ACCT 3860 Chapter 8 (exam 3)

remaining of Ch7 too

Subsequent Valuation of Notes Receivable

companies must estimate bad debts (credit losses) on notes receivable, and use an Allowance account

this is similar to AR accounting

3 parts:

• loan modification

• Fair Value Option

• public business entities MUST disclose fair value of Notes Receivable in the notes to FS (or parenthetically on BS)

  • private companies no longer required to disclose it

Loan Modification

If the borrower faces financial difficulties, a company grants concessions to the borrower (forgives principal, lowers the interest rate, delays payments, or extends the term)

lender accounts for it like any other modification: a new loan or a continuation of the existing loan

lender discloses these modifications in the notes to financial statements

no Special “troubled debt restructuring” (TDR) accounting for lenders since ASU 2022-02 (fiscal years beg Dec 15, 2022) - TDR accounting remains for borrowers onky

Fair Value Option

companies may choose to value the receivable at fair value instead of cost

• use “Unrealized Holding Gain or Loss - Income” account I/S (for changes in fair value)

• adjust the receivable account up or down each reporting period

• must Consistently (cannot change) use the fair value option for the receivable

Financing with Receivables - 3 conditions

3 conditions that must be met to treat a financial arrangement as a sale of receivables (indicative of seller surrendering control over the assets transferred)

1. Receivables are beyond the reach of the seller and its creditors

2. Buyer has right to pledge or exchange receivables

3. Seller does not maintain effective control over the receivables

Does the arrangement meet all 3 conditions for treatment as a sale of receivables? NO

Secured Borrowing: Assign or Pledge

• Assign: specific receivables used as collateral; borrow money with collateral (A/R)

  • record liability (Notes Payable)

  • record interest expense

• Pledge: the entire receivables balance is used as collateral; borrow money with A/R as collateral

  • disclose arrangement

  • often a revolving line of credit

Does the arrangement meet all 3 conditions for treatment as a sale of receivables? YES

Sale of Receivables (factoring): factor without recourse or factor with recourse

• Factor without recourse: buyer assumes risk of bad debts; sell A/R

  • record loss or gain on sale

• Factor with recourse: seller retains risk of bad debts; sell A/R and liability in journal entries

  • record loss or gain on sale

  • recognize recourse liability

    • recourse liability affects amount of gain or loss on sale of receivables

Note not issued at face value, zero-interest bearing note

if a 3 yr note is $10,000 and pv is $7,721.80 / mkt rate is 9%

interest revenue and discount (premium) amortized will be the same each year, put discount at top of schedule and FV at bottom and multiple that by mkt rate, same as usual

journal entries:
at issuance, dr NR at FV, cr cash at PV, cr discount (OR dr premium)
end of each yr, dr discount and cr Interest revenue

end, dr cash, cr NR at FV

Balance Sheet Presentation of NR

Discount, contra asset account:

Notes Receivable

Less: Discount on NR

= Carrying Value

FV:

Notes Receivable

= carrying value

Premium:

Notes Receivable

Add: Premium on NR
= carrying value

Secured Borrowing vs Factoring Journal Entries (ex 14, ch 7, pg 18)

Secured Borrowing (assign): borrowing
dr cash

cr NP
borrowing w AR as collateral

dr Cash (AR * %receivables collected)
cr AR (same amt)

dr Notes payable (entire principal)
dr Interest Exp (principal interest (1/12 if one month))

cr Cash (2 amts added together)

Factoring Without Recourse: transferring

dr cash (amt borrowed * 100% - %bank fee)

dr loss on sale of receivables (amt borrowed * % bank fee)

cr AR (amt transferred)
sale of AR without recourse

unsold remaining AR (beg AR - trasnferred amt = x * %receivables collected)

dr cash
cr AR

Factoring with and without Recourse

With Recourse:

dr Cash (1) → remittance (AR transferred*90% remittance) - fee paid to bank (AR transferred * %fee to bank)

dr Loss on sale of receivables (5)

dr Receivables (due) from factor (3) (due from bank = given estimated fair value)

cr Recourse Liability (4)
cr AR (2)

Without Recourse:

dr cash (AR transferred* 90% remittance) (1)
dr Loss on sale of receivables (4 - filler number)
Receivables from factor (due from factor) → fv of 10% retained of AR - (amt transferred*%fee of total factored amt) (3)
cr AR (amt transferred) (2)

Flow of costs for a manufacturing company

1. raw materials purchased (dr raw materials)

2. direct labor incurred (dr direct labor)

3. Manufacturing Overhead (dr MO)

4. Raw materials used (cr raw materials)
   direct labor applied (cr direct labor)
   MO applied (cr MO) → 4-6 equals debit amt in WIP
   Work in process transferred to finish goods (cr WIP) → becomes dr amt in Finished goods

5. Finished Goods Sold (cr finished goods) → COGS

Inventory Equation

Beg Inventory, Cost of Goods Purchase → Cost of Goods Available for Sale

Cost of goods available for sale → COGS, Ending Inventory

Perpetual Inventory System

maintain a continuous record of inventory changes

• debit purchases and freight-in to Inventory account

• credit purchase returns and allowances and purchase discounts to the Inventory Account

