Plant Assets and Depreciation (2)

Depreciation Methods
We will study a couple of depreciation methods. There are other methods. If you study international accounting, you will find that other countries deal with these issues in a very different way than we do in the US. But we're #1, so we must be right (hee, hee).

Depreciation Method	my silly comments
Straight-Line Method	causes problems with my spell checker because of the hyphenated word
Declining-Balance Method	oh, no. another hyphenated word. my spell checker is not happy today
MACRS (income tax method)	US congress made up this word. its not in my spell checker dictionary either. whatever they were drinking that night, I want a bottle of it.

OK, let's try this again.

Depreciation Method	my serious comments
Straight-Line Method	an easy method that allocates an equal amount of depreciation to each time period; salvage value is used
Declining-Balance Method (200% & 150% DB)	allocates more depreciation expense to the early years of an asset's life, when it is new; since there should be less down-time and fewer repairs in the early years, the company should get more use out of the asset in the beginning of it's life; no salvage value is used.
MACRS (income tax method)	uses the double-declining balance method, but you only take one-half year's depreciation in the first year, and then you switch to the straight-line method in the middle of the asset's life, so a 5 year asset takes 6 years to depreciate. salvage value? salvage value? we don't need no stinking salvage value!! I still want a bottle of whatever they were drinking when they dreamed this one up.

[It is a little known fact that the US congress is responsible for the rapid growth of the computer industry during the 1980s and 1990s. The MACRS depreciation rules were so complex everyone had to buy computers just to do the calculations each year. Millions of computers were sold, just to calculate MACRS depreciation ........ OK, I'm just kidding. You didn't really think I was serious, did you?. Hey, this is week 8, we're almost done.]

Selling or disposing of Fixed Assets
After selling or disposing of fixed assets, the company no longer has the asset. This requires a journal entry to remove everything in the accounting records relating to the asset.

The depreciable cost and accumulated depreciation relating to the asset must both be removed, or reversed. There might be a gain or loss when disposing of assets. There might also be incidental costs relating to disposing of the asset. All these things should be included in the journal entry recording the disposal.

Let's assume on September 1, the ledger shows these balances for a piece of equipment.

General Ledger
Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000

Accumulated Depreciation - Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)

Removing these amounts from the books with a journal entry
When assets disposed of there might be a gain, loss or a wash (no gain or loss). In either case all such journal entries will start from the same place, removing the related asset cost and accumulated depreciation. This journal entry does not balance; is the beginnings of a journal entry, and must be completed when all the information is available.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Equipment		$7,000
	To record disposal of equipment

Notice the exact opposite of the account balances is entered for each account. This causes the account balances to go to zero after this journal entry is posted.

General Ledger
Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000
Sep-15	Disposal of asset		$7000	$0

Accumulated Depreciation - Equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)
Sep-15	Disposal of asset	$5600		$0

The asset and related accumulated depreciation have both been removed from the books.

Calculating Book Value
Book Value is the difference between the asset cost and accumulated depreciation:

Equipment cost	$ 7,000
Less: accumulated depreciation	-5,600
Book Value before sale	$ 1,400

Gains and losses are calculated using the Book Value.

Equipment sold for a Gain
If the equipment is sold for more than its book value there will be a gain. Gains are similar to revenues, and will be recorded with a credit entry. Let's say the equipment is sold on September 15 for $2,000. The gain will be:

Selling Price	$ 2,000
Less: Book Value	- 1,400
Gain	$ 600

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$2,000
	Gain on disposal of equipment		$ 600
	Equipment		$7,000
	To record disposal of equipment

The journal entry is now in balance. Did you notice what I did? I started the journal entry with what I already knew - the cost and accumulated depreciation. I left 2 lines blank in the middle of the journal entry, so the sales price and gain or loss could be recorded.

Equipment sold for a Loss
If the equipment is sold for less than its book value there will be a loss. Losses are similar to expenses, and will be recorded with a debit entry. Let's say the equipment is sold on September 15 for $1,000. The loss will be:

Selling Price	$ 1,000
Less: Book Value	- 1,400
Loss	($ 400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,000
	Loss on disposal of equipment	$ 400
	Equipment		$7,000
	To record disposal of equipment

Equipment sold for a Wash
If the equipment is sold equal to its book value there will be a wash. Let's say the equipment is sold on September 15 for $1,400.

