FINANCIAL ACCOUNTING

Professor Pascal Dumontier

 CONTENTS

The Goal of Financial accounting........................................................................................................... 4

The financial view of the firm................................................................................................................. 4

Scope and purpose of financial accounting............................................................................................. 6
Problems ................................................................................................................................................. 7

Financial statements................................................................................................................................ 9

The balance sheet .................................................................................................................................... 9

The income statement ........................................................................................................................... 12
Problems ............................................................................................................................................... 14

Analyzing and recording transactions................................................................................................... 17

The accounting equation ....................................................................................................................... 17

Accounts for recording transactions ..................................................................................................... 18
Ledger ................................................................................................................................................... 19
The chart of accounts ............................................................................................................................ 20
The journal ............................................................................................................................................ 20
The trial balance.................................................................................................................................... 21
Problems ............................................................................................................................................... 22

Inventories ............................................................................................................................................ 26

Perpetual and periodic inventory methods............................................................................................ 26

Inventory valuation method .................................................................................................................. 27
Problems ............................................................................................................................................... 29

Adjustments of expenses and revenues................................................................................................. 30

Principles of accrual accounting ........................................................................................................... 30

Adjusting entries to make expenses match with revenues .................................................................... 30
Problem ................................................................................................................................................. 31

Depreciating Fixed assets...................................................................................................................... 32

Recording the acquisition of fixed assets.............................................................................................. 32

Depreciation of fixed assets .................................................................................................................. 32
Depreciation methods ........................................................................................................................... 33

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Disposal of fixed assets......................................................................................................................... 34
Problems ............................................................................................................................................... 35

Depreciating receivables ....................................................................................................................... 37

Calculating the depreciation amount..................................................................................................... 37

Accounting for depreciation of receivables .......................................................................................... 37
Writing-off allowances for uncollectible receivables ........................................................................... 38
Problems ............................................................................................................................................... 38

Provisions.............................................................................................................................................. 40

Provisions and contingent liabilities ..................................................................................................... 40

Reporting provisions............................................................................................................................. 40
Problems ............................................................................................................................................... 41

Novartis – Consolidated financial statements ....................................................................................... 44

Consolidated balance sheets.................................................................................................................. 44

Consolidated income statements ........................................................................................................... 45
Consolidated cash flow statements ....................................................................................................... 45
Glossary of Accounting Terms ............................................................................................................. 46

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THE GOAL OF FINANCIAL ACCOUNTING

The financial view of the firm

The following figure describes the financial view of the firm, i.e. cash flows between
shareholders and lenders, who are both providers of capital, and the firm’s operations. The
flow starts when the firm raises the money to pay for the investments in real assets. To obtain
financing, the firm can invite investors to buy shares and become a shareholder. It can also
borrow money from banks or issue bonds. The cash received from shareholders or lenders,
i.e. banks or bondholders, is employed to purchase real assets. Through the business cycle,
these assets generate operating income which is used to pay interest to lenders and to pay
income taxes to the tax administration. Whatever is left over constitutes net income that is
returned to shareholders. The net income may be reinvested (retained earnings) or paid to
shareholders (dividends).

Equity

Shareholders Investment

Dividend Net income

Assets
Financial debt Operating income
Banks

Interest

Tax Administration
Income taxes

To carry on business, companies need to invest in real assets. These are both tangible
(machinery, factories …) and intangible (patents, trademarks …). To obtain the necessary
money, the company sells financial assets to shareholders and to bondholders or to banks.
When the firm borrows money from a bank or from bondholders, it promises to repay the
debt with interest. If it does not keep its promise, the lenders may force the firm into

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bankruptcy. No such commitments are made to equity-holders. These are entitled to whatever
is left over after the lenders have been paid off. The firm’s real assets must produce enough
cash (i.e. operating income) to satisfy both lenders and shareholders.

They are several forms of business organization. A sole proprietorship is a business owned
by one person. This is the simplest form of business and the least regulated form of
organization. The owner keeps all the profits, but he has an unlimited liability for business
debts. This means that creditors, such as lenders or suppliers, can look beyond business assets
to the owner's personal assets for payment in case of bankruptcy. There is also no distinction
between personal and business income, so all business income is taxed as personal income.

A partnership is similar to a proprietorship except that there are two or more owners
(partners) who share all the profits between them, as described in a partnership agreement.

A corporation is a legal “person” separate and distinct from its owners. It has many of the
rights and duties of an actual person. It can enter into contracts, to borrow money for
instance. The corporation’s owners are shareholders. While they control the firm, they only
have limited liability for corporate debts. The most they can lose is what they have invested
in shares.

In major corporations, shareholders and managers are commonly separate groups.

Shareholders have the ultimate control of the business, but they do not manage the firm
themselves. They control the firm because they elect the Board of Directors. Directors hire
managers. These are charged with running the corporation in the shareholders’ interest. If
shareholders do not like the policies the management team pursue, they can vote in another
board of directors who will bring a change in policy. This separation between ownership and
management creates a potential conflict between shareholders and managers. Several
mechanisms are aimed at mitigating these conflicts: managers’ remuneration is tied to their
performance, poorly performing companies are taken over and the management is replaced
by a new team, shareholders can elect a new board of directors and so on.

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Scope and purpose of financial accounting

Accounting is the language of business. It is aimed at recording financial transactions in

order to prepare reports, i.e. balance sheet and income statement. These financial statements
reflect the financial position of the firm. The information generated by the accounting process
is used by many diverse parties:
− Shareholders are concerned with evaluating the return they are receiving on their
investment.
− Investors (i.e. potential future shareholders) are concerned with whether the firm
represents a good opportunity for investment.
− Creditors are concerned with whether the firm will be able to meet its obligations when
they become due. In the same line, employees are concerned with evaluating the firm’s
ability to meet wage demands.
− The tax administration is concerned with evaluating tax revenues based on the firm’s
net income.
− Customers are concerned with the firm’s continuing ability to supply their needs.
− Managers are concerned with determining the financial strengths and weaknesses of the
business.

In Europe, financial accounting requirements (the International Accounting Standards - IAS-

or International Financial Reporting Standards - IFRS) are promulgated by the International
Accounting Standards Board (IASB), which is the principal rule-making body. These
requirements are mandatory for all listed companies. In Switzerland, smaller non-listed
companies may follow Swiss Financial Reporting Standards. They do not differ significantly
from IAS-IFRS, even though they are often less constraining.

Companies provide stakeholders, i.e. shareholders, investors, lenders, suppliers, customers,

employees, governments, with financial information using financial statements. According ti
IAS-IFRS, financial statements are aimed at providing information that is useful in making
economic decisions. Financial statements are prepared on a going-concern basis, unless
management either intends to liquidate the entity or to cease trading, or has no realistic
alternative but to do so. They must ensure comparability with the information of previous
periods and with the financial statements of other entities.

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A complete set of financial statements comprises a balance sheet, income statement,
statement of changes in equity, cash flow statement and explanatory notes (including
accounting policies). However, balance sheet and income statement are the two major ones.

The balance sheet presents a firm’s financial position at a specific point in time. It provides
information about the amounts that have been received from shareholders or lenders. It also
provides information about the assets acquired with the money invested by shareholders or
lenders. The income statement provides information about where the operating income comes
from (i.e. the operating revenue and the operating expenses), and how it is used to pay
interest, income taxes.

Balance sheet

Assets Equity

Financial debt

Income statement
Operating revenue (net sales)
- Cost of goods sold
- Operating expenses (cost of goods sold,
selling expenses, general and administrative
expenses)
Operating income
- Interest expense
- Taxes
Net income

Problems

1. From the data in the figure below, determine the amount of investments, the operating
income, the interest expense if the interest rate is 10 percent, the tax expense if the tax rate
is 30%, the net income.

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 Services Customers
or goods
Shareholders 100’000
Equity
?
250’000
Net income Investments

? 160’000
Manpower

Work
Banks 50’000
Borrowings Assets
Operating income
Interest
payments ? 60’000

?
Goods or Providers of
services goods and
services

Taxes
State
?

2. Prepare a simplified income statement and a simplified balance sheet of the company
described in problem 1 above.

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FINANCIAL STATEMENTS

Financial accounting is the process of preparing financial statements, essentially the balance
sheet on the one hand, and the income statement on the other hand. However, according to
IAS-IFRS, a complete set of financial statements should also include a statement of changes
in equity showing, a cash flow statement, and explanatory notes.

The balance sheet

The balance sheet portrays the financial position of the entity by communicating the balances
of what a company owns (called assets), what it owes (called liabilities), the difference
between assets and liabilities (called equity) representing the amount that belongs to
shareholders. Assets consist of anything that is owned and has value. Liabilities are
obligations to pay an asset at some time in the future, or to provide a service or goods at a
later date.

