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21 Cri&cally discuss the need for adjus&ng entries as well as the way adjustments sa&sfy that need. At the end of every period we need to make some adjustment entries in order to report a net income that is a fair representa8on of the en8ty’s ac8vity during the period, every adjustment entry involves a change in either a revenue or expense and an asset or a liability. It is needed because the effect of certain transac8ons could affect more than one accoun8ng period, however, companies usually record transac8ons when there is a source document (an evidence). It follows that there is the need of matching revenues with expenses, even if there is yet no source document and that is done adjus8ng entries. An example are wages expenses, which can be recorded at the end of an accoun8ng period, even if the payment has not happened yet (indeed “wages payable” is credited), in order to give a faithful representa8on. 22 Cri&cally discuss the Accruals type of adjustments, giving examples. Accruals represent transac8ons for which there were not cash flows yet (so there is no source document); however, the effect of such transac8on must be recorded in the accounts anyway, in order to accomplish a matching and a fair representa8on of revenues and expenses (accruals basis of accoun8ng). Examples may be: interest, property taxes, wages and salaries. For instance, whenever a company needs to accrue wages owed to an employee (an example of unpaid expense), in the balance sheet it will report a liability to be paid in future 8mes and the cost incurred in the actual period in order to generate a revenue. The liability generated by the lack of payment will be reduced when the debt is paid. On the Journal entry the firm will record a wages expense and a liability posted as "wages payable", which will decrease at the 8me of payment (when an ouPlow of cash will follow). 23 Cri&cally discuss the Reclassifica&ons type of adjustments, giving examples. The reclassifica8on type of adjustments occurs whenever an ini8al recording of a transac8on was a correct representa8on of it at the 8me, but fails to assign revenues to the period in which they were earned, or to assign expenses in the period in which they actually incurred. Therefore, the amount must be reclassified from one account to another in order to accomplish the proper matching of revenues and expenses.
Example of reclassifica8on of assets to expenses could be: prepaid insurance may be turned into insurance expense and example of reclassifica8on of liabili8es to revenues could be: unearned rental revenue becoming a rental revenue. 24 Cri&cally discuss the difference between temporary and permanent accounts. At the end of each accoun8ng period a bookkeeper should make ready the accounts for the next one. This process consist in closing all temporary accounts, which are the ones regarding expenses, revenues and dividends, they are closed at the end of every year so as not to be mixed with the income and expenses of the next periods. While assets accounts, liabili8es account and equi8es accounts remain open, hence, they are measure cumula8vely (ending balance of previous year is beginning balance of subsequent year). Temporary accounts’ balance is moved to zero. 25 Cri&cally discuss the func&oning of the closing process. At the end of each accoun8ng period a bookkeeper should make ready the accounts for the next one. The closing process consist in formally recognize in the ledger the movement from net income (or loss) and dividends to retained earnings (net income will be used to make new investments in the following year, if not distributed to shareholders through dividends). Closing entries produce zero balance in all temporary accounts, they are closed at the end of every year so as not to be mixed with the income and expenses of the next periods. Expenses, dividends and losses decrease retained earnings, while revenues and gains increase retained earnings. 26 Cri&cally discuss the difference between perpetual and periodic system to account for inventory. In the perpetual system company determines cost of goods sold any 8me they perform a sale. This means maintain detailed records of the cost of each inventory purchased and sold, be aware of the inventory on hand and provide a beVer control on inventory. In the periodic system the cost of goods sold is recorded only once a year aWer a physical count of the item in inventory at the end of the year. The cost of goods sold is determined adding from the beginning balance purchases made during the year and subtrac8ng ending balance. Nowadays the perpetual system is more used (automa8c and easier), mostly in big companies, while periodic inventory system was more used in the past, when recording was done by hand.
