total Working capacity of machine is 150000 hours and salvage value is IQD 100000.

Required :- Compute the machine cost and pass the journal entry.

Solution:

-Cost of machine = 3000 000+ 100 000+ 300 000 = 3 400 000- Journal entry:-

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Machine 3400 000 Cash 3400 000

Disposal of fixed assets: التصرف باألصول غير المتداولة When fixed assets wear out or become obsolete , they are no longer useful in a business. They are scrapped sold, or exchanged for new assets On the disposal of an asset , the cost as well as the accumulated depreciation of the asset is removed from the books . Seldom is the disposal value of an asset equal to its book value , so it is usually necessary to recognize or loss on disposal. (1) Calculation of Gains or Losses on the Sale of Fixed Assets احتساب مكاسب أو خسائر بيع األصول غير When the fixed assets like machinery and:المتداولةfurniture are sold it is necessary for the business to calculate the main or loss that results due to the disposal. The following entries are required in this connection.Gain or Loss on the sale of assets is calculated as follow:No. Particulars $

Amount realized on the sale of the assetTotal Depreciation calculated on the sale of the asset till the date of its disposal

XXXXXX

Total Realization of the asset Less XXX Less Total Cost of the asset (XX) Gain / Loss XXX

Rule: (قاعدة)If the total realization is more than the total cost, there will be a gain and if the total realization is less than cost, there will be a lossdate Particulars $

1. When the asset is sold: Cash Asset

(Being the asset sold and amount realized)

xxx xxx

2 .For Depreciation to be provided from

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the beginning of the financial year to the date of sale : Depreciation Asset ( Being the Provision of depreciation till the date of sale )

xxx xxx

3 .When there is a profit on the sale of the asset : Gain on the Sale Asset Profit & Loss( Being the gain on the sale of the asset )

xxx xxx

4. there is a loss on the sale of a particular asset P&L Loss on the sale of Asset

( Being the loss on the sale of asset )

xxx xxx

Exercise (3) Assume that an item of equipment acquired at cost of IQD 600000 was discarded on 19, July, 2011. On 31 December 2010, the balance of accumulated depreciation was IQD 450000. The depreciation expense on the every item at the date of discarding amounted to IQD 100000 . Required :- Recorded entries should be passed.1, July, 2011

Depreciation Expense - Equipment 100000 Accumulated Depreciation – equipment 100000

(being record current depreciation on equipment discarded)

31, Dec, 2011

Accumulated Depreciation - Equipment 550000 Loss Equipment disposal 50000 Equipment 600000

(Being write off equipment discarded)

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31, Dec, 2011

Profit and Loss 150000 Loss on equipment disposed 50000 Depreciation Expense - equipment 10000(Being transferring the result (Loss) of | equipment disposal

depreciation expense to P & L)

Sale of fixed assets

Rule: lf the selling price is more than the book value of the asset, the transaction results in alternatively if the selling price is less than the book value of the asset, the result will be loss.

Example (1): Assume a car that cost $20 000 000 and has a book value of $4000 000 is sold for $5000 000. The journal entry to record this disposal is as follow:

Cash 5000 000 Accumulate Depreciation- Car 16 000 000

Car 20000000 Gain on Disposal of Car 1000 000

(To record sale of car at price above Book value)

Example (2): Assume that the same car is sold for $2000 000. The journal entry, in this case, would be as follows:

Cash 2000 000 Accumulate Depreciation- Car 16 000 000

loss on Disposal of Car 2000 000

Car 20 000 000(To record sale of car at price below Book value)

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Exercise (4): If a car costing $4500 000 was sold on 1st, April, 2011 by $700 000 cash, The balance of accumulated depreciation - car on 31 December 2010 is $ 3000 000. The annual depreciation is $1000 000.

Required: Record the entries for sale a car.

