Accounting for Inventory When Costs Vary Over Time

Question: In the coverage of financial accounting to this point, general standardization has been evident. Most transactions are reported in an identical fashion by all companies. This defined structure (created by U.S. GAAP or IFRS) helps ensure understandable communication. It also enhances the ability of decision makers to compare results from one year to the next and from one company to another. For example, inventory—except in unusual circumstances—appears on a balance sheet at historical cost unless its value is lower. Consequently, experienced decision makers should be well aware of the normal meaning of a reported inventory figure.

However, an examination of the notes to financial statements for several well-known businesses shows an interesting inconsistency in the reporting of inventory (emphasis added).

Mitsui & Co. (U.S.A.)—as of March 31, 2011: “Commodities and materials for resale are stated at the lower of cost or market. Cost is determined using the specific identification method or average cost.”

Johnson & Johnson—as of January 2, 2011: “Inventories are stated at the lower of cost or market determined by the first-in, first-out method.”

Safeway Inc.—as of January 1, 2011: “Merchandise inventory of $1,685 million at year-end 2010 and $1,629 million at year-end 2009 is valued at the lower of cost on a last-in, first-out (“LIFO”) basis or market value.”

Bristol-Myers Squibb—as of December 31, 2010: “Inventories are stated at the lower of average cost or market.”

“Specific-identification method,” “first-in, first-out method,” “last-in, first-out basis,” “average cost”—these are cost flow assumptions. What information do these terms provide about reported inventory balances? Why are such methods necessary? Why are all four of these businesses using different cost flow assumptions? In the financial reporting of inventory, what is the significance of disclosing that a company applies “first-in, first-out,” “last-in, first-out,” or the like?

Answer: In the previous chapter, the cost of all inventory items was kept constant over time. The first bicycle cost $260 and every bicycle purchased thereafter also had a cost of $260. This consistency helped simplify the introductory presentation of accounting issues in the coverage of inventory. However, such stability is hardly a realistic assumption. For example, the retail price of gasoline has moved up and down like a yo-yo in recent years. The costs of some commodities, such as bread and soft drinks, have increased gradually for many decades. In other industries, prices actually tend to fall over time. New technology products often start with a high price that drops as the manufacturing process ramps up and becomes more efficient. Several years ago, personal computers cost tens of thousands of dollars and now sell for hundreds.

A key event in accounting for inventory is the transfer of cost from the inventory T-account to cost of goods sold as the result of a sale. The inventory balance is reduced and the related expense is increased. For large organizations, such transactions take place thousands of times each day. If each item has an identical cost, no problem exists. This established amount is reclassified from asset to expense to reflect the sale (either at the time of sale in a perpetual system or when financial statements are produced in a periodic system).

However, if inventory items are acquired at different costs, a problem is created: Which of these costs is moved from asset to expense to reflect a sale? To resolve that question, a cost flow assumption must be selected by company officials to identify the cost that remains in inventory and the cost that moves to cost of goods sold. This choice can have a significant and ongoing impact on both income statement and balance sheet figures. Investors and creditors cannot properly analyze the reported net income and inventory balance of a company such as ExxonMobil without knowing the cost flow assumption that has been utilized.

Applying Cost Flow Assumptions

Question: To illustrate, assume a men’s retail clothing store holds $120 in cash. Numbers will be kept artificially low in this example so that the impact of the various cost flow assumptions is easier to visualize. On December 2, Year One, one blue dress shirt is bought for $50 in cash and added to inventory. Later, near the end of the year, this style of shirt suddenly becomes especially popular and prices skyrocket. On December 29, Year One, the store manager buys a second shirt exactly like the first but this time at a cost of $70. Cash on hand has been depleted ($120 less $50 and $70), but the company holds two shirts in its inventory.

On December 31, Year One, a customer buys one of these two shirts by paying cash of $110. Regardless of the cost flow assumption, the company retains one blue dress shirt in inventory at the end of the year and cash of $110. It also reports sales revenue of $110. Those facts are not in dispute.