Selling Price	$ 1,400
Less: Book Value	- 1,400
Wash	$ 0

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. In this case there is a wash, so no gain or loss is recorded. The equipment is simply removed from the books.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,400
	Equipment		$7,000
	To record disposal of equipment

Equipment Junked
If the equipment is junked there will be a loss equal to its book value. We call this abandonment. The item is usually just thrown in the trash, or hauled to the dump. Sometimes a company will have to pay to have the item hauled away. Incidental costs are revenue expenditures, and are not included in calculating the capital gain or loss.

Selling Price	$ 0
Less: Book Value	- 1,400
Loss	($ 1,400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Loss on abandonment of equipment	$1,400
	Equipment		$7,000
	To record abandonment of equipment

Intangible Assets
Intangibles are assets that have no physical existence. They are legal assets or accounting assets, such as copyrights, patents, trademarks or goodwill. We use a simple form of amortization, usually straight-line, to allocate the cost of these items to expenses.

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Plant Assets and Depreciation (1)

Depreciation expense spreads the cost of major equipment and assets over a period of time that spans a number of years. Amortization is used to allocate the cost of intangible assets, such as patents, copyrights, trademarks, and franchises. Depletion is used to record the cost of natural resources extracted from the earth.

There are three main events in the life of any asset:

1. acquisition
2. useful life
3. disposal or retirement

We will make journal entries for each of these events. Over the useful life we will enter depreciation expense. At the end of the life we will record any gain or loss at the time of disposal or retirement of the asset. Sometimes assets are traded for other assets, and that must be accounted for in the same manner as a disposal or retirement.

Fixed asset acquisition
Fixed asset accounts are debited for the actual cost of fixed assets. The correct account should be debited. Some companies use a Fixed Asset Subsidiary Ledger and show a control account on the Balance Sheet, called Property, Plant and Equipment (PPE) or something similar. In these cases all fixed assets acquisitions debit PPE and the subsidiary ledger carries the details pertaining to the asset.

Depreciable cost
Buildings, equipment, vehicles, computers, furniture and fixtures are all examples of depreciable assets. We will depreciate the depreciable cost of assets. This includes the purchase price paid, sales tax, shipping and installation costs, and possibly incidental costs if they are material. Cost of fixing damage caused during shipping and installation is treated as a Repair Expense.

Some costs are incidental to buying new equipment. A specialist might be hired to install a large printing press, or other specialized, complex piece of manufacturing equipment. This type of cost is included in the depreciable cost of the asset.

Sometimes employees have to be trained. The cost of training may be considered part of the depreciable cost, it the amount is material to the purchase of the asset. A brief training session for one or two machine operators will probably be an immaterial amount.

The cost of training the entire company's personnel when a new computer system is installed would probably be a material amount, especially in a large company. Every employee might require a day's training or more in the new system. The loss of productivity would be a material amount, and should be classified as part of the depreciable cost of the asset.

Recording Asset Acquisitions
If a company buys land, building, equipment etc. all at the same time, the total purchase price has to be divided correctly among the various assets.

Land is a non-depreciable asset. It falls into its own category in the books and on the Balance Sheet. Don't include land costs with other fixed asset costs, such as buildings. They must always be entered separately. Buildings will be depreciated; land will not be depreciated.

General Journal

Date	Account	Debit	Credit
Apr-15	Land	$5,000
	Building	$45,000
	Cash		$10,000
	Mortgage Note Payable		$40,000
	To record purchase of land and building
Apr-30	Manufacturing Equipment	$7,000
	Computers and peripherals	$10,000
	Computer software	$3,000
	Accounts Payable		$20,000
	To record purchase of equipment, computers and software

The Useful Life of an asset, is the period of time the company expects to use the asset in the business. It is also important that the asset be used as it is intended, and for the production of income. For instance, a computer that is being used as a doorstop is not contributing to the production of income, and it is also not being used as it was intended.

[Of course, at this point some very clever student will say something like, "What if the computer is used as part of an art project displayed in the foyer of an office building? It's not being used as intended nor in the production of income." Well, young Einstein, objects d'art are Investments, not depreciable plant assets. Nice try, but no banana for the monkey.]

