Financial Assets

What are financial assets
Financial assets include Cash, and those assets that can be converted to cash in a reasonably short period of time - one year at most, but less time in many cases. We will study the following financial assets:

• Cash
• Cash Equivalents
• Short Term Investments
• Accounts Receivable

Valuation of financial assets
Financial assets are valued as of balance sheet date, when financial statements are prepared. They are valued at the equivalent of their current Cash value - what they would be worth if we could convert them to cash now. In the case of Cash, it is already at it's current value. Short Term Investments are reported at their current market value. Accounts Receivable are adjusted for possible bad debts.

Cash and Cash Equivalents
Cash is just as the word suggests. It includes cash money including paper and coins, checks and money orders to be deposited, money deposited in bank accounts that can be accessed quickly. The term liquid refers to Cash, and the ease or difficulty of converting an asset into Cash.

Cash Equivalents are highly liquid short term investments that can be turned into Cash very quickly. These include US Treasury bills, money market accounts and high grade commercial paper. When corporations need to borrow money for a very short time, they often sell commercial paper. These come due within a few months at most, and pay a higher interest rate than other investments.

Short Term Investments
Short Term Investments include stocks and bonds that the company intends to hold only for a short time, and then sell and convert back to Cash. We consider it a good practice to convert unneeded cash to an investment account, where it can earn interest, dividends or show capital gains. These are shown on the balance sheet at their current market value, even if that is higher than the price paid for the investments. This is one of the few times we increase a balance sheet item above it's historic cost.

Accounts Receivable
Companies often sell to their customers on credit. The amount the customers owe is called Accounts Receivable (AR). We would record AR at the same time the sale is made, deducting any cash paid at the time of purchase, etc. When customers pay, we subtract the payment from their accounts receivable balance.

Most companies use an Accounts Receivable Subsidiary Ledger, which is similar to the General Ledger. The subsidiary ledger contains detailed information about each customer's account - purchases, payments, returns, adjustments, etc. Most companies send statements at the of each month, listing the monthly transactions and ending balance due from each customer.

Uncollectible Accounts
When businesses sell on credit, they run the risk that some customers will not pay their bill. Legitimate complaints, errors in billing , etc. are dealt with in an appropriate manner, and the books are adjusted as needed to correct any errors, or show returns and allowances (price adjustments). Still, some customers don't pay their bill, for any of a variety of reasons, and we must have a way to deal with this in the books, and on the financial statements.

We do this by setting up an account that is a companion to Accounts Receivable. It is called the Allowance for Uncollectible Accounts (or something similar - Allowance for Doubtful Accounts is often used click here for funny true accounting story).

Allowance for Doubtful Accounts is called a contra-asset account. It is a companion to Accounts Receivable, and has an opposite balance. When we net the two balances, we get the amount we expect to collect from customers, allowing for those who don't pay.

The allowance account is established each year, at balance sheet date. We usually prepare an Accounts Receivable aging report, which gives us a history of customers accounts tabulated in columns, each column representing one month. We can quickly see which customers are late paying their bills by 30 day, 60 days, 90 days, etc. We would expect that if a customer hadn't paid their bill after 90 days there is a good chance they won't pay at all. The risk of loss goes up as accounts go unpaid for longer periods of time.

Companies use the aging report to make a dollar estimate of how much they will lose in unpaid account balances. At that time we have no way to know exactly which customers won't pay. But by tracking its business history a company can estimate a dollar amount that they believe is reasonable.

When the allowance account is established, an expense account is also debited. That account is called Uncollectible Accounts Expense, Bad Debt Expense, Provision for Bad Debt, or something similar. So the loss due to bad debts is recognized as a normal business expense on the Income Statement.

Writing Off Bad Debts
Periodically, and no less than once a year, a company must review it's accounts receivable and identify any customers who have not paid their bill for a very long time, generally over 90 days. Information is gathered about these customers, and attempts at collection should be made. However, the customer may be out of business, bankrupt, etc. and it is unlikely the company will be paid by these customers.

When this happens, the debt is no good and should be removed from the books. We do that by making an entry to both Accounts Receivable and the allowance account, reducing the balance in both accounts. Writing off bad debt should be done with management's approval. Potentially collectible accounts should be pursued; only legitimately uncollectible accounts should be written off.

The allowance method is acceptable for accounting, and correct under GAAP. However, no allowance expense is permitted for tax returns. Only accounts actually written off can be expensed on a tax return, and then only in the year the account is deemed uncollectible.

Financial Analysis
Financial statements contain valuable information, but it must be analyzed to make relevant and correct decisions. Certain ratios are commonly used by investors and analysts. These are not difficult. All the information you need is already in the financial statements, as required by GAAP. And these ratios are used by thousands of people on a daily basis. No college degree or great math skills are required to use financial ratios.

Ratios can be used to evaluate a company's performance over a number of years. It can also be used to compare several different companies. Bankers often use ratios when considering a loan application. And investors calculate ratios to decide which stocks to buy or sell.

Read more...

Bank Reconciliation

Banks send statements to their depositors each month. A bank reconciliation compares the information in the bank statement with the company's Cash account, and finds any discrepancies. These are recorded or dealt with as needed. The process is fairly simple.

The bank balance and book Cash balance are listed on a piece of paper (now we often use computers). Some items show up on the bank statement, but have not been reflected in the books yet. These items will be added to or subtracted from the book balance.

Some transactions have been recorded in the books, but have not yet cleared the bank. These include deposits in transit, which are not yet posted in the bank's records - those made after the date of the bank statement. And outstanding checks - those which have been written and mailed, but haven't cleared the bank yet. These items are added to or subtracted from the bank balance.