From an accounting perspective, only two questions must be resolved: (1) what is the cost of goods sold reported for the one shirt that was sold, and (2) what is the cost remaining in inventory for the one item still on hand?

Should the $50 or $70 cost be reclassified to cost of goods sold? Should the $50 or $70 cost remain in ending inventory? In financial accounting, the importance of the answers to those questions cannot be overemphasized. If the shirts are truly identical, answers cannot be determined by any type of inspection; thus, a cost flow assumption is necessary. What are the various cost flow assumptions, and how are they applied to inventory?

Answer:

Specific Identification. In a literal sense, specific identificationInventory cost flow method in which a company physically identifies both its remaining inventory and the inventory that was sold to customers. is not a cost flow assumption. Companies that use this method are not making an assumption because they know which item was sold. In some way, the inventory conveyed to the customer can be identified so that the actual cost is reclassified to expense to reflect the sale.

For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply. Each vehicle tends to be somewhat unique and can be tracked through identification numbers. Unfortunately, for many other types of inventory, no practical method exists for determining the physical flow of specific goods from seller to buyer.

Thus, if the men’s retail store maintains a system where individual shirts are coded when acquired, it will be possible to know whether the $50 shirt or the $70 shirt was actually conveyed to the first customer. That cost can then be moved from inventory to cost of goods sold.

However, for identical items like shirts, cans of tuna fish, bags of coffee beans, hammers, packs of notebook paper and the like, the idea of maintaining such precise records is ludicrous. What informational benefit could be gained by knowing whether the first blue shirt was sold or the second? In most cases, unless merchandise items are both expensive and unique, the cost of creating such a meticulous record-keeping system far outweighs any potential advantages.

First-in, first-out (FIFO). The FIFOInventory cost flow assumption based on the oldest costs being transferred first from inventory to cost of goods sold so that the most recent costs remain in ending inventory. cost flow assumption is based on the premise that selling the oldest item first is most likely to mirror reality. Stores do not want inventory to lose freshness. The oldest items are often displayed on top in hopes that they will sell before becoming stale or damaged. Therefore, although the identity of the actual item sold is rarely known, the assumption is made in applying FIFO that the first (or oldest) cost is moved from inventory to cost of goods sold when a sale occurs.

Note that it is not the oldest item that is necessarily sold but rather the oldest cost that is reclassified first. No attempt is made to determine which shirt was purchased by the customer. Consequently, an assumption is necessary.

Here, because the first shirt cost $50, the entry in Figure 9.1 “Journal Entry—Reclassification of the Cost of One Piece of Inventory Using FIFO” is made to reduce the inventory and record the expense.

Figure 9.1 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using FIFO

After the sale is recorded, the following financial information is reported by the retail story but only if FIFO is applied. Two shirts were bought for ($50 and $70), and one shirt was sold for $110.

In a period of rising prices, the earliest (cheapest) cost moves to cost of goods sold and the latest (more expensive) cost remains in ending inventory. For this reason, in inflationary times, FIFO is associated with a higher reported net income as well as a higher reported inventory total on the company’s balance sheet. Not surprisingly, these characteristics help make FIFO a popular choice.

Last-in, first-out (LIFO). LIFOInventory cost flow assumption based on the most recent costs being transferred first from inventory to cost of goods sold so that the oldest costs remain in ending inventory. is the opposite of FIFO: The most recent costs are moved to expense as sales are made.

Theoretically, the LIFO assumption is often justified as more in line with the matching principle. Shirt One was bought on December 2 whereas Shirt Two was not acquired until December 29. The sales revenue was generated on December 31. Proponents of LIFO argue that matching the December 29 cost with the December 31 revenue is more appropriate than using a cost incurred several weeks earlier. According to this reasoning, income is more properly determined with LIFO because a relatively current cost is shown as cost of goods sold rather than a figure that is out-of-date.