Why do assets depreciate?
For Federal Income Tax purposes, depreciation is referred to as cost recovery. The government allows you to use the cost of plant assets to offset income. You recover your cost a little bit at a time, over a number of years. Each year you reduce your income tax expense, by an amount relative to the cost recovery amount for that year. It's a slightly strange concept if you're not involved in preparing income taxes. But it does make sense if you think about it a bit.

For financial statement purposes, depreciation reflects a number of different influences that each affect an asset over its useful life.

• recognize physical deterioration
• recognize obsolescence
• recognize a reduction in market value
• recognize benefits derived from using the asset
• apply a logical, systematic cost allocation over a relevant period of time
• apply the matching principle

Each of these is important to a company. When assets are purchased, the cost is reflected in the Balance Sheet. Depreciation expense transfers that cost to the Income Statement in order to reflect the effect of the items listed above, in the financial statements.

Usually, at this point, students are a showing a slight glaze over their eyes. I then reiterate that depreciation expense reduces income, which in turn cuts income taxes. Cutting our taxes, that's something most of us can relate to. So depreciation is a good thing, an important thing, a joyous and wonderful thing.

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Inventories and Cost of Goods Sold (3)

Using the Periodic system
If you use a Periodic inventory system, you value your inventory only once a year - at the end of the year! So the job is fairly easy, and you should have little problem making the calculation. You apply a cost flow assumption once at the end of the year, and it pertains only to the physical merchandise still on hand at the end of the year.

It doesn't matter when sales take place, or when inventory is purchased. We ignore all that when we use the Periodic system. All we have to care about is what inventory is on hand at the end of the year.

Using the Perpetual System
If you use the Perpetual system you have to track each and every purchase and sale of inventory. Time is definitely of the essence. We will use a cost flow and apply it continuously, updating the Sales, Inventory and COGS accounts daily, as merchandise is purchased and sold.

This can be a daunting task, and usually is done by sophisticated and expensive computerized systems. When you go to a grocery or department store, notice that all the products have a bar code, which is scanned by an electronic cash register. All the merchandise is scanned into the the computer inventory records when it arrives at the store, and is scanned out as it is sold. The inventory records are continuously updated, along with the inventory value.

The type of system a company uses will depend on how much it can afford to spend. Obviously, not all companies can or need to spend $50,000 to $100,000 for each scanning cash register, plus the cost of the computer and software itself. Installing such a system can easily cost $1 million or more per store. That's a high price tag, so most companies use a Periodic system, and update their inventory only once a year.

Estimating Inventory
Let's say a company uses the Periodic system. In the middle of the year they go to the bank seeking a loan for expansion. The banker asks to see a set of financial statements. Taking a complete physical inventory can be a huge, time-consuming task. The company may simply not have time to drop everything and take a physical inventory at this time. Do they have any options?

In fact, they do. They can estimate the inventory on hand. They can reconstruct the inventory based on their purchase and sales records for the year to date. There are a couple of methods used to do this. They are both similar.

The Gross Profit method is one method. The store needs to know it's gross profit rate or cost ratio (the inverse of gross profit rate). They start with the beginning inventory balance, add purchases, and deduct for sales made using the cost ratio. The result is an estimate of the merchandise on hand.

This method is especially useful when there has been a loss due to theft, fire, flood and so forth. The Gross Profit or Retail methods can be used to substantiate an insurance claim for loss in these situations.

Inventory Turnover
Inventory turnover is not some sort of exotic pastry. It also does not mean we physically pick up our inventory and turn it over or upside down. Having dispensed with those misconceptions, just what is inventory turnover?

Each time you sell your entire inventory, you are said to have "turned" or "turned over" your inventory. We measure this as the number of times per year that this happens. We also measure it in a dollar amount, not by the actual physical objects. A store might have a year-old can of "Uncle Simon's Nasty Stuff That Only Your Aunt Ethel Will Eat". Not selling that can will have not effect on inventory turnover, in the larger sense of the word.

[Managers are definitely interested in micro-inventory management: looking at the sales pattern of individual items. Walmart has been an aggressive pioneer in this area. Right now we are dealing with macro-inventory management: looking at the dollar value of the entire inventory, taken as a whole.]