32 Inventories: Net realizable value. IFRS require to disclose inventory at the lower between cost and net realizable value which is determined subtrac8ng from the es8mated selling price the cost of comple8on (if any) and the costs necessary to perform a sale. The amount of inventory should be the lower among its cost and its NRV. In case of net realizable value lower than the cost, we have to record a loss on inventory through a registra8on that debit the amount to Loss on inventory and credit the same amount to Inventory. The loss on inventory must be recorded in Profit and loss, indeed IFRS requires to record a loss as soon as it becomes predictable in order to not overes8mates assets. It is possible to recover the loss, whenever the NRV will be higher than costs, a revenue is recorded in the income statement as “recovery in inventory”, however the laVer cannot exceed the original loss. 33 Receivables: Defini&ons and Measurement of receivables. An account receivable is the promise that the customer will pay the firm in the foreseeable future, but since this promise is stated without a contract, the customer might eventually fail to pay. Therefore, receivables may be either collectable or uncollectable. Because IFRS requires to record a loss as soon as it becomes predictable in order to not overes8mates assets, it obliges companies to disclose accounts receivables at their collectable amount. There are two ways to es8mate it: the direct write-off method (not allowed under IFRS) and the allowance method (allowed under IFRS). The allowance method requires to make an es8mate on how many receivables will not be collected, so to calculate poten8al losses either on the percentage of sales or the percentage of accounts receivable (which results in a beVer representa8on because the es8ma8on is focused on the accounts receivable). The percentage to use is determined on past experience of the company. The adjus8ng entry to record the es8mated uncollectables is: Allowance for doubPul account works as a contra asset account that is disclosed in the balance sheet in a nega8ve value. Whenever the company fail to collect receivables, it should credit accounts receivable and debit the allowance. In case of unexpected collec8on of the receivable we can reverse the write off entry and record the collec8on. Bad debt expense XXX Allowance for doubPul account XXX Allowance for doubPul account XXX Accounts receivable XXX
In case of unexpected collec8on of the receivable we can reverse the write off entry and record the collec8on. 34 Cri&cally discuss how the original cost of a Property, Plant, and Equipment item is determined. We can record the acquisi8on of a PPE only when we control the asset. In order to determine its cost we have to include all costs necessary to bring the item in the condi8on and loca8on intended to use it (installa8on cost, transporta8on cost, cost of permits…). So costs are capitalized (included as cost of the asset) when you cannot use the asset in the produc8on process without those expenses (costs). However, IFRS excludes some of these costs, such as, for example, administra8on costs or staff training costs because they do not represent a secure value (companies do not own employees). 35 Cri&cally discuss the Straight-line deprecia&on method. Every 8me an asset is used, the firm using it faces an expense, PPE items are, generally, useful for several years. Therefor, the management of the company will need to es8mate how much the asset will last and, based on that, it will calculate how much (each year) the cost of that asset will be used up. In order to allocate the cost of the asset in the years in which we benefit from its use, we have to depreciate it. Deprecia8on will represent the expenses for the usage of a PPE item. According to the straight-line deprecia8on method, in order to find the deprecia8on expense we subtract from the cost of the PPE the es8mated salvage value (leW value at the end of its useful life), then divide it by the es8mated useful life. Than we make the following entry: Deprecia8on expenses is disclosed in the Income statement, while Accumulated deprecia8on is disclosed in the Statement of financial posi8on as a contra-asset. According to this method we depreciate the asset for the same amount every year (deprecia8on stops when net book value = salvage value). This method is recommended to depreciate buildings. 36 Cri&cally discuss the Units-of-produc&on deprecia&on method. Every 8me an asset is used, the firm using it faces an expense, PPE items are, generally, useful for several years. Therefore, the management of the company will need to es8mate how much the asset will last and, based on that, it will calculate how much (each year) the cost of that asset will be used up. In order to allocate the Deprecia8on expenses XXX Accumulated deprecia8on XXX