The difference in reported figures is especially apparent in periods of high inflation which makes this accounting decision even more important. “By matching current costs against current sales, LIFO produces a truer picture of income; that is, the quality of income produced by the use of LIFO is higher because it more nearly approximates disposable income.”Clayton T. Rumble, “So You Still Have Not Adopted LIFO,” Management Accountant, October 1983, 50. Note 1 to the 2010 financial statements for ConocoPhillips reiterates that point: “LIFO is used to better match current inventory costs with current revenues.”

The last cost incurred in buying blue shirts was $70 so this amount is reclassified to expense at the time of the first sale as shown in Figure 9.2 “Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO”.

Figure 9.2 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO

Although the physical results of these transaction are the same (one unit was sold, one unit was retained, and the company holds $110 in cash), the financial picture painted using the LIFO cost flow assumption is quite different from that shown previously in the FIFO example.

Characteristics commonly associated with LIFO can be seen in this example. When prices rise, LIFO companies report lower net income (the most recent and, thus, the most costly purchases are moved to expense) and a lower inventory account on the balance sheet (the earlier, cheaper costs remain in the inventory T-account). As will be discussed in a subsequent section, LIFO is popular in the United States because it helps reduce the amount many companies must pay in income taxes.

Averaging. Because the identity of the items conveyed to buyers is unknown, this final cost flow assumption holds that averagingInventory cost flow assumption based on the average cost being transferred from inventory to cost of goods sold so that this same average cost remains in ending inventory. all costs is the most logical solution. Why choose any individual cost if no evidence exists of its validity? The first item received might have been sold or the last. Selecting either is an arbitrary decision. If items with varying costs are held, using an average provides a very appealing logic. In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60 ($120/2 units).

Figure 9.3 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using Averaging

Although no shirt actually cost $60, this average serves as the basis for reporting both cost of goods sold and the item still on hand. Therefore, all costs are included in arriving at each of these figures.

Averaging has many supporters. However, it can be a rather complicated system to implement especially if inventory costs change frequently. In addition, it does not offer the benefits that make FIFO (higher reported income) and LIFO (lower taxes in the United States) so appealing. Company officials often arrive at practical accounting decisions based more on an evaluation of advantages and disadvantages rather than on theoretical merit.

Presenting Inventory Balances Fairly

Question: FIFO, LIFO, and averaging can present radically different portraits of identical events. Is the gross profit for this men’s clothing store really $60 (FIFO), $40 (LIFO), or $50 (averaging) following the sale of one blue dress shirt? Analyzing inventory numbers presented by most companies can be difficult if not impossible without understanding the implications of the cost flow assumption that was applied. Which cost flow assumption is viewed as most appropriate in producing fairly presented financial statements?

Answer: Because specific identification reclassifies the cost of the actual unit that was sold, finding theoretical fault with that approach is difficult. Unfortunately, specific identification is nearly impossible to apply unless easily distinguishable differences exist between similar inventory items. For a vast majority of companies, that leaves FIFO, LIFO, and averaging. Arguments over their merits and their problems have raged for decades. Ultimately, information in financial statements must be presented fairly based on the cost flow assumption that is utilized.

In a previous chapter, an important clarification was made about the report of the independent auditor. It never assures decision makers that financial statements are “presented fairly.” That is a hopelessly abstract concept like truth and beauty. Instead, the auditor states that the statements “present fairly…in conformity with accounting principles generally accepted in the United States of America.” That is a substantially more objective standard. Thus, for this men’s clothing store, all the numbers in Figure 9.4 “Results of Possible Cost Flows Assumptions Used by Clothing Store” are presented fairly but only in conformity with the specific cost flow assumption that was applied.

Figure 9.4 Results of Possible Cost Flows Assumptions Used by Clothing Store

Most Popular Cost Flow Assumptions

Question: Since company officials are allowed to select a cost flow assumption, which of these methods is most typically found in the financial reporting of companies operating in the United States?

Answer: To help interested parties gauge the usage of various accounting methods and procedures, a survey is carried out annually of the financial statements of 500 large companies. The resulting information allows accountants, auditors, and decision makers to weigh the validity of a particular presentation. For 2009, this survey found the following frequency for the various cost flow assumptions. Some companies actually use multiple assumptions: one for a particular portion of its inventory and a different one for the remainder. Thus, the total here is above 500 even though 98 of the surveyed companies did not report having inventory or mention a cost flow assumption (inventory was probably an immaterial amount). As will be discussed later in this chapter, applying multiple assumptions is especially common when a U.S. company owns subsidiaries that are located internationally.