Once all items have been included, the adjusted bank and book balances should be equal. If they are not, the reconciliation needs to be reviewed and corrected until the two amounts are equal.

Bank Reconciliation

Adjustments to Bank Balance	Adjustments to Book Balance
Add Deposits in transit	Add anything on bank statement that increases cash balance, but has not been recorded in the books: bank collections, interest earned
Subtract Outstanding checks	Subtract anything on bank statement that decreases cash balance, but has not been recorded in the books: bank charges and fees, bad checks, interest charges
Bank errors (add or subtract as needed); notify bank of error; these don't happen very often, but we need to watch for them	Add or subtract for accounting errors relating to deposits or checks.
Do not record any of these adjustments in the books.	These adjustments must be entered as journal entries, so the books agree with the bank balance.

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Merchandising Activities (2)

Inventory Shrinkage
If you throw a good wool sweater in a washing machine full of hot water, what will happen? You ladies already know the answer to that question. If you're a guy you may need to ask you wife, girlfriend, sister, or mother. Go ahead.... we'll wait.......

OK, now that you know the sweater will shrink, or get smaller. Guys, if you do this to your wife's favorite cashmere sweater we'll be forwarding your mail to the doghouse for the next month or so.

Well, inventory also shrinks. But not because we washed it in hot water. In fact inventory shrinkage occurs for a number of reasons, and it is just as it sound - inventory gets smaller. But how should this happen? Things happen to merchandise while the store has it available for sale. Here are some of the things:

Theft - by employees or customers
Spoilage - milk, meat, vegetables, past the expiration date
Obsolescence - computers, software, clothing (last year's styles)
Display - merchandise put on display often can't be sold later or must be discounted
Grazing - customers or employees eating food available for sale
Damage - broken bottles, bent cans, frozen foods left out of the freezer

The sum total of all these items contributes to the difference between the Inventory account and the physical count. There might also have been errors made in the Inventory account during the year, adding to the difference.

Special Sales and Purchase Accounts

Merchandisers use a few special accounts. When a sale is made, sometimes the customer returns merchandise for a refund. We do not reduce the sales revenue account. We enter the refund in a different account. This is done to help track the number and dollar amount of these types of transactions.

Sales accounts deal with customers and sale transactions

• Sales Returns and Refunds
• Sales Allowances
• Sales Discounts

Purchase accounts deal with suppliers and purchase transactions

• Purchase Returns and Refunds
• Purchase Allowances
• Purchase Discounts

Notice the close similarity between the account titles. They are almost identical, but apply on opposite sides of the purchase and sales cycles. Sales accounts are used in conjunction with selling merchandise and dealing with customers. Purchase accounts are used in conjunction with buying merchandise and dealing with suppliers.

By tracking these types of transactions in their own account managers have the opportunity to better understand their business. Are too many refunds being given? Why? Are we buying defective merchandise from a certain supplier? Are Sales Allowances cutting into our gross profit too much? Are we taking advantage of our Purchase Discounts when available?

The key to business profits is to identify each and every item that can be improved, and then improve it. Managers can raise prices. But they can also cut costs, reduce waste, increase efficiency, take discounts when available, and many other things to improve the profitability of their business.

Freight In vs Delivery Expense
Freight In is the cost to have merchandise shipped to your store. Freight In is a cost of purchasing merchandise, and becomes part of Cost of Goods Sold in the Income Statement. Sometimes a company has to pay a separate charge for Freight In. At other times the cost may be included in the cost of merchandise from the supplier. In any case, the cost of Freight In is added to the cost of the merchandise.

example:
XYZ, Co. buys 100 units of Product R for $7500. The trucking company charges $500 for the shipment. The total cost of the merchandise is $8000. Each unit costs $8000 / 100 = $80. They should set their selling price based on a cost of $80.

Delivery Expense is the cost to ship or deliver merchandise to your customer after a sale. Delivery Expense is a Selling Expense, and is included under that caption in the Income Statement.

Read more...

Merchandising Activities (2)

Inventory Shrinkage
If you throw a good wool sweater in a washing machine full of hot water, what will happen? You ladies already know the answer to that question. If you're a guy you may need to ask you wife, girlfriend, sister, or mother. Go ahead.... we'll wait.......

OK, now that you know the sweater will shrink, or get smaller. Guys, if you do this to your wife's favorite cashmere sweater we'll be forwarding your mail to the doghouse for the next month or so.

Well, inventory also shrinks. But not because we washed it in hot water. In fact inventory shrinkage occurs for a number of reasons, and it is just as it sound - inventory gets smaller. But how should this happen? Things happen to merchandise while the store has it available for sale. Here are some of the things:

Theft - by employees or customers
Spoilage - milk, meat, vegetables, past the expiration date
Obsolescence - computers, software, clothing (last year's styles)
Display - merchandise put on display often can't be sold later or must be discounted
Grazing - customers or employees eating food available for sale
Damage - broken bottles, bent cans, frozen foods left out of the freezer

The sum total of all these items contributes to the difference between the Inventory account and the physical count. There might also have been errors made in the Inventory account during the year, adding to the difference.

Special Sales and Purchase Accounts

Merchandisers use a few special accounts. When a sale is made, sometimes the customer returns merchandise for a refund. We do not reduce the sales revenue account. We enter the refund in a different account. This is done to help track the number and dollar amount of these types of transactions.

Sales accounts deal with customers and sale transactions

• Sales Returns and Refunds
• Sales Allowances
• Sales Discounts

Purchase accounts deal with suppliers and purchase transactions

• Purchase Returns and Refunds
• Purchase Allowances
• Purchase Discounts

Notice the close similarity between the account titles. They are almost identical, but apply on opposite sides of the purchase and sales cycles. Sales accounts are used in conjunction with selling merchandise and dealing with customers. Purchase accounts are used in conjunction with buying merchandise and dealing with suppliers.