How to prepare a balance sheet ?A balance sheet is a statement of a firm’s assets, liabilities and net worth. The key to understanding a balance sheet is the simple formula:

Assets = Liabilities + Owners equity

Assets

Current Assets Cash On Hand XXX Cash in Bank XXX Accounts Receivable (Debtors) XXX allowance for doubtful account (XXX) Merchandise Inventory XXXPrepaid Expenses(1) XXXAccrued revenuesNotes Receivable XXXShort-term investment XXX

Total Current Assets XXX

Fixed Assets

Tangible Assets

Land XXXBuilding XXXLong-term investment XXX

1, مقدما : ) المدفوع االيجار مصروف مثل مقدما المدفوعة المصاريف انواع من نوع أي يشمل ,) لإليرادات بالنسبة وكذلك مقدما مدفوع اخر مصروف أي او مقدما المدفوع الرواتب مصروف

المستحقة 6

Equipment XXX) less: Accumulated depreciation-equipment)2 (XX) Property and Plant XXX

Intangible Assets

Good will XXXTrademark XXXAuthoring and propagation XXXLicenses XXXpatent XXX

Total Fixed Assets XXX

Total Assets XXX

Liabilities

Current Liabilities

Accounts payables (creditors) XXXShort-term loans XXXAccrued expenses(3) XXXDeferred Revenues XXXNotes payable XXX

Total Current Liabilities XXX

Non- Current Liabilities

Long-term loans XXXBonds XXX

Non- Current Liabilities XXX

Total Liabilities XXX

Owner , s Equity

Common Stock XXXPreferred stock XXX

2. االراضي : بإستثناء متراكم اندثار مخصص المتداولة غير االصول انواع من نوع لكل3 : , ( مصروف المستحق االيجار مصروف مثل المستحقة المصاريف انواع من نوع أي يشمل

) اخر مستحق مصروف أي او المستحق .الرواتب مقدما المستلمة لإليرادات بالنسبة وكذلك ،7

Treasury Stock XXXReserves XXXReturned earning XXX

Total Owner,s Equity XXX

Total Liabilities and Equity XXX

Chapter Two

ACCOUNTING FOR DEPRECIATION

LEARNING OBJECTIVES

After studying this chapter, you should be able to:1- Explain the concept of depreciation.2- Identify the factors involved in the depreciation process.3- Compare activity, straight-line, and decreasing charge methods of depreciation.4- Explain special depreciation methods.

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DEPRECIATION—A METHOD OF COST ALLOCATIONMost individuals at one time or another purchase and trade in an automobile. The automobile dealer and the buyer typically discuss what the trade-in value of the old car is. Also, they may talk about what the trade-in value of the new car will be in several years. In both cases, a decline in value is considered to be an example of depreciation.To accountants, however, depreciation is not a matter of valuation. Rather, depreciation is a means of cost allocation. Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. For example, a company like Goodyear)one of the world’s largest tire manufacturers) does not depreciate assets on the basis of a decline in their fair value. Instead, it depreciates through systematic charges to expense.This approach is employed because the value of the asset may fluctuate between the time the asset is purchased and the time it is sold or junked. Attempts to measure these interim value changes have not been well received because values are difficult to measure objectively. Therefore, Goodyear charges the asset’s cost to depreciation expense over its estimated life. It makes no attempt to value the asset at fair value between acquisition and disposition. Companies use the cost allocation approach because it recognizes the expense in the periods expected to benefit and because fluctuations in fair value are uncertain and difficult to measure.

Factors Involved in the Depreciation Process

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The costs are allocated in a rational and systematic manner depreciation experience to each period in which the asset is used, beginning when the asset is placed in service, generally this amounts four criteria:

cost of the asset, expected salvage value of the asset, estimated useful life of the asset, and a method of apportioning the cost over such life.

Methods of DepreciationCompanies may use a number of depreciation methods, as follows.1- Activity method (units of use or production).

2- Straight-line method.

3- Decreasing-charge methods (accelerated):

(A) Sum-of-the-years’-digits.(B) Declining-balance method.4- Special depreciation methods:

(A) Group and composite methods.(B) Hybrid or combination methods.To illustrate these depreciation methods, assume that S. company recently purchased an additional crane for digging purposes.

Cost of crane $500,000Estimated useful life 5 yearsEstimated salvage value $ 50,000Productive life in hours 30,000 hours

1- Activity method (units of use or production): The activity method (also called the variable-charge or units-of-production approach) assumes that depreciation is a

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function of use or productivity, instead of the passage of time

Exercise (1): A company purchased a car at $12000 its salvage value is 2000, the number of Kilometers estimated during the useful life 100 000 000 KM.Required: Compute depreciation amount for the first two years if it went 20 000 Km, 15000 respectively.2- Straight-line method: It considers depreciation as a function of time rather than a function of usage.

