Tag: Practice of Life Insurance Osmania University B.com Notes

Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct labor cost, and direct factory overheads, and is directly proportional to revenue.

Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to “cost of services”). In a retail or wholesale business, the cost of goods sold is likely to be merchandise that was bought from a manufacturer. It does not include any general, selling, or administrative costs of running a business.

As revenue increases, more resources are required to produce the goods or service. COGS is often the second line item appearing on the income statement, coming right after sales revenue. COGS is deducted from revenue to find gross profit.

Accounting for Cost of Goods Sold

IFRS and US GAAP allow different policies for accounting for inventory and cost of goods sold. Very briefly, there are four main valuation methods for inventory and cost of goods sold.

• First-in-first-out (FIFO): Assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time produces or purchased. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold.
• Last-in-first-out (LIFO): The reverse of FIFO. Some systems permit determining the costs of goods at the time acquired or made, but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. Such reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions.
• Weighted average:
• Specific identification: Under this method, particular items are identified, and costs are tracked with respect to each item. This may require considerable recordkeeping. This method cannot be used where the goods or items are indistinguishable or fungible.

Calculate the Cost of Goods Sold

The cost of goods sold is derived by adding together beginning inventory and all inventory purchases made during the reporting period, and then subtracting out the ending inventory balance. Beginning inventory is the value of the raw materials and finished goods in stock at the beginning of the reporting period. Purchases made during the reporting period include all raw materials, components, and merchandise acquired from other parties during the period. Ending inventory is the amount counted as being on hand at the end of the reporting period. The formula is:

Cost of goods sold = Beginning inventory + Purchases – Ending inventory

Items Included in Cost of Goods Sold

The items that make up costs of goods sold include:

• Cost of raw materials
• Cost of items intended for resale
• Cost of parts used to make a product
• Supplies used in either making or selling the product
• Direct labor costs
• Overhead costs, like utilities for the manufacturing site
• Shipping or freight in costs
• Indirect costs, like distribution or sales force costs
• Container costs

Inventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated. It is often deemed the most illiquid of all current assets and, thus, it is excluded from the numerator in the quick ratio calculation.

The ending balance of inventory for a period depends on the volume of sales a company makes in each period.

You can calculate this amount with the following information:

• Total valuation of beginning inventory. This information appears on the balance sheet of the immediately preceding accounting period.
• Cost of goods sold. This information appears on the income statement of the accounting period for which purchases are being measured.
• Total valuation of ending inventory. This information appears on the balance sheet of the accounting period for which purchases are being measured.

The formula for this is as follows:

Ending Inventory = Beginning Balance + Purchases – Cost of Goods Sold

Inventory and COGS

Ending inventory is also determined by the accounting method for Cost of Goods Sold. There are four main methods of inventory calculation: namely FIFO (“First in, First out”), LIFO (“Last in, First out”), Weighted-Average, and the Specific Identification method. These all have certain criteria to be applied and some methods may be prohibited in certain countries, under certain accounting standards.

In an inflationary period, LIFO will generate higher Cost of Goods Sold than the FIFO method. As such, using the LIFO method would generate a lower inventory balance than the FIFO method. This must be kept in mind when an analyst is analyzing the inventory account.

Turnover and Accounts Payable

The average inventory balance between two periods is needed to find the turnover ratio, as well as for determining the average number of days required for inventory turnover. In these calculations, either net sales or cost of goods sold can be used as the numerator, although the latter is generally preferred, as it is a more direct representation of the value of the raw materials, work-in-progress, and goods ready for sale.

Accounts payable turnover requires the value for purchases as the numerator. This is indirectly linked to the inventory account, as purchases of raw materials and work-in-progress may be made on credit thus, the accounts payable account is impacted.

Inventory Best Practices

Inventory best practices include careful inventory management. The business saying “If you can’t measure it, you can’t manage it” applies here. The first best practice is to track inventory. Others include:

Invest in a Cloud-based Inventory Management Program:

Cloud-based inventory management systems let companies know in real time where every product and SKU are globally. This data helps an organization be more responsive, up-to-date, and flexible.