Earlier I discussed how a grocery store stocks milk. The buy enough for one week. There are 52 weeks in a year, so we would expect their inventory turnover, for milk, to be roughly 52. We usually calculate this using dollars, rather than tracking actual cartons of milk.

Number of Days in Inventory is the concept expressed in number of days. It tells us how many days, on average, inventory stays on a shelf before it is sold. Since there are 365 days in a year, we can divide 365 by the inventory turnover rate and get the number of days in inventory.

365 / 52 = 7 (rounded) or roughly 1 week

There are 52 weeks in the year, and the store wants to stock enough for 1 week at a time. Their weekly milk inventory is sold 52 times a year (turnover), or once every 7 days (days in inventory).

Let's look at a table and see some typical correlation's. Notice the inverse relationship between turnover rate and days in inventory. As one goes up, the other goes down.

Turnover Rate	Days in Inventory	Frequency
52	7	weekly
12	30.4	monthly
6	60.8	2 months
4	91.25	quarter (3 months)
2	182.5	half year
1	365	one year

What I'm hoping you'll get from this is a little common sense. Eggs would not have a turnover rate of 4. Perishable items will have a high turnover rate and low number of days in inventory.

Automobiles, diamond rings, and works of art would probably not have a turnover rate of 52. It can take much longer to sell these expensive items. They will have a low turnover rate, and a high number of days in inventory.

How Turnover relates to Gross Profit
Profits depend on several things. One of the most important is the relationship between turnover and gross profit. Higher turnover brings greater profit. Lets look at a simple example.

A store buys Item X for $20, and sells it for $30. The Gross Profit from each item is $10.

Annual Turnover Rate	Sales	COGS	GP
1	30	20	10
2	60	40	20
4	120	80	40

Guess what, we can just multiply the annual turnover rate and the GP per unit ($10). That would be an easier calculation!

Annual Turnover Rate	$GP x TO Rate	Total $GP
1	$10 x 1	$10
2	$10 x 2	$20
4	$10 x 4	$40
6	$10 x 6	$60
12	$10 x 12	$120
52	$10 x 52	$520

If you sell 1 unit per year, you will only make $10 per year.
If you sell 1 unit per week you make $520 per year.

Which is better?

(I sincerely hope you chose $520 per year. If not, please consult a physician. You may need professional help.)

Turnover is essential to profits. Higher turnover = higher profits.

Let's look at an example
Jim buys pocket knives from the manufacturers and resells them on e-bay. He buys by the case and pays $5 for each knife. At the both the start and end of the year he had 30 knives on hand (to make this example a little easier).

Jim bought and sold 800 knives during the year. He had 32 knives on hand at the start and end of the year, so his average inventory is 32 (32+32/2 = 32).

Cost Component	Units	$ Cost
COGS @ $5	800	$ 4,000
Avg Inventory @ $5	32	$ 160
Results
Turnover rate	$4000 / $160 =	25
Days in inventory	365 / 25 =	14.6

What this is telling us:
His average inventory was 32 knives last year.
He sells 32 knives every 25 days.
Each batch of 32 knives is in inventory 14.6 days.
If he sells 800 knives every year, that's about 800 / 365 = 2.19 knives per day.
This is consistent with our results. 32 knives / 14.6 days = 2.19 knives per day.
He sells about 2 x 32 = 64 knives each month (avg 66.6 knives per month).

Inventory Management - a delicate balance
By now you should be seeing the correlation between Gross Profit and sales. No matter what your gross profit is, making more sales will always mean making more GP. Since each and every unit of product you sell earns you a GP, you will always do better selling more, rather than less.

Inventory turnover is a measure of ow often your average inventory is sold. Since business managers have access to all the detailed operating information of their company, they can manage inventory on a product by product basis. They can effectively look at the turnover of a single product, and more accurately gauge their real average inventory held for that item.

There is one very important thing that all businesses have to deal with: carrying the right amount of inventory - not too much, not too little.

If you carry too little inventory you will lose sales, and that will reduce your GP.

If you carry too much inventory the surplus will tie up your cash flow. You will have to warehouse, protect and insure the excess inventory. And you run a high risk of spoilage, obsolescence, theft and damage.