Interestingly, individual cost flow assumptions tend to be more prevalent in certain industries. In this same survey, 92 percent of the financial statements issued by food and drug stores made use of LIFO whereas only 11 percent of the companies labeled as “computers, office equipment” had adopted this same approach. This difference is likely caused by the presence of inflation or deflation in those industries. Prices of food and drugs tend to escalate consistently over time while computer prices often fall as technology advances.

The LIFO Conformity Rule

Question: In periods of inflation, FIFO reports a higher gross profit (and, hence, net income) and a higher inventory balance than does LIFO. Averaging presents figures that normally fall between these two extremes. Such results are widely expected by the readers of financial statements who understand the impact of the various cost flow assumptions.

In the United States, all of these methods are permitted for financial reporting. Why is FIFO not the obvious choice for every organization that anticipates inflation in its inventory costs? Officials must prefer to report figures that make the company look stronger and more profitable. With every rise in prices, FIFO shows a higher income because the earlier (cheaper) costs are transferred to cost of goods sold. Likewise, FIFO reports a higher total for ending inventory because the later (higher) cost figures are retained in the inventory T-account. The company is no different physically as a result of this decision but FIFO makes it look better. Why does any company voluntarily choose LIFO, an approach that reduces reported income and total assets when prices rise?

Answer: LIFO might well have faded into oblivion because of its negative impact on key reported figures (during inflationary periods) except for a U.S. income tax requirement known as the LIFO conformity ruleA United States income tax rule that requires LIFO to be used for financial reporting purposes if it is adopted for taxation purposes.. Although this tax regulation is not part of U.S. GAAP and looks rather innocuous, it has a huge impact on the way inventory and cost of goods sold are reported in this country.

If costs are increasing, companies prefer to apply LIFO for tax purposes because this assumption reduces reported income and, hence, required cash payments to the government. In the United States, LIFO has come to be universally equated with the saving of tax dollars. When LIFO was first proposed as a tax method in the 1930s, the United States Treasury Department appointed a panel of three experts to consider its validity. The members of this group were split over a final resolution. They eventually agreed to recommend that LIFO be allowed for income tax purposes but only if the company was also willing to use LIFO for financial reporting. At that point, tax rules bled over into U.S. GAAP.

The rationale behind this compromise was that companies were allowed the option but probably would not choose LIFO for their tax returns because of the potential negative effect on the figures reported to investors, creditors, and others. During inflationary periods, companies that apply LIFO do not look as financially healthy as those that adopt FIFO. Eventually this recommendation was put into law and the LIFO conformity rule was born. It is a federal law and not an accounting principle. If LIFO is used on a company’s income tax return, it must also be applied on the financial statements.

However, as the previous statistics on usage point out, this requirement did not prove to be the deterrent that was anticipated. Actual use of LIFO has remained popular for decades. For many companies, the money saved in income tax dollars more than outweighs the problem of having to report numbers that make the company look weaker. Figure 9.5 “Advantages and Disadvantages of FIFO and LIFO” shows that both methods have advantages and disadvantages. Company officials must weigh the options and make a decision.

As discussed later in this chapter, IFRS does not permit the use of LIFO. Therefore, if IFRS is ever mandated in the United States, a significant tax advantage will be lost unless the LIFO conformity rule is abolished.

Figure 9.5 Advantages and Disadvantages of FIFO and LIFO

*Assumes a rise in prices over time.

Two Sets of Books

Question: The LIFO conformity rule requires companies that apply LIFO for income tax purposes to also use that same cost flow assumption in conveying financial information to investors and creditors. Are the balances submitted to the government for income tax purposes not always the same as that presented to decision makers in a set of financial statements? Reporting different numbers to different parties seems unethical.