Advantages : I) It is a simple method to understand 2) The value of the asset at the end will be scrap value 3) The annual charge to profit and loss account is same for all the years. Disadvantages: 1) It is complicated when new asset is purchased during a year, as new calculations are to be made for the new asset.2) There is no provision for the replacement of the asset when it is Warm - out. 3) This method does not take into account seasonal fluctuations like booms or depression or number of fluctuations. An equal amount of depreciable cost is allocated to each period, by means of this formula:

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(Historical cost –Salvage Value)÷ Estimated useful life

A- When asset is used for FULL year:Depreciation amount = Original cost × Rate of

depreciation

A- When asset is used for part a year:Depreciation amount = Original cost × Rate of

depreciation × period of use

Exercise (2): H. Co. acquired a machine on 1st July 2010 at Cost of $28000 and Spent $2000 on its repairs and erection. The firm writes off Depreciation at 10% of original cost every year. The books are closed on 31st Dec. of each year.Required: Show The machinery account & Depreciation account for the Five years.

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3- A- Sum-of-the-Years’-Digits. It method results in a decreasing depreciation charge based on a decreasing fraction of depreciable cost (original cost less salvage value). Each fraction uses the sum of the years as a denominator (5 + 4 + 3+2+1= 15). The numerator is the number of years of estimated life remaining as of thebeginning of the year. In this method, the numerator decreases year by year, and the denominator remains constant (5/15, 4/15, 3/15, 2/15, and 1/15). At the end of the asset’s useful life, the balance remaining should equal the salvage value. Illustration this method of computation as follow:

Exercise (3): Assume That the estimated useful life for a fixed asset is 4 years and its cost $12000, the salvage value is $2000.Required: Compute the depreciation for the four year.

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Chapter Three

Accounting for Receivables

After studying this chapter, you should be able to:

1- Define receivables and identify the different types of receivables.

2- Explain accounting issues related to recognition of accounts receivable.

3- Explain accounting issues related to valuation of accounts receivable.

-4 Explain accounting issues related to recognition and valuation of notes receivable.

5- Explain the fair value option.

-6 Explain accounting issues related to disposition of accounts and notes receivable.

7- Describe how to report and analyze receivables.

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Concept of ReceivablesReceivables are claims held against customers and others for money, goods, or services. For financial statement purposes, companies classify receivables in to:

1- Current receivables (short-term receivables): The Companies classify all receivables as expect to collect within a year or during the current operating cycle, whichever is longer.

2- Noncurrent receivables (long-term receivables). The Companies classify all receivables as not expect to collect within a year or during the current operating cycle.

Receivables are further classified in the balance sheet as either trade or nontrade receivables.

Customers often owe a company amounts for goods bought or services rendered. A company may sub-classify these trade receivables, usually the most significant item it possesses, into accounts receivable and notes receivable as follow:

Accounts receivable are oral promises of the purchaser to pay for goods and services sold. They represent “open

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accounts” resulting from short-term extensions of credit. A company normally collects them within 30 to 60 days.

Notes receivable are written promises to pay a certain sum of money on a specified future date. They may arise from sales, financing, or other transactions. Notes may be short-term or long-term.

Nontrade receivables arise from a variety of transactions. Some examples of nontrade receivables are:

1. Advances to officers and employees.2. Advances to subsidiaries.3. Deposits paid to cover potential damages or losses.4. Deposits paid as a guarantee of performance or payment.5. Dividends and interest receivable.6. Claims against:A. Insurance companies for casualties sustained.B. Defendants under suit.C. Governmental bodies for tax refunds. D. Common carriers for damaged or lost goods.E. Creditors for returned, damaged, or lost goods.F. Customers for returnable items (crates, containers, etc.).

Recognition of Accounts Receivable In most receivables transactions, the amount to be recognized is the exchange price between the two parties. The exchange price is the amount due from the debtor (a customer or a borrower). Some type of business document, often an invoice, serves as evidence of the exchange price. Two factors may complicate the measurement of the exchange price: (1) the availability of discounts (trade and cash discounts), and (2) the

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length of time between the sale and the due date of payments (the interest element).

