Merchandising Activities (1)

>> Saturday, November 28, 2009

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)

>> Friday, November 27, 2009

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

>> Thursday, November 26, 2009

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

>> Wednesday, November 25, 2009

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.

Read more...

Depreciation

>> Tuesday, November 24, 2009

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).

Read more...

Revenue and Expense

>> Monday, November 23, 2009

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.

Read more...

Accruals and Deferrals

>> Sunday, November 22, 2009

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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Example for journal

>> Friday, November 20, 2009

Another example .... without cash. April 20, the company opens a charge account at Office Emporium. They buy a $1000 computer, and say "charge it!"

1) Is Cash used in this transaction? No. [We will use the substitution method]
2) If Cash were used...Would it be received or paid? Paid. [Decrease = Credit Column]
--- enter the "cash" portion of the journal entry.
Pencil "cash" in lightly, you will replace it later with the correct account title.
3) Enter the balancing dollar amount in the opposite column.

Date
Account
Debit
Credit
Apr-20
$1000


cash
$1000




Notice that I have roughed in the structure of the journal entry, but the actual accounts have not been entered yet.

4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part. This is an example of buying equipment, in this case we will use the account Office Equipment.

5) Refer to the Chart of Accounts and replace "cash" with the appropriate account, which will usually end with "Payable" or "Receivable" such as Accounts Payable, Interest Receivable, etc.

In this case we will use Accounts Payable, one of the most frequently used accounts. Accounts Payable is used to refer to most of the common, day-to-day debts and current liabilities that a company incurs. It is short-term debt, meant to be paid soon, like the phone bill, utility bill, etc.

Date
Account
Debit
Credit
Apr-20 Office Equipment
$1000


Accounts Payable
$1000




These are all examples of simple journal entries. There is one debit and one credit. Some transactions might involve more then two accounts, and we would use three or more lines to write those entries. These are called compound journal entries (or complex journal entries). There is no limit to the number of debit or credit accounts that can be included in a journal entry. All necessary accounts will be used. The journal entry will balance, regardless of the number of accounts used.

Let's try an example of a compound journal entry. June 5, the company buys building and land for $100,000. They make a down payment of $20,000 and sign a mortgage note with their bank for the balance. An appraisal shows the land alone has a value of $10,000.

1) Is Cash used in this transaction? Yes & No. [We will use the substitution method along with Cash]
2) If Cash were used...Would it be received or paid? Paid. [Decrease = Credit Column]
--- enter the Cash portion of the journal entry. We will use Notes Payable to enter the $80,000 we borrowed from the bank, on its own line, but on the same side as Cash - the Credit side in this case.

Date
Account
Debit
Credit
June-5








Notes Payable
$80,000

Cash
$20,000

3) Enter the balancing dollar amount in the opposite column.
4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part. I left 2 blank lines above, because I knew we had both land and a building, which must be entered separately.

Date
Account
Debit
Credit
June-5
Land
$10,000


Building
$90,000


Notes Payable
$80,000

Cash
$20,000


--------
--------

Total
$100,000
$100,000

In this example I have totaled the columns to show that the journal entry is in balance. In real accounting systems a total is only drawn at the bottom of the page, not after each journal entry.

Here's another example of a compound journal entry. This one also shows how to record the issue of common stock, a very important journal entry to know. On May 1, Bill, Bob and Quinn create a new corporation, BBQ, Inc. They raise capital in the company by selling 10,000 shares of Common Stock for $5 per share. The common stock has a Par value of $1 per share.

1) Is Cash used in this transaction? Yes. The organizers are raising initial capital to start a new company. If the stock were sold on a stock exchange this would be referred to as an IPO (Initial Public Offering).
2) If Cash were used...Would it be received or paid? Received. [Increase = Debit Column]
--- enter the Cash portion of the journal entry. They sold 10,000 shares of stock at $5 per share, so they have raised 10,000 x $5 = $50,000.

Date
Account
Debit
Credit
May-1
Cash
$50,000





3) Enter the balancing dollar amount in the opposite column.
4) Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part.
Common stock is recorded as a credit to the Common Stock account. It is recorded at Par value, in this case $1 per share. So 10,000 x $1 = $10,000.

Date
Account
Debit
Credit
May-1
Cash
$50,000


Common Stock
$10,000




The journal entry is out of balance and we need to finish it up. Any excess raised by the sale of stock is credited to the Additional Paid-In Capital account.