The balance sheet can be viewed as a picture of the company at a point in time. This picture
can be taken whenever necessary, but it is always taken at the end of the corporation’s
business year.

The balance sheet is classified into major groups of assets and liabilities in order to facilitate
analysis of the company's financial position. A classified balance sheet generally breaks
down assets into two categories: current assets and non-current assets. In the same line, it
breaks down liabilities into two categories: current and non-current liabilities.

Current assets are assets which are expected to be converted into cash or used up within the
normal operating cycle of the business. The operating cycfe is the time period between the
purchase of inventory to transfer of inventory through sales, listed as accounts receivable,
and receipt of cash. Examples of current assets are cash, accounts receivable, and
inventories.

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Cash includes money a company holds and money deposited with financial institutions that
can be withdrawn without notice. Cash equivalents are defined as short-term, highly liquid
investments that are readily convertible to known amounts of cash.

Accounts receivable represents the amounts due from customers for services rendered or for
merchandise, or for any asset sold on credit.

Inventories are assets held for sale in the ordinary course of business; in the process of
production for sale; or in the form of materials or supplies to be consumed in production or in
rendering services. The inventory of manufacturing entities is raw materials and consumable
stores; work in progress and finished goods, awaiting sale.

Non-current assets include financial assets, intangible assets and fixed assets. Financial
assets (or long-term investments) refer to investments in other companies' stocks or bonds
where the intent is to hold them for a period greater than one year. Fixed assets (or property,
plant, and equipment) are assets employed in the production of goods or rendering of services
and have a life greater than one year. They are tangible in nature, which means that they
have physical substance. These assets are actually being used. Examples are land, buildings,
machinery, and automobiles. Unlike inventory, these assets are not being held for sale in the
normal course of business. Intangible assets are assets with a long-term life that lack physical
substance, such as patents, copyrights, trademarks, or franchise fees (the right acquired by
paying a fee to open a fast-food franchise and use the name of McDonald's for instance).

Current liabilities are obligations to pay an asset at some time in the future, or to provide a
service or goods resulting from the normal operating cycle of the business. Examples are
accounts payable and accrued liabilities. Accounts payable represents amounts owed to
creditors resulting from purchases on credit. Accrued liabilities are defined as obligations
from expenses incurred but not paid at the end of the reporting period. Salaries payable,
telephone or interest payable are typical accrued liabilities. Current liabilities are liabilities
for which the amount to be settled is usually known

Non-current liabilities include financial debts and provisions. Debt obligations represent
money borrowed from third parties. Financial debts include bonds, bank overdrafts,

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mortgages 1 and other loans. Provisions are distinguished from other liabilities such as trade
payables and financial debts because there is uncertainty about the timing or amount required
in settlement. Provisions arise from a number of different types of events. The more common
of these arise from obligations in relation to site decommissioning, guarantees, outstanding
litigation and business restructuring.

Shareholders’ equity includes share capital and reserves. Share capital is own by the holders
of the company. There are many types of share capital, including ordinary shares, preference
shares, non-voting shares, and treasury shares. The classification depends on the rights
associated with the shares. Ordinary shares are the main form of share capital and confer a
residual interest in a company's net assets to the ordinary shareholders. An entity's charter
prescribes the number of ordinary shares that an entity is authorised to issue (authorised
capital). Preference shares have some form of preferential rights over other classes of
shareholders, usually ordinary shareholders. Preferential rights might include a fixed
dividend, first call on the assets in a liquidation, redemption rights or other rights that give
them priority over ordinary shareholders. An entity may repurchase and hold its own equity
shares. These shares are treasury shares. Reserves or retained earnings reflect the company's
accumulated earnings less dividends accrued and paid to shareholders

Company X Balance Sheet, as at December 31, 20XX

Cash and cash equivalents 27 Trade payable 320
Trade receivable 544 Wages payable 129
Other receivables 48 VAT due 65
Inventories 657 Income tax payable 48
Total current assets 1276 Total current liabilities 562
Intangible assets 67 Borrowings 1270
Equipment 950 Provisions 142
Land and buildings 540 Total non-current liabilities 1412
Other fixed assets 43 Net income 87
Total non-current assets 1600 Retained earnings (reserves) 315
Common equity (share capital) 500
Total shareholders' equity 902
Total assets 2876 Total equity and liabilities 2876

1
A mortgage debt is a debt that is secured by a specific asset. A company may arrange a loan with a bank and
give to the bank as security a mortgage on its land and building for instance. The mortgage is actually the legal
document by which the debt is secured.

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The balance sheet is useful for those who want to understand the financial position of a
company. It indicates what resources (assets) the company has at its disposal and what it
owes. The balance sheet may be prepared either in report form or account form. In the report
form, assets, liabilities, and capital are listed vertically. In the account form, assets are listed
on the left side and liabilities and capital on the right side.

The income statement

The income statement shows the profit earned for a given time interval. It describes all the
revenues earned and expenses supported during the accounting period. Revenue is the
increase in capital arising from the sale of merchandise or the performance of services. When
revenue is earned it results in an increase in either Cash or Accounts Receivable.

Expenses decrease capital and result from performing functions which are necessary to
generate revenue. The amount of an expense is either equal to the cost of the inventory sold,
the value of the services rendered (e.g., salary expense), or the expenditures necessary for
conducting business operations (e.g., rent expense) during the period.

Net income is the amount by which total revenue exceeds total expenses for the reporting
period. The resulting profit is added to the owner's capital account. However, if total
expenses are greater than total revenue, a net loss ensues and decreases the capital account.

It should be noted that revenue does not necessarily mean receipt of cash and expense does
not automatically imply a cash payment. Net income and net cash flow (cash receipts less
cash payments) are different. For example, taking out a bank loan will generate cash but this
is not revenue since merchandise has not been sold nor have services been provided. Further,
capital has not been altered because of the loan.

The income statement describes the revenue, expenses, and net income (or net loss) for a
period of time. It differs from the balance sheet because it is not cumulative. Income
statement accounts are of a temporary nature and are closed out at the end of the period with
the net difference being transferred to the shareholders’ equity.

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 Balance sheet Income statement

Equity
Fixed assets
Expense Revenue
Net

Inventories
Financial debts Net income

Receivables

Payables
Cash

In a classified income statement the amounts of each major revenue and expense function are
listed to facilitate analysis of the statement. All entries in an income statement are usually
classified into four major functions: Revenues, cost of goods sold, operating expenses, and
other revenues or expenses.

Revenue comprises the gross income generated by selling goods (sales) or performing
services (professional fees, commission income).

Cost of goods sold is the cost of the merchandise or services sold. In a retail store, it is the
cost of buying goods from the manufacturer. In a service business, it is the cost of the
employee services rendered. For a manufacturing company, determining the cost of goods
sold is considerably more complex. It represents the production cost of products that have
been produced and sold during the period under consideration.

Operating expenses consists of all expenses incurred or resources used in generating revenue.
Two types of operating expenses exist-selling expenses and general and administrative
expenses. Selling expenses are those incurred in obtaining the sale of goods or services (e.g.,
advertising, salespeople's salaries) and in distributing the merchandise to the customer (e.g.,
freight paid on a shipment). General and administrative expenses apply to the costs of

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running the business as a whole and do not relate to the selling function. Examples are the
salaries of the general office clerical staff, administrative executive salaries, and depreciation
on office equipment.

Other revenue (expense) applies to incidental sources of revenue and expense that are of a
non-operating nature. These revenue (expense) sources do not relate to the major purpose of
the business. Examples are interest income, dividend income, and interest expense.

Company X Income Statement, as at December 31, 20XX

Net sales 7658
Inventory, January 1 32
Purchases 3526
Cost of goods available for sale 3558
Inventory, December 31 -54
Cost of goods sold 3504
Selling expenses 1765
General and administrative expenses 1550
Operating expenses 189
Interest expense 72
Income tax 30
Net income 87

Problems

3. Prepare a classified balance sheet as of December 31 based upon the following data: cash,
CHF2,000; patents, CHF1,000; accounts payable, CHF3,000; accounts receivable,
CHF4,000; taxes payable, CHF1,000; machinery, CHF17,000; mortgage payable,
CHF7,000; retained earnings (December 31), CHF3,000; capital stock, CHF10,000.

4. Westside Corporation had the following account balances as of December 31, 20X8:
equipment, CHF18,000; cash, CHF10,000; sales, CHF30,000; capital stock, CHF10,000;
accounts payable, CHF9,000; retained earnings (January 1, 20X8), CHF4,000; advertising
expense, CHF2,000; cost of goods sold, CHF18,000; sales commissions, CHF5,000.
Prepare (a) a classified income statement, and (c) a classified balance sheet.