1- Trade Discounts: Prices may be subject to a trade or quantity discount. Companies use such trade discounts to avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from competitors. Trade discounts are commonly quoted in percentages. For example, say your cell phone has a list price of $90, and the manufacturer sells it to Best Buy for list less a 30 percent trade discount. The manufacturer then records the receivable at $63 per phone. The manufacturer, per normal practice, simply deducts the trade discount from the list price and bills the customer net.

2- Cash Discounts (Sales Discounts): Companies offer cash discounts (sales discounts) to induce prompt payment. Cash discounts generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2 percent if paid any time before the tenth day of the following month, with full payment due by the thirtieth of the following month(.

Companies usually take sales discounts unless their cash is severely limited. Why?

A company that receives a 1 percent reduction in the sales price for payment within 10 days, total payment due within 30 days, effectively earns 18.25 percent [.01 4÷ (20/365)] or at least avoids that rate of interest cost.

Companies usually record sales and related sales discount transactions by entering the receivable and sale at the gross

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amount. Under this method, companies recognize sales discounts only when they receive payment within the discount period.The income statement shows sales discounts as a deduction from sales to arrive at net sales.

Some contend that sales discounts not taken reflect penalties added to an established price to encourage prompt payment. That is, the seller offers sales on account at a slightly higher price than if selling for cash. The cash discount offered offsets the increase. Thus, customers who pay within the discount period actually purchase at the cash price. Those who pay after expiration of the discount period pay a penalty for the delay—an amount in excess of the cash price. Per this reasoning, some companies record sales and receivables net. They subsequently debit any discounts not taken to Accounts Receivable and credit to Sales Discounts Forfeited.

If using the gross method, a company reports sales discounts as a deduction from sales in the income statement. Proper expense recognition dictates that the company also reasonably estimates the expected discounts to be taken and charges that amount against sales. If using the net method, a company considers Sales Discounts Forfeited as an “Other revenue” item, The entries in the following Illustration show the difference between the gross and net methods:

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Valuation of Accounts Receivable:Reporting of receivables involves: (1) classification: Classification involves determining the length of time each receivable will be outstanding. Companies classify receivables intended to be collected within a year or the operating cycle, whichever is longer, as current. All other receivables are classified as long-term.

(2) valuation on the balance sheet: Companies value and report short-term receivables at net realizable value—the net amount they expect to receive in cash. Determining net realizable value requires estimating both uncollectible receivables and any returns or allowances to be granted.

Uncollectible Accounts Receivable: There are Two methods are used in accounting for uncollectible accounts:

(1) The direct write off method for Uncollectible Accounts:Under the direct write-off method, when a company determines a particular account to be uncollectible, it charges the loss to Bad Debt Expense. Record the following entry:

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Bad Debt Expense XXX

Accounts Receivable (XX) XXX

(To record write-off of XX account)

Assume, for example, that on

December 10 C. Co. writes off as uncollectible Yusado’s $8,000 balance. The entry is: December 10

Bad Debt Expense 8,000

Accounts Receivable (Yusado) 8,000

(To record write-off of Yusado account)

Under this method, Bad Debt Expense will show only actual losses from uncollectibles. The company will report accounts receivable at its gross amount. As a result, using the direct write-off method is not considered appropriate, except when the amount uncollectible is immaterial.

(2) Allowance method for Uncollectible Accounts:This method has three essential features:

A. Companies estimate uncollectible accounts receivable. They match this estimated expense against revenues in the same accounting period in which they record the revenues.

B. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period.

C. When companies write off a specific account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable.

Recording Estimated Uncollectibles.. To illustrate the allowance method, assume that Brown Furniture has credit sales of $1,800,000 in 2014. Of this amount, $150,000 remains uncollected at December 31. The credit manager estimates that $10,000 of these sales will be uncollectible. The adjusting entry to record the estimated uncollectibles is:

December 31, 2014

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Brown reports Bad Debt Expense in the income statement as an operating expense.Thus, the estimated uncollectibles are matched with sales in 2014. Brown records the expense in the same year it made the sales.

Recording the Write-Off of an Uncollectible Account. As following Illustration shows, the company deducts the allowance account from accounts receivable in the current assets section of the balance sheet.

The amount of $140,000 in Illustration represents the net realizable value of the accounts receivable at the statement date. Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year.

Recovery of an Uncollectible Account. Occasionally, a company collects from a customer after it has written off the account as uncollectible. The company makes two entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off the account. This reinstates the customer’s account.