• debit COGS and credit Inventory for each sale transaction

Periodic Inventory System

update inventory records periodically

• debit purhcases to purchase account

• debt freight-in and credit purchase returns and allowances AND purchase discounts

  • COGS is computed at the end of the period

COGS and inventory and GP equations

COGS = Cost of goods available for sale - ending inventory

Beg Inv + purchases + freight in - purchase returns and allowance - purchase discounts - COGS = End Inv

Net Sales - COGS = GP

Inventory Control

Periodic Verification - all companies need periodic verification of the inventory records

Periodic Inventory Accounts - companies should perform the periodic inventory accounts near the end of their fiscal year

under periodic system: any shortage becomes part of COGS

Inventory Control: If there is a difference bw perpetual inventory balance and physical inventory account

dr Inventory Over/short
Cr Inventory

Pg 3

What affects inventory?

physical goods included in inventory

inventory costs

Cost Flow Assumptions

Physical Goods included in Inventory

in theory: record purchases when the company obtains legal title to the goods

in practice: often record inventory when the good are received (with exceptions)

• FOB shipping point - inventory is buyer’s at time of delivery to the common carrier (not seller’s as soon as reach carrier)

• Goods on Consignment - seller’s (consignor’s), Not consignee’s (shop)

• FOB destination - buyer’s after it reaches the destination

• Sales Returns - seller’s for estimated returns (dr Estimated Inventory Returns)

• Sales with Buybacks - (repurchase agreements) seller’s, not buyer’s (acts more as collateral)

• Installment sales - Buyer’s if the seller can estimate collectability of cash payments (car w a loan)

Inventory Costs

B/S amount in Inventory account

Generally accounted for on a cost basis

Parts:

• Product Costs - inventoriable accounts

• Period Costs are NOT

• Purchase returns - reduce inventory

• Purchase Discounts (gross vs net method)

example 3, pg 6 and 1 pg5

Product Costs

Inventoriable accounts on the Balance Sheet, include

• Purchase price of merchandise

• Freight-In on purchases

  • note - shipping charge on outgoing goods (freight-out) are Not part of the cost of inventory (COGS or Selling Exp)

• Insurance paid on purchases (sugar)

• Labor and other production costs incurred (direct material + direct labor + manufacturing overhead) → inventory

Period Costs

NOT inventoriable accounts (I/S)

indirect costs (selling and admin costs)

Purchase Discounts

Gross Method, record purchase at 100%

• record purchase at full invoice price

• use Purchase Discounts for discounts taken within the discount period (a contra account to the Purchases account)

Net Method, record at discounted price

• record purchases assuming purchase discounts will be taken

  • debit Purchase Discounts Lost account for discounts not taken (an “other expense” account on I/S)

Gross Method Journal Entries - perpetual

purchase:

dr Inventory (if periodic, “Purchases”)

cr A/P

paid within discount period:
dr A/P

cr Cash

cr Inventory (“Purchase Discount” if periodic)

not within discount period:

dr A/P

cr Cash

Net Method - perpetual

at purchase:

dr Inventory (amt times price times 98%)

cr A/P

within discount period:

dr A/P

cr Cash

outside discount period:

dr A/P (amt times price times 98%)

dr Purcahse Discount lost (same for periodic and perpetual)

cr Cash (100% of invoice amt)

Cost Flow Assumptions

do not need to match the physical movement of the goods

method adopted should be the one which most clearly reflects periodic income

FIFO, LIFO, Avg Cost, & specific identification

Specific Identification

COGS = cost of specific items sold (cars w VINS, pieces of art)

Ending Inventory = cost of specific items on hand

Advantage: better matching of revenues and expenses

Disadvantage: not feasible for many businesses with high volumes of products sold

Average Cost - Periodic System

calculate average cost of inventory available during the period → weighted average

• ending inventory = average cost per unit times units on hand

• COGS = COGAS - ending inventory

Average Cost - advantage

simpler to apply, not subject to income manipulation

Average Cost - Perpetual System

calculate a new average cost whenever a purchase is made - moving average

• COGS = moving-average cost times units sold

• Ending inventory = COGAS - COGS

FIFO

first goods purchased are the first sold or used

• COGS = Cost of the oldest units available for sale

• Ending inventory = cost of most recent purchase

no difference in cost for periodic or perpetual system

FIFO adv/disadv

Advantage: approximates the physical flow of goods

FIFO tends to reflect the current costs on the B/S

Disadvantage: current costs are not matched against current revenues on the I/S

LIFO

assumes most recent inventory costs are first costs recorded for goods manufactured or sold

• COGS = Cost of most recent units available for sale

• Ending Inventory = Cost of the oldest units

results in different ending inventory and COGS when using perpetual and periodic methods

LIFO periodic vs perpetual

Periodic system matches the total withdrawals for month with total purchases for the month