A company will maximize its profits by carrying the correct amount of each item in its inventory. This amount is determined by careful analysis and tracking of customer's buying patters. Stores have to pay attention to the seasonal and cyclic buying trends their customers display. Effective inventory management requires both day-to-day attention, and ongoing analysis of customer preferences and buying habits.

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Inventories and Cost of Goods Sold (2)

FIFO
For instance, a grocery store will buy only the amount of milk it can sell in a week. Because milk spoils quickly, the store will buy small amounts each week, and make sure the milk it has for sale is the freshest milk available.

Further, one gallon of milk is basically the same as the next gallon (with only minor differences). We say that milk is a homogeneous product. All the milk can be viewed as a single product group, that follows an almost identical weekly sales and spoilage pattern.

The grocery will use a flow assumption to value its milk inventory at the end of the year. They will use FIFO, assuming that the milk on hand is the last milk that was bought during the year.

The LIFO method would assume that the milk bought in the first week of the year is the same milk on the shelf at the end of the year. Obviously year old milk will probably be coagulated into a solid, stinking block of green muck. So we know that LIFO would be an incorrect flow assumption for milk. So when will the LIFO assumption will be valid?

LIFO
Let's now picture a clothing store. There are basically 4 clothing seasons: Winter, Spring, Summer and Autumn. There is a line of clothing for each season. Further, clothing styles change each year. Except for a few items (socks, handkerchiefs, belts) customers will prefer to buy this year's fashions, rather than last year's fashions. Here's how that works into the LIFO method.

At the end of the year the clothing store looks at its merchandise. If their year ends in December, they have Winter clothes in the show room. But when they look in the storage room, most of the clothes there are from earlier seasons that year. So Last In, First Out means, the most current seasons clothes (Last In) are the ones that people want now (First Out). After all, you wouldn't be buying last summer's clothes in the middle of winter, would you? Most people will wait until the following year and buy clothes in style in the coming summer.

Average Cost
Some merchandise is nearly identical and is carried in large quantities, like lumber, nails, nuts and bolts or gasoline. If you have a tank on gasoline with say 50 gallons in it, and you add 200 more gallons, you can't separate the first 50 gallons out from the rest of it. It all just becomes on take with 250 gallons of gasoline in it. So companies use the average cost method to account for things like this.

If you run a gas station, your costs will change every week. You will always have some left in the tank from the week before, and the delivery truck will dump more gas in your tank at this week's prices. Gas stations use a moving average method - they take the moving average from last week, and calculate a new moving average after adding this weeks batch of gasoline to the tank. So a moving average updates the cost frequently, and applies that particular average cost to that week's gasoline sales. Next week they will calculate a new moving average and apply it to next week's gasoline sales, etc.

At one time my office was next to a company that sold nuts, bolts, screws, nails, washers and other types of small hardware items. They bought directly from the manufacturers, mostly foreign. Their goods came packed in small wooden barrels. Believe me, a small wooden barrel full of nails is heavy!

They repackaged the items into small plastic bags for resale to stores, and ultimately to end consumers. They had a very sophisticated set of scales that would accurately weigh out the pieces into the desired quantity. For instance ,they could weigh out 10 flat washers accurately, and drop them into a small plastic bag. It was much quicker and easier than counting pieces manually.

How do you think they counted and valued their ending inventory? They weighted all the opened containers (no need to weigh a full, unopened one), and used their cost per pound, to calculate the value of their ending inventory. This may seem a bit unconventional, but it is a very good method, and entirely acceptable.

Some bulk products and how they might be measured for average costing:

product	measurement
gasoline, oil, milk, orange juice	gallon, liter
crude oil	barrel
natural gas	cubic yard, cubic meter
nails, nuts and bolts	pound, kilo
wheat, oats, corn, other grains	bushel
electric, telephone or TV cable	foot, meter

The importance of time when working with inventory methods
When it comes to inventory values, time is of the essence. That's a legal term, and means that time is more than just important, it is essential. You can't sell something you don't have, right? You can sell only what you have on hand in your inventory. Once an item is sold we have to determine how much cost to transfer from the Inventory account to the COGS account.