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Bad Debt Expense 10,000

Allowance for Doubtful Accounts 10,000

(To record estimate of uncollectible accounts)

Accounts Receivable XXX

Allowance for Doubtful Accounts XXX

(To reverse write-off of account)

(2) It journalizes the collection in the usual manner.

To illustrate, assume that on July 1, 2015, Randall Co. pays the $1,000 amount that Brown had written off on March 1. These are the entries:

July 1, 2015

Accounts Receivable (Randall Co.) 1,000

Allowance for Doubtful Accounts 1,000

(To reverse write-off of account)

Cash 1,000

Accounts Receivable (Randall Co.) 1,000

(Collection of account)

Bases Used for Allowance Method: There are Two bases are used to determine this amount: (1) percentage of sales and (2) percentage of receivables. Both bases are generally accepted. The choice is a management decision. It depends on the relative emphasis that management wishes to give to expenses and revenues on the one hand or to net realizable value of the accounts receivable on the other. The choice is whether to emphasize income statement or balance sheet relationships. The following Illustration compares the two bases.

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Cash 1,000

Accounts Receivable 1,000

(Collection of account)

(1) Percentage-of-sales (income statement) approach. In the percentage-of-sales approach, management estimates what percentage of credit sales will be uncollectible. This percentage is based on past experience and anticipated credit policy.The company applies this percentage to either total credit sales or net credit sales of the current year. To illustrate, assume that G. Co. elects to use the percentage-of-sales basis. It concludes that 1 percent of net credit sales will become uncollectible. If net credit sales for 2014 are $800,000, the estimated bad debts expenseis $8,000 (1%× 3 $800,000). The adjusting entry is:December 31, 2014 Bad Debt Expense 8,000 Allowance for Doubtful Accounts 8,000(2) Percentage-of-receivables (balance sheet) approach. Using past experience, a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts. This procedure provides a reasonably accurate estimate of the receivables’ realizable value. But, it does not fit the concept of matching cost and revenues. Rather, it simply reports receivables in the balance sheet at net realizable value. Hence, it is referred to as the percentage-of-receivables (or balance sheet approach). Companies may apply this method using one composite rate that reflects an estimate of the uncollectible receivables. The schedule of Wilson & Co. in Illustration it

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Wilson reports bad debt expense of $37,650 for this year, assuming that no balance existed in the allowance account.

To change the illustration slightly, assume that the allowance account had a credit balance of $800 before adjustment. In this case, Wilson adds $36,850 ($37,650 - 2 $800) to the allowance account and makes the following entry.

Bad Debt Expense 36,850

Allowance for Doubtful Accounts 36,850

Q1- R. Co. uses the gross method to record sales made on credit. On June 1, 2014, it made sales of $50,000 with terms 3/15, n/45. On June 12, 2014, R. co. received full payment for the June 1 sale. Required: Prepare the required journal entries for R. Co.SOL:June 1Accounts Receivable 50000 Sales Revenue 50000June 12Cash 48,500*Sales Discounts 1,500

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Accounts Receivable 50000*$50,000 – ($50,000 X .03) = $48,500Q2- Use the information from Q1, assuming R. Co. uses the net method to account for cash discounts.Required: Prepare the required journal entries for R. Co.SOL:June 1Accounts Receivable 48,500* Sales Revenue 48,500

June 12Cash 48,500 Accounts Receivable 48,500*$50,000 – ($50,000 X .03) = $48,500

Q3- E. Co. had net sales in 2014 of $1,400,000. At December 31, 2014, before adjusting entries, the balances in selected accounts were: Accounts Receivable $250,000 debit, and Allowance for Doubtful Accounts $2,400 credit. Required:1-If E. Co. estimates that 2% of its net sales will prove to be uncollectible, prepare the December 31, 2014, journal entry to record bad debt expense.2- Prepare the entry to record bad debt expense: a- Instead of estimating the uncollectibles at 2% of net sales, assume that 10% of accounts receivable will prove to be uncollectible. Prepare the entry to record bad debt expense.b- Instead of estimating uncollectibles at 2% of net sales, assume E. Co. prepares an aging schedule that estimates total uncollectible accounts at $24,600.SOL:1- Bad Debt Expense 28,000

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Allowance for Doubtful Accounts $1,400,000)X 2%) 28,0002- a- Bad Debt Expense 22600. Allowance for Doubtful Accounts [10%X $250,000 – $2,400] 22,600