5. The following are the account balances for Harris Corporation as of December 31, 20X8:
investment in Belami SA stock, CHF9,000; trucks, CHF22,000; cash, CHF10,000;
accounts payable, CHF2,000; notes receivable, CHF6,000; trademark, CHF4,000; capital
stock, CHF20,000; taxes payable, CHF1,000; retained earnings (January 1, 20X6),
CHF7,000; professional fee income, CHF30,000; mortgage payable, CHF10,000;
telephone expense, CHF8,000; advertising expense, CHF11,000. Prepare an income
statement and a classified balance sheet.

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6. After six months of operations, Consuelo Gonzalez wanted to analyze the performance of
Los Ninos Day Care Center. She wanted to know where the company stood as of
December 31, 2007 and what its future prospects were.
Los Ninos Day Care Centre was a company organized by Ms. Gonzalez in 2007 to provide
supervised care, preschool education, a snack, and a noonday meal primarily for children
of working mothers. To provide for the centre’s initial capital, Ms. Gonzalez took out a
€42,000 mortgage on her own house. She invested €36,000 of this in common stock of the
centre. Friends of hers invested €18,000 in cash, receiving stock in return. A government
agency made a one-year loan of €11,930 to the centre.
With these funds, the centre purchased property for €67,200, of which €13,400 was for
land and €53,800 was for a building on the land. The purchase was financed in part with a
€45,400 mortgage, the remainder being paid in cash. Interest on the mortgage was to be
paid quarterly, but no principal repayment was required until the company had become
established. The centre also purchased €23,400 of furniture and equipment for cash.
During the first six months of operation, which ended December 31, 2007, the centre paid
out the following additional amounts in cash:
Salary to Mrs Gonzalez 13’500
Salaries (part-time employees) 8’842
Insurance (one-year policy) 2’650
Utilities 1’710
Food and supplies 7’340
Interest and miscellaneous 5’750
Total paid out 39’792

The centre received €28,600 in student fees in cash. In addition, parents owed the centre
€1,100 for student fees. As of December 31, 2007, Ms Gonzalez estimated that €660 of
supplies were still on hand. The centre owed food suppliers €1,140.
In thinking about the future, Ms Gonzalez estimated that for the next six months, ending
June 30, student fees received (in addition to the €1,100 student fees that applied to the
first six months) would be €43,100. This was higher than the amount for the first six
months because enrolments were higher.
She estimated that the centre would pay €22,030 in salaries, €2,150 cash for utilities
(which was higher than the first six months because of expected colder weather), €9,400
for additional food and supplies (higher because of higher enrolments), and €4,560 for
interest and miscellaneous (lower than the first six months because certain start-up costs
were paid for during the first six months). She also expected to pay back the government
loan.
She estimated that supplies on hand as of June 30 would be €660 and that nothing would
be owed suppliers. She did not include any additional amount for insurance because the
amount paid in the first six months covered this cost for the whole year.
She knew that many companies recorded depreciation on buildings, furniture, and
equipment; however, she had a firm offer of €95,000 for these assets from someone who
wanted to buy the centre, so she thought that under these circumstances depreciation was
inappropriate.

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a) Prepare a balance sheet and an income statement for Los Ninos Day Care Centre as of
December 31, 2007.
b) Using Ms. Gonzalez’s predictions, prepare an estimated balance sheet, an estimated
income statement and an estimated cash flow statement for the Centre as of June 30, 2008.

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ANALYZING AND RECORDING TRANSACTIONS

The accounting equation

A company’s financial position is reflected by the relationship between its assets and its
liabilities and capital. The accounting equation reflects these elements by expressing the
equality of assets to creditors' claims and owners' equity as follows:

Assets = Liabilities + Equity

The accounting equation is the basis for double entry accounting, which means that each
transaction has a dual effect. A transaction affects either both sides of the equation by the
same amount or one side of the equation only, by both increasing and decreasing it by
identical amounts and thus netting to zero. The following example illustrates how the
transactions of a business are recorded and what effect they have on the accounting equation.

On July, 1, Jane opened a small antique shop by investing CHF5’000 in cash. The following
transactions occurred during the month of July:

− Purchased CHF2’000 of merchandise on account from a supplier

− Purchased store equipment for CHF1’500 cash

− Sold merchandise for cash: cost CHF1’200, selling price CHF1’600

− Paid salary expense for the month, CHF500

− Paid rental expense for the month, CGH350

− Sold merchandise for cash: cost CHF700, selling price CHF1’200

− Purchased merchandise for CHF2’500, paid CHF1’100, the remainder on account

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We can list the entries in the accounting equation as follows:
Transaction Accounts
s Cash Inventory Equipment payable Jane's equity
a. 5000 = 5000
b. 2000 = 2000
c. -1500 1500 =
d. 1600 -1200 = 400
e. -500 = -500
f. -350 = -350
g. 1200 -700 = 500
h. -1100 2500 = 1400
Balance 4350 2600 1500 = 3400 5050

The net income comes to 50: 5050-5000 = 400-500-350+500. It corresponds to the increase
in equity.

Accounts for recording transactions

Recording each transaction directly in the balance sheet and in the income statement would
be extremely time consuming. Also, information about a specific item (e.g., accounts
receivable) would be lost through this process. This is why an account is established for each
item of the financial statements, i.e. balance sheet and income statement. At the end of the
reporting period, the financial statements can then be prepared based upon the balances of
these accounts.

The T account is the simplest form of account. It consists of a name and number, a debit side
(left side), and a credit side (right side).
Ca sh
Debit side Credit side

Increases and decreases in an item are entered in the account. For each transaction, two or
more accounts are always involved. In recording a transaction, debits always equal credits.
This is referred to as the double-entry system. If a transaction affects the left side of an
account, it also affects the right side of at least another account.

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The side in which the increase or decrease is placed depends upon the nature of the account.
A debit records an increase in assets or a decrease in liabilities and equity. A credit records
an increase in liabilities and equity or a decrease in assets.

Debit side Credit side

An increase in assets, or a decrease in A decrease in assets, or an increase in
liabilities or owners' equity. liabilities or owners' equity.

Consequently, before recording a transaction, one must determine whether the account that is
used comes from the assets side or from the liabilities and equity side of the balance sheet. If
it is an assets side account, the account is debited if the transaction increases the amount of
the account. It is credited otherwise. If it is a liabilities and equity side account, the account is
credited if the transaction increases the amount of the account. It is debited otherwise.
Negative signs are never shown in T accounts.

A single account has a debit balance when the sum of its debits exceeds the sum of its credits.
A credit balance ensues when total credits exceed total debits. Accounts with a debit balance
are mechanically reported on the asset (left) side of the balance sheet. Accounts with a credit
balance are mechanically reported on the liabilities or shareholders’ equity (right) side of the
balance sheet.

At last, remember that the net income is one of the shareholders’ equity account.
Consequently, income statement accounts are treated as any equity account. The income
statement account is credited if the transaction increases the net income, i.e. if it is a revenue.
It is debited if the transaction decreases the net income, i.e. if it is an expense.

Ledger

All accounts of a company are kept in a specific binder called ledger. The ledger provides a
classification and summarization of financial transactions and is the basis for the preparation
of the balance sheet and income statement. It is also useful for decision making because it
provides the manager with the balance in a given account at a particular time. For firms

19
utilizing computers, the accounts may be stored on magnetic tapes or disks rather than in a
ledger binder.

The chart of accounts

The sequence and numbering of ledger accounts (or T accounts) is customarily in the order in
which they will appear in the financial statements. Listed first are the balance sheet accounts-
assets, liabilities, and stockholders' equity, in that order. The income statement accounts -
revenue and expenses - follow. Of course, the more complex the organization, the greater the
number of ledger accounts required. Each account has its own number. A listing of the
account names and numbers is called the chart of accounts. The chart serves as a useful
source for locating a given account within the ledger.

The numbering system for the chart of accounts must leave room for new accounts. A range
of numbers is assigned to each financial statement category. For example, asset accounts
may be assigned the numbers 1-39, liabilities 40-59, stockholders' equity 60-69, revenue 70-
89, and expenses 90-120. For large firms, a wider range of numbers can be required for each
financial statement grouping. In fact, some companies employ a three-digit numbering
system for each account. In such a case, the first digit identifies the financial statement
category and the remaining digits apply to the position of that account within that category.
For example, 1 may be the first digit for Assets, and Cash, being the first asset account,
would be identified as 101.

The journal

The entries made in the ledger "T" accounts do not furnish all the data required about a given
transaction nor is listing of transactions in chronological order possible on "T" accounts.
These deficiencies are overcome through the use of a journal.

