CPA FAR F3

Where should restricted cash be disclosed?

• The nature, amount, and timing of restrictions should be disclosed in the footnotes

  • If the restriction is associated with a current asset or current liability. Classify as a current asset separate from unrestricted cash

  • If the restriction is associated with a non-current asset or non-current liability, classify as a non-current asset but separate from either the investments or other assets section

Bank Reconciliation

• Bank reconciliations explain the difference between the cash balance reported by the bank and the cash balance per the depositor’s records

• Goal is to calculate the “true balance”

Steps in a Simple Bank Reconciliation

1. After the adjustments are made:

2. Adjust book balance to reflect any corrections reported by the bank

   1. Adjusted book balance = True balance

3. The bank balance per the bank statement is reconciled to the “true balance”

Reconciliation of Cash Receipts & Disbursements

• Commonly referred to as the four-column reconciliation or proof of cash

• Serves as a proof of the proper recording of cash transactions

• The objective of the four columns is to reconcile any differences between:

  • The amount the depositor has recorded as cash receipts; and

  • The amount the bank has recorded as deposits

Net Realizable Value

• NRV means the amount to be collected; however, it may be adjusted for:

  • Sales discounts

  • Current expected credit losses (CECL)

  • Sales returns & allowances

Valuation of Accounts Receivable with Discounts

• Accounts receivables are generally valued at the historical cost, net of estimated credit losses, but may be adjusted for discounts

• Discounts are allowed to:

  • Encourage prompt payments for a sale

  • Avoid spending time chasing payments

Accounting for Sales Discounts (Gross Method)

• Ignore the offered discount on the sale

• If payment is received within the discount period

  • Record the difference between the receivables and the discount

  • A sales discount (contra-revenue) account is debited to reflect the sales discount

Accounting for Sales Discounts (Net Method)

• Assume net discount is offered on sale

• Record net revenue and receivables

• If payment is not received within the discount period

  • Record additional revenue

  • Credit “sales discount not taken” account (supplemental revenue account)

• Recording revenue in different accounts doesn’t affect total revenue

Current Expected Credit Loss (CECL) Method

• Once collection for goods or services provided is determined to be probable, an estimate of expected credit losses over the life of the receivable should be recorded

• Balance in allowance for uncollectibles should be based on

  • Past experiences 

  • Current conditions

  • Future expectations

• The allowance should take into account the possibility of credit losses over the entire life of each receivable

• A percentage of each period’s ending A/R is estimated to be uncollectible

• The allowance for expected credit losses is reviewed and adjusted each reporting period for changes to customer credit risk

Direct Write-off Method (Not GAAP)

• Used for federal income tax purposes

• The account is written off and the credit loss expense (or bad debt expense) is recognized when the account becomes uncollectible

• Doesn’t properly match the credit loss expense (or bad debt expense) with revenue

• Accounts receivable are always overstated

• There is no allowance account

• No attempt is made to estimate current expected credit losses included in the balance on the financial statements by IRS

Computing the Allowance for Credit Losses

• The allowance for credit losses is reviewed and adjusted each reporting period for changes to customer credit risk

• The method used to determine the estimate of current expected credit loss should be applied consistently by management each reporting period

• The method for many companies is similar to a traditional aged receivable analysis

  • A schedule is prepared categorizing invoices by number of days or months outstanding

  • Each category’s total amount outstanding is then multiplied by a percentage representing a credit loss rate for that aging category

Write-off of a Specific Accounts Receivable

• The entry to record credit loss expense and the allowance for expected credit losses is a general estimate, as it is unknown which customer will default on paying its receivable

• Original entry is to debit credit loss expense and credit the allowance for expected credit losses

• To remove the allowance, debit the allowance for credit losses

• Credit accounts receivable for the same amount in order to get rid of the matching receivable

• Additional credit loss can be recorded if there is a significant balance in A/R

• The allowance account will also need to be credit

Pledging

• A company uses the existing accounts receivable and assigns it as collateral for a loan

