Financial Accounting and Reporting

Equity investment – Dividend, Share Split, and Share Right (Valix Practical Accounting 1): Mistakes and
Realization

• Take note when there is share dividend declaration because it affects the cost of the shares when
it is sold. The share dividend increases the number of shares making the cost per share lesser.
• For average approach, get the total cost of the investment and divide it with the remaining shares
to get the average cost. Make sure you divide it with the current number of the shares. Meaning,
check if there was a previous sales transaction or share dividend declaration or share splits.
• For the share in dividends, multiply the dividends declared with the percentage share – including
preference shares.
• Be careful with the percentage share, if the financial asset reaches the quantitative threshold of
20%, if the problem is silent as to its classification, the FA is accounted using the equity method.
• Liquidating dividends are not considered Dividend Income or Dividend Revenue.
• Initial Measurement of share rights is at FV.
• Cost of the shares when the share rights are exercised: Initial Measurement of SR + Cash paid for
the purchase of shares.
Journal entry for exercising share rights:
Investment in Shares xxx
Cash xxx
Share rights xxx
• Theoretical or parity value of the share (assumed Fair Value derived from the market value of
the share). To get the VALUE OF ONE RIGHT:

When the shares are selling right on:

Market Value of shares right on minus subscription price
Number of rights to purchase one share + 1

When the shares are selling ex-right:

Market Value of shares ex-right minus subscription price
Number of rights to purchase one share

• When the share rights are not accounted for separately, the receipt of share rights requires only
a memorandum entry. “Received 10,0000 share rights to subscribe for new shares at P 100 per
share for every five rights held, or a total of 2,000 shares.”

When it is exercised the JE would be:

Investment in Shares 200,000
Cash (2,000 shares x P 100) 200,000
If the share rights are sold, the sale is simple recorded by debiting cash and crediting the original
investment account. NO GAIN OR LOSS is RECOGNIZED from the SALE.

Thus is the SR are sold for 150,000, the JE is:

 Cash 150,000
Investment in Shares 150,000
• If the SR are not exercised but expired, only a memorandum is necessary to record the
expiration.

PAS 28 – Investment in Associate

An intercorporate share investment is the purchase of the equity shares of one entity investing in another
through the acquisition of share capital. An entity may purchase enough shares of another entity in order
to exert significant influence over the financial and operating policies.

The assessment of significant influence is a matter of judgement.

Significant influence: is the power to participate in the financial and operating policy decisions of the
investee but not control or joint control over those policies.

If the investor holds, directly or indirectly through subsidiaries 20% or more of the voting power of the
investee, it is presumed that the investor has significant influence, unless it is presumed that the investor
has significant influence, unless it can be clearly demonstrated that it is not the case.

Beyond the 20% threshold of ownership, PAS 28 provides that the existence of significant influence
evidence by the following factors. (PaReProMI)

a. Participation in the policy making process

b. Representation in the Board of Directors
c. Provision of essential technical information
d. Material transactions between the investor and investee
e. Interchange of managerial personnel

Potential Voting rights:

• An entity may own share warrants (share rights/pre-emptive right), debt or equity instruments
that are convertible into ordinary shares that have the potential, if exercised or converted, to
give the entity additional voting power over the financial and operating policies of another entity.

• PAS 28, par. 7, provides that the existence of such potential voting rights should be considered in
assessing whether an entity has significant influence.

• The potential voting rights should be currently exercisable or convertible.

• However, when potential rights exist, the investor’s share in profit or loss of the investee and of
changes in the investee’s equity is determined on the basis of “present ownership interest” and
does not reflect the possible exercise or conversion of potential voting rights.
Loss of significant influence: An entity loses significant influence over an investee when it loses the power
to participate in the financial and operating policy decisions of the investee.

The loss of significant influence can occur with or without change in the absolute or relative ownership
interest. For example:
• When an associate becomes subject to control of a government, court, administrator or regular;
or
• As a result of a contractual agreement.

Equity Method - is based on the economic relationship between the investor and the investee. The
investor and the investee are viewed as a single economic unit. The investor and the investee are one and
the same.
The equity method is applicable when the investor has a significant influence over the investee.

