ACCT Final Exam Notes

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1 LO1: Identify the different types of receivables. - The term receivables refers to amounts due from individuals and businesses. They are claims expected to be collected in cash and are important, as they represent one of an entity s most liquid assets and for some, one of the largest assets. - Accounts receivable are amounts owed by customers on account; generally collected within days. - Notes receivable are claims for which formal instruments of credit are issued as evidence for the debt. The instrument normally requires the debtor to pay interest and extends for time periods of days or longer. - There are three main accounting problems associated with accounts receivable, which are: 1. Recognising accounts receivable; 2. Valuing accounts receivable; and 3. Accelerating cash receipts from receivables. - Recognising accounts receivable is relatively straightforward. For a service entity, a receivable is recorded when a service is provided on account. For a merchandiser, accounts receivable are recorded at the point of sale of goods on account. Receivables are also reduced as a result of sales discounts and sales returns. LO2: Apply methods used to account for receivables, including bad debts. - Valuing accounts receivable is more complex. While each customer must satisfy the credit requirements of the seller before the sale is approved, some receivables become uncollectable (i.e. customer defaults on the transaction). Therefore, unrecoverable receivables are written off according to two methods: - Direct Write-Off Method: assumes all receivables will be collected, with a bad debt recognised only when the entity knows it will not be pid (evidence-based), while accounts receivable is reported at its gross amount on the statement of financial position. After writing off bad debts, the new gross amount for accounts receivable is recorded on the statement of financial position. - PROBLEM: under this method, the bad debts expense account is often recorded in the period following that in which the revenue was recorded. Therefore, it is not until the account receivable has been outstanding for a while that it becomes apparent that is uncollectable; making it unacceptable for financial reporting purposes. - Allowance Method: recognises that not all receivables will be collected, with accounts receivable recorded on the balance sheet at its net amount. - The allowance method is used in order to give financial statement users a more accurate picture and involves three main steps. Allowance for Doubtful Debts is used as a contra asset account, instead of a direct credit to Accounts Receivable, as we would not know which customers are not going to pay. The credit balance is the allowance account will absorb the specific write-offs when they occur.

2 1. Recording estimated uncollectables - a journal entry is made as an adjustment at the end of the period to established the allowance for bad debts: DR Bad Debts Expense CR Allowance for Doubtful Debts (To record estimate of uncollectable amounts) 2. Recording the write-off of an uncollectable amount - when all methods of collecting a past-due account have been exhausted, the account should be written off: DR Allowance for Doubtful Debts CR Accounts Receivable - Customer X (To record the write-off of Customer X) 3. Recovery of an uncollectable account - in some scenarios, a debt may be collected AFTER it has been written off as uncollectable, in which case two journal entries are required: DR Accounts Receivable - Customer X CR Allowance for Doubtful Debts (To reverse the write-off of Customer X) DR Cash CR Accounts Receivable - Customer X (To record the collection from Customer X) - AASB 139 suggests using the allowance is far more beneficial as it meets the criteria of recording receivables initially at fair value and subsequently at amortised cost. If a receivable has been impaired, its carrying amount is written down to its recoverable amount, which is the present value of cash flows expected to be derived. 4. Estimation of the allowance - two methods; the percentage of net sales OR ageing of accounts receivable.! Percentage of net sales - involves calculating the additional estimated bad debt by taking a % of net sales made during the period. This amount is then added to the balance of Allowance for Doubtful Debts.! Ageing of accounts receivable - involves preparing a schedule in which customer balances are classified by the length of time they have been unpaid. The balance of Allowance for Doubtful Debts is then adjusted to bring it up (or down) to the new amount calculated. LO3: Describe how receivables are reported in financial statements. - For external financial reporting, receivables are classified as current (mature within 12 months or the entity s operating cycle) or non-current assets on the statement of financial position. Details regarding receivables, their maturity and the allowance for doubtful debts are disclosed in the notes to the financial statements. LO4: Explain the principles of receivables management. The principles of receivables management concern five aspects: Extending credit - a firm needs to be careful that it does not end up with risky customers from extending its credit policy who cannot, or will not, pay their debt. However, steps such as requiring letters of credit or bank guarantees (as well as reference letters to check financial health) from risky customers can minimise losses.