• Company retains title to the receivables

• Company “pledges” it will use the proceeds to pay loan

• Pledging requires footnote disclosure only

  • A/R account isn’t adjusted and not taken off the books

• Pledging facilitates the company in getting a loan

Factoring of Accounts Receivable

• Buyer of the A/R is known as a factor

  • Factoring is considered a sale of receivables

  • Or converting receivables to cash

• Factoring is opted for when:

  • The company doesn’t want to deal with collecting receivables from delinquent customers or writing off bad debt

• The company chooses to convert the receivable into cash by assigning it to a factor

• Factoring can be done with or without recourse

• Under factoring arrangements, the customer doesn’t need to be notified

• Factoring without recourse is similar to true sale

Sale (A/R)

• In order to be considered a sale, the transfer must meet the following conditions

  • The transferor’s (seller’s) obligations for uncollectible accounts can be reasonably estimated

  • The transferor surrenders control of the receivables to the buyer

  • The transferor cannot be required to repurchase the receivable

    • The transferor may be required to replace them with new receivables

  • If any of the above conditions are not met, the transfer is treated as a loan

Subledger

• When there are large volumes of transactions, a subsidiary ledger (or subledger) is often used to record the details

• A subledger is used to record and store detailed information, which is summarized in the control account in the general ledger

• The control account in the general ledger will reflect single-line totals for items such as:

  • Trade receivables

  • Inventory

  • PP&E

  • A/P & and accrued liabilities

Reconciliation Process: Trade Receivable

• The reconciliation process should be done at least monthly and is often performed electronically due to the volume of date

• The process involves first comparing the total from the receivables subledger accounts to the overall balance of receivables in the general ledger

• If there are differences, transactions in both ledgers must be reviewed and compared

• Once the discrepancies are identified and the locations of the necessary adjustments are determined, either:

  • Adjusted journal entries will be recorded in receivables in the general ledger

  • Updates will be made to the receivables subledger

• The process is complete when the adjusted balances are equal

Valuation and Presentation of Notes Receivable

• Unearned interest and finance charges are deducted from the face amount of the related promissory note

  • Accrue earned interest over time, when money is not received

  • Present Value = Face value - Unearned interest

  • Value of the note should be determined by imputing the market rate of interest

  • No one borrows money for nothing

• Notes receivable are similar to trade receivable

• The initial value of the note receivable is adjusted for current expected credit losses

• The value of the note receivable must reflect an adjustment for expected losses that may occur due to changes in macroeconomic conditions

Differences between Accounts Receivable and Notes Receivable

• A/R can be collected, written off, or factored

• Notes receivables can be discounted

  • Is it with recourse or without recourse

  • Does the buyer of the note have any recourse against the seller

Discounting With Recourse

• If the notes receivable is sold (discounted) with recourse, the holder remains contingently liable for the ultimate payment of the note, when it becomes due

  • It has to be reported on the B/S with a corresponding contra-account mentioning that they have been discounted to a third-party; or

  • It may be removed from the B/S and the contingent liability disclosed in the footnotes to the financial statements

• The risk of any loss stays with the buyer of the note

Dishonored Discounted Notes Receivable - Steps

• The contingent liability should be removed by a debit to notes receivable discounted and a credit to notes receivable

• Notes receivable dishonor should be recorded to the estimated recoverable amount of the note

• A loss is recognized if the estimated recoverable amount is less than the amount required to settle the note and any applicable penalties

FOB Shipping Point

Buyer gets the title when the seller loads the goods to the common carrier (In the truck) → Buyer gets the inventory (even though they do not have the possession yet)

FOB Destination

Seller loads the goods in the truck → Seller retains the inventory until the goods are received by the buyer from the common carrier

Shipment of Nonconforming Goods

If the seller ships the wrong goods → Breach of contract

• Title reverts to the seller upon rejection by the buyer

• The goods can be included in the buyer’s inventory upon the discretion of the buyer → if the buyer is willing to sell the goods anyways