Answer: In both jokes and editorials, businesses are often derisively accused of “keeping two sets of books.” The implication is that one is skewed toward making the company look good (for external reporting purposes) whereas the other makes the company look bad (for taxation purposes). However, the existence of separate accounting records is a practical necessity. One set is based on applicable tax laws while the other enables the company to prepare financial statements according to U.S. GAAP. With two different sets of rules, the outcomes have to look different.

In filing income taxes with the United States government, a company must follow the regulations of the Internal Revenue Code.Many states and some cities also charge a tax on income. Those governments have their own unique set of laws although they often resemble the tax laws applied by the federal government. Those laws have several underlying objectives that influence their development.

First, income tax laws are designed to raise money for the operation of the federal government. Without adequate funding, the government could not provide hospitals, build roads, maintain a military and the like.

Second, income tax laws enable the government to help regulate the health of the economy. Simply by raising or lowering tax rates, the government can take money out of the economy (and slow public spending) or leave money in the economy (and increase public spending). For example, in a recent year, a significant tax break was passed by Congress to aid first-time home buyers. This move was designed to stimulate the housing market by encouraging individuals to consider making a purchase.

Third, income tax laws enable the government to assist certain members of society who are viewed as deserving help. For example, taxpayers who encounter high medical costs or casualty losses are entitled to a tax break. Donations conveyed to an approved charity can also reduce a taxpayer’s tax bill. The rules and regulations were designed to provide assistance for specified needs.

In contrast, in the United States, external financial reporting is governed by U.S. GAAP, a system designed to achieve the fair presentation of accounting information. That is the reason U.S. GAAP exists. Because the goals are different, financial data reported according to U.S. GAAP will not necessarily correspond to the tax figures submitted by the same company to the Internal Revenue Service (IRS). At places, though, agreement can be found between the two sets of rules. For example, both normally recognize a cash sale of merchandise as revenue at the time of sale. However, many differences do exist between the two. A loss on the sale of an investment in equity securities is just one example of a transaction that is handled quite differently for taxes and financial reporting.

Although separately developed, financial statements and income tax returns are tied together at one significant spot: the LIFO conformity rule. If a company chooses to use LIFO in filing its United States income tax return, it must do the same for financial reporting. Without that legal requirement, many companies would likely use FIFO in creating their financial statements and LIFO for their income tax returns. Much of the popularity of LIFO is undoubtedly derived from this tax requirement rather than from any theoretical merit.

Reporting Ending Inventory Using LIFO

Question: As a result of the LIFO conformity rule in the tax laws, this cost flow assumption is widely used in the United States. LIFO, though, is not allowed in many other areas of the world. It is not simply unpopular in those locations; its application is strictly forbidden by IFRS. Thus, international companies are often forced to resort to alternatives in reporting their foreign subsidiaries. For example, a note to the 2010 financial statements of American Biltrite Inc. explains that “cost is determined by the last-in, first-out (LIFO) method for approximately 47% of the Company’s domestic inventories. The use of LIFO results in a better matching of costs and revenues. Cost is determined by the first-in, first-out (FIFO) method for the Company’s foreign inventories.”

Why is LIFO not accepted in most countries outside the United States?

Answer: Although LIFO can be supported as providing a better matching of expenses (cost of goods sold) with revenues, a number of serious problems arise from its application. The most common accusation made against LIFO is that it often presents a balance sheet figure that is out-of-date and completely useless. When applying this assumption, the latest costs are moved to cost of goods sold so that earlier costs remain in the inventory account—possibly for years and even decades. After some period of time, this asset balance is likely to report a number that has no relevance to today’s prices.

For example, in its 2010 financial statements, ExxonMobil reported inventory on its balance sheet of approximately $13.0 billion based on applying the LIFO cost flow assumption. In the notes to those financial statements, the company disclosed that the current cost to acquire this same inventory was actually $21.3 billion higher than the number being reported. The asset was shown as $13.0 billion but the price to obtain that merchandise on the balance sheet date was $34.3 billion ($13.0 billion plus $21.3). What is the possible informational value of reporting an asset (one that is being held for sale) at an amount more than $21 billion below its current replacement cost?As will be seen in the next chapter, similar arguments are made in connection with property and equipment—the reported amount and the value can vary greatly. However, those assets are not normally held for resale purpose so that their current worth is of less interest to decision makers. That is the essential problem attributed to LIFO.