In actual accounting practice, business transactions are first recorded in the journal from
information in the source documents (e.g., electricity bill). The data are then transferred from
the journal to the ledger by debiting and crediting the particular accounts involved. This
process is called posting.

20
The journal is the book of original entries in which transactions are entered on a daily basis in
chronological order. This process is called journalizing. Debits and credits are listed along
with the appropriate explanations. Thus, the journal reflects in one place all information
about a transaction.

Debited account
Amount of the debit
Dat
Furnitur 5678
Accounts payable
5678
Meublobois SA - Invoice # 4375L

Amount of the
Credited

Explanation of the

The trial balance

In the process of posting to the ledger accounts, debits must equal credits; therefore the total
debits in the ledger must be in agreement with the total credits. A trial balance is prepared
which shows this equality in a schedule containing two columns - debit and credit. All
accounts are listed in the order in which they appear in the ledger, and their balances are
placed under the appropriate columns. When all accounts have been listed, the total in the
debit column must prove to the total in the credit column. If so, there is an equality of debits
and credits for the transactions entered into the ledger. If not, an error has been made.

The trial balance is a worksheet and not a formal financial statement. It serves as a
convenient basis for the preparation of the balance sheet and income statement. Balance sheet
accounts with a debit balance are classified among the assets. Those with a credit balance are
classified among the liabilities or among the shareholders’ equity. In the same way, income
statement accounts with a debit balance are classified among the expenses. Those with a
credit balance are classified among the revenues.

21
 Trial balance Income statement Balance sheet
List of accounts Liabilities
Debit Credit Debit Credit Assets
and equity
Balance sheet
accounts

Income statement
accounts

Total

Problems

7. On 2 March, Jane and John start their business by opening a bank account and depositing
CHF50’000.
On 3 March 20x5, they rent the office in which they will run their business. They pay the
first rent by bank transfer, CHF4’000. The same day, they purchase furniture for
CHF26’500. They pay immediately 50% of this amount by bank transfer. The remaining
will be paid at the end of March.
On 4 March 20x5, they run an advertising campaign costing CHF3’328, which are paid by
bank transfer.
On 15 March 20x5, they send their first invoice to their first client, CH15’800.
On 22 March 20x5, the client pays CH5’800 through a bank transfer.
On 30 March 20x5, John and Jane pays a phone bill by a bank transfer, CHF530. They pay
their debt to the furniture supplier through a bank transfer.
a) Report the transactions in the Jane and John’s balance sheet.
b) Report the transactions in both the balance sheet and in the income statement.
c) Report the transactions in the ledger of JJ.
d) Report the transactions in the journal of JJ and fill in the trial balance as of March 31.

8. Prepare the journal entries, including explanations, for the following transactions, which
occurred during the month of January 20X8:
Sept. 1. Issued capital stock for cash, CHF20,000
Sept. 11. Bought a building for CHF10,000 with a down payment of CHF3,500 and a note
payable for the balance
Sept. 23. Purchased a truck for CHF3,000 on account
Sept. 28. Bought supplies on account, CHF800

9. The following transactions are presented in the Frisky Consulting Company's journal. They
refer to the first semester of 20X9. For each transaction provide a short explanation.
Indicate whether the event acts to increase (+), decrease (-), or does not affect (n/a) the net
income. Indicate whether the event acts to increase (+), decrease (-), or does not affect

22
 (n/a) the cash position. Determine if the transaction is included into the financing (FA),
operating (OA), or investing (IA) section of the statement of cash flows.

Impact on Impact on
Date Account titles Debit Credit net cash
income position
Cash X
Jan. 5
Capital X
Cash X
Feb. 11
Loan X
Land X
Feb. 27 Cash X
Payables X
March Equipment X
15 Cash X
March Receivables X
18 Consulting Revenue X
Payables X
April 4
Cash X
Operating Expense X
April 16
Cash X
Cash X
May 15
Receivables X
Operating Expense X
April 16
Payables X
Interest X
May 26
Cash X
Payables X
June 3
Cash X
Loan X
June 12 Interest X
Cash X
Depreciation Expense X
June 31
Equipment X

10. Prepare the journal entries for the following transactions of Botox Corporation. Post the
journal entries to the appropriate "T" accounts. Prepare a trial balance, the income
statement and the balance sheet at the end of the period.
1. Paid CHF3,000 for office equipment
2. Received professional fees of CHF12,000 for services rendered
3. Bought an equipment for CHF10,000, paying 20 percent down and the balance with a
note payable
4. Purchased a machine for CHF6,000 on credit from Lawrence Machine Company
5. Paid 30 percent of the amount owed Lawrence Machine Company
6. Paid maintenance expenses of CHF300

23
11. Babcock's trial balance on March 31, 20X6, was as follows:

Babcock Trial Balance, March 31, 20X6

Debit Credit
Cash 4,000
Accounts Receivable 7,000
Auto 9,000
Building 10,000
Accounts Payable 7,000
Common Stock 20,000
Retained Earnings 3,000
30,000 30,000

The following transactions occurred in April 20X6:

April 5. Paid creditors in cash, CHF1,000
April 17. Received collections from customers in cash, CHF2,000
April 19. Professional fees earned received in cash, CHF7,000
April 30. Paid rent expense in cash, CHF2,000

The account numbers are: Cash, 101; Accounts Receivable, 102; Auto, 120; Building,
121; Accounts Payable, 201; Capital Stock, 301; Retained Earnings, 302; Professional Fee
Income, 401; Rent Expense, 502.

Based on these data, prepare the appropriate April entries on the journal, and post April
entries from the journal to the ledger. Based upon the ledger accounts, prepare a trial
balance for April. Based upon the trial balance, prepare the income statement and the
balance sheet for Babcock.

12. The Onellon company sells air-conditioners. The company does not hold inventory since
air-conditioners are not delivered by suppliers until they are sold. The transactions for
June are described below. You will record these transactions in the journal and in the
ledger of the company. You will prepare the trial balance, the income statement and the
balance sheet at the end of June.

Transactions

June 4: Sales of air-conditioners:

* Invoice # 722, payment in cash, 3622 Fr
* Invoice # 723, bank transfer, 9420 Fr
* Invoice # 724, on credit, 9435 Fr
June 6: Payment of a receivable, bank transfer, 6690 Fr
June 12: Operating expenses paid in cash, 1500 Fr.
June 14: Interest on a bank loan, 350 Fr, by bank transfer
June 18: Rent, 3420 Fr, paid by bank transfer
June 19: Acquisition of air-conditioners, Invoice # 15027, for 10780 Fr. Payment 50% by a
bank transfer, 50 % on credit.
June 21: Deposit of cash on the company’s bank account, 2500 Fr
June 25: Taxes, 880 Fr, by bank transfer

24
June 26: Payment of payables by bank transfer: 3 050Fr
June 29: Salary of an employee by bank transfer: 5 700Fr

Onellon - Trial balance, as of June 1st Debit balance Credit Balance

Capital 80 000,00
Equipment 66 000,00
Furniture 14 070,00
Payables 13 407,00
Receivables 6 690,00
Bank 4 905,00
Cash 1 812,00
Purchase 6 500,00
Operating expenses 975,00
Sales 7 545,00
100 952,00 100 952,00

25
INVENTORIES

A merchandising business or retail store is mainly involved in selling goods. The

merchandise it for resale is called inventory. Inventory is classified as a current asset since it
will be converted into cash in the short run. For a manufacturing business, three types of
inventories exist: raw materials, goods in process, and finished goods.

Perpetual and periodic inventory methods

In the perpetual method of inventory valuation an account of the inventory is made upon
each purchase and sale. This method is usually used in business where units sold are of
relatively high value, since the expense of maintaining individual inventory records otherwise
would be prohibitive. In the periodic method the inventory is counted manually at regular
intervals, either monthly, quarterly, semi-annually, or annually. The typical journal entries
recorded under each method are described below:

Perpetual Periodic

Inventory Purchase
Purchases
Cash Cash
Cash Cash
Sales
Sales Sales
Cost of goods sold
Inventory
Cost of goods sold
Periodic close-outs Inventory (beginning)
Purchases
Inventory (ending)
Cost of goods sold

26
Inventory valuation method

There are various methods for determining the value of inventory when identical goods are
acquired at different times and prices. The method used does not have to conform to the
actual, physical flow of the goods. The following data will be used to illustrate the first three
methods:

Date/Type Units Cost per Unit Total Cost

Jan. 1 Inventory 150 8 1,200
Feb. 20 Purchases 200 9 1,800
April 12 Purchases 250 10 2,500
Sept. 20 Purchases 200 11 2,200...
Goods available for sale 800 7,700

We assume that the physical inventory on December 31 is 430 units.