3 Establishing a payment period - must be consistent with that of periods set by competitors. Ensuring that customers are aware of the payment policy is essential, with discounts encouraging sales. Monitoring collections - credit risk refers to the threat of non-payment of receivables, which could impair the entity s financial position. Analysing the credit risk ratio is one method of monitoring receivables. Increases in ratio may suggest increased extension of credit to questionable customers, which may require the evaluation of credit policies. Credit risk ratio (%) = Allowance for Doubtful Debts / Accounts Receivable Evaluating the receivables balance - the relationship between sales, accounts receivable and cash collections is extremely important. A disproportionate increase in accounts receivable may signal that the entity increased its sales by loosening its credit policy, resulting in less liquid receivables. The receivables turnover measures the number of times, on average receivables are collected during the period. The average collection period ratio is used to assess the effectiveness of credit and collection policies; general rule is the collection period should not greatly exceed the credit term period (i.e. time allowed for payment). An increase in this ratio may suggest a decline in the financial health of the entity s customers. Receivables Turnover (times) = Net Credit Sales (Net Sales - Cash Sales ) / Average Net Receivables Collection Period (days) = 365 / Receivables Turnover Accelerating cash receipts - offer incentives for prompt payment (settlement discounts) and the use of credit card sales (increase sales without bad debts). LO5: Identify the principles of internal control. - Internal control consists of all the processed and policies implemented by management to provide effective and efficient operations, compliance with laws, safeguard assets and enhance the completeness, accuracy and reliability of accounting records. There are five main principles: 1. Establishment of responsibility: assign responsibility to specific individuals and monitoring the compliance of enforced procedures/practices. 2. Segregation of duties: responsibility for related activities are assigned to different people, especially tasks involving the recording and physical handling of the asset. 3. Documentation procedures: all documents generated by the business to be pre-numbered and initiallied to provide an audit trail for the checking of transactions. 4. Physical, mechanical and electronic control: use of safes, alarms, passwords and time clocks. 5. Independent internal verification: checking procedures to ensure segregation of duties, monitoring by supervisors, verification by internal auditors and a rotation of duties. The limitations of internal control include: - Cost vs. Benefit: cost of establishing procedure should not exceed expected benefit. - Human element: fatigue, carelessness, indifference. - Collusion: two or more individuals who work together to get around controls. - Size of business: larger businesses may find it tough to reduce fraudulent behaviour. LO6: Explain the application of internal control principles. - Cash is the most desirable asset, consisting of cash on hand, cash at bank, cheque accounts and equivalents. - Internal control over cash receipts: authorised personnel handle cash receipts, different individuals handle cash, remittance advices and cash register tapes, cash stored securely in safes and banked frequently as well as counted daily and compared to bank deposits (via the bank reconciliation). LO7: Discuss the basic principles of cash management. - Basic principles of cash management: increase the speed of collection of receivables, keep inventory levels low, don t pay earlier than necessary, plan the timing of major expenditures and invest idle cash. The ratio of cash to daily cash expenses evaluates whether cash on hand is adequate to meet its daily needs. A low measure should be investigated, as additional financing may be necessary. Cash to Daily Cash Expenses = Cash / Average Daily Cash Expense.

4 Recording, Analysing, Managing and Reporting Non-Current Assets LO1: Describe how the cost principle applies to property, plant and equipment assets. - The cost principle dictates that all assets are initially recorded in the accounts at their purchase price or cost. This applies not only at the time the asset is purchased, but also over the time it is held. - Property, plant and equipment (PPE) refer to assets that have physical substance (definite size and shape), are used in the operations of an entity for more than one period, and are not intended for sale to customers. They are generally long-lived and expected to provide future economic benefits for a number of years. - AASB 116 requires the decline in economic benefits derived from the use of an asset to be recognised on a systematic basis over the asset s useful life. This decline is recognised as the depreciation expense in the income statement and as accumulated depreciation (contra asset account) in the balance sheet. - PPE assets are subdivided into two classes: property (includes land, buildings and land improvements such as driveways and fences) and plant and equipment (e.g. cash registers, computers, furniture and vehicles). - PPE assets are initially recorded at cost in accordance with the cost principle. AASB 116 states cost refers to the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset. For constructed or built assets, costs are accumulated until the asset is ready for its intended use. Fair value refers to the amount for which an asset could be exchanged between knowledgeable willing parties in an arm s-length transaction. - The cost of an asset consists of the fair value of all expenditure necessary to acquire the asset and make it ready for its intended use (e.g. purchase price, freight costs, installation costs). This excludes non-capital expenditure (such as replacing tyres or a windscreen of a company vehicle), which are expensed immediately. - For property, the cost of land includes: purchase price, settlement cost (e.g. solicitor s fees), stamp duty and accrued property taxes (assumed by purchaser). For plant and equipment, the cost includes: purchase price, freight charges and insurance during transit paid by the purchaser. It also comprises expenditures required in assembling, installing and testing the unit (however, registration and insurance are treated as expenses). Two points to consider in determining the cost of equipment are: the frequency of the cost (one-off or recurring) and the benefit period (the life of the asset or just 1 year). LO2: Explain the concept of depreciation. - Depreciation refers to the process of allocating to expense the cost of a PPE asset over its useful (service) life in a rational and systematic manner. Such cost allocation is designed to properly recognise expenses in line with the period concept. - The journal entry to record depreciation for the period is to debit the Depreciation Expense account and credit not the asset account where the cost was recorded, but to a separate account, Accumulated Depreciation. It is a contra asset asset, and is reported as an offset to or reduction from a related account, the PPE asset. In the statement of financial position, the carrying amount (or book value) = cost less accumulated depreciation, is reported, while the original cost of the PPE asset and accumulated depreciation information are provided as a note for statement users. - Depreciation applies to land improvements, buildings, and plant and equipment (all depreciable assets), as their usefulness and revenue-generating ability decline over the asset s useful life. Exception: land. - AASB 116 outlines 4 factors that contribute to the decline in economic benefit: usage of the asset (determined by the expected capacity or physical output), wear and tear through physical use of the asset (e.g. a truck s exposure to salt air and rain), technical and commercial obsolescence (out of date before it physically wears out; revenue-producing ability of the asset declines as there is a fall in the demand for the good or service produced by that PPE asset) and legal life (expiry of a lease). - There are 3 factors that affect the calculation of depreciation: cost, useful life (an estimate of the expected productive life of the asset, expressed in time, units of activity/output) and residual value (an estimate of the asset s value at the end of its useful life; based on its worth as scrap or salvage or on its trade-in value). LO3: Calculate the depreciation using various methods and contrast the expense patterns of the methods. - Management chooses the method they believe best measures an asset s decline in future benefits over its useful life; but must remain consist, as it enhances the comparability of financial statements over periods.