To illustrate, assume that a convenience store begins operations and has a tank that holds ten thousand gallons of gasoline. On January 1, 1972, the tank is filled at a cost of $1 per gallon. Almost immediately the price of gasoline jumps to $2 per gallon. During the remainder of 1972, the store buys and sells gas. The tank is filled one final time at the very end of the year bringing total purchases to one million gallons. The first 10,000 gallons were bought at $1.00 per gallon; the next one million gallons cost $2.00 per gallon.

LIFO and FIFO report these results as follows:

After just this initial period, the ending inventory balance shown for LIFO (10,000 gallons at $1 per gallon) already differs significantly from the current cost of $2 per gallon.

If this convenience store continues to finish each year with a full tank of 10,000 gallons (certainly not an unreasonable assumption), LIFO will report this inventory at $1 per gallon for the following decades regardless of current prices. The most recent costs get transferred to cost of goods sold every period leaving the first costs ($1 per gallon) in inventory. The tendency to report this asset at a cost expended years in the past is the single biggest reason that LIFO is viewed as an illegitimate cost flow assumption in many countries. That same sentiment would probably exist in the United States except for the LIFO conformity rule.

LIFO Liquidation

Question: In discussions of financial reporting, LIFO is also criticized because of the possibility of an event known as a LIFO liquidationA decrease in the quantity of inventory on hand when LIFO is applied so that costs incurred in a previous period are mismatched with revenues of the current period; if inflation has occurred, it can cause a significant increase in reported net income.. What is a LIFO liquidation and why does it create a theoretical problem for accountants?

Answer: As demonstrated above, costs from much earlier years often remain in the inventory T-account over a long period of time if LIFO is applied. With that cost flow assumption, a convenience store that opens in 1972 and ends each year with a full tank of 10,000 gallons of gasoline reports ending inventory at 1972 costs for years or even decades. Every balance sheet will show inventory as $10,000 (10,000 gallons in ending inventory at $1.00 per gallon).

However, if the quantity of inventory is ever allowed to decrease (accidentally or on purpose), some or all of those 1972 costs move to cost of goods sold. For example, if the convenience store ends 2012 with less than 10,000 gallons of gasoline, the reduction means that costs sitting in the inventory T-account since 1972 are recognized as an expense in the current year. Costs from 40 years earlier are matched with revenue in 2012. That is a LIFO liquidation and it can artificially inflate reported earnings if those earlier costs are especially low.

To illustrate, assume that this convenience store starts 2012 with 10,000 gallons of gasoline. LIFO has been applied over the years so that this inventory is reported at the 1972 cost of $1.00 per gallon. In 2012, gasoline costs the store $3.35 per gallon to buy and is then sold to the public for $3.50 per gallon creating a gross profit of $0.15 per gallon. That is the amount of income the store is making this year.

At the beginning of 2012, the convenience store sells its entire stock of 10,000 gallons of gasoline at the market price of $3.50 and then ceases to carry this product (perhaps the owners want to focus on groceries or automobile parts). Without any replacement of the inventory, the cost of the gasoline bought in 1972 for $1.00 per gallon is shifted from inventory to cost of goods sold in 2012. Instead of recognizing the normal profit margin of $0.15 per gallon or $1,500 for the 10,000 gallons, the store reports gross profit of $2.50 per gallon ($3.50 sales price minus $1.00 cost of goods sold) or $25,000 in total. The reported profit ($25,000) does not reflect the reality of current market conditions. This LIFO liquidation allows the store to look overly profitable.

In a LIFO liquidation, costs from an earlier period are matched with revenues of the present year. Revenue is measured in 2012 dollars but cost of goods sold is stated in 1972 prices. Although the reported figures are technically correct, the implication that this store earned a gross profit of $2.50 per gallon is misleading.