2-b-Bad Debt Expense 22200

Allowance for Doubtful Accounts ($24,600 – $2,400) 22,200

Q4- Duncan Company reports the following financial information before

adjustments. DR. CRAccounts Receivable $100,000Allowance for Doubtful Accounts $ 2,000Sales Revenue (all on credit) 900,000Sales Returns and Allowances 50,000Required:Prepare the journal entry to record Bad Debt Expense assuming Duncan Company estimates bad debts at (a) 1% of net sales and (b) 5% of accounts receivable.SOL:a- Bad Debt Expense 8500 Allowance for Doubtful Accounts 8,500* *0.1% X ($900,000 – $50,000) = $8,500b-Bad Debt Expense 3000 Allowance for Doubtful Accounts 3,000**Step 1: .05 X $100,000 = $5,000 (desired credit balance in allowance account)Step 2: $5,000 – $2,000 = $3,000 (required credit entry to bring allowance account to $5,000 credit balance).

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Q5- On June 3, Arnold Company sold to Chester Company merchandise having a sale price of $3,000 with terms of 2/10, n/60, f.o.b. shipping point. An invoice totaling $90, terms n/30, was received by Chester on June 8 from John Booth Transport Service for the freight cost. On June 12, the company received a check for the balance due from Chester Company.Required:(a) Prepare journal entries on the Arnold Company books to record all the events noted above under each of the following bases.(1) Sales and receivables are entered at gross selling price.(2) Sales and receivables are entered at net of cash discounts.(b) Prepare the journal entry under basis 2, assuming that Chester Company did not remit payment until July 29.SOL:(a) 1-June 3Accounts Receivable 3000 Sales Revenue 3,000June 12Cash 2940Sales Discounts ($3,000 X 2%) 60 Accounts Receivable 3,000(2)June 3Accounts Receivable 2940 Sales Revenue ($3,000 X 98%) 2,940June 12Cash 2940 Accounts Receivable 2,940

((Chapter Four))

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Valuation of Inventories: A Cost-Basis Approach

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 . Identify major classifications of inventory.2. Distinguish between perpetual and periodic inventory systems.3 . Determine the goods included in inventory and the effects of inventory errors on the financial statements.4. Understand the items to include as inventory cost.5. Describe and compare the cost flow assumptions used to account for inventories.6. Explain the significance and use of a LIFO reserve.7. Identify the major advantages and disadvantages of LIFO.8. Understand why companies select given inventory methods.Identify major classifications of inventory:Inventories are asset items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold. The investment in inventories is frequently the largest current asset of merchandising (retail) and manufacturing businesses.

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Only one inventory account, Inventory, appears in the financial statements of a merchandising concern. A manufacturer normally has three inventory accounts: 1- Raw Materials: goods and materials on hand but not yetplaced into production. It include the wood to make a baseball bat or the steel to make a car. These materials can be traced directly to the end product.2- Work in Process: units are only partially processed. They report the cost of the raw materials on which production has been started but not completed, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, as work in process inventory3- Finished Goods: report the costs identified with the completed but unsold units on hand at the end of the fiscal period as finished goods inventory.

Distinguish between perpetual and periodic inventory systems

1- Perpetual System: A perpetual inventory system maintains a continuous record of inventory changes in the Inventory account. That is, a company records all purchases and sales (issues) of goods directly in the Inventory account as they occur.

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The perpetual inventory system provides a continuous record of the balances in both the Inventory account and the Cost of Goods Sold account.2- periodic inventory system: Under a periodic inventory system, companies determine the quantity of inventory on hand only periodically. A company debits a Purchases account, but the Inventory account remains the same.Comparing Perpetual and Periodic SystemsTo illustrate the difference between a perpetual and a periodic system, assume that F. Co. had the following transactions during the current year.

Beginning inventory 100 units at $6 5 $ 600Purchases 900 units at $65 $5,400Sales 600 units at $125 $7,200

Ending inventory 400 units at $65 $2,400Perpetual Inventory System Periodic Inventory System

Beginning inventory, 100 units at $6The Inventory account shows The Inventory account shows

the inventory on hand at $600. the inventory on hand at $600.