5 Recording, Analysing, Managing and Reporting Non-Current Assets! Straight-line method: depreciation expense is the same for each year of the asset s useful life, as the future benefits are consumed at the same rate each year. This methods depreciates assets appropriately when its use is reasonably uniform throughout its service life (daily use doesn t affect productivity, e.g. buildings, furniture). Cost - Residual Value = Depreciable Amount Depreciable Amount / Useful Life (Years) = Depreciation Expense.! Diminishing balance method: is an accelerated method, as the depreciation expense is higher in the early years of an asset s life. However, it still produces a decreasing annual depreciation expense over the useful life, as the depreciable amount remains the same. Managers might choose this approach if they think an asset s usefulness will decline very quickly (i.e. future economic benefits are obtained in the earlier years). Carrying Amount (beginning of the year) x Diminishing Balance Rate = Depreciation Expense.! Units-of-production method: has the useful life expressed in terms of the total units of production or the use expected from the asset. It is ideally suited to factory machinery (output or machine hours). Depreciation Amount / Total Units of Production = Depreciation Cost per Unit Depreciation Cost per Unit x Units (during the year) = Depreciation Expense. - Periodic depreciation varies considerably among the methods, but total depreciation is the same for the 5-year period. Annual depreciation expense should also be reviewed yearly, because if there is a significant change in the consumption of future benefits, the method should correspondingly change. LO4: Account for subsequent expenditures. - During an asset s useful life, a firm may incur costs for ordinary repairs, which are expenditures to maintain the operating efficiency and expected productive life of the asset. They are fairly small amounts that occur frequently throughout the service life (e.g. replacing parts on aircraft and repainting buildings) and are debited to Repair and Maintenance Expense as incurred (operating component of the Income Statement). On the other hand, additions and improvements, are expenditures incurred to increase the the operating efficiency, productive capacity or expected useful life of the PPE asset. They are usually material in amount and occur infrequently during the period of ownership, being capitalised and depreciated over the remaining useful life. LO5: Account for the disposal of property, plant and equipment assets. - PPE assets can be disposed of via a sale, scrapping or exchange. Whatever the disposal method, the entity must determine the carrying amount (cost - accumulated depreciation to date) of the asset at the time of disposal. If the disposal occurs at any time during the year, depreciation for the portion of the year to the date of disposal must be recorded. The carrying amount is then eliminated by reducing (debiting) Accumulated Depreciation for the total depreciation associated with that asset and reducing (crediting) the asset account. LO6: Indicate how non-current assets are reported in the statement of financial position. - AASB 101 gives minimum classification of assets which must be shown on the balance sheet. Under the noncurrent assets heading, property, plant and equipment, intangibles and agricultural/biological assets are listed separately. Also, assets intended for sale rather than use are reported at the lower of carrying amount and fair value less costs to sell.

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