Investment in Associate
Beg. Balance XX XX Share in Dividends
Investment Income (P/L) XX XX Share in Investee’s OCL
Share in Investee’s OCI (OCI)/ Revaluation Surplus XX XX Impairment Loss
XX Ending Balance

Note:
• The investee and investor are viewed as a single economic unit. Hence, the movement of the
investee’s equity is also the same with the investor’s investment account (only proportionate to
his share).
• If the investment is in preference shares, the equity method is not appropriate regardless of the
percentage because the preference shares are non-voting equity.
• Investment in preference shares may be accounted for as at FVPL or FVOCI or at cost.
• The Investment in Associate is Noncurrent Asset.
• Cumulative PS: Deduction from the Investee’s total income even when it is not declared.
• Non-cumulative PS: have to be declared before it is deductible from the Investee’s total income.
Excess of Cost over carrying amount: Cost of the Investment > CA of the Net Assets Acquired
If the Investor pays more than the CA of the NA acquired, the DIFFERENCE is commonly known as “EXCESS
OF COST OVER CA” and may be attributed to the following:
• Undervaluation of the investees’ assets such as building land and inventory.
• Goodwill
If the assets are fairly valued, accountants frequently attribute the excess of cost over carrying amount
of the underlying net assets to goodwill.
Note:
• If the excess is attributable to the undervaluation of depreciable asset, it is amortized over the
remaining life of the depreciable asset.
• If excess is attributable to the undervaluation of LAND, it is not amortized because the land is
undepreciable. The amount is expensed when the land is sold.
• If the excess is attributable to inventory, the amount is expensed when the inventory is sold.
• If the excess is attributable to goodwill, it is not amortized but is included in the carrying amount
(not separately presented).
• The entire investment in Investment in Assoc. including the goodwill is tested for impairment at
the end of the reporting period.
 INVENTORIES (PAS 2)

Definition.

Inventories are assets held for sale in the ordinary course of business (OCB) (1), in the process of
production for such sale (2) or in the form of materials or supplies (3) to be consumed in the production
or in the rendering of services.

• Inventories encompass goods purchased and held for resale.

• It also encompasses finished goods produced, goods in process and materials and supplies
awaiting use in the production process.

Classes of inventories:

1. Inventories of a trading concern – one that buys and sells goods in the same form purchased
(merchandise inventory)
2. Inventories of a manufacturing concern – one that buys goods which are altered or converted
into another form before they are made available for sale

Inventories of a manufacturing concern are:

1. Finished goods – are completed products which are available for sale. Finished goods have
been assigned their full share of manufacturing costs.
2. Goods in process or work in process – are partially completed products which require further
process or work before they can be sold.
3. Raw materials – are goods that are yet to be used in the production process. No work has
been done on them as yet by the entity inventorying them.
• Broadly, raw materials cover all materials used in the manufacturing process.
• However, frequently raw materials are RESTRICTED to materials that will be physically
incorporated in the production of other goods and which can be traced directly to
the end product of the production process.
4. Factory or manufacturing supplies – are similar to raw materials but their relationship to the
end product is indirect. Factory or manufacturing supplies can be referred to as indirect
materials.
• It is indirect because they are not physically incorporated in the products being
manufactured.
• There are other manufacturing supplies like paint and nails which become part of the
finished product. However, since the amounts involved are insignificant it is
impractical to attempt to allocate their costs directly to the product.
• These supplies find their way into the product as part of the manufacturing overhead.

Goods includible in the inventory:

As a rule, all goods to which the entity has TITLE shall be included in the inventory, regardless of location.

Applying the legal test, the following items are includible in inventory:

1. Good owned and on hand

2. Goods in transit and sold FOB Destination
 3. Goods in transit and purchased FOB Shipping point
4. Goods out on consignment
5. Goods in the hands of salesmen or agents
6. Goods held by customers on approval or trial.

Exception to the legal test:

Installment contracts – may provide for retention of title by the seller until the selling price is fully
collected. Following the LEGAL TEST, the goods sold on installment basis are still the property of the seller
and therefore normally includible in his inventory.

In such a case, it is an ACCEPTED ACCOUNTING PROCEDURE to record the installment sale as a regular
sale involving deferred income on the part of the seller and as a regular purchase on the part of the buyer.

Thus, the goods sold on installment are included in the inventory of the buyer and excluded from that of
the seller. This is a clear example of economic substance prevailing over the legal form.

FOB – Free on Board

FOB Destination – ownership of goods purchased is transferred only upon receipt of the goods by the
buyer at the POINT of DESTINATION.

When the goods are still in transit, the seller still owns the goods. Hence, the seller is legally be responsible
for freight charges and other expenses up to the point of destination.

FOB Shipping point – ownership is transferred upon shipment of the goods and therefore, the goods in
transit are the property of the buyer.