By tracking these types of transactions in their own account managers have the opportunity to better understand their business. Are too many refunds being given? Why? Are we buying defective merchandise from a certain supplier? Are Sales Allowances cutting into our gross profit too much? Are we taking advantage of our Purchase Discounts when available?

The key to business profits is to identify each and every item that can be improved, and then improve it. Managers can raise prices. But they can also cut costs, reduce waste, increase efficiency, take discounts when available, and many other things to improve the profitability of their business.

Freight In vs Delivery Expense
Freight In is the cost to have merchandise shipped to your store. Freight In is a cost of purchasing merchandise, and becomes part of Cost of Goods Sold in the Income Statement. Sometimes a company has to pay a separate charge for Freight In. At other times the cost may be included in the cost of merchandise from the supplier. In any case, the cost of Freight In is added to the cost of the merchandise.

example:
XYZ, Co. buys 100 units of Product R for $7500. The trucking company charges $500 for the shipment. The total cost of the merchandise is $8000. Each unit costs $8000 / 100 = $80. They should set their selling price based on a cost of $80.

Delivery Expense is the cost to ship or deliver merchandise to your customer after a sale. Delivery Expense is a Selling Expense, and is included under that caption in the Income Statement.

Read more...

Merchandising Activities (1)

Merchandising means selling products to retail customers. Merchandisers, also called retailers, buy products from wholesalers and manufacturers, add a markup or gross profit amount, and sell the products to consumers at a higher price than what they paid. When you go to the mall, all the stores there are retailers, and you are a retail customer.

Retailers deal with an inventory: all the goods (products) they have for sale. They account for inventory purchases and sales in one of two ways: Periodic and Perpetual. As the names suggest these methods refer to how often the inventory account balances are updated.

In a Periodic system, inventory account balances are updated once a year (some companies may do it more often, but all must do so at least once per year).

In a Perpetual system, inventory account balances are updated after each sale. This type of system is much more complex. Scanning cash registers, bar coded merchandise, and similar devices are used to update the inventory records after each sale. Obviously, this type of system is very expensive, but it gives managers a high degree of control over inventory, helps purchasing agents order replacement merchandise in time, detects and deters theft and helps identify other problems relating to inventory.

The main differences between the two relate to the journal entries used to record purchases and sales. The system a company chooses should be cost effective and provide the desired levels of inventory management. Special journals are often used to record sale and purchase transactions.

Accounts Used
You can usually tell whether a company is using the Periodic or Perpetual system by the accounts they use to record inventory purchases. Here's a chart that shows the differences:
[COGS = Cost of Goods Sold]

Method >>>	Periodic	Perpetual
Account used to record inventory purchases:	Purchases	Inventory
Appears on:	Income Statement	Balance Sheet
When a sale is made:	No adjustment to inventory is necessary; merchandise cost is already on the Income Statement	Merchandise cost is transferred from Inventory to Cost of Goods Sold -an Income Statement account
Year-end procedures:	Adjust Inventory balance to agree with year-end physical count and merchandise value	Adjust Inventory balance to agree with year-end physical count and merchandise value
Other procedures:	Transfer Purchases balance to Cost of Goods Sold	Balances should now be correct

Physical Inventory
The "physical inventory" simply means the actual, real, tangible, touchable stuff the company has for resale. In the case of a manufacturing company, the physical inventory includes raw materials, the value of goods in the process of production, and the value of finished goods (Chapter 16).

Taking a physical inventory means counting the number of units of stuff you have for sale. This is usually done at the end of the year, so the balance sheet Inventory amount accurately reflects the true value of the ending physical inventory.

If you run a grocery store, you would count all the cans, packages and containers of food, and everything else you have available for sale. You would then have to assign a value to everything: it's cost to you when you bought each item. A small piece of your inventory records might look something like the one below.

Quantity is the number of units on the shelf, and also in boxes in storage; this is the amount we counted in taking the physical inventory. Unit Cost is what was paid for each unit of product. The extension column is the total cost of each item.

Item	Quantity	Unit Cost	Extension
soup, tomato, can, 8 oz	65	.24	15.60
soup, chicken noodle, can, 8 oz	79	.21	16.59
soup, cream of mushroom, can, 8 oz	53	.16	8.48

Once all items are counted, priced and extended, the total cost is the ending value for Inventory.

Adjusting the Inventory Account
The Inventory account usually does not agree with the physical count. If the Periodic method is being used, the Inventory account has the balance as adjusted at the end of the prior year. If the Perpetual method is being used, the Inventory account should be close to the physical value calculated from the physical inventory count. There will always be a difference, and the accounts must be adjusted so the Inventory account agrees with the physical count and valuation. You will study valuation methods more in Chapter 8.

The Inventory account is adjusted to agree with the physical count and valuation. Let's look at an example of how the adjustment is made. The Inventory account has a balance of $12,500. You take a physical count and calculate the correct inventory value is $11,975. You will decrease inventory by $525 to adjust the Inventory account the equal the actual physical inventory value.

General Journal

Date	Account	Debit	Credit
Dec-31	Cost of Goods Sold	$525
	Inventory		$525
	To adjust Inventory to year-end physical count and valuation

General Ledger
Inventory
[a Balance Sheet account]

Date	Description	Debit	Credit	Balance
Jan-1	Beginning balance forward	12,500		12,500
Dec-31	Year-end adjustment		525	11,975

Cost of Goods Sold
[an Income Statement account]

Date	Description	Debit	Credit	Balance
Dec-31	Balance			100,000
Dec-31	Year-end Inventory adjustment	525		100,525

The adjusting entry correctly uses an Income Statement account and a Balance Sheet account. The additional merchandise cost is transferred to the Income Statement in this case, but the reverse adjustment could just as easily be made.