Carry Safety Stock:

Also known as buffer stock, these products help keep companies from running out of materials or high-demand items. Once companies deplete their calculated supply, safety stock serves as a backup should the level of demand increase unexpectedly.

Use Batch/Lot Tracking:

Record information associated with each batch or lot of a product. Some businesses log precise details, such as expiration dates that provide information about their products’ sellable dates. Companies that do not have perishable goods use batch/lot tracking to understand their products’ landing costs or shelf lives.

Start a Cycle Count Program:

Save time, money and customers. Cycle counting benefits extend well past the warehouse by keeping stock reconciled and customers happy.

Inventory Turnover

Inventory turnover is the number of times a company sells or uses an item in a specific timeframe. The number can reveal whether a company has too much inventory on-hand. To determine inventory turnover, use the following equations:

Average inventory = (Beginning Inventory + Ending Inventory) / 2

Inventory turnover = Sales + Average Inventory

Accounts payable (AP) is money owed by a business to its suppliers shown as a liability on a company’s balance sheet. It is distinct from notes payable liabilities, which are debts created by formal legal instrument documents. An accounts payable department’s main responsibility is to process and review transactions between the company and its suppliers and to make sure that all outstanding invoices from their suppliers are approved, processed, and paid. Processing an invoice includes recording important data from the invoice and inputting it into the company’s financial, or bookkeeping, system. After this is accomplished, the invoices must go through the company’s respective business process in order to be paid.

Accounts receivable and accounts payable are essentially opposites. Accounts payable is the money a company owes its vendors, while accounts receivable is the money that is owed to the company, typically by customers. When one company transacts with another on credit, one will record an entry to accounts payable on their books while the other records an entry to accounts receivable.

An accounts payable is recorded in the Account Payable sub-ledger at the time an invoice is vouched for payment. Vouchered, or vouched, means that an invoice is approved for payment and has been recorded in the General Ledger or AP subledger as an outstanding, or open, liability because it has not been paid. Payables are often categorized as Trade Payables, payables for the purchase of physical goods that are recorded in Inventory, and Expense Payables, payables for the purchase of goods or services that are expensed. Common examples of Expense Payables are advertising, travel, entertainment, office supplies and utilities. AP is a form of credit that suppliers offer to their customers by allowing them to pay for a product or service after it has already been received. Suppliers offer various payment terms for an invoice. Payment terms may include the offer of a cash discount for paying an invoice within a defined number of days. For example, 2%, Net 30 terms mean that the payer will deduct 2% from the invoice if payment is made within 30 days. If the payment is made on Day 31 then the full amount is paid. This is also referred to as 2/10 Net 30.

The accounts payable departments are responsible for more than just paying incoming bills and invoices. Accounts Payable are usually their own department in larger companies but in smaller businesses accounts payable and receivable tasks are usually combined.

While the size of the business ultimately determines the role accounts payable plays, AP fulfills at least three basic functions in addition to paying bills.

Internal Payments

Accounts Payable is responsible for distributing internal reimbursement payments, controlling and administering petty cash and controlling the distribution of sales tax exemption certificates.

Employees must turn in a manual log report, receipts or both substantiate reimbursement requests. Small expenses such as miscellaneous postage, out-of-pocket office supplies or company meeting lunch are handled as petty cash. AP often handles a supply of sales tax exemption certificates issued to managers to ensure qualifying business purchases don’t include sales tax expense.

Business Travel Expenses

Larger businesses or business that require staff to travel may have their AP department manage their travel expenses. The travel management by the AP department might include making advance airline, car rental and hotel reservations. Depending on the controls of a company, account payable might processes requests and distributes funds to cover travel expenses. After a business travel has occurred, AP would then be responsible for settling funds distributed versus funds actually spent or for processing travel reimbursement requests.

Vendor Payments

Accounts Payable organizes and maintains vendor contact information, payment terms and Internal Revenue Service W-9 information either manually or using a computer database. Depending on the internal controls of a company, an AP department either handle pre-approved purchase orders or accounts payable verifies purchases after a purchase is made. The AP department also handles end-of-month aging analysis reports that lets management how much the business currently owes.