Accordingly, the buyer shall legally be responsible for freight charges and other expenses from the point
of shipment to the point of destination.

An accountant should carefully analyze the invoice terms of goods that are in transit at the end of the
accounting period to determine who has legal title.

Freight terms

a. Freight collect – freight charge on the goods shipped is not yet paid. The common carrier shall
collect the same from the buyer. Under this, the freight charge is actually paid by the buyer.
b. Freight prepaid – freight charge is already paid by the seller.

No adjustments in JE: FOB Destination: Freight Prepaid; FOB Shipping point: Freight collect

Maritime shipping terms:

c. FAS or free alongside: A seller who ships FAS must bear all expenses and risk involved in delivering
the goods to the DOCK or ALONGSIDE the vessel on which the goods are to be shipped.
The buyer bears the cost of LOADING and SHIPMENT and thus, title passes to the buyer when the
carrier takes possession of the goods.
d. CIF or Cost, Insurance and freight: Under this shipping contract, the buyer agrees to pay in a
lumpsum the cost of the goods, insurance cost and freight charge. May be modified to CF (without
Insurance cost).
 Either case, the seller must pay for the cost of loading. Thus, title and risk of loss shall pass to the
buyer upon delivery of the goods to the carrier.
e. Ex-ship: seller bears all expenses and risk of loss until the goods are unloaded at which time and
risk of loss shall pass to the buyer.

Consigned goods

A consignment is a method of marketing goods in which the owner called the consignor transfers physical
possession of certain goods to an agent called the consignee who sells them on the owner’s behalf.

Consigned goods should be included in the consignor’s inventory and excluded from the consignee’s
inventories.

Freight and other handling charges on goods OUT ON CONSIGNMENT are part of the cost of goods
consigned.

When consigned goods are sold by the consignee, a report is made to the consignor together with a cash
remittance for the amount of sales minus commission and other expenses chargeable to the consignor.

For example: Sales P 100,000; Commission P 15,000; Advertising P 2,000

J.E.

Cash 83,000
Commission 15,000
Advertising 2,000
Sales 100,000

Incidentally, consigned goods are recorded by the consignor by means of MEMORANDOM ENTRY.

Accounting for inventories:

1. Periodic system – calls for the physical counting of goods on hand at the end of the accounting
period to determine quantities. The quantities are then multiplied by the corresponding unit costs to
get the inventory value for balance sheet purposes. This approach gives actual or physical
inventories.
Generally used when the individual inventories have small peso investment, such as groceries,
hardware and auto parts.
2. Perpetual system – REQUIRES the maintenance of records called stock cards (these are kept to reflect
and control both units and costs) that usually offer a running summary of the inventory flow and
outflow (shows the inventory on hand at a particular moment). Inventory increases and decreases
are reflected in the stock cards and the resulting balance represents the inventory. This approach
gives BOOK or PERPETUAL INVENTORIES.
Perpetual inventory procedure is commonly used where the inventory items are treated individually
represent a relatively large peso investment such as jewelry and cars.
When the perpetual system is used, a physical count of the units on hand should at least be made
once a year to confirm the balances appearing on the stock cards.
 Inventory and perpetual JE…..

Inventory shortage or overage

For example, if the merchandise inventory account has a debit balance of P 65,000. If at the end of
the accounting period, a physical count indicates a different amount, an adjustment is necessary to
recognize any inventory shortage or overage. If the physical count shows an inventory on hand of
55,000, the following adjustment is necessary:

Inventory shortage 10,000

Merchandise Inventory 10,000

The inventory shortage is usually closed to COGS because this is often the result of normal shrinkage
and breakage in inventory. Abnormal and material shortage shall be classified and presented as
OTHER EXPENSE.

Trade discounts: to encourage trade or increase sales (not recorded); a reduction to the catalog price.
Cash discounts: to encourage prompt payment (recorded); a deduction from the invoice price
(purchase discount – buyer; sales discount – seller)

Purchases less PD = Net purchases

Sales less sales discount = Net sales

If payment is within the discount period:

Accounts payable xx
Purchase discount xx
Cash xx

Methods of recording purchases: Gross method & Net method

GM:
Purchases xxx
AP xxx

AP xxx
PD xxx
Cash xxx

AP xxx
Cash xxx
NM:
Purchases (net of discount) xxx
 AP xxx

AP xxx
Cash xxx

AP xxx
Purchase discount loss (other expense) xxx
Cash xxx

If no payment at the end of the accounting period and the discount period has expired:

PDL xxx
AP xxx

Gross method vs. Net Method

• The cost measured under the net method represents the cash equivalent price on the date of
payment and therefore the theoretically correct historical cost.
• However, in practice, most entities record purchases at gross invoice amount.
• Technically, the gross method violates the matching principle because the discounts are recorded
only when taken or when cash is paid rather than when purchases that give rise to the discount
are made. If applied consistently over time, it usually produces no material errors in the financial
statements.