Read more...

Merchandising Activities (1)

Merchandising means selling products to retail customers. Merchandisers, also called retailers, buy products from wholesalers and manufacturers, add a markup or gross profit amount, and sell the products to consumers at a higher price than what they paid. When you go to the mall, all the stores there are retailers, and you are a retail customer.

Retailers deal with an inventory: all the goods (products) they have for sale. They account for inventory purchases and sales in one of two ways: Periodic and Perpetual. As the names suggest these methods refer to how often the inventory account balances are updated.

In a Periodic system, inventory account balances are updated once a year (some companies may do it more often, but all must do so at least once per year).

In a Perpetual system, inventory account balances are updated after each sale. This type of system is much more complex. Scanning cash registers, bar coded merchandise, and similar devices are used to update the inventory records after each sale. Obviously, this type of system is very expensive, but it gives managers a high degree of control over inventory, helps purchasing agents order replacement merchandise in time, detects and deters theft and helps identify other problems relating to inventory.

The main differences between the two relate to the journal entries used to record purchases and sales. The system a company chooses should be cost effective and provide the desired levels of inventory management. Special journals are often used to record sale and purchase transactions.

Accounts Used
You can usually tell whether a company is using the Periodic or Perpetual system by the accounts they use to record inventory purchases. Here's a chart that shows the differences:
[COGS = Cost of Goods Sold]

Method >>>	Periodic	Perpetual
Account used to record inventory purchases:	Purchases	Inventory
Appears on:	Income Statement	Balance Sheet
When a sale is made:	No adjustment to inventory is necessary; merchandise cost is already on the Income Statement	Merchandise cost is transferred from Inventory to Cost of Goods Sold -an Income Statement account
Year-end procedures:	Adjust Inventory balance to agree with year-end physical count and merchandise value	Adjust Inventory balance to agree with year-end physical count and merchandise value
Other procedures:	Transfer Purchases balance to Cost of Goods Sold	Balances should now be correct

Physical Inventory
The "physical inventory" simply means the actual, real, tangible, touchable stuff the company has for resale. In the case of a manufacturing company, the physical inventory includes raw materials, the value of goods in the process of production, and the value of finished goods (Chapter 16).

Taking a physical inventory means counting the number of units of stuff you have for sale. This is usually done at the end of the year, so the balance sheet Inventory amount accurately reflects the true value of the ending physical inventory.

If you run a grocery store, you would count all the cans, packages and containers of food, and everything else you have available for sale. You would then have to assign a value to everything: it's cost to you when you bought each item. A small piece of your inventory records might look something like the one below.

Quantity is the number of units on the shelf, and also in boxes in storage; this is the amount we counted in taking the physical inventory. Unit Cost is what was paid for each unit of product. The extension column is the total cost of each item.

Item	Quantity	Unit Cost	Extension
soup, tomato, can, 8 oz	65	.24	15.60
soup, chicken noodle, can, 8 oz	79	.21	16.59
soup, cream of mushroom, can, 8 oz	53	.16	8.48

Once all items are counted, priced and extended, the total cost is the ending value for Inventory.

Adjusting the Inventory Account
The Inventory account usually does not agree with the physical count. If the Periodic method is being used, the Inventory account has the balance as adjusted at the end of the prior year. If the Perpetual method is being used, the Inventory account should be close to the physical value calculated from the physical inventory count. There will always be a difference, and the accounts must be adjusted so the Inventory account agrees with the physical count and valuation. You will study valuation methods more in Chapter 8.

The Inventory account is adjusted to agree with the physical count and valuation. Let's look at an example of how the adjustment is made. The Inventory account has a balance of $12,500. You take a physical count and calculate the correct inventory value is $11,975. You will decrease inventory by $525 to adjust the Inventory account the equal the actual physical inventory value.

General Journal

Date	Account	Debit	Credit
Dec-31	Cost of Goods Sold	$525
	Inventory		$525
	To adjust Inventory to year-end physical count and valuation

General Ledger
Inventory
[a Balance Sheet account]

Date	Description	Debit	Credit	Balance
Jan-1	Beginning balance forward	12,500		12,500
Dec-31	Year-end adjustment		525	11,975

Cost of Goods Sold
[an Income Statement account]

Date	Description	Debit	Credit	Balance
Dec-31	Balance			100,000
Dec-31	Year-end Inventory adjustment	525		100,525

The adjusting entry correctly uses an Income Statement account and a Balance Sheet account. The additional merchandise cost is transferred to the Income Statement in this case, but the reverse adjustment could just as easily be made.

Read more...

Reporting Financial Results (2)

The Trial Balance (TB)
The Trial Balance is a list of the balance in all accounts. The balances are separated into debit and credit columns, and the columns are totaled (footed) to be sure the financial system is in balance. Just because the system is in balance doesn't mean everything is correct, or that financial statements can be prepared. First we must make any necessary adjusting entries to bring our books into alignment with GAAP.

The Trial Balance Worksheet
The TB Worksheet provides accountants with a tool to organize the process of preparing adjusting entries and financial statements. A completed worksheet is presented on p. 192 of your text. It lets us organize the entire set of books on one or two pages of paper, so we can easily see all the balances and calculate the net profit for the year.

After completing the TB Worksheet, all that is left to do is transfer the information from the Income Statement and Balance Sheet columns to their respective financial statements, in the correct format. The worksheet greatly simplifies the process of preparing financial statements. It is also used by auditors when conducting an examination or review of a company's books.

Articulation and Preparing the Financial Statements
The textbook shows how information flows back and forth between the Income Statement and Balance Sheet. This is called articulation. There are some very important articulations to watch when preparing financial statements. The financial statements should be prepared in the correct order, so the information articulates (flows) correctly.