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Inventories and Cost of Goods Sold (1)

Manufacturing companies have three types of inventory: materials, work in process and finished goods. Retailers have one inventory: merchandise. In all cases, inventory is something the company will re-sell to someone else. Inventory cost is an asset until it is sold; after merchandise is sold, the cost becomes an expense, called Cost of Goods Sold (COGS). A journal entry transfers costs from the Balance Sheet to the Income Statement.

There are several important points, or events, in the life on an inventory item. The company must first order and buy the item. It then holds the item on a shelf or warehouse, until a customer wants to but the item. Once the item is sold, the cost is transferred to COGS. So the three important times in an item's life are buying, holding and selling.

Let's think for a moment about a hypothetical inventory item, we'll call it Item X. If you buy, hold and sell Item X all in the same year, say 2002, the entire transaction relating to Item X will be a completed and realized transaction. If the customer has paid for Item X there will be absolutely no accounting left to do, except show the sale and related COGS on the 2002 Income Statement. Nothing about Item X will affect the company in the future. Everything about Item X relates only to the past.

If Item X costs you $40, and you sell it for $65, you made a Gross Profit on the item of $25.

Income Statement 2002

Selling Price of Item X	$ 65.00
Less: Cost of Item X	40.00
Gross Profit from selling Item X	$25.00

This is the information that will be included in the 2002 Income Statement. Nothing will be left on the Balance Sheet.

Now let's think for a moment about Item Z. Assume you buy Item Z for late in 2002, and you are still holding it. There will be no sale to report, so the cost will remain on the Balance Sheet. If Item Z cost $50 that is the amount that will be shown on the Balance Sheet.

Balance Sheet Dec. 31, 2002

Inventory at December 31, 2002
Cost of Item Z	$50.00

If Item Z is sold in 2003, the cost will flow to the Income Statement for 2003, and the gross profit will be reported on that income statement.

Inventory Valuation
In the example above, you determined a value for Item Z at the end of the year. It is important for companies to count the physical inventory at the end of the year (Chapter 6). They must also place a dollar value on that inventory. The inventory value will be reported on the Balance Sheet at the end of the year.

It is also important to know the correct value of merchandise sold. That is the cost used to determine Gross Profit. Without enough Gross Profit a company can't pay it's operating expenses, such as salaries and wages, rent and utilities, etc. We will discuss Gross Profit a little more later in this section.

There are four methods commonly used to calculate a value for ending inventory. A company should select and use the method that best matches their merchandise and how it is sold.

4 methods of inventory valuation

Inventory method	How it works	When used
Specific Identification	the cost of each individual inventory item is tracked separately; the exact cost of each item is used in the value of ending inventory	auto sales, gems and jewelry, works of art, unique, one of a kind items
First In, First Out (FIFO)	cost of earliest purchases flow to COGS; we assume that the items remaining at the end are the last ones bought in the year	eggs, milk, meat, produce; this is the default flow assumption, unless a different method is specified
Last In, First Out (LIFO)	cost of last purchases flow to COGS; we assume that the items remaining at the end are the earliest ones bought in the year	clothing, seasonal items; a highly specialized method of retail inventory
Average Cost	cost of items bought are averaged across the year; the average cost is used at the end of the year; a moving weighted average is sometimes used	lumber, nails, nuts and bolts (simple average); gasoline (moving average)

Using a Cost Flow Assumption

• must meet cost-benefit rule
• accounts for quantities of homogeneous products
• matches the physical flow of goods
• can be used with either Periodic or Perpetual costing system

Specific Identification
The Specific Identification method assumes that each inventory item is special enough, unique enough, and costly enough to merit tracking one at a time. But does that apply to each and every item? What about a ream (500 sheets) of typing paper. Is it necessary to place a value on each and every sheet of paper?

Most business would answer "No" to that question. The cost of keeping that much detailed information would exceed the usefulness, or benefit, of the information. We call that the cost-benefit rule. The cost of an accounting system (or any other venture) should be outweighed by the benefits, or it is not cost-effective to follow that course of action.

For most companies, the Specific Identification method is far too costly and the additional information that could be gained is of little value. Most companies use a cost flow assumption. This simply means that the flow of inventory follows a certain pattern. Companies will buy merchandise in a manner consistent with the merchandise itself.

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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.

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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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