First-In, First-Out (FIFO) Method

This method assumes that merchandise is sold in the order of its receipt. Under the FIFO
method, merchandise on hand is considered to be that which was most recently received.
Hence, year-end inventory of 430 units is valued as follows:

Last purchase (Sept. 20) 200 units @ 11 = 2,200

Next most recent purchase (April 12) 230 units @ 10 = 2,300

Total 430 4,500

The FIFO method really turns out to be first-price-in, first-price-out. Hence, cost of goods
sold is based on the older costs. Ending inventory is reflected at the latest costs.

Last-In, First-Out (LIFO) method

In this method we assume that goods are sold in the reverse order of their acquisition. Under
the LIFO method, ending inventory is reflected at the beginning costs of the purchases made.

27
Therefore, cost of goods sold is based upon the most recent costs. The year-end inventory is
computed as follows:
Initial purchase (Jan. 1) 150 units @ 8 = 1,200
Next purchase (Feb. 20) 200 units @ 9 = 1,800
Next later purchase (April 12) 80 units @ 10 = 800

Total 430 3,800

LIFO has two advantages over FIFO. First, LIFO matches most recent costs with current
sales. Therefore, in a rising spiral net income and thus tax would be reduced. Second, LIFO
results in a more accurate measurement of net income in an inflationary period because
current costs are matched against current revenue. It therefore results in less "paper" profit.

Weighted average method

To obtain a weighted-average unit cost, the total cost of goods available for sale is divided by
the total units available for sale. This average unit cost is then used to determine inventory
and cost of goods sold. The advantage of the method is that costs are assigned equally to
both inventory and goods sold. The average unit cost is computed as follows:

Cost per unit = Cost of goods available / Units available = 7700/800 = 9.63

The value of the ending inventory is therefore: 430 units at 9.63 = 4,141

The tabulated results of these three methods reveal the following comparisons:

First-In, First-Out Last-In, First-Out Weighted Average

Cost of Goods Available for Sale 7’700 7’700 7’700
Less: Ending Inventory, Dec. 31 4’500 3’800 4’141
Cost of Goods Sold 3’200 3’900 3’559

It is to be noted that if the ending inventory is overstated, then the cost of goods sold will be
understated and net income overstated. On the other hand, if the ending inventory is
understated, then the cost of goods sold will be overstated and net income understated. It is
thus evident that the method selected can have a material effect upon the company's net
income and related tax. It also has an effect upon the balance sheet in terms of the inventory
valuation.

28
Problems

13. You have decided to launch a new business aimed at selling printed T-shirts. Each T-shirt
is sold for CHF10. Plain T-shirts are bought for CHF5 a piece. Expenses related to the
printing and sale of T-shirts (ink, electricity…) are paid cash. They amount to CHF 0.75
per T-shirt. To print T-shirts you have acquired a printing press for CHF50’000 with your
savings. The estimated life of the press is 10 years.
During your first year in business, you have acquired 8’000 plain T-shirts, 300 of them
have not yet been paid to your supplier. Over the same period, you have printed and sold
7’200 T-shirts but only 7’000 have been paid in cash. The other 200 will be paid in a near
future.
a) What is your cash position at the end of your first year in business? What is the
financial performance (i.e. net income) of your venture? Prepare the income statement and
the cash flow statement of your enterprise for your first year in business. Prepare the
balance sheet at the end of this first year. There is no income tax.
b) During your second year in business, you have acquired 15’000 plain T-shirts, 2’000 of
them have not yet been paid to your supplier. Over the same period, you have printed
13’500 T-shirts but only 13’000 have been sold, 12’700 of them having been paid in cash.
No additional investment was required in year 2. Costs and selling price per unit have not
changed. No dividend was paid. What is your cash position at the end of your second year
in business? What is the net income for this second year? Prepare the balance sheet, the
income statement and the cash flow statement at the end of this second year.

14. On January 1, the merchandise inventory of a XX company was CHF300’000. During the
year, XX company purchased CHF1’900’000 of merchandise and recorded sales for
CHF2’000’000. The gross margin on these sales was 20%. What is the cost of goods sold?
What is the merchandise inventory on December 31, at the end of the accounting period?
[The gross margin corresponds to the difference between sales and the cost of goods sold]

15. Let’s go back to the T-shirt company. In year 2, 13’500 T-shirts have been printed (unit
cost, 0.75), 13’000 printed T-shirts have been sold, 12’700 of these have been paid (unit
price, 10), 15’000 plain T-shirts have been purchased, 13’000 of those have been paid
(unit price, 5). a) Show the entries related to the purchase of plain T-shirts, to the sale of
printed ones, and to the payment of operating expenses. b) Show the entries related to the
valuation of inventories and to the determination of the cost of T-shirts sold.

16. The following information pertains for a given product.

Jan. 1 Inventory 15 units CHF20
Feb. 20 Purchase 12 units CHF24
April 10 Purchase 20 units CHF25
Nov. 15 Purchase 8 units CHF16

The physical count of ending inventory reveals that 16 units are on hand. What is the
inventory cost under the FIFO method? Under the LIFO method? Under the weighted
average method?

29
ADJUSTMENTS OF EXPENSES AND REVENUES

Principles of accrual accounting

Under accruals accounting principles, revenues are recognized when earned (the revenue
principle) and expenses are recorded when incurred to generate revenues during the same
period (the matching principle). Cash is sometimes received before or after the company
performs and earns the revenues. The same is true for expenses. The difference in the timing
of recording cash receipts and payments versus revenues and expenses require adjustments.
Since recording revenues and expenses daily as they are earned or incurred would be too
costly in terms of time and labour needed to make all the necessary entries, companies wait
until the end of the accounting period to adjust expense and revenue accounts.

Adjusting entries to make expenses match with revenues

Deferrals
a) Expenses that have been recorded but not yet realized have to be written off.

Pre-paid expenses (As) XXX

Expense (Exp) XXX

b) Revenues that have been recorded but not yet earned have to be to be written off.

Revenue (Rev) XXX

Unearned revenue (Liab) XXX

Accruals
c) Expenses that have not been recorded while realized have to be to be recognized.

Expense (Exp) XXX

Unrecognized expenses (Liab) XXX

30
d) Revenues that have not been recorded while earned have to be to be recognized.

Unrecognized revenue (As) XXX

Revenue (Rev) XXX

Problem

17. Prepare journal entries on December 31 to record the following unrelated year-end
adjustments.
The ‘Insurance expense’ account has a $4,680 debit balance before adjustment. An
examination of insurance policies shows $950 of insurance expired.
The company has three office employees who earn $100 per day for a five-day workweek
that ends on Friday. The employees were paid on Friday, December 26, and have worked
full days on Monday, Tuesday, and Wednesday, December 29, 30, and 31.
On November 1, the company received 6 months' rent in advance from a tenant whose rent
is $700 per month. The $4,200 was credited to the Unearned Rent account.
The company collects rent monthly from another tenant whose rent is $750 per month. He
has not paid his rent for December.

31
DEPRECIATING FIXED ASSETS

Recording the acquisition of fixed assets

Fixed assets are tangible, long-term assets used in the production or sale of goods or services.
They are not held for the purpose of resale to customers. Items included in this category
include land, building, machinery, equipment, and auto. Fixed assets are recorded at
historical cost, which is equal to the list price paid plus all normal incidental costs necessary
to bring the asset into existing use and location.

Depreciation of fixed assets

A fixed asset has a limited life because of physical deterioration and obsolescence. The asset
will eventually be worth only its salvage value (scrap value). The yearly expiration of the
original cost of a fixed asset is termed depreciation. Under the accrual concept, depreciation
expense is matched against the revenues from the asset. Depreciation expense is listed as an
operating expense in income statement. The accumulated depreciation of an asset serves to
reduce its original cost to arrive at the book value (carrying value). Accumulated depreciation
constitutes the portion of the asset's cost which has been recognized as expense up to the
present time. The book value of the asset is reported on the balance sheet. As the asset
becomes older, its book value declines. All fixed assets are subject to depreciation with the
exception of land. Land is retained at its original cost. If a machine originally acquired for
25’000 is depreciated for 5’000 every year. The journal entry is

Depreciation expense 5'000

Acc. depreciation of machinery 5'000

If the accumulated depreciation of the machine at year end comes to 7’500. The machine's
book value is reported on the balance sheet as follows:
Machinery 25,000
Less: Accumulated Depreciation 7,500
Book Value 17,500

32
Depreciation methods

The depreciable cost of a fixed asset (original cost less salvage value) may be charged to
expense over the asset's life under different methods. The straight-line method results in
equal depreciation charges for every period. The double-declining-balance method results in
higher depreciation charges in the earlier years and lower depreciation charges in the later
years. This method is more realistic in measuring the decline in value of fixed assets when
those are most efficient when new. Variable charge methods also exist and depend upon the
usage of the asset. An example is the units-of-production method where the depreciation
expense is directly traceable to the volume produced.