Perpetual system matches each withdrawal with the immediately preceding purchase

IFRS Implications

IFRS does not allow LIFO
convergence bw IFRS and GAAP would mean all US corporations to use FIFO

inventory prices increase → inventory costs increase

COGS under LIFO is higher than COGS under FIFO, meaning that gross profit would decrease (bc sales - the higher COGS = lower gp) and taxable income would decrease

LIFO Conformity Rule

If LIFO is used for tax purposes (IRS) then it MUST be used for financial reporting purposes (10-ks)

LIFO reserve

• many companies keep internal inventory records on FIFO or average cost during the yr, but use LIFO for financial reporting and taxes

• at end of period, they need to adjust the inventory from FIFO or avg cost to LIFO

LIFO Reserve - accounts, journal entry, effect

• the difference bw 2 amounts is recorded as a contra account to Inventory

  • account is LIFO reserve or LIFO allowance

• journal entry records only the change in the reserve (ending balance - beg balance)

  • reserve goes up: Dr. COGS and Cr. LIFO Reserve

  • reserve goes down: Dr. LIFO reserve and Cr. COGS

• decrease in LIFO reserve creates lower COGS and higher NI

LIFO liquidation

when a company sells more units than it buys, using up older layers

distorts gross profit

LIFO liquidation is a problem bc it distorts NI

pg 14 chart

LIFO layers

each yr a company buys more units than it sells, it adds a new LIFO layer at that yr’s costs. older years stay at their old costs

lifo liquidation

those older costs go to COGS and are matched against current sale prices

when prices are rising, the result is lower COGS, higher NI, and a higher tax bill

Methods for Simplifying LIFO

previously discussed LIFO methods are called unit LIFO because the concept is applied to each individual unit of inventory

this approach can be costly to implement

Solutions: LIFO Inventory Pools and Dollar-Value LIFO (DVL)

LIFO Inventory Pools

• within the pool, all purchases during the period are considered to have been made at the same time and at the same cost

• Individual unit costs become the average costs for the pool

  • method is not perfect: company may discontinue a product within a pool - periodic redefining of pools is time-consuming

LIFO Inventory Pools - Advantages

• simplifies recordkeeping by grouping inventory into pools based on physical similarities (hardwood, lumber, paneling, plywood)

• reduces risk of layer liquidation (various types of inventories in the pool offset each other in terms of cost increases and decreases)

DVL

• Pools are not based on physical units

• inventory pool is viewed as consisting of layers of dollar value from different periods - focus is on the value of inventory, not units of inventory

• use inflation cost indexes (ex. CPI) to make changes in inventory from period to period comparable

DVL Advantages

• DVL simplifies recordkeeping compared to unit LIFO

• Minimizes the liquidation of LIFO layers probability

• Useful for firms that do not replace units in pools with very similar units (ex. annual model changes)

Compute COGS Periodic FIFO (example 7)

EI = units available for sale - units sold

EI * most recent purchasing price = x

COGS = COGAS - EI

Compute COGS Perpetual FIFO (example 7)

can use this method, even if periodic FIFO bc FIFO produces same EI and COGS

COGS = beg inv sold (quantity*price) + next purchase sold (quantity*price) + part of 2nd purchase if need remaining for units in EI

Compute COGS/EI Periodic LIFO (example 7)

COGS = last purchase/most recent Sold + part of next most recent purchase Sold (determine amt needed by calculating overall units sold - most recent purchase

EI = beg inv calculated + remaining of purchase*price

Check: COGAS - EI (just calculated) = COGS

Compute COGS/EI Perpetual LIFO (example 7)

be careful, tricky

COGS = most recent sale (quantity*price of most recent purchase) + previous sale (quantity of sale - quantity of previous purchase*previous purchase price + remaining Q of sale from BegInv*beg inv price)

EI = COGAS - COGS

Compute COGS/EI Periodic Weighted Average (example 7)

Cost per Unit = COGAS / units available for sale

COGS = units sold * cost per unit

EI = units in EI * cost per unit

Compute COGS/EI Perpetual Moving Average (example 7)

In order, as transactions go

COGAS #1 = beg inv Q * beg inv P + purchase1 Q *purchase1 P

cost per unit #1 = COGAS #1 / (beg inv Q + p1 Q)

COGS #1 = sale 1 quantity * cpu1 (units left is beg inv + p1 - sale)

COGAS #2 = units left * cpu1 + purchase 2 (Q*P)

cost per unit #2 = cogas2 / (units left + purchase2)

COGS #2 = sale 2 units * cpu2

COGS = COGS1 + COGS2

EI = units in EI * cpu2

dollar-value LIFO Example 9, pg 17

Given: EI at Year-end costs And Cost Index

divide EI at year-end costs by cost index = Base Year, determine change each year

to get EI each year:
end yr 1, base costs + amt change * cost index = y

end yr 2 = y + amt change * new cost index = z

end yr 3, if amt change is negative instead of positive = y (amt change yr 2 - amt decrease yr 3) * yr 2 cost index

cross out year’s cost index if change is negative, add base year to chart, if negative change is greater than prior years positive increase, take from year before that and use THAT year’s cost index