Other Functions

The accounts payable department also work to reduce costs by recognizing details and developing strategies to save a business money. An example is if an invoice gets paid within a discount period that many vendors provide. AP is also a direct line contact between a business and its vendor representatives. Strong business relationships between the two could benefit the company and a vendor might offer relaxed credit terms.

Process involves:

Receiving the bill: If goods were purchased, the bill helps trace the quantity of what was received. The validity of the bill can be known during this time too.

Review bill details: Ensure that the bill includes vendor name, authorization, date and verified and matching requirements to the purchase order.

Updating records once the bill is received: Ledger accounts need to be updated based on the received bills and an expense entry is usually required. Managerial approval might be required at this stage with the approval hierarchy attached to the bill value.

Making timely payment: All payments should be processed before or at their due date on a bill, as agreed upon between a vendor and a purchasing company. Required documents need to be prepared and verified. Details entered on the cheque, vendor bank account details, payment vouchers, the original bill and purchase order need to be scrutinized. A managerial authorization might be required at this point too.

Notes receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note. The credit instrument normally requires the debtor to pay interest and extends for time periods of 30 days or longer. Notes receivable are considered current assets if they are to be paid within one year, and non-current if they are expected to be paid after one year.

Notes receivable is an asset of a company, bank or other organization that holds a written promissory note from another party.

If the note receivable is due within a year, then it is treated as a current asset on the balance sheet. If it is not due until a date that is more than one year in the future, then it is treated as a non-current asset on the balance sheet.

Often, a business will allow customers to convert their overdue accounts (the business’ accounts receivable) into notes receivable. By doing so, the debtor typically benefits by having more time to pay.

Key Components of Notes Receivable

Maker: The person who makes the note and therefore promises to pay the note’s holder. To a maker, the note is classified as a note payable.

Principal value: The face value of the note.

Payee: The person who holds the note and therefore is due to receive payment from the maker. To a payee, the note is classified as a note receivable.

Timeframe: The length of time during which the note is to be repaid. Notes receivable are not usually subject to prepayment penalties, so the maker of the note is free to pay off the note on or before the note’s stated due, or maturity, date.

Stated interest: A note receivable generally includes a predetermined interest rate; the maker of the note is obligated to pay the interest amount due, in addition to the principal amount, at the same time that they pay the principal amount.

Notes Receivable Terms

The payee is the party who receives payment under the terms of the note, and the maker is the party obligated to send funds to the payee. The amount of payment to be made, as listed in the terms of the note, is the principal. The principal is to be paid on the maturity date of the note.

A note receivable usually includes a specific interest rate, or a rate which is tied to another interest rate, such as a bank’s prime rate. The calculation of the interest earned on a note receivable is:

Interest earned = Principal x Interest rate x Time period

If an entity has a large number of notes receivable outstanding, it should consider setting up an allowance for doubtful notes receivable, in which it can accrue a bad debt balance that it can use to write off any notes receivable that later become uncollectible. An uncollectible note receivable is said to be a dishonored note.

Transfers of financial assets take many forms, including sales, assignments, factoring arrangements and securitizations. Often transfers involve the seller (transferor) having some continuing involvement either with the transferred assets or with the buyer (transferee). Continuing involvement can exist in different forms such as seller recourse provisions, servicing arrangements and call options.

Accounting for transfers in which the transferor has no continuing involvement with the transferred financial assets or with the transferee is not a controversial topic. However, transfers of financial assets with continuing involvement often raise questions about the circumstances under which the transfers should be accounted for as sales (i.e., assets are removed from the balance sheet and a resulting gain or loss is recognized) or secured borrowings (i.e., assets remain on the balance sheet with no change in measurement).