The Income Statement should be prepared first. Net Income or Net Loss flows to the Statement of Retained Earnings (or Statement of Stockholders’ Equity). The ending balance of Retained Earnings flows to the Stockholder’s Equity section of the Balance Sheet.

How information articulates between financial statements

Income Statement	Retained Earnings Stmt	Balance Sheet
Net Income or Loss ==>	Retained Earnings ===>	Stockholders' Equity

Because of articulation, financial statements must be prepared in this order.

Closing the books at the end of the year
At the end of each year, the books are closed. What this means is that certain account balances are reset to zero, in preparation of a new year. Since the Income Statement reports information on a yearly basis, the income statement accounts are the ones that will be closed.

Have you ever seen an automobile odometer that had a trip odometer, with a button you can push to set the trip odometer to zero? When you want to measure your mileage you can press the button, reset the odometer to zero, then drive to your destination. The trip odometer will tell you how far you've driven. Then you can reset it again for the next trip.

Closing the accounts is very similar. We close the income statement accounts so we can start counting again for a new year. These accounts are all the revenue and expense accounts, and they make up the total we call Net Income.

How to close an account
You close an account by looking at its balance, then entering a journal entry that is the exact opposite of its account balance. For instance, if an account has a $1000 debit balance, we would enter a $1000 credit to bring the account to zero.

General Ledger
Insurance Expense

Date	Description	Debit	Credit	Balance
Dec-31	year end balance			$1000
Dec-31	year end closing entry		$1000	$0

Here we see the Insurance Expense ledger account. It has a debit balance of $1000. The closing entry credits the account, and brings the balance to zero. The account is now ready to begin entering transactions for the new year.

We will close all revenue and expense accounts. We will leave all balance sheet accounts alone, except for the dividend accounts, which closes directly to Retained Earnings.

The Income Summary Account
Income Summary is an account used for a single purpose to close the books at the end of the year. All income statement accounts are closed to the Income Summary account.

All revenues accounts are debited, and the Income Summary account is credited for the total of the debits. Then all expense accounts are credited, and the Income Summary account is debited for the total of all credits. At this point all revenue and expense accounts have a zero balance. The balance in Income Summary is equal to the Net Income or Net Loss for the year.

Finally the Income Summary account has to be closed. We make the entry necessary to bring that account to zero, and post the opposite side of the entry to the Retained Earnings account. The last entry is to close all dividend accounts to Retained Earnings. And we are done for the year.

We usually prepare a Post-Closing Trial Balance to make sure all revenue and expense accounts were closed out to zero, and none remain with a balance. We also check to see that all the account balances are correct, and match with the TB Worksheet and financial statements we have just prepared. If all is well, we are done for the year, and can begin entering transactions for the new year.

At this point I usually tell my students about life as an accountant. Since many companies close their books on December 31, all accountants have to stay and work late on New Year's Eve, and make sure all the adjusting and closing entries have been made so business can start up on January 1. And if you believe that story I have a bridge located right on the Mississippi river I’d like to sell you.

Actually, most accountants like to take New Year's Eve off, and they are usually sleeping in late on January 1 as well. In the real world, financial statements are prepared after the close of the year, often several months later. It is a time consuming process, and many things need to be done before financial statements can be prepared.

Inventories must be counted and valued. Missing information has to be found. Depreciation and various other accruals and deferrals must be calculated. Companies with many branches, or those that do business on a global scale, must gather up the information from all parts of their company, before financial statements can be prepared. So don't worry, you won't have to work late on New Year's Eve if you become an accountant. Now, tax season.... well, that's another story. And we'll save it for another day.

The textbook gives some good illustrations that show the basic mechanics of the closing process, and the final outcome. All that's left to do is analyze the financial information, and see what kind of year the company had.

Your text shows a few financial ratios on p. 189. Most chapters from now on will show some financial ratios, that relate to the specific chapter topics. Chapter 14 of the text recaps all the financial ratios presented in the text. you can see them all on pp 628-29.

These ratios are used by investors and financial analysts on a daily basis. These are nothing new, and are not difficult to use. All you have to do is carefully follow the instructions and formula. Financial ratios can help you understand how your business is doing from year to year, and can also help you compare one business to another.

Financial statements have these elements:

• A proper heading, consisting of
• Company Name
• Title of Statement
• Time Period or Date of Statement
• The body of the statement presenting financial information, in correct format.
• Totals and subtotals, specific to each financial statement.
• Articulation of balances and totals between statements.
• Notes disclosing additional information according to GAAP

Read more...

Reporting Financial Results

Preparing Financial Statements
The ultimate purpose of the accounting process is to prepare financial statements. Everything else, all the routine journal entries & posting, corrections and adjusting entries finally culminate in an organized set of information that follows a set of rules known as GAAP.

GAAP gives us guidance as to what should be included in the financial statements, and how things should be reported and disclosed. The financial statements must include three specific reports, and notes that describe and disclose certain additional information.

The required elements of financial statements:
The Income Statement
The Balance Sheet
The Statement of Cash Flows
Notes to the Financial Statements

Optional (but recommended) financial statements:
The Statement of Retained Earnings
The Statement of Stockholders’ Equity
[Only one optional statement will be included in a set of financial statements]

Although GAAP gives us guidance, it also allows for a considerable amount of flexibility in presenting financial information. The Notes must accompany the other financial information, and includes disclosure about accounting principles, lawsuits, lease obligations, concentrations of receivables, and other information the FASB considers necessary for adequate disclosure of important information.