The straight-line method is the easiest and most popular method. It results in equal periodic
depreciation expenses. The method is most appropriate when the asset's usage is uniform
from period to period, as is the case with furniture. Depreciation expense is equal to

(Cost – Salvage value) / Number of years of useful life

Under the double-declining-balance method, depreciation expense is higher during the early
years. First, a depreciation rate is determined by applying a coefficient to the straight-line
rate. For example, if an asset has a life of 5 years, the straight-line depreciation rate is 20%,
and the double-declining rate will be 20% time the selected coefficient. The magnitude of the
coefficient depends on the speed of the depreciation during the first years. The higher the
coefficient, the larger the depreciation during the first years. Second, depreciation expense is
computed by multiplying the double-declining rate by the book value of the asset at the
beginning of each year. Since book values decline over time, depreciation expense will
become less each year. The method ignores salvage value in the computation. However, the
book value of the fixed asset at the end of its useful life cannot be below its salvage value.

This method is advantageous for tax purposes since higher depreciation charges in the earlier
years result in less income and thus less tax to be paid. The tax savings may then be invested
for a return. Of course, over the life of the fixed asset, the total depreciation charges will be
the same no matter what depreciation method is used. However, the timing of the tax savings
will differ. It should be noted that a company can use one depreciation method in its income
tax report and another in its stockholders' report.

33
Disposal of fixed assets

Discarding of fixed assets

When a fixed asset is no longer used, it is discarded. The asset is then removed from the
accounts. If the asset has no residual value because it is fully depreciated, the fixed asset
account is credited and the accumulated depreciation account is debited. Assume that a
company decides to discard a fixed asset purchased for 25’000 that is fully depreciated in the
accounts. The journal entry is

Acc. depreciation 25'000

Fixed asset 25'000

If the asset is not fully depreciated at the time of disposal, an entry is needed to update the
depreciation and a loss is recorded. Assume that a company decides to discard a fixed asset
purchased for 6’400. The asset is depreciated at a straight-line rate of 25 percent. The overall
depreciation recorded in the accumulated depreciation account amounts to 4’600. The asset
was used 3 months during the current accounting period. The journal entries are

Depreciation expense 400

Acc. depreciation 400
Acc. Depreciation 5’000
Loss on discard of fixed asset 1’000
Fixed asset 6’000

If a fixed asset is still being used, its cost and accumulated depreciation must remain in the
accounts even if the asset is fully depreciated. Removing the asset from the accounts would
suggest that the asset is not use.

Disposal of fixed assets

Before the sale of fixed assets may be recorded, depreciation is recognized for the fraction of
the year ending with the disposal date. The difference between the asset's selling price and
updated book value will result in a gain (selling price is greater than book value) or a loss
(selling price is less than book value). Of course, in the unlikely case that an asset is sold for
an amount identical to its book value, no gain or loss will arise.

34
On March 31, 20X9, an equipment costing 20’000 with accumulated depreciation of 18’000
as of December 31, 20X8, is sold for 2’000. The annual straight-line depreciation rate is 10
percent. Two journal entries are required. The first is to update the accumulated
depreciation account.

Depreciation expense 500

Accumulated depreciation 500

The second entry is to record the sale.

Cash 2,600
Accumulated depreciation 18,500
Equipment 20,000
Gain on disposal of fixed assets 1,100

The gain may be proved by comparing the selling price to the book value as follows:
Selling Price 2’600
Book Value (20’000-18’500) 1’500
Gain 1’100

The gain account is shown under ‘other income’ in the income statement.

Problems

18. Martin Company purchased a machine having a list price of 75’000. Because the
machine was immediately paid for, the company was entitled to a 2 percent discount.
Costs incurred to make the machine ready for use included: freight, 3’000; installation,
485; electrical wiring, 700; repair expense because the machine was improperly handled,
100; and rental of a special crane, 435. What is the acquisition cost of the machine?

19. On January 1, 20X5, a machine was purchased for 30’000. The estimated life is six years
and the salvage value is 1’500. Determine the annual depreciation a) using the straight-
line method, b) using the double-declining-balance method, coefficient=2.

20. Equipment costing 19,500 with accumulated depreciation of 12’000 is discarded. Prepare
the appropriate journal entry.

21. A printing press was purchased on January 1, 20X3, for 15’000. It has an estimated life
of 14 years and a salvage value of 1’000. The straight-line depreciation method is used.
How would the printing press and the related accumulated depreciation be shown on the
balance sheet at (a) December 31, 20X7? The press is sold for at the end of June 20X8 for
9’700. Prepare the appropriate journal entries.

22. During 2009, Kosik Company disposed of an equipment that was acquired on June 30,
2005. On January 1, 2009, prior to its disposal, the company’s accounts reflected the

35
 following: original cost 24’000, accumulated depreciation 18’000. No salvage value was
expected. The equipment was sold on March 31, 2009 for 6’300. The only entry recorded
for this transaction was

Equipment 6’300
Cash at bank 6’300
Show the entries that should be recorded to make the accounts accurate.

23. Novartis reported the following information in the notes to 2008 financial statements.

a) Why is the net book value of PPEs amounting to 13’100?

b) Where do reclassifications come from?
c) What is the amount of the PPEs’ depreciation expenses for 2008? What is the amount of
accumulated depreciations as of December 31, 2008? Why is the amount of depreciation
expenses lower than the one of accumulated depreciation?
d) Why is depreciation on disposals positive?
e) Why is there no depreciation charge on PPEs under construction?
f) What is the average estimated useful life of buildings and of other PPEs assuming that
most of them are depreciated on a straight-line basis?
g) What was the book value of PPEs sold?
h) What is the proportion of PPEs investments dedicated to growth? What is the
proportion aimed at replacing existing assets?

36
DEPRECIATING RECEIVABLES

Calculating the depreciation amount

When customers are expected not to pay their balances, receivables must be depreciated. The
depreciation is based upon a given percentage of current year net credit sales, a stated
percentage of gross accounts receivable, or an aging of the year-end gross accounts
receivable balance. The percent-of-sales method is an income statement approach to
estimating bad debts. The amount of the depreciation is computed by multiplying the current
year's net credit sales by a flat rate for uncollectible receivables. The rate is based upon past
experience and modified in light of the current environment. The aging method is balance-
sheet oriented in that each customer's account balance is aged based upon the date of sale.
The longer an account past due, the greater the probability of being uncollectible, and the
higher the depreciation.

Accounting for depreciation of receivables

The amount of the depreciation is recorded in the income statement using a ‘Bad debt
expense’ account. Under the direct write-off method, receivables are directly depreciated. If a
receivable is depreciated for 80, the journal entry is
Bad debt expense 80
Receivables 80

Instead of depreciating receivables directly, a ‘Allowance for uncollectible receivables’

account is frequently used. The journal entry is
Bad debt expense 80
Allowance for
80
uncollectible receivable

Before being depreciated, receivables that are potentially uncollectible can be posted to a
‘Uncollectible receivables’ account. Assume that a receivable of 150 must be depreciated for
123, the journal entries are

37
Uncollectible receivables 150
Receivables 150
Bad debt expense 123
Allowance for
123
uncollectible receivable

Writing-off allowances for uncollectible receivables

When it is obvious that a customer is no longer able to pay the amount due (for example, the
customer has declared bankruptcy), the account should be written off. The journal entry is

Allowance for uncollectible accounts XX

Accounts receivable XX

The allowance account is debited because part of the allowance provision established for
future uncollectibles has now been used up. In case of a full or partial recovery of a
previously written-off customer account balance, because the customer may unexpectedly
receive funds from another source and wish to reinstate his or her business activities for
instance, a journal entry must restore the account.

Problems

24. The uncollectible accounts of a company are as follows at the end of 20X6.
Receivables Allowance for uncollectible Payments
Customers at the end of accounts before 20X6 occurring in Estimated loss at the end of 20X6
(in percent of the amount due)
20X5 adjustments 20X6
Albert 57'400 33'600 23'912 100% (Totally insolvent)
Benoît 35'880 15'000 11'960 80%
Charles 14'352 3'600 5'980 100% (Totally insolvent)
Didier 9'568 - - 30%

Prepare the appropriate journal entries at the end of 20X6.

38
25. The uncollectible accounts of the KK Company were as follows at the end of 20X5.