Transfers and Servicing, establishes principles and a control-based accounting framework for evaluating transfers of financial assets, which can be summarized as follows:

• The economic benefits provided by a financial asset (generally, the right to future cash flows) are derived from the contractual provisions of that asset, and the entity that controls those benefits should recognize them as its asset.
• An entire financial asset cannot be divided into components prior to a transfer unless all of the components meet the definition of a participating interest.
• A transferred financial asset should be considered sold and therefore should be derecognized if “control” is surrendered.
• A transferred financial asset should be considered pledged as collateral to secure an obligation of the transferor (and therefore should not be derecognized) if the transferor has not surrendered control.
• The recognition or derecognition of financial assets and liabilities should not be affected by the sequence of transactions that led to their existence unless the effect of those transactions is to maintain effective control over a transferred financial asset.
• To the extent that a transfer of financial assets does not qualify for sale accounting, the transferor’s contractual rights or obligations related to the transferred assets are not accounted for separately if doing so would result in recognizing the same rights or obligations twice. For example, a call option retained by the transferor may prevent a transfer from being accounted for as a sale. In that case, the call option is not separately recognized as a derivative asset.
• Transferors and transferees generally should account symmetrically for transfers of financial assets.
• When determining whether control has been surrendered over transferred financial assets, the transferor (and its consolidated affiliates included in the financial statements being presented) should consider its continuing involvement in the transferred financial assets and all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer. Certain exceptions apply (e.g., accounting for repurchase financings, as defined).

A transfer of a financial assets can take many forms; from the sale of a widely-held equity security for cash to sales of trade receivables to a securitization entity in exchange for cash, a subordinated economic interest in the receivables, and servicing rights. A transfer may involve the conveyance of all rights and title in a financial asset to its purchaser or, alternatively, a transferor may sell an ownership interest in only certain of an underlying financial asset’s cash flows. In other instances, the transferor may grant only a security interest in a financial asset pledged with the transferee.

ASC 860, Transfers and Servicing, provides comprehensive guidance to assist a transferor of financial assets to account for transactions that involve a transfer of a recognized financial asset or an interest therein. Perhaps most importantly, ASC 860 prescribes the conditions that a transfer must satisfy to allow the transferor to derecognize the financial asset from its balance sheet. The guidance in ASC 860 addresses not only the transferor’s accounting, but also informs the corresponding accounting by the transferee.

ASC 860’s derecognition model incorporates the so-called financial components approach. The fundamental tenets of that approach include:

• The economic benefits provided by a financial asset (generally, the right to future cash flows) stem from the asset’s underlying contractual provisions, and the entity that controls those benefits should recognize them as its asset.
• A financial asset should be considered sold–and therefore derecognized–if it is transferred and control is surrendered.
• If a transferor has not surrendered control of a financial asset, derecognition is inappropriate; the asset should be considered pledged as collateral to secure an obligation of the transferor.
• The recognition of financial assets (and liabilities) should not be affected by the sequence of transactions that led to their existence; the controlling principle instead is whether a transferor maintains effective control over a transferred asset.
• Transferors and transferees should account for transfers of financial assets similarly (symmetrical reporting).

ASC 860’s derecognition model does not incorporate consideration of an asset’s “risks and rewards” and how a transfer impacts the transacting parties’ assumption or retention of those risks. Instead, it is a control-based framework.

To apply ASC 860’s derecognition template, companies must first identify which party to a transfer controls the financial assets after the exchange. This assessment should consider the transferor’s continuing involvement in the transferred financial asset, including all arrangements or agreements made contemporaneous with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer. Under the financial components approach, an entity that has surrendered control over a transferred financial asset should derecognize the asset. Conversely, an entity must recognize all financial assets acquired (controlled), and any liabilities incurred, stemming from a transfer.

Financial Asset: Cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right to do either of the following:

• Receive cash or another financial instrument from a second entity
• Exchange other financial instruments on potentially favorable terms with the second entity.

There are some similarities between securities lending transactions and repurchase agreements, both of which represent securities financing transactions. For example, in both types of transactions:

• One party generally transfers legal title to a security or basket of securities to another party for a limited time in exchange for the receipt of a legal interest in the collateral pledged as part of the transaction. Therefore, in both types of transactions, there is a lender and a borrower of the security.
• Fees are involved.
• An entity generally accounts for the transaction as a secured borrowing, though this may not always be the case.

Salary payable is the amount of liability or payment of the company towards its employees against the services provided by them but not yet paid at the end of the month, year, or for a specific period of time. These amounts include the basic salary, overtime, bonus, and other allowance. These payables are required to recognize along with the salary’s expenses in the company’s financial statements at the end of the period. Salary payable is a current liability account containing all the balance or unpaid wages at the end of the accounting period.