The Accounting Cycle revisited
1) Capture and Record business transactions,
2) Classify transactions into appropriate Accounts,
3) Post transactions to their individual Ledger Accounts,
4) Summarize and Report the balances of Ledger Accounts in financial statements.
5) Post adjusting and closing journal entries.
6) Prepare a post-closing trial balance

Read more...

Adjusting Journal Entries

Adjusting Journal Entries
All companies must make adjusting entries at the end of a year, before preparing their annual financial statements. Some companies make adjusting entries monthly, to prepare monthly financial statements.

Adjusting entries fall outside the routine daily journal entries and activities of special departments, such as purchasing, sales and payroll. Accountants make adjusting and reversing journal entries in a way that does not interfere with the efficient daily operations of these essential departments.

Adjusting entries should not be confused with correcting entries, which are used to correct an error. That should be done separately from adjusting entries, so there is no confusion between the two, and a clear audit trail will be left behind in the books and records documenting the corrections.

In practice, accountants may find errors while preparing adjusting entries. To save time they will write the journal entries at the same time, but students should be clearly aware of the difference between the two, and the need to keep them separate in our minds.

Adjusting entries don't involve the Cash account. Any adjustments to Cash should be made in with the bank reconciliation (Chapter 7), or as a correcting entry.

Adjusting entries involve a balance sheet account and an income statement account. Here are some common pairs of accounts and when you would use them.

Income Statement Account	Balance Sheet Account	Adjustment to be made
Sales Revenue (cr)	Accounts Receivable (dr)	Accrue unrecorded sales
Earned Revenue (cr)	Unearned Revenue (dr)	Recognize earned revenue
Depreciation Expense (dr)	Accumulated Depreciation (cr)	Recognize depreciation expense
Insurance Expense (dr)	Prepaid Insurance (cr)	Apportion prepaid expense
Interest Expense (dr)	Interest Payable (cr)	Accrue interest expense
Supplies Expense (dr or cr)	Supplies (dr to increase, or cr to decrease account)	Recognize supplies used as an expense, and/or adjust Supplies account
Cost of Goods Sold (dr or (cr, as needed to offset Inventory adjustment)	Inventory (dr to increase, cr to decrease balance)	Adjust Inventory account to match year-end physical count

Legend: dr = debit; cr = credit; these are general rules of thumb. In all adjustments you should make the entry that is needed.

Notice most examples follow general rules: Revenues are credited, Expenses are debited, receivables are debited, payables are credited.

The Supplies or Inventory accounts need to be adjusted to reflect the physical amount of inventory or supplies at the end of the year. With Supplies we will count the physical items, for instance: 3 boxes of paper, 4 dozen pens, etc. and calculate a total value for supplies on hand, based on what we paid for the items originally. The Supplies account will be increased or decreased, as needed, to bring it to the correct balance.

Correcting entries
A correcting entry should be entered whenever an error is found. If errors are found at the end of the year, while preparing financial statements, accountants usually go ahead and correct the error at that time. There are various reasons a correction might be needed. A wrong account or dollar amount might have been entered. The entry could have used a debit, when a credit should have been entered.

Errors will carry through to the financial statements, so it is important to detect and correct them. The type of error should be noted, and brought to management's attention, if the accountant feels the error might be intentional. Intentional errors are called "falsifications" and are an indication there might be fraud.

Reclassifications
A reclassification is a correction entry used to correct a mis-classification or to change the classification of an entry. This might be necessary if an entry is made without complete information. For instance, the company might purchase a building and land for a single price. The two assets need to be entered separately. The company may have to wait for an appraisal, and will make a journal entry to record the purchase, then reclassify a portion of the purchase price to allocate the correct values to the land and building.

Reversing entries
A reversing entry is a very special type of adjusting entry. They can be extremely useful and should be used where necessary. A reversing entry comes in two parts: the original adjusting entry, and the reverse, or opposite entry. The second entry is written by simply reversing the position of all debits and credits. Ultimately, the end result on the books is zero, but the adjusting entry serves to correctly allocate an expense, so the financial statements are correct.

Let's look at an example. X Company has a payroll department, and cuts checks every two weeks after tabulating hours, and calculating net pay. A large number of allocations have to be made to various withholding accounts. The accountants don't want to interfere with the operations of the payroll department. And the employees also want the department to run efficiently so they can get their pay checks on time.

At the end of the year the accountants need to appropriately allocate payroll expenses, plus taxes due and payable. Rather than interfere with the payroll department the calculation is made on paper (or computer), and entered as an adjusting entry. It is marked to be reversed. After the closing entries are made, the first entries of the new year are the reversing entries. They undo the effects of the adjusting entry.

If the adjusting entry is not reversed, the books will not be correct. Both the accountants and payroll department will be making entries related to payroll. The reversing entry effectively allows the accountants to make adjusting entries without causing the books to be incorrect; the payroll department continues to make routine entries, and doesn't need to make any special entries or allocations.

Until you actually work with reversing entries they seem strange. Here's how the numbers play out. Let's look at a really simple example.

X Company's payroll expense is $1,500 per week; they pay salaries every two weeks. Assume that December 31 falls at the end of the week, and in the middle of the pay period. The payroll expense for the two week period needs to be split between two years, with $1,500 in year 1 and $1,500 in year 2.

Total for 2 week payroll = $3000

This is how the expense should be allocated:
Dec 31

Last week of year 1	First week of year 2
$1500	$1500

This is the journal entry the payroll department will make
Dec 31

Last week of year 1	First week of year 2
$0	$3000

At the end of the first week in January the payroll department will make its journal entry to record the two week payroll. But that journal entry will be for $3000, and not $1500 as it should be. Two things need to happen: 1) $1500 needs to be accrued in the year 1 financial statements; 2) the first week of year 2 needs to be adjusted, because it will record too much payroll expense.