Receivables at Allowance for uncollectible Estimated loss at the

the end of end of 20X5 (in percent
Customers accounts before 20X5
20X5 of the amount due)
adjustments
Octave 150’000 25’000 15%
Pierre 35’000 0 25%
Gustave 65’000 35’000 60%
Prepare the appropriate journal entries at the end of 20X5.
In 20X6, Octave has paid CHF75’000. Gustave has paid CHF40’000. He has declared
bankruptcy. He is henceforth totally insolvent. Pierre did not pay anything. The
uncollectible accounts of the KK Company are as follows at the end of 20X6.

Allowance for uncollectible Estimated loss at the end of

Receivables at the 20X6 (in percent of the amount
Customers accounts before 20X6
end of 20X6 adjustments due)

Octave ? ? 50 %
Pierre ? ? 40 %
Gustave ? ? 100% (Totally insolvent)
Jacques 200 000 ? 15 %
Fill the table above, and prepare the appropriate journal entries at the end of 20X6.

39
PROVISIONS

Provisions and contingent liabilities

A liability is a present obligation resulting from past events. Settlement is expected to result
in a cash outflow. A company may face potential liabilities arising from events that occurred
during the accounting period. However, uncertainty exists with regard to the amount and to
the timing of the company liability. Such liabilities are called contingent liabilities. They are
reported as a provision.

An enterprise must recognize a provision if, and only if

− a present obligation (legal or constructive) has arisen as a result of a past event (the
obligating event),

− a payment is probable ('more likely than not')

− the amount can be estimated reliably.

Provisions may result from litigation, product warranties, restructuring by closure or

reorganization, land contamination, etc. The amount recognized as a provision should be the
best estimate of the expenditure required to settle the present obligation at the balance sheet
date, that is, the amount that an enterprise would rationally pay to settle the obligation at the
balance sheet date.

Reporting provisions

Recording a provision causes a provision expense to be recognized. A provision account is

created on the balance sheet with the non-current liabilities. Assume that a company has
reported a provision for restoration costs related to the dismantlement of a transmitter station.
This provision amounted to 70.

40
Provision expense 70
Provision for site restoration 70

The following year, the restoration costs are estimated to 65. The provision is then too high.
It has to be lowered by 5.

Provision for site restoration 5

Overestimated provision 5

Finally, the station is dismantled for 74. In a first step, the expenses related to the
dismantlement are recorded without considering the provision.

Expenses 74
Cash at bank 74

In a second step the provision is written off. This leads the company to record a revenue that
offsets the expenses associated with the transaction covered by the provision.

Provision for site restoration 65

Expense covered by a provision 65

Problems

26. Buzz Coffee Shop is famous for its large servings of hot coffee. After a famous case
involving Mc-Donald’s, the lawyer of Buzz warned management that it could be sued if
someone were to spill hot coffee and be burned. Unfortunately, in 2007, the prediction
came true when a customer filed suit. The company’s lawyer estimated the company were
to pay $350’000 in damages. The case went to trial in 2009 and the jury awarded the
customer $400’000 in damages, which the company immediately appealed. During 2009,
the customer and the company settled their dispute for $150’000. What is the proper
reporting of this liability each year?

27. Buzz Coffee Shop is famous for its large servings of hot coffee. After a famous case
involving Mc-Donald’s, the lawyer of Buzz warned management that it could be sued if
someone were to spill hot coffee and be burned. Unfortunately, in 2007, the prediction
came true when a customer filed suit. The company’s lawyer estimated the company were
to pay $350’000 in damages. The case went to trial in 2009 and the jury awarded the
customer $400’000 in damages, which the company immediately appealed. During 2009,

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 the customer and the company settled their dispute for $150’000. What is the proper
reporting of this liability each year?

28. Belauto SA is a reseller of used cars. It offers a one-year warranty for all vehicles sold.
On average, only 4 percent of the cars sold during the last ten years have used the
warranty. The average cost of a repair amounted to 1’230 Fr. In 2008, Belauto has sold
1'457 vehicles. The provision for warranty recorded in 2007 was 82'445 Fr. Prepare the
necessary entry for 2008.

29. The Bol company plans to renovate its buildings in 2011for a cost estimated at 60'000 Fr.
The management wishes to spread the expenditure over three years by recording a
provision of 30'000 Fr both in 2009 and 2010. Prepare the necessary entries.

30. Discuss the following information reported in the notes to Novartis 2008 financial
statements.
 
Environmental provisions 
The material components of the environmental provisions consist of costs to sufficiently clean and refurbish 
contaminated sites and to treat and where necessary continue surveillance at sites where the environmental 
exposure is less significant. The provision recorded at December 31, 2008 totals USD 966 million (2007: USD 
874 million) of which USD 42 million (2007: USD 26 million) is included in current liabilities and consists of USD 
798 million (2007: USD 713 million) provided for remediation at third party sites and USD 168 million (2007: 
USD 161 million) for remediation at owned facilities. 
In  2007  Novartis  substantially  increased  its  provision  for  worldwide  environmental  liabilities  by  USD  614 
million. This increase included amounts related to the creation of a Swiss foundation for the remediation of 
the  Basel  regional  landfills  in  the  border  area  of  Switzerland,  Germany  and  France  following  internal  and 
external investigations completed during the year. 
In  the  US,  Novartis  has  been  named  under  federal  legislation  (the  Comprehensive  Environmental  Response, 
Compensation  and  Liability  Act  of  1980,  as  amended)  as  a  potentially  responsible  party  (PRP)  in  respect  of 
certain sites. Novartis actively participates in, or monitors, the clean‐up activities at the sites in which it is a 
PRP.  The  provision  takes  into  consideration  the  number  of  other  PRPs  at  each  site  and  the  identity  and 
financial position of such parties in light of the joint and several nature of the liability. 
The requirement in the future for Novartis ultimately to take action to correct the effects on the environment 
of  prior  disposal  or  release  of  chemical  substances  by  Novartis  or  other  parties,  and  its  costs,  pursuant  to 
environmental  laws  and  regulations,  is  inherently  difficult  to  estimate.  The  Novartis  future  remediation  ex‐
penses are affected by a number of uncertainties which include, but are not limited to, the method and extent 
of  remediation,  the  percentage  of  material  attributable  to  Novartis  at  the  remediation  sites  relative  to  that 
attributable  to  other  parties,  the  financial  capabilities  of  the  other  potentially  responsible  parties  and  the 
timing  of  expected  expenditures.  Novartis  believes  that  its  total  provisions  for  environmental  matters  are 
adequate  based  upon  currently  available  information.  However,  given  the  inherent  difficulties  in  estimating 
liabilities in this area, Novartis may incur additional costs beyond the amounts provided. 
Legal matters 
A number of Novartis subsidiaries are, and will likely continue to be, subject to various legal proceedings that 
arise  from  time  to  time,  including  product  liability,  commercial,  employment  and  wrongful  discharge, 
antitrust, securities, sales and marketing practices, health and safety, environmental and tax litigation claims, 
government  investigations  and  intellectual  property  disputes.  As  a  result,the  Group  may  become  subject  to 
substantial liabilities that may not be covered by insurance. While Novartis does not believe that any of these 
legal  proceedings  will  have  a  material  adverse  effect  on  its  financial  position,  litigation  is  inherently 
unpredictable  and  large  verdicts  sometimes  occur.  As  a  consequence,  Novartis  may  in  the  future  incur 
judgments  or  enter  into  settlements  of  claims  that  could  have  a  material  adverse  effect  on  its  results  of 
operations or cash flows.  
Governments  and  regulatory  authorities  have  been  stepping  up  their  compliance  and  law  enforcement 
activities  in  recent  years  in  key  areas,  including  corruption,  marketing  practices,  antitrust  and  trade 
restrictions.  The  Group’s  businesses  have  been  subject,  from  time  to  time,  to  such  governmental 
investigations and information requests by regulatory authorities. In some instances, the inherent uncertainty 

42
of litigation, the resources required to defend against governmental actions and the risk to reputation as well 
as of potential exclusion from US federal government reimbursement programs have contributed to decisions 
by companies in the Group’s industry to enter into settlement agreements with governmental, and particularly 
federal,  authorities.  Those  settlements  have  involved  and  may  continue  to  involve  large  cash  payments, 
including  the  potential  repayment  of  amounts  allegedly  obtained  improperly  and  penalties  up  to  treble 
damages. In addition, settlements of healthcare fraud cases typically involve corporate integrity agreements 
which are intended to regulate company behaviour for a period of years. 

31. In 1980, the Remco company was authorized to run a golden mine in the North of
Canada. Operating the mine was the only business of Remco. Restoration costs of the site
were estimated at 500’000 $ per year, but Remco never recorded any provision.
The business was highly profitable. Annual profits came to about 750’000$, and each year
the company paid out dividends corresponding to the overall net income.
At the end of the 90s, as the vein ran out, the financial position of the company started
deteriorating. Management decided to close the business. Fixed assets were sold for 60%
of book value. Receivables were all recovered. The Canadian government invested
urgently $1.8 million to finance the strictly necessary cleaning-up actions.
How this disaster could have been avoided had the firm recorded annual provisions?