Consigned Goods

In a consignment arrangement, the seller (consignor) delivers goods to an agent (consignee) to hold and sell on the consignor’s behalf

• Even though the consignee possess the goods, consignor should include the consigned goods in his or her inventory because title and risk of loss is retained by consignor

• Until the sale, goods remain in the consignor’s inventory

• Title passes directly to the third-party buyer (not to the consignee and then to the third-party buyer) at the point of sale

• The consignee (sales agent) receives sales commission for the goods sold

Sales with a Mandatory Buyback

Occasionally, as part of a financing arrangement, a seller has a requirement to repurchase goods from the buyer. If so, the seller should include the goods in inventory even though the title has passed to the buyer (completed sale)

Installment Sales

Seller sells goods on installment but retains legal title as loan security → Who should include those goods in inventory on an installment sale?

• Buyer has possession

• Seller has legal title

• Can we reasonably estimate the uncollectible debts?

  • If the percentage of uncollectible debts cannot be estimated, include in the seller’s inventory

  • If percentage of uncollectible debts can be estimated, include in the buyer’s inventory

Valuation of Inventory

Apply Rule of Conservatism

• Any transactional gain is not recorded until it’s actually realized

In the B/S, inventory is shown as a current asset, not as an expense until the product is sold

Reversals of inventory write-downs which are prohibited under GAAP

IFRS

• Reversal of inventory allowed

GAAP

• Reversal of inventory NOT allowed

Departures from the cost basis include:

Departures from the cost basis include:

• Precious metals (gold, silver, etc) and farm products (meat, agricultural products, etc), are valued at net realizable value

• Lower of cost or market (LIFO or Retail) and lower of cost and NRV (FIFO or weighted average

• Losses → should be booked immediately (recognized in current period either within COGS or independently)

  • Material losses (substantial and unusual) → disclose separately in the I/S

  • Immaterial losses → increase COGS

Lower of Cost and NRV

• Used for all inventory that is costed using FIFO or weighted average

• NRV = Net selling price - Costs to complete and dispose of the inventory

Lower of Cost and Market

• Used for all inventory that is costed using LIFO of the retail inventory method

• Lower of cost or market - middle value

  • Market ceiling - NRV

  • Market floor - NRV - normal profit margin

  • Replacement cost - Cost to purchase the item as of the valuation date

Disclosure

• Substantial and unusual losses from the subsequent measurement of inventory should be disclosed in the financial statements

• Small losses from a decline in value are included in COGS

• If a significant change takes place in the measurement of inventory, adequate disclosure of the nature of the change and, if material, the effect on income should be disclosed

Periodic Inventory

• When buying inventory, debit purchases → not inventory

• Physical count of ending inventory is required at the end of the period to calculate the COGS

• Inventory available for sale is determined by adding beginning inventory and goods purchased

• The quantity of inventory is determined only by a physical count: quarterly, semiannually, or annually at the end of the period

• When buying inventory debit purchases

• Units of inventory and associated costs are counted and valued at the end of the accounting period

• Ending inventory is physically counted and priced, WIth actual COGS determined after each physical inventory

Perpetual Inventory

• The inventory record for each item of inventory is updated for each purchase and each sale as they occur

  • When buying inventory, debit inventory and credit cash

  • When selling inventory, credit inventory and debit COGS

Units of Inventory on Hand: Quantities Only (Hybrid System)

• Some companies maintain a perpetual record of quantities only. (Known as the modified perpetual system)

• A regular perpetual system keeps an updated count of both the inventory and costs

• Modified perpetual system keeps an updated count of the quantities only

Perpetual with Periodic at Year-end (Hybrid Stystem)

• Most companies that maintain a perpetual inventory system still perform either complete periodic physical inventories or test count inventories on a random (or cyclical) basis