If this adjusting entry is made, the year 1 payroll expense will be correct:

Adjusting Entry

Date	Account	Debit	Credit
Dec-31	Payroll Expense	$1500
	Accrued Payroll Expense		$1500
	To record payroll for last week of the year

Reversing Entry

Date	Account	Debit	Credit
Jan-1	Accrued Payroll Expense	$1500
	Payroll Expense		$1500
	To reverse payroll accrual

After the books are closed for the year the reversing entry is made, dated the first day of the new year. The Payroll Expense account carries a credit balance, which is not the normal balance for an expense account, and would normally indicate an error in posting or classifying the transaction. But for a reversing entry this is correct.

General Ledger
Payroll Expense

Date	Description	Debit	Credit	Balance
Jan-1	Reversing entry		$1500	($1500)
Jan-7	2-week payroll expense	$3000		$1500

After the payroll department post the 2-week payroll the Payroll Expense account will be correct. The balance is a debit of $1500, which is exactly what the Payroll Expense account should have for one week's payroll. If the reversing entry had not been made, the Payroll Expense account would need to be adjusted, because it would be overstated by $1500.

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Depreciation

Depreciation is an exaple of a deferred expense. In this case the cost is deferred over a number of years, rather than a number of months, as in the insurance example above.

In 2000 the company buys a delivery truck for 12,000. They expect the truck to last 5 years. They decide to use the straight line method, with a salvage value (SV) of $2,000. The depreciable value is $10,000 ($12,000 cost - $2,000 SV). The annual depreciation expense is $2,000 ($10,000/ 5 years).

Year>	2001	2002	2003	2004	2005	total
$ spent>	$12,000	$0	$0	$0	$0	$12,000
Expense taken	$2,000	$2,000	$2,000	$2,000	$2,000	$10,000
Salvage Value						$2,000

At the end of 5 years, the company has expensed $10,000 of the total cost. The $2,000 salvage value remains on the books.

General Journal

Date	Account	Debit	Credit
Jan-2	Delivery Trucks	$12,000
	Cash		$12,000
	To record purchase of delivery truck
Dec-31	Depreciation Expense	$2,000
	Accumulated Depreciation		$2,000
	To record depreciation expense for the year

The straight line method is only one method used to calculate depreciation. The subject will be covered more in Chapter 9.

General Ledger
Delivery Trucks

Date	Description	Debit	Credit	Balance
2001	To record purchase of truck	$12,000		$12,000

Accumulated Depreciation

Date	Description	Debit	Credit	Balance
2001	To record annual depreciation		$2,000	$2,000
2002	To record annual depreciation		$2,000	$4,000
2003	To record annual depreciation		$2,000	$6,000
2004	To record annual depreciation		$2,000	$8,000
2005	To record annual depreciation		$2,000	$10,000

Book Value & Salvage Value
Book value is the difference between the cost of an asset, and the related accumulated depreciation for that asset.

Book Value = Cost - Accumulated Depreciation

Book Value = ($12,000 - $10,000) = $2,000

The company will stop depreciating the truck after the end of the fifth year. The truck cost $12,000, but only $10,000 in depreciation expense was taken. The remaining book value is equivalent to the salvage value established when the vehicle was purchased. Book value will be used to calculate any gain or loss when the truck is sold or traded (Chapter 9).

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Revenue and Expense

As with everything else in accounting, the terms revenue and expense have definitions. They are not difficult so define, but professional judgment is required to apply the definitions correctly, and in conformity with GAAP. You need to develop a working definition for both terms.

According to FASB in SFAC No. 3, "revenue is derived from delivering or producing goods, rendering services, or other major activities of the firm.” In his book Accounting Theory, (fourth edition, Irwin), Eldon S. Hendriksen comments,

"Revenue is best measured by the exchange value of the product or service of the enterprise....we still have the problem of deciding the point or points in time when we should measure and report the revenue....[I am] in general agreement with [the] view that revenue should be acknowledged and reported at the time of the accomplishment of the major economic activity if its measurement is verifiable and free from bias.

The term revenue realization is used in a technical sense by accountants to establish specific rules for the timing of reporting revenue under circumstances where no single solution is necessarily superior to others in the above context of revenue…..The general view is that realization represents the reporting of revenue when an exchange or severance has occurred. That is, goods or services must have been transferred to a customer or client, giving rise to either the receipt of cash or a claim to cash or other assets [accounts or notes receivable]….Thus, the term realization has come generally to mean the reporting of revenue when it has been validated by sale."

There might be other times revenue will be recorded and reported, not related to making a sale. For instance, long term construction projects are reported on the percentage of completion basis. But under most circumstances, revenue will be recorded and reported after a sale is complete, and the customer has received the goods or services.

According to Hendriksen, "...expenses are the using or consuming of goods and services in the process of obtaining revenues.... Frequently, expenses are defined in terms of cost expirations or cost allocations...be careful to distinguish between the measurement of an expense based on cost and the definition of an expense as an activity or process. Emphasis on the latter has the advantage of leaving the measurement of expense open for further discussion."

At the end of the year, or anytime before financial statements are prepared, accountants have to make certain adjustments to the books to make sure that all revenues and expenses are correctly recorded and reported. This is where adjusting entries, accruals and deferrals, come in. Some companies make adjusting entries monthly, in preparation of monthly financial statements.

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Accruals and Deferrals

In order for revenues and expenses to be reported in the time period in which they are earned or incurred, adjusting entries must be made at the end of the accounting period. Adjusting entries are made so the revenue recognition and matching principles are followed.