Date
Account
Debit
Credit
May-1
Cash
$50,000


Common Stock
$10,000

Additional Paid-In Capital
$40,000

This is a good example of an important journal entry every accountant and bookkeeper should know. We don't use it very often, but it's important to know how to make this type of journal entry.

A word about issuing stock.
Each state has slightly different laws regarding corporations. Most states permit Par value stock, and some have a Legal Capital rule, forcing corporations to maintain tangible capital equal to the Legal Capital. This is in place to protect stockholders. Some states permit No-Par stock.

States also allow Preferred stock, which pays a fixed dividend, similar to an interest-bearing investment. Preferred stock usually has a Par value, and is recorded as in the example above, except the Preferred Stock account is used. Some company's maintain a separate account Additional Paid-In Capital on Preferred Stock, but Additional Paid-In Capital usually reverts to the Common stockholders, regardless of it's source.

Posting to the Ledger
Journal entries must be posted to the Ledger accounts on a regular basis. In many computer based systems this is done automatically, when journal entries are made. In a manual system, and some computer systems, the journal entries are posted on a daily, weekly or monthly basis, called "batch posting."

When you Post, you simply take each line from the journal entries, and transfer the amounts to the corresponding Ledger accounts. You have to be very careful to post all journal entries, get the dollar amounts right, and enter them in the correct column of the correct account. Needless to say, in a manual system errors do get made.

Posting is actually a routine and mechanical procedure.

Using T-Accounts
You will see many examples of T-Accounts in your textbook. A T-Account is just a simple way to represent a Ledger account. It's handy for accounting students, because you can make quite a few T-Accounts on one page, and post journal entries quickly. This makes it easier to do homework assignments or analyze transactions.

Most of your homework assignments will only use a few accounts, and there will only be one or two entries to each account. You can make 3 T-Accounts across a page, and several rows down the page. The Cash account should be larger than the rest, since it will have quite a few entries in most assignments.

When you post to T-Accounts, make a large T and write the name of the account above it. Write the Debit entries on the left half of the T, and Credit entries on the right side of the T. I usually draw a line underneath the entries, net all the entries together, and put the balance on the correct side of the T below the line.

The Income Statement
Relates to a period of time.
Revenue - the price of your goods and services
Expenses - costs incurred in earning revenue

Net Income - the excess of Revenue over Expenses, on the Income Statement
Net Loss - the excess of Expenses over Revenue, on the Income Statement

Net Income is synonymous with Net Profit.

Debit and Credit Rules
Revenues = Credit Entry
Expenses = Debit Entry

All revenue and expense entries follow these simple rules. The opposite side entry is usually made only to correct an error in an earlier journal entry. This is true of all income statement accounts.

Many balance sheet accounts tend to increase and decrease on a regular basis. Cash, Inventory, Accounts Receivable, Supplies, Accounts Payable all change on a frequent basis. Income statement accounts only increase, and do so according the the rules above. It is really easy to remember this simple rule.

..... Revenue .....
Example February 3, the company makes a credit sale of $250.

Date
Account
Debit
Credit
Feb-3 Accounts Receivable
$250


Sales Revenue
$250




Example February 5, the company makes a cash sale of $250.

Date
Account
Debit
Credit
Feb-5 Cash
$250


Sales Revenue
$250




These two entries are almost identical. Notice that Sales Revenue is on the Credit side in both entries. Remember this and it will make all your journal entries easier. When you record a revenue you will put it on the Credit side.

..... Expenses .....
Example February 1, the company pays rent, $500.

Date
Account
Debit
Credit
Feb-1 Rent Expense
$500


Cash
$500




Example February 5, the company has an service company clean their office every week. The fee is $100 each week, and the bill is paid at the end of the month. This is the first time the office has been cleaned this month.

Date
Account
Debit
Credit
Feb-5 Office Expense
$100


Accounts Payable
$100




These are both examples of an Expense entry. The expense part is always in the Debit column. You will list it first, and then either Cash or Accounts Payable. An entry to record Payroll Expense would credit Wages Payable. An entry to record Interest Expense would credit Interest Payable. These are special payable accounts. Most common business expenses will credit Accounts Payable or occasionally Cash.

When to record Revenue
Realization Principle - at the time goods are sold or services are rendered.

When to record Expenses
Matching Principle - offsetting expenses against revenues in the appropriate time period. For instance, the bill for June's long distance phone calls is paid in July. The long distance expense should show up on the June income statement.

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