Purchase 900 units at $6

Inventory 5,400 Purchases 5,400 Accounts Payable 5,400 Accounts Payable 5,400

Sale of 600 units at $12

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(A) Accounts Receivable 7,200 Accounts Receivable 7,200 Sales Revenue 7,200 Sales Revenue 7,200

(B) Cost of Goods Sold 3,600 (No entry) (600 at $6) Inventory 3,600

End-of-period entries for inventory accounts, 400 units at $6

No entry necessary. Inventory (ending, by count) 2,400The Inventory account shows Cost of Goods Sold 3,600the ending balance of$2,400 Purchases 5,400 ($600 + $5,400 - $3,600). Inventory (beg.) 600

COSTS INCLUDED IN INVENTORYCompanies generally account for the acquisition of inventories, like other assets, on a cost basis. Product costs: are those costs that attach to the inventory and are recorded in the Inventory account. Such charges include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale.

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Period costs :are those costs that are indirectly related to the acquisition or production of goods. These changes, such as selling expense and general and administrative expenses, are therefore not included as part of inventory cost.Describe and compare the cost flow assumptions used to account for inventories. (1) Average-cost method: prices items in the inventory on the basis of the average cost of all similar goods available during the period.To illustrate use of the periodic inventory method (amount of inventory computed at the end of the period), Call-Mart computes the ending inventory and cost of goods sold using a weighted average method as follows:

In computing the average cost per unit, Call-Mart includes the beginning inventory, if any, both in the total units available and in the total cost of goods available.

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Companies use the moving-average method with perpetual inventory records. The following illustration shows the application of the average-cost method for perpetual records.

In this method, Call-Mart computes a new average unit cost each time it makes a purchase. For example, on March 15, after purchasing 6,000 units for $26,400, Call-Mart has 8,000 units costing $34,400 ($8,000 plus $26,400) on hand. The average unit cost is $34,400 divided by 8,000, or $4.30. Call-Mart uses this unit cost in costing withdrawals until it makes another purchase. At that point, Call-Mart computes a new average unit cost. Accordingly, the company shows the cost of the 4,000 units withdrawn on March 19 at $4.30, for a total cost of goods sold of $17,200. On March 30, following the purchase of 2,000 units for $9,500, Call-Mart determines a new unit cost of $4.45, for an ending inventory of $26,700.

(2) First-in, first-out (FIFO): assumes that a company uses goods in the order in which it purchases them. The inventory remaining must therefore represent the most recent purchases.To illustrate, assume that Call-Mart uses the periodic inventory system. It determines its cost of the ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the

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inventory. Call-Mart determines its ending inventory and cost of goods sold as shown in the following Illustration

Whereas, The following Illustration shows the inventory on a FIFO basis perpetual system for Call-Mart.

Here, the ending inventory is $27,100, and the cost of goods sold is $16,800 [(2,000 @ $4.00)+ (2,000 @ $4.40)]. Notice that in these two FIFO examples, the cost of goods sold ($16,800) and ending inventory ($27,100) are the same. In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used.(3) Last-in, first-out (LIFO): Matches the cost of the last goods purchased against revenue.9 The major advantages of LIFO are the following: (1) It matches recent costs against current revenues to provide a better measure of current earnings.

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(2) As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs in LIFO.(3) Because of the deferral of income tax, cash flow improves. The Major disadvantages are: (1) reduced earnings, (2) understated inventory, (3) does not approximate physical flow of the items except in peculiar situations, and (4) involuntary liquidation issues.If Call-Mart keeps a perpetual inventory record in quantities and dollars, use of the LIFO method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method.

LIFO Method—Periodic Inventory

Following illustration shows these differences under the perpetual method.

LIFO Method—Perpetual Inventory

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BASIS FOR SELECTION OF INVENTORY METHODCompanies ordinarily prefer LIFO in the following circumstances: (1) if selling prices and revenues have been increasing faster than costs and (2) if a company has a fairly constant “base stock. Conversely, LIFO would probably not be appropriate in the following circumstances: (1) if sale prices tend to lag behind costs, (2) if specific identification is traditional, and (3) when unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.EX: Amsterdam Company uses a periodic inventory system. For April, when the company sold 600 units, the following information is available. Unit Unit Cost Total CostApril 1 inventory 250 $10 $ 2,500April 15 purchase 400 12 4,800April 23 purchase 350 13 4,550 1,000 $11, 850Required: Compute the April 30 inventory and the April cost of goods sold using:

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1- the average-cost method. 2- FIFO method. 3- LIFO method.SOL:

1-

2-

3-

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Chapter Five

INVESTMENTS IN DEBT SECURITIES

Debt securities: represent a creditor relationship with another entity. Debt securities include government securities, corporate bonds, convertible debt, and commercial paper.