The amount of salary payable is reported in the balance sheet at the end of the month or year, and it is not reported in the income statement.

Accounting treatment of salary payable:

Salary payable is classified as a current liability account under the head of current liabilities on the balance sheet. All the general rules of accounting are also applicable to this account.

Salary expenses are the income statement account. It is sometimes recording under the cost of goods sold, cost of services, or operating expenses depending on how the staff is involved in the operation.

Salary payable and accrued salaries expenses are the balance sheet account, and they are recording under the current liabilities sections. This account is decreasing when the company makes payable to its staff.

When the salaries expenses are recognized, but the company has not paid yet to its staff, the following journal entries should be recorded:

Dr Salary expenses XXXX

Cr Salary payable XXXX

And if the salaries are pay to its staff, then the following journal entries should be recorded:

Dr Salary payable XXXX

Cr Cash or bank XXXX

Salary expenses are the income statement account, and it records all of the salary expenses that occur during the period or year. However, the salary payable account is the balance sheet account that reports only the unpaid amount.

The same as other liabilities accounts, salary payable increase is recording on the credit side, and when it is decreasing is recording on the debit side. The recording is different from the recording of assets or expenses, and it is the same effect as revenues and equity.

Salary payable Vs Accrued salary expenses:

Accrued salary expenses are different from the salaries payable. The company knows the exact amount of payment to be paid and actually incurred in the salaries payable.

However, the company’s accrued salary expenses are the expenses that the company is expected to incur based on their best estimate. However, the company does not know yet the exact amount incurred. The company needs to accrue the expenses.

Payroll journal entries fall under the payroll account and are part of your general ledger. Record the following expenses in your payroll account:

• Payroll taxes: Federal income, Social Security, Medicare, and applicable state or local income taxes withheld from employee wages.
• Employee compensation: Salaries, wages, bonuses, commissions, and other taxable income reported on Form.
• Employer taxes: Employer match of Social Security and Medicare taxes, as well as federal and state unemployment taxes
• Employee deductions for benefits: Health insurance, retirement plan, etc.
• Employer portion of fringe benefits: Health insurance, life insurance, education assistance, etc.
• Other deductions: Child support, spousal support, outstanding tax liabilities, etc.

The cost principle

The cost principle, also known as the historical cost principle, states that virtually everything the company owns or controls (assets) must be recorded at its value at the date of acquisition. For most assets, this value is easy to determine as it is the price agreed to when buying the asset from the vendor. There are some exceptions to this rule, but always apply the cost principle unless FASB has specifically stated that a different valuation method should be used in a given circumstance.

The primary exceptions to this historical cost treatment, at this time, are financial instruments, such as stocks and bonds, which might be recorded at their fair market value. This is called mark-to-market accounting or fair value accounting and is more advanced than the general basic concepts underlying the introduction to basic accounting concepts; therefore, it is addressed in more advanced accounting courses.

Expense Recognition (Matching) Principle

The expense recognition principle (also referred to as the matching principle) states that we must match expenses with associated revenues in the period in which the revenues were earned. A mismatch in expenses and revenues could be an understated net income in one period with an overstated net income in another period. There would be no reliability in statements if expenses were recorded separately from the revenues generated.

Revenue Recognition Principle

The revenue recognition principle directs a company to recognize revenue in the period in which it is earned; revenue is not considered earned until a product or service has been provided. This means the period of time in which you performed the service or gave the customer the product is the period in which revenue is recognized.

There also does not have to be a correlation between when cash is collected and when revenue is recognized. A customer may not pay for the service on the day it was provided. Even though the customer has not yet paid cash, there is a reasonable expectation that the customer will pay in the future. Since the company has provided the service, it would recognize the revenue as earned, even though cash has yet to be collected.

The objective of IAS 34 is to prescribe the minimum content of an interim financial report and to prescribe the principles for recognition and measurement in financial statements presented for an interim period.