Four types of adjusting entries
1) converting assets to expenses
2) converting liabilities to revenue
3) accruing unpaid expenses
4) accruing uncollected revenues

Accounting systems are designed to handle a large number of routine transactions during the year very efficiently, usually with the aid of computers and devices like scanning cash registers, bar code inventory management systems and automatic credit card processing systems. The accounting system has the built-in capability to handle these items with little human intervention, creating appropriate journal entries, and posting thousands of transactions with little effort.

However, at the end of the year accountants must step in and prepare financial statements from all the information that has been collected throughout the year. An accounting system is designed to efficiently capture a large number of transactions. But this information is only partially in accordance to GAAP. The information needs a small amount of adjustment at the end of the year to bring the financial statements in alignment with the requirements of GAAP. And this is where adjusting entries come in.

GAAP also requires certain additional information, referred to as Notes to the Financial Statement. This is a combination of narrative and numerical information that must be prepared by a real live human. Computers can do many things, but the process of preparing financial statements requires professional judgment.

Accruals
- conditions are satisfied to record a revenue or expense, but money has not changed hands yet. Examples:

Accounts Receivable - work done or goods sold but the customer has not yet paid us

Accounts Payable - expenses incurred but we have not yet paid the supplier

These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred.

Example - Accrued Revenue (accounts receivable)
ComputerRx repairs computers. During March they fixed a computer, but the customer not picked it up or paid by the end of the month. The total value of the work done was $200, including parts, labor, etc.

The company should record both revenue and accounts receivable for $200 each. The work was done by the end of the month. Repair technicians were paid for their time and labor. Parts used in the repairs were also paid for. The company should record both the revenue and related expenses.

General Journal

Date	Account	Debit	Credit
Mar-31	Accounts Receivable	$200
	Computer Repair Revenue		$200
	To accrue revenue from repairs made during the month.

The following month when the customer picks up the computer and pays for it, the company will record the receipt of payment as follows.

Date	Account	Debit	Credit
Apr-15	Cash	$200
	Accounts Receivable		$200
	To record receipt of payments on account.

This is a generalized example of a journal entry. Many companies use an accounts receivable subsidiary ledger to keep track of each individual customer.

Example - Accrued Expense (accounts payable)
ComputerRx installs computer networks. They often hire an independent contractor to run cables for the network. They are billed twice a month at a rate of $1.50 per foot of installed cable, including parts and labor. At the end of the month they estimate the contractor installed 500 feet of cable that they had not been billed for.

The company should record an accounts payable for $750 ($1.50 x 500 ft).

General Journal

Date	Account	Debit	Credit
Mar-31	Installation Expense	$750
	Accounts Payable		$750
	To accrue installation expense at end of month.

The following month when the company pays the installer, they will record the payment, as follows.

Date	Account	Debit	Credit
Apr-10	Accounts Payable	$750
	Cash		$750
	To record payment on account.

Note, in both examples above, the revenue or expense is recorded only once, and in the correct month. The second journal entry reflects the receipt or payment of cash to clear the account receivable or payable.

Deferrals
- money has changed hands, but conditions are not yet satisfied to record a revenue or expense.

Prepaid Expenses - insurance, rent, advertising paid in advance but the expense shows up on future income statements.

Unearned Revenue - subscriptions, maintenance contracts paid in advance but the revenue shows up on future income statements.

These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred. Let's look at a time line and see how it works.

Deferrals are often referred to as allocations. Costs are spread over a number of months using a reasonable method of allocation. In the example below, we use the straight line method - an equal amount is allocated to each month. Other reasonable methods can be used as well.

Example - Deferred Expense
The company has an option of paying its insurance policy once per year, twice a year (2 installments) or monthly (12 installments). They decide to pay it twice a year, in January and July. To get a proper matching of expense to the period we spread each 6-month payment equally over the period the insurance policy covers. The effect of this is to 1) match the appropriate expense with the month it relates to, and 2) eliminate

Month>	Jan	Feb	Mar	Apr	May	Jun	total
$ spent>	$600	$0	$0	$0	$0	$0	$600
Expense taken	$100	$100	$100	$100	$100	$100	$600

Money is spent only once each 6 months, but the expense is allocated to each month by enter an adjusting journal entry in the books. Here's how the first journal entry would look.

General Journal

Date	Account	Debit	Credit
Jan-2	Prepaid Insurance	$600
	Cash		$600
	To record payment of 6 months insurance policy

And the entry to record January insurance expense at the end of the month.

Date	Account	Debit	Credit
Jan-31	Insurance Expense	$100
	Prepaid Insurance		$100
	To record one month insurance policy

And finally, the Ledger accounts.

General Ledger
Prepaid Insurance

Date	Description	Debit	Credit	Balance
Jan-2		$600		$600
Jan-31			$100	$500

Prepaid Insurance declines each month as the expense is transferred from the Balance Sheet to the Income Statement.

Insurance Expense

Date	Description	Debit	Credit	Balance
Jan-31		$100		$100

Example - Deferred Revenue
American Artist sells subscriptions to their magazine, published 12 times a year. A subscription costs $36 per year. People can subscribe at any time during the year. They record unearned subscription revenue when payment is received for a subscription.

General Journal

Date	Account	Debit	Credit
Apr-2	Cash	$36
	Unearned Subscription revenue		$36
	To record 1 year subscription received

Each month, as issues of the magazine are mailed, the company recognizes subscription revenue. How do they calculate their total subscription revenue? Each subscription earns them $3 per month ($36/12 issues). Last month they mailed out 3000 copies of the magazine. They will recognize $9,000 in subscription revenue
($3 x 3000 copies).

General Journal

Date	Account	Debit	Credit
Apr-30	Unearned Subscription revenue	$9,000
	Subscription revenue		$9,000
	To record 1 year subscription received

In both examples above, the company is transferring a deferred cost or revenue from the balance sheet to the income statement. We call this articulation.

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