Companies have different motivations for investing in securities issued by other companies: One motivation is to earn a high rate of return. Another motivation for investing (in equity securities) is to secure certain operating or financing arrangements with another company.

Debt Investment Classifications: Companies group investments in debt securities into three separate categories for accounting and reporting purposes:

1. Held-to-maturity: Debt securities that the company has the

positive intent and ability to hold to maturity.

2. Trading: Debt securities bought and held primarily for sale

in the near term to generate income on short-term price

differences.

3. Available-for-sale: Debt securities not classified as held-to-

maturity or trading securities.

The following Illustration (1) identifies these categories, along with the accounting and reporting treatments required for each.

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Amortized cost: is the acquisition cost adjusted for the amortization of discount or premium, if appropriate.

Fair value: is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Held-to-Maturity Securities: Only debt securities can be classified as held-to-maturity. equity securities have no maturity date. A company should classify a debt security as held-to-maturity only if it has both:

(1) the positive intent and

(2) the ability to hold those securities to maturity.

Companies account for held-to-maturity securities at amortized cost, not fair value.

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To illustrate the accounting for held-to-maturity debt securities, assume that Robinson Company purchased $100,000 of 8 percent bonds of Evermaster Corporation on January 1, 2013, at a discount, paying $92,278. The bonds mature January 1, 2018 and yield 10%. Interest is payable each July 1 and January 1. Robinson records the investment as follows.

January 1, 2013

Debt Investments 92,278

Cash 92,278

Following illustration shows the effect of the discount amortization on the interest revenue that Robinson records each period for its investment in Evermaster bonds.

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Robinson records the receipt of the first semiannual interest payment on July 1, 2013)using the data in Illustration 2), as follows.

July 1, 2013

Cash 4,000

Debt Investments 614

Interest Revenue 4,614

Because Robinson is on a calendar-year basis, it accrues interest and amortizes the discount at December 31, 2013, as follows.

December 31, 2013

Interest Receivable 4,000Debt Investments 645 Interest Revenue 4,645Again, Illustration 2 shows the interest and amortization amounts.

Robinson reports its investment in Evermaster bonds in its December 31, 2013, financial statements, as follows.

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Available-for-Sale Securities: Companies record the unrealized gains and losses related to changes in the fair value of available-for-sale debt securities in an unrealized holding gain or loss account. adds this amount to other comprehensive income for the period. companies report available-for-sale securities at fair value on the balance sheet but do not report changes in fair value as part of net income until after selling the security. This approach reduces the volatility of net income.

To illustrate the accounting for available-for-sale securities, assume that Graff Corporation purchases $100,000, 10 percent, five-year bonds on January 1, 2013, with interest payable on July 1 and January 1. The bonds sell for $108,111, which results in a bond premium of $8,111 and an effective-interest rate of 8 percent. Graff records the purchase of the bonds as follows.

January 1, 2013

Debt Investments 108,111

Cash 108,111

Illustration 3 discloses the effect of the premium amortization on the interest revenue Graff records each period using the effective-interest method

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The entry to record interest revenue on July 1, 2013, is as follows.

July 1, 2013

Cash 5,000Debt Investments 676 Interest Revenue 4,324

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At December 31, 2013, Graff makes the following entry to recognize interest revenue.

December 31, 2013

Interest Receivable 5,000Debt Investments 703 Interest Revenue 4,297

As a result, Graff reports revenue for 2013 of $8,621 ($4,324 + $4,297).

To apply the fair value method to these debt investments, assume that at year-end the fair value of the bonds is $105,000 and that the carrying amount of the investments is $106,732.

Comparing this fair value with the carrying amount (amortized cost) of the bonds at December 31, 2013, Graff recognizes an unrealized holding loss of $1,732 ($106,732 - $105,000). It reports this loss as other comprehensive income. Graff makes

the following entry.

December 31, 2013

Unrealized Holding Gain or Loss—Equity 1,732

Fair Value Adjustment (available-for-sale) 1,732

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