Inventory Valuation Methods under GAAP

• Specific identification - unique goods

• FIFO - sell old; ending inventory new

• Weighted average - periodic system

• Moving average - perpetual system

• LIFO - sell newest - ending inventory is old

• Dollar-value LIFO - need a price index

Specific Identification Method

• Cost of each item in inventory is uniquely identified to that item

• Cost follows the physical flow of the item in and out of inventory to COGS

• Method is used for physically large or high-value items

FIFO

• Sell = old; Unsold = new

• Ending inventory & COGS is same under period and perpetual inventory systems

Weighted Average Method

• Follows periodic system only

• At the end of the period, the average cost of each item in inventory is the weighted average of the costs of all items in inventory

• Particularly suitable for homogenous products

Moving Average Method

• Follows perpetual inventory system only

• Computes the weighted average cost after each purchase

• More current than the weighted average

LIFO

• LIFO: Sell = New; Unsold = Old

LIFO conformity rule

• If used for tax purposes, it shows the government in an inflationary environment

  • A higher COGS

  • Reduced taxable income

• If used for tax purposes, it must be used for GAAP financial statements

• Greater matching of expenses and revenues

• In periods of rising prices, LIFO produces the lowest ending inventory, highest COGS, and lowest net income

• If you are using LIFO in a rising price environment, and price per unit goes up, you are selling the new expensive higher costs, hence, lower profit

• Lower profit = Lower retained earnings = Lower equity = Lower assets (ending inventory balance)

Dollar Value LIFO

• Inventory is measured relative to base-year dollar values and adjusted for changing price levels using a price index

• Price index formula

• If prices are rising, then price index > 1

Gross Profit Method

• Gross profit method is used for interim financial statements as part of a periodic inventory system

• Inventory is valued at retail

• Gross profit percentage is known and used to calculate cost of sales

Rule of Conservatism: If loss is probably and can be reasonably estimated → Book the loss immediately

Firm Purchase Committments

• Firm purchase commitment → A forward contract, is a legally enforceable agreement to purchase a specified amount of goods at some time in the future

  • If the prices go up, profit is incurred on the contract

  • If the prices go down, loss is incurred on the contract

• If the contracted price exceeds the market price and if it is expected that losses will occur when the purchase is actually made, the loss should be recognized at the time of the decline in price

Valuation of Fixed Assets

Historical cost is the basis for purchased fixed asset valuation

• Measured by the cash or cash equivalent price

• Historical cost incorporates the costs of:

  • Obtaining the asset

  • Transporting the asset to its intended location

  • Getting the asset into the condition necessary for its intended use

Donated fixed assets are recorded at FMV (along with incidental costs incurred) and will result in the recognition of a nonoperating gain on the I/S

• Debit the fixed asset at FMV and credit the gain

PP&E Property Land Costs

Land purchased for the purpose of building construction includes all costs incurred up until excavation for the new building. Costs include:

• Purchase price

• Broker’s commissions

• Title, recording, and legal fees

• Draining swamps & clearing of brush & trees

• Site development

• Existing obligations assumed by the buyer (e.g., mortgages & back taxes)

• Costs of removing an old building

Subtract the proceeds from the sale of existing buildings and natural resources such as timber from the land

PP&E Property Land Improvement Costs

Land improvements, which are depreciable, include the following

• Fences

• Water systems

• Sidewalks

• Paving

• Landscaping

• Lighting

Interest costs during the construction period should be added to the cost of land improvements

PP&E Plant Costs

Cost of buildings (plant) include:

• Purchase price

• Deferred maintenance

• Alterations and improvements

• Architects’ fees

• Digging a hole for the foundation (building cost versus filling a hole or leveling land)

• Construction-period interest (potentially)

Basket purchases of land and building require the allocation of the purchase price based on the ratio or appraised values of the individual items

PP&E Cost Basis of Equipment

• Equipment includes office equipment, machinery, furniture, fixtures, and factory equipment

• Cost includes all expenditures related directly to the acquisition or construction of the equipment

  • Invoice price

  • Less cash discounts and other discounts (if any)

  • Add freight-in (and insurance while in transit & construction)

  • Add installation charges (including testing and preparation for use)

  • Add sales & deferral excise taxes

  • Possible addition of construction period interest

PP&E Equipment Costs Capitalization

PP&E: Equipment Costs Capitalization

Equipment costs will either be:

• Capitalized as an asset on the B/S and depreciated over its useful life (GENERAL RULE)

• Expensed on the I/S

• Additions increases the quantity of fixed assets and are capitalized

• Improvements improve the quality of fixed assets and are capitalized

• Replacement occurs when the substitution of a new, similar asset is made for an old one and is capitalized

Replacement

• If old asset’s carrying value is known, remove it and recognize any gain/loss

• If carrying value of old asset is unknown

  • Extend asset’s life through improvement or replacement

  • Debit to accumulated depreciation for the cost of the improvement/replacement

Key Rules Related to Capitalized Interest

For the CPA exam it is important to remember two rules concerning capitalized interest:

• Rule 1: Only capitalized money actually spent, not total amount borrowed

• Amount of capitalized interest is lower of:

  • Actual interest cost incurred or

  • Computed capitalized interest (avoidable interest)

Required Conditions for Capitalization of Interest Period

• Expenditures for the asset have been made

• Activities that are necessary to get the asset ready for its intended use are in progress

• Interest cost is being incurred

Impact of Construction Delays

• Ordinary

  • Wil not impact the capitalization of interest period

• Intentional

  • Will cause capitalization of interest period to stop

Types of Depreciation

Physical Depreciation

• Relates to an asset’s deterioration and wear and tear over a period

Functional Depreciation

• Arises from obsolescence or inadequacy of the asset to perform efficiently

Considerations when Calculating Depreciation

• If a company chooses a higher salvage value for an asset, that will reduce the depreciable base, resulting in less depreciation expense.

• If a company assigns a longer useful life and/or higher salvage value to an asset, its annual depreciation expense will reduce

• Lower expense → Higher Profit → Higher Retained Earnings → Higher Equity

Component Depreciation

• The separate depreciation of each part of an item that is significant to the total cost of the fixed asset

• Consider the entire class of assets and appreciates them over a single useful life; more accurate depreciation

Composite Depreciation

• Process of averaging the economic lives of a number of PP&E units and depreciating the entire class of assets over a single life

  • If you sell one of the items in that class, you'll debit your cash for your selling price. You’ll credit the cost of that machine you sold off, and there won’t be a debit to loss or a credit to gain

  • Make the journal entry balance depending upon the selling price and historical cost; plug in accumulated depreciation

Disclosures in Financial Statement or Notes For Depreciable Assets & Depreciation

• Depreciation expense for the period

• Balance of major classes of depreciable assets by nature or function

• Accumulated depreciation allowances by classes or in total

• The methods used, by major classes, in computing depreciation

Two Depletion Method

1. Cost depletion (GAAP)

   1. Cost depletion rate is computed by dividing the current estimated recoverable units into unrecovered cost (less salvage)

   2. Cost depletion rate is multiplied by units produced to allocate the costs to production

2. Percentage depletion: For tax purposes (not GAAP)

   1. Based on a percentage of sales

   2. Typically exceeds cost depletion

   3. Limited to 50% of net income from the depletion property computed before the percentage depletion allowance

Impairment of PP&E

• The carrying amounts of fixed assets held for use and to be disposed of need to be reviewed whenever events or changes in circumstances indicate that the carrying amount may not be recoverable

Test for Recoverability

• When a fixed asset is tested for impairment, the future cash flows expected to result from the use of the asset and its eventual disposition need to be estimated

• If the sum of the undiscounted expected (future) cash flows is less than the carrying amount, an impairment loss needs to be recognized

Important to remember the following rules when performing your calculations:

• Determining the impairment: Use undiscounted future net cash flows

• Amount of the impairment: Use the FC or discounted (PV) future net cash flows

Long-Lived Assets Held for Sale

Long-lived asset going to be sold should be classified as held for sale in period it meets all six criteria:

1. Management commits to a plan to sell the asset

2. Asset is available for immediate sale in present conditions

3. Active program to locate a buyer and other actions required to complete the plan to sell have been initiated

4. Sale of asset is probable, and transfer is expected to be completed within a year

5. Asset is being actively marketed for sale at a reasonable price relative to FV

6. Significant changes in the plan to sell are not expected

If any of the six criteria are no longer met, asset will be reclassified as held and used

Long-lived asset classified as held for sale (and doesn’t meet criteria for presentation as discontinued operations) should be presented separately on the face of the B/S of the current period

Measurement and Calculation of the Gain or Loss Associated with Long-Lived Assets Held for Sale

• Long-lived assets held for sale are measured at the lower of

  • Carrying value

  • FV less costs to sell

• There is no depreciation or amortization expense while an asset is classified as held for sale

• Costs to sell are the direct costs of the sale transaction

  • These are costs that would not have been incurred by the entity if the sale had not taken place

  • These costs can include items such as commissions, legal fees, title transfer fees, and closing costs

Measurement and Calculation of the Gain or Loss Associated with Long-Lived Assets Held for Sale Part 2

• Each reporting period, there should be an adjustment to the carrying value of the held for sale asset to recognize any change in the fair value less costs to sell

• Loss would be recognized for any initial or subsequent write-down to fair value less the cost to sell

• A gain would be recognized for any subsequent increases in fair value less the cost to sell

• However, a gain cannot be recognized in excess of the cumulative loss previously recognized

Amortization

• Value of intangible assets eventually disappears

• Cost of each type of intangible asset (except intangible assets with indefinite lives, including goodwill) should be amortized by systematic charges to income over the period estimated to be benefited (useful economic life)

Amortization Method of Intangible Assets

• Straight-line method of amortization should be applied, unless a company demonstrates that another systematic method is more appropriate

• Should be adequately disclosed in the notes to the financial statements

• Expenses that increase the useful life of the intangible asset require an adjustment to the calculation of the annual amortization

Valuation of Intangibles

• Finite-life intangible assets are reported at cost less amortization and impairment

• Indefinite-life intangible assets are reported at cost less impairment

• Crypto assets are similar to indefinite-lived assets, but US GAAP outlines different recognition and measurement requirements

• Crypto assets are measured at FV each reporting period, which changes from remeasurement reflected in current period net income

Two-Step Impairment Test

Step 1 (Recoverability Test)

• Carrying amount of the asset is compared with the sum of the undiscounted cash flows expected to result from the use of the asset and its eventual disposition

• Note: When testing indefinite-life intangible assets, use FV instead of the sum of the undiscounted future cash flows

Step 2 

• If the carrying amount exceeds the total undiscounted future cash flows, then the asset is impaired and an impairment loss equal to the difference between the carrying amount of the asset and its fair value is recorded

  • If FV isn’t given, use PV of the future cash flows

Reporting an Impairment Loss

• Reported as a component of income from continuing operations before income taxes, unless the impairment loss is related to discontinued operations

• Carrying amount of the asset is reduced by the amount of the impairment loss

• Restoration of previously recognized impairment losses is prohibited, unless the asset is held for disposal

Initial Franchise Fees

Present value of the amount to be paid (or to be paid) by a franchisee is capitalized

Cash paid + PV of any note issued + FMV of any stock issued

• Recorded as an intangible asset on the B/S

• Amortized over the expected period of benefit of the franchise (i.e., the expected life of the franchise

Continuing Franchise Fees

• Are expensed as incurred

• Received for ongoing services provided by the franchisor to the franchisee (often referred to as franchise royalties)

• Calculated based on a % of franchise revenues

• Such services include

  • Management training

  • Promotion

  • Legal assistance

Fees should be reported by the franchisee as an expense and as revenue by the franchisor, in the period incurred

Start-up Costs

• Expenses incurred in the formation of a corporation are:

  • Considered organizational costs

• Should be expensed when incurred

Include costs of one-time activities associated with:

• Organizing a new entity

• Opening a new facility

• Introducing a new product or service

• Conducting business in a new territory or with a new class of customer

• Initiating a new process in an existing facility