The objective of this Standard is to prescribe the minimum content of an interim financial report and to prescribe the principles for recognition and measurement in a complete or condensed financial statements for an interim period. Timely and reliable interim financial reporting improves the ability of investors, creditors, and others to understand an enterprise’s capacity to generate earnings and cash flows, its financial condition and liquidity.

An interim financial report should include, at a minimum, the following components:

(a) Condensed balance sheet

(b) Condensed statement of profit and loss

(c) Condensed cash flow statement

(d) Selected explanatory notes.

Components:

A complete set of financial statements normally includes:

(a) Balance sheet

(b) Statement of profit and loss

(c) Cash flow statement

(d) Notes including those relating to accounting policies and other statements and explanatory material that are an integral part of the financial statements.

In the interest of timeliness and cost considerations and to avoid repetition of information previously reported, an enterprise may be required to or may elect to present less information at interim dates as compared with its annual financial statements.

The benefit of timeliness of presentation may be partially offset by a reduction in detail in the information provided. Therefore, this Standard requires preparation and presentation of an interim financial report containing, as a minimum, a set of condensed financial statements. The interim financial report containing condensed financial statements is intended to provide an update on the latest annual financial statements. Accordingly, it focuses on new activities, events, and circumstances and does not duplicate information previously reported.

This Standard does not prohibit or discourage an enterprise from presenting a complete set of financial statements in its interim financial report, rather than a set of condensed financial statements. This Standard also does not prohibit or discourage an enterprise from including, in condensed interim financial statements, more than the minimum line items or selected explanatory notes as set out in this Standard. The recognition and measurement principles set out in this Standard apply also to complete financial statements for an interim period, and such statements would include all disclosures required by this Standard (particularly the selected disclosures in paragraph as well as those required by other Accounting Standards.

The periods to be covered by the interim financial statements are as follows: [IAS 34.20]

balance sheet (statement of financial position) as of the end of the current interim period and a comparative balance sheet as of the end of the immediately preceding financial year statement of comprehensive income (and income statement, if presented) for the current interim period and cumulatively for the current financial year to date, with comparative statements for the comparable interim periods (current and year-to-date) of the immediately preceding financial year statement of changes in equity cumulatively for the current financial year to date, with a comparative statement for the comparable year-to-date period of the immediately preceding financial year statement of cash flows cumulatively for the current financial year to date, with a comparative statement for the comparable year-to-date period of the immediately preceding financial year.

Note disclosures

The explanatory notes required are designed to provide an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the last annual reporting date. IAS 34 states a presumption that anyone who reads an entity’s interim report will also have access to its most recent annual report. Consequently, IAS 34 avoids repeating annual disclosures in interim condensed reports. [IAS 34.15].

The main differences between interim and annual statements can be found in the following areas:

• Some accompanying disclosures are not required in interim financial statements, or can be presented in a more summarized format.
• The revenues generated by a business may be significantly impacted by seasonality. If so, interim statements may reveal periods of major losses and profits, which are not apparent in the annual financial statements.
• Accrual basis. The basis upon which accrued expenses are made can vary within interim reporting periods. For example, an expense could be recorded entirely within one reporting period, or its recognition may be spread across multiple periods. These issues can make the results and financial positions contained within interim periods appear to be somewhat inconsistent, when reviewed on a comparative basis.

Construction workers tend to work based on contractors they make with the owners of property. Traditionally these contractors could choose from a variety of accounting procedures to account for the revenue they received from such contracts.

Long-term contracts are contracts for the building, installation, construction, or manufacturing in which the contract is completed in a later tax year than when it was started. However, a manufacturing contract only qualifies if it is for the manufacture of a unique item for a particular customer or is an item that ordinarily takes more than 1 year to manufacture.

Long term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. Examples of long-term contracts are construction-type contracts, development of military and commercial aircraft, weapons-delivery systems, and space exploration hardware. When the project consists of separable units, such as a group of buildings or miles of roadway, contract provisions may provide for delivery in installments. In that case, the seller would bill the buyer and transfer title at stated stages of completion, such as the completion of each building unit or every 10 miles of road. The accounting records should record sales when installments are “delivered.”