Cost of purchase of inventories: (PIIF-H)

1. Purchase price (less trade discounts, rebates, etc.)

2. Import Duties
3. Irrevocable taxes
4. Freight
5. Handling and other costs directly attributable to the acquisition of FG, materials and services.

Note:

• Does not include foreign exchange differences

• Deferred settlement terms: Purchase price for normal credit terms less Amount Paid = Interest
Expense (over the period of financing)

Cost of Conversion

• Includes cost directly related to the units of production such as Direct Labor; and
• Also includes systematic allocation of Fixed and Variable production overhead that is incurred in
converting the materials into FG.
• Fixed production overhead: is the indirect cost of production that remains relatively constant
regardless of the volume of the production. Example: depreciation and maintenance of factory
building and equipment, and the cost of factory management and administration.
• Variable production overhead: indirect cost of production that varies directly with the volume of
production.
Example: indirect labor and indirect materials

Allocation of fixed factory overhead

Other cost – is included in the cost of inventories only to the extent that it is incurred in bringing
the inventories to their present location and condition.

For example: it may be appropriate to include the cost of designing product for specific customers
in the cost of inventories.

The following costs are EXCLUDED from the cost of inventories and recognized as expenses in the
period when incurred: (ASAD)

a. Abnormal amounts of wasted materials, labor and other production costs

b. Storage costs, unless these costs are necessary in the production process prior to a further
production stage
c. Administrative overheads that do not contribute to bringing inventories to their present
location and condition
d. Distribution or selling costs

Cost of inventories of a service provider

The cost of service provide consists primarily of the labor and other costs of personnel directly
engaged in providing the service, including supervisory personnel and attributable overhead.

Sales and general administrative personnel are not included but are recognized as expenses in the
period in which they were incurred.

Valix Problems

Notes:

• Bodega, shipping department, and Receiving department are different locations.

• Items segregated as per sales contract should NOT be included in inventory even though
the entity still has custody of the inventories.
• Items currently being used for window display or counter for sale are still part of
inventories.
• Advance payments and insurance, these costs are not included in computing for
inventory balance.
• Advertising catalogs and shipping cartoons are not included in inventory balance.
• If % based on cost, it means the percentage is the mark up on cost (50% profit on cost:
/150% to get the cost of the inventories
• If % based on profit, the percentage is the gross profit. For example: Sales (100%) and the
% is 40, then 60% of sales price must be the cost of the inventories.
• If the problem does not indicate whether the inventories are shipped by the company or
to be received by the company, look at the terms: Materials in transit (meaning the
company has purchased new materials for production) – to be received by the company.
Items or FG in transit (meaning the company has delivered to the customers its finished
product) hence – shipment has been made by the company.
• If materials are returned to suppliers, it is not included in inventory. But, if the materials
are returned for replacement, it is included in inventory balance.
• Sales return under Perpetual inventory: The debit to MI and COS should be AT COST.
• If the balance between the periodic and perpetual inventory, the discrepancy is adjusted
by inventory overage or shortage. Shortage if COS in Periodic is higher than COS in
Perpetual inventory system.
• At the end of the accounting period:
Dr. Ending Inventory xxx
Cr. Income summary xxx
• If the entity received the invoice and it was recorded, it means an entry has been made
by the entity:
Purchases xxx
AP xxx
• If the entity has received and recorded the invoice but the transaction was not included
in the inventory, the adjusting entry would be:
Inventory xxx
Income Summary xxx
• If the entity paid for the freight that the customer should have paid for it, the entity is
titled for reimbursement. For example, the payment for AR: 684,000; Freight paid by the
seller instead of buyer: P50,000. Hence, the total cash that needs to be remitted to the
entity by the buyer is P734,000.
• If there is a debit balance in Accounts payable resulting from erroneous entry for advance
payment for goods, the accounts payable account should be adjusted to original balance.
• If the company issued a check for 2M to pay creditors and it resulted into a bank overdraft
of P500,000, and then these checks were mailed to the creditors after the reporting
period, the total amount of Accounts Payable aren’t paid and resulting bank overdraft is
not recognized since payment was only after the reporting period.