most from the usage of an item of PPE are the firsts, mostly when items loose efficiency easily. So we will charge a higher amount of expenses in first years and a lower in the last ones, moreover it is not difficult to es8mate it. Comparing the effects of the two methods, it can be said that the accelerated method results in a lower net income in the first years (higher expenses), but a higher one (lower expenses) in the last years, while in the straight line method expenses and so net incomes over the years are constant. Units of produc8on method is the closer to the real usage of an asset, but is more complicate to apply because requires a lot of informa8on. About it we cannot say if result in a higher or lower net income compared to the other method because the annual expense depends directly on the units produced during the year. 39 Property, plant and equipment: Measurement a]er recogni&on – revalua&on model. AWer the recogni8on of an asset, to measure the value of an item of PPE (in order to present the asset in the SFP with that amount), an en8ty can choose between two models: cost model or revalua8on model. The cost model will compute the carrying amount aWer recogni8on as its original cost, minus any accumulated deprecia8on and accumulated impairment losses. With the revalua8on model, the item can be revalued and recorded at the revalued amount, calculated as: its fair value at the date of the revalua8on, less any accumulated deprecia8on and accumulated impairment losses. This model used whenever the fair value of the PPE item can be measured in a reliable way. Apart from that, other two condi8ons are to be met in order to use this kind of model: the revalua8on must occur with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the repor8ng period, and if an item of PPE is revalued, all items that fall under the same category have to be revalued If an asset’s carrying amount is increased as a result of a revalua8on, the increase should be recognized in the OCI (because IFRS requires not to overes8mates assets) as an unrealized gain and accumulated under the heading of revalua8on surplus; or in Profit or Loss if it reverses a revalua8on decrease of the same asset previously recognized in profit or loss. If an asset’s carrying amount is decreased as a result of a revalua8on, the decrease shall be recognized: in profit or loss; or in the OCI if it reverses a revalua8on increase previously recorded in respect of that asset. 40 Impairment test
Methodologies for the impairment test are stated under IAS 36. Impairment of an asset, or CGU (=cash genera8ng unit), occurs when the carrying amount of the asset (or CGU) is grater than its recoverable amount (recoverable amount: higher of Fair value less costs of disposal and Value in use (the present value of the future cash flows expected to be derived from an asset or CGU) ). in this case there’s an impairment loss that has to be recognized in the separated income statement in the year in which the impairment has risen. Moreover, if the asset has been previously revalued, the impairment loss is charged against the revalua8on surplus (equity) to the extent that the revalua8on surplus contains an amount rela8ng to the same asset. 41 Financial instruments: Defini&on and measurement of financial assets classified as held for trading (FVTPL). Financial assets are financial instruments iden8fied as: cash, contractual rights to receive cash or another financial asset from another en8ty or, lastly, a contractual right to exchange financial assets or financial liabili8es with another en8ty under favorable condi8ons to the en8ty. Financial assets held for trading are a type of financial investment that are acquired to be sold in the foreseeable future, indeed, in this case the “business model test” is not achieved, meaning that the business plan for the company is not to hold the assets (even if the cash flow characteris8c test is met). The firm should recognize the asset through fair value in the profit or loss. Ini8ally the assets are measured at their FV, with transac8on costs charged in the Income Statement, and subsequently recorded at their amor8zed costs, although, at the end of the year the company should adjust the amor8zed cost to the FV, recognizing gains/losses in Profit or Loss. The assets measured at amor8zed cost shall be the carrying amount, plus the interest income computed through the effec8ve interest rate, minus the principal repayments, interest received and the impairment loss. 42 Financial instruments: Defini&on and Measurement of Hold to Collect (HTC) debt instruments. HTC debt instruments should meet both the Cash flow characteris8cs test (the terms of the contract give the right to receive interests and reimbursements only) and the Business model test (objec8ve of the company is to hold the instrument in order to collect the contractual cash flows instead of selling it in a short term). These assets must be ini8ally measured at their fair values plus transac8on costs and subsequently recorded at amor8zed cost using the effec8ve interest rate
45 Financial instruments: Defini&on and Measurement of Non-trading Financial Liabili&es. Non-trading financial liabili8es are any contractual obliga8on to pay a certain amount of cash or any other kind of asset to another en8ty within a term. So, the en8ty would have either to pay cash or to transfer another financial asset to another company. Specifically, Non-trading financial liabili8es are non-deriva8ve, but neither held-for-trading financial instruments. They are indeed “standard” liabili8es (either current or non-current): notes/accounts payable, bonds/loan payable. These liabili8es must be ini8ally measured at their FV minus transac8on costs and subsequently recorded at their amor8zed costs using the effec8ng interest rate method. The resul8ng interest expense is recognized in the separate income statement. The amor8zed cost is equal to the carrying amount, plus the interest expense, minus principal repayment and interests paid.