A company satisfies a performance obligation and recognizes revenue over time if at least one of the following three criteria is met:

• The customer simultaneously receives and consumes the benefits of the seller’s performance as the seller performs.
• The company’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
• The company’s performance does not create an asset with an alternative use. For example, the asset cannot be used by another customer.

In addition to this alternative use element, at least one of the following criteria must be met:

(a) Another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer.

(b) The company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised.

Long-Term Methods of Accounting

There are 2 primary methods of accounting to determine when revenue is recognized for long-term contracts:

• Completed contract method (CCM)
• Percentage of completion method (PCM)

Completed Contract Method

Using the completed contract method, the taxpayer does not recognize revenue until the contract is completed and accepted by the customer. Except for home construction contracts, CCM can only be used by small contractors for contracts with an estimated life that does not exceed 2 years. There should be no terms in the contract with the only purpose of deferring tax.

The CCM is required for home construction contracts that are for the construction of residential buildings with 4 or fewer dwelling units, where at least 80% of the estimated cost is for the dwelling units and related land improvements, even if the contract is for longer than 2 years or the contractor is a large contractor. Other types of construction contracts qualify for the completed contract method if they satisfy the general CCM requirements.

Percentage of Completion Method

Except for home construction contracts, large contractors must use the percentage of completion method for long-term contracts. PCM must also be used to determine liability under the alternative minimum tax (AMT) system. Under the PCM, the amount of progress on the project is determined by the total costs actually incurred as compared to the total estimated cost. Hence, revenue in any given year is determined by the actual contract costs incurred for that year divided by the total estimated cost multiplied by the total contract price:

Reportable Income = Contract Price × Annual Contract Cost/Estimated Total Cost

Qualitative Characteristics of Financial statement

Comparability

Comparability is the degree to which accounting standards and policies are consistently applied from one period to another. Financial statements that are comparable, with consistent accounting standards and policies applied throughout each accounting period, enable users to draw insightful conclusions about the trends and performance of the company over time. In addition, comparability also refers to the ability to easily compare a company’s financial statements with those of other companies.

• Financial statement of an enterprise through time to identify trends in financial position and performance
• Financial statement of different enterprise to evaluate financial position, performance and change in financial position.
• Consistent measurement and display of financial effect of like transactions and other events
• Implementation users must be informed of accounting policies employed, any changes in those policies an defects of such changes
• Annual statements must show corresponding information for preceding periods.

Relevance:

The predictive and conformity role of information is interrelated. The information has the quality of relevance when it influences the economic decision making of the users by helping them:

• Evaluate past, present or future events.
• Confirming or correcting their past evaluations.

Reliability

Users must be able to depend on it being faithful representation.

The information has the quality of reliability when:

• Financial statement are free from material error and bias
• Can be depended by the users
• Reliability comprises
• Faithful representation
• Substance over form: Substance and economic reality, not merely the legal form
• Neutrality free from biasness
• Prudence: Including a degree of caution in making estimates under conditions of un-certainty such that assets or income are not overstated and liabilities or expenses are not understated.

Understandability

Users must be able to understand the financial statements

For this user are assumed to have reasonable knowledge of business and economic activities and accounting and a willingness to study information with reasonable diligence. Understandability is the degree to which information is easily understood. In today’s society, corporate annual reports are in excess of 100 pages, with significant qualitative information. Information that is understandable to the average user of financial statements is highly desirable. It is common for poorly performing companies to use a lot of jargon and difficult phrasing in its annual report in an attempt to disguise the underperformance.

Financial statement Fundamental

Financial Statement: Statement of Changes in Equity

If you are interested in how much of the income a shareholder retains in the company, this is the place to be. The Statement of changes in equity describes the change in owner’s equity over an accounting period. The main things included on this statement are net income or losses that will be added or subtracted from the equity, any dividend payments to owners, as well as the previous and new shareholder equity balance.

Financial Statement: Cash Flow Statement

Where did the organization’s cash and cash equivalents go? That’s what you are likely to see in the statement of cash flow (or cash flow statement). It’s derived from the balance sheet and income statement. It shows how each balance sheet account and income affects a company’s cash flow.