Remco balance sheet, as of Decembre 2001 (x1000 $)

Equipment 12’582 Equity 5’429
Drills 6’581 Net income -622
Trucks 2’488 Bank loan 14’005
Receivables 323 Payables 3’589
Cash 157
Total 22’401 Total 22’401

43
NOVARTIS – CONSOLIDATED FINANCIAL STATEMENTS

Consolidated balance sheets

44
Consolidated income statements

Consolidated cash flow statements

45
 Glossary of Accounting Terms
Account balance is the difference between the debit and the credit side of a T account.

Accounts receivable refer to amounts of future cash receipts that are due from customers
(i.e., amounts to be collected in the future). Accounts receivable are shown on the asset side
of the balance sheet.

Accrual (or accrual-based) accounting recognizes the effects of accounting events when
such events occur regardless of the time cash is exchanged.
Accrued expenses are expenses incurred but not yet paid in cash. When recorded, such
expenses are usually shown in the liabilities section of the balance sheet.

Accrued revenue is revenue earned but not yet received. When recorded, such amounts are
usually shown as interest receivable in the balance sheet and interest revenue in the income
statement.

Accumulated depreciation is a cumulative of all depreciation expenses recognized for a

particular asset. It represents the estimated cost of an asset used in operations. Accumulated
depreciation is an example of a contra asset account. This account is included in the balance
sheet under related asset accounts.

Adjusting entries adjust the account balances before the final financial statements are
prepared. Each adjusting entry affects one balance sheet account and one income statement
account.

Allowance for doubtful accounts (also called allowance or reserve for bad debts) is the
company's best estimate of uncollectible accounts receivable. It is determined based on
certain historical or current data about the company's financial activity.

Amortization is allocation of the cost of intangible assets to expense in a systematic and

rational manner over the useful life of the asset.
Assets are economic recourses of a business used to accomplish its main goal, i.e., increase
owners' wealth.

Balance sheet presents assets, liabilities and owner's equity at a specific date. A balance
sheet is also called Statement of Financial Position.

Book value, also referred to as carrying value, is the result of asset and related contra asset
accounts offset. In other words, book value is the difference between an asset account
(i.e.,cost) and corresponding contra asset account (i.e., accumulated depreciation).

Cash (or cash-basis) accounting recognizes the effects of accounting events when cash is
exchanged regardless of the time events occur. Cash-basis accounting is not in accordance
with generally accepted accounting principles (GAAP).

Cash flow statement summarizes information about cash outflows (payments) and inflows
(receipts). This statement may also include certain information not related to actual cash
flows.

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Cash inflows are sources of cash; for example, payments from customers, capital
acquisitions, etc.
Cash outflows are uses of cash; for example, payments to vendors, paying off bank loans,
etc.

Claims: A company's assets belong to the resource providers who are said to have claims on
the assets.

Contra asset account is one that is offset against an asset account on the balance sheet.
Contra asset accounts have credit balances and thus, reduce asset account balances.

Cost of goods available for sale is the cost of goods acquired during a period plus the cost of
goods on hand at the beginning of the period. This cost represents all inventories available for
sale during the period.
Cost of goods sold (COGS) is the difference between the cost of goods available for sale and
the cost of goods on hand at period end. This cost represents the cost of goods sold by the
company during the period.

Credit is the right side of a T account.

Debit is the left side of a T account.

Deferral refers to recognition of revenues or expenses at some time after cash has been
transferred.
Depreciation is allocation of the cost of property, plant, and equipment to expenses over their
useful (economic) life in a systematic and rational manner.

Double-declining method applies a constant rate (double of the straight-line rate) to the net
book value of the asset and produces a decreasing annual depreciation expense over the asset
useful life. The decrease in depreciation relates to the decrease in the asset's net book value in
each subsequent period.

Double-entry bookkeeping rule states that any transaction is recorded at least twice.

Equity is what the company "owes" to owners.

Expenses are decreases in assets or increases in liabilities that result from operating activities
undertaken to generate revenue.

Financial accounting provides information that is designed to satisfy the needs of external
users. Such reporting is usually done in the form of financial statements.

Financial reporting is a process through which companies communicate information to the

public.

First-in, first-out (FIFO) inventory costing method assumes that the costs of earliest
inventories acquired are the first to be recognized as the cost of goods sold.

Gains are similar to revenues; however, gains result from incidental transactions rather than
from operating activities.

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General journal (book of original entry) contains records about all transactions of an entity.
In particular, the journal includes such data as the event date, accounts involved, explanations
and amount(s).
Generally Accepted Accounting Principles (GAAP) are common standards that indicate how
to report economic events.

Gross margin is the difference between the sales revenue (i.e., revenue generated from sales)
and the cost of goods sold. Gross margin shows what profit the company made after cost of
goods sold, but before any other expenses (selling and administrative, etc.).

Historical cost is based on the amount originally exchanged to acquire an asset. Such cost
includes the purchase price and any additional costs necessary to obtain the asset and prepare
it for the intended use. Additional costs (costs besides the purchase price) may include
transportation costs, insurance for asset delivery and others. A historical cost also refers to an
accounting principle requiring financial statements to be based on original costs.

Income statement presents revenues and expenses and resulting net income or loss for a
period of time. An income statement is also called Statement of Operations, Earnings
Statement, or Profit and Loss Statement (P/L).

Intangible assets may be represented by a piece of paper or document. The real value of such
assets is the rights and privileges extended to their owners. Examples of intangible assets can
be patents, trademarks and customer lists.

Inventory is a current asset on a company's balance sheet. Inventory includes goods for
resale, raw materials, spare parts, etc.
Last-in, first-out (LIFO) inventory costing method assumes that the last acquisitions in
inventories are the first to be recognized as the cost of goods sold.

Ledger is a collection of all accounts a business maintains in its accounting system. With the
development of computerized accounting systems, ledgers are often in the form of electronic
records (databases).

Liabilities are debts and obligations of a company.

Losses are similar to expenses in the way that both decrease assets or increase liabilities;
however, losses differ from expenses in that they are caused by incidental transactions, rather
than from ordinary operating activities.

Net income is the excess of asset increases (revenues) and asset decreases (expenses) for a
period. Note that distributions do not fall under expenses caption and thus are not used in
calculating the net income.
Operating income is the difference between the gross margin and selling and administrative
expenses.

Periodic inventory system adjusts the inventory account only at the end of an accounting
period. Purchases and sales do not affect the inventory account during the accounting period,
but do affect at the period end.

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Permanent accounts are balance sheet accounts. They are not closed each period. Their
balances are carried forward into the next period. Permanent accounts are also called real
accounts.

Perpetual inventory system means that the inventory account is adjusted perpetually. The
inventory account is affected each time inventory is sold or purchased.

Posting is the process of transferring the accounting information from journals to the ledger.
For example, all information from a cash journal is posted to the ledger to update the cash
account(s).

Prepaid expenses are expenses paid in cash and recorded as assets before they are used or
consumed. Prepaid expenses are usually shown in the assets section on the balance sheet.
Recognition is the fact of recording an event in financial records (books).

Retained earnings form a component of equity resulting from earnings activities.

Revenue is an increase in assets or decrease in liabilities resulting from the operating

activities of an entity.

Salvage value is portion of an asset cost that is expected to be recovered at the end of its
useful life.

Selling and administrative expenses are expenses of selling and administrative nature that
are not directly traceable to a specific product. Examples are advertising, administrative
salaries and insurance, among others.

Source documents (also called business documents) serve as a basis for accounting entries.
They are what accountants use to record accounting transactions.

Statement of changes in equity shows all changes in owner's equity for a period of time. This
statement is also called Owners' Equity Statement.
Straight-line depreciation is a depreciation method in which periodic depreciation is the
same for each period of the asset useful life.

T account is an individual accounting record that shows information about increases and
decreases in one balance sheet or income statement account. It is so called because it has a
form of letter T.

Tangible assets are those which one can touch and include natural recourses, machinery,
tools, equipment, buildings and land, among others.

Temporary accounts are closed at the end of each period. These are mostly income statement
accounts, except for a distribution account that is equity statement account. Temporary
accounts are also called nominal accounts.
Trial balance is a list of all accounts with their balances at a point in time.

Unearned revenue represents cash received and recorded as liabilities before revenue is
earned. These amounts are shown in the liabilities section on the balance sheet.

49
Useful life is a term of service during which an asset is expected to provide benefits to a
company.
Weighted-average (average cost) inventory costing method assumes that the average cost of
inventories is to be recognized as the cost of goods sold.

50