When prepared using the direct method, the cash flow statement is divided into operating, investing and financing activities. This way you’re able to determine which type of activity generates or consumes the most cash.

Financial Statement: Income Statement

The income statement is perhaps one of the most common financial statements that you will be encountering in fundamental analysis. An income statement encompasses the organization’s revenue and expenses together with its gains/profits and losses. Unlike the balance sheet that’s a snapshot of financial health in time, the income statement is more like a change in financial health over a specific time period. The standard is that there are monthly, quarterly, annual income statements. However, technically a company can create an income statement for any time period.

For non-accountants, revenue and income may seem the same but they are not.

Revenue is the gross amount that a company earns from its principal operations such as a bakery selling bread and pastries. It includes all the funds that are coming in from these operations without accounting for any expenses.

Expenses are the costs of conducting business. Some examples include cost of goods sold, administrative costs, legal fees, insurance costs, office supplies, rent, repair, maintenance costs, and many more. When you subtract all expenses from revenue you arrive at the net profit or net income.

Net Income is the net of everything or revenue minus all expenses, including taxes.

Financial Statement: Balance Sheet

The balance sheet, otherwise known as the statement of financial position, shows the financial standing of a company. It’s a snapshot in time of a company’s financial health. This financial statement is organized into three sections, including assets, liabilities, and equity.

Assets = liabilities + equity.

Assets Section on a Balance Sheet

The assets section on a balance sheet includes the totals of all types of assets. Assets are the property and items that a company owns. There are three main types of assets. They include current assets, fixed assets, and intangible assets. Current assets are cash and other assets that can easily be converted into cash within a year. Current assets include cash equivalents, marketable securities, inventory, account’s receivables, and other liquid assets. Fixed assets are property plant and equipment that cannot be easily liquidated or sold. Intangible assets are not physical items such as patents, goodwill, company recognition, trademarks, copyright, and other similar things.

Liabilities Section on a Balance Sheet

Liabilities are debts and obligations a company owes to its creditors and customers. Every company incurs liabilities at one point of its operations. They can be broken down into current liabilities and long-term liabilities. Current liabilities are those debts and obligations which are due within a year. Examples include accounts payable, customer deposits, interest payable, the current due portion of long term debt and other short term debt. Whereas, long-term liabilities are those that are due after one year. They include multi-year loans, bonds payable, deferred revenue, pension obligations, mortgages, and other long term debt.

The important thing to remember for company health analysis is that the company should be able to meet its short-term and long-term obligations in a timely manner. If a company is unable to meet these obligations, it has a risk of becoming insolvent and could go bankrupt.

Equity Section on a Balance Sheet

Equity is the owner’s interest or residual claim in the business after deducting the company’s liabilities from its total assets. The amount of equity in the balance sheet will give you an idea of the net worth of a company or its value to its owners. Though, often it’s merely just book value in the balance sheet, especially for publicly traded companies (i.e. stocks).

Financial statement Assumptions

The period assumption

This assumption describes the time interval between financial statement reports.

Going concern

The financial statements are prepared under the going concern basis, which assumes that the business will continue its operations as normal into the foreseeable future.

Accrual basis

The financial statements are prepared under the accrual basis, which is a method of financial reporting that measures all cash relating to the business as it comes in and as it goes out, called ‘cash accounting’.

Fair presentation

Fair presentation is an assumption to ensure that the financial statements are prepared and presented fairly the financial position, performance and cash flows in accordance with all relevant International Accounting Standard (IASs)/International Financial Reporting Standard (IFRSs). This means that an entity need to disclose about the compliance with the IASs/IFRSs and all relevant IASs/IFRSs must be followed if the entity is in compliance with IASs/IFRSs.

The economic entity

The financial statements are prepared under the economic entity assumption, meaning that the business itself is separate from the owners of the business and any other businesses.

Consistency

Consistency of presentation refers to the presentation and classification of items in the financial statements should be in the same way from one period to another. There are two exceptions where an entity can depart from this consistency principle. First, when there is a significant changes in the nature of operations or a review of financial statements indicate to be more appropriate presentation. Last but not least, when the changes in presentation is required by IFRS.