To warn decision makers of the impact that a LIFO liquidation has on reported net income, disclosure in the notes to the financial statements is needed whenever costs are mismatched in this manner. According to a note in the 2010 financial statements for Alcoa Inc. (all numbers in millions), “During the three-year period ended December 31, 2010, reductions in LIFO inventory quantities caused partial liquidations of the lower cost LIFO inventory base. These liquidations resulted in the recognition of income of $27 ($17 after-tax) in 2010, $175 ($114 after-tax) in 2009, and $38 ($25 after-tax) in 2008.”

Cost Flow Assumptions and Inventory Systems

Question: In the previous chapter, periodic and perpetual inventory systems were introduced. FIFO, LIFO, and averaging have now been presented. How does all of this material come together for reporting purposes? How does the application of a cost flow assumption impact the operation of a periodic or a perpetual inventory system?

Answer: Each company that holds inventory must develop a mechanism to both (a) monitor the balances and (b) allow for the creation of financial statements. If a periodic system is used, officials simply wait until financial statements are to be produced before taking a physical count. Then, a formula (beginning inventory plus all purchase costs less ending inventory) is applied to derive cost of goods sold.

In contrast, a perpetual system maintains an ongoing record of the goods that remain on hand and those that have been sold. As noted, both of these systems have advantages and disadvantages.

Companies also select a cost flow assumption to specify the cost that is transferred from inventory to cost of goods sold (and, hence, the cost that remains in the inventory T-account). For a periodic system, the cost flow assumption is only applied when the physical inventory count is taken and the cost of the ending inventory is determined. In a perpetual system, the cost flow assumption is used each time a sale is made to identify the cost to be reclassified to cost of goods sold. That can occur thousands of times each day.

Therefore, companies normally choose one of six systems to monitor their merchandise balances and determine the cost assignment between ending inventory and cost of goods sold:

• Periodic FIFO
• Perpetual FIFO
• Periodic LIFO
• Perpetual LIFO
• Periodic averaging (also called weighted averaging)
• Perpetual averaging (also called moving averaging)

Periodic and Perpetual FIFO

Question: To illustrate, assume that the Mayberry Home Improvement Store starts the new year with four bathtubs (Model WET-5) in its inventory, costing $110 each ($440 in total) when bought on December 9 of the previous period. The following events then take place during the current year.

• On February 2, three of these bathtubs are sold for $200 each. (revenue $600)
• On February 6, three new bathtubs of this model are bought for $120 each. (cost $360)
• On June 8, three of these bathtubs are sold for $250 each. (revenue $750)
• On June 13, three new bathtubs of this model are bought for $130 each. (cost $390)
• On September 9, two of these bathtubs are sold for $300 each. (revenue $600)
• On September 22, two new bathtub of this model are bought for $149. (cost $298)

At the end of the year, on December 31, a physical inventory is taken that finds that four bathtubs, Model WET-5, are in stock (4 – 3 + 3 – 3 + 3 – 2 + 2). None were stolen, lost, or damaged during the period. How does a periodic FIFO system differ from a perpetual FIFO system in maintaining accounting records and reporting inventory totals?

Answer: Regardless of the inventory system in use, several pieces of information are established in this example. These figures are factual, not impacted by accounting.

The Facts—Purchase and Sale of WET-5 Bathtubs

• Revenue: Eight units were sold for $1,950 ($600 + $750 + $600)
• Beginning Inventory: Four units costing $110 each or $440 in total
• Purchases: Eight units were bought during the year costing a total of $1,048 ($360 + $390 + $298)
• Ending Inventory: Four units are still held according to the physical inventory

Periodic FIFO. In a periodic system, the cost of all new purchases is the focus of the record keeping. Then, at the end of the period, the accountant must count and also determine the cost of the items held in ending inventory. When using FIFO, the first costs are transferred to cost of goods sold so the cost of the last four bathtubs remain in the inventory T-account. That is the FIFO assumption. The first costs are now in cost of goods sold while the most recent costs remain in the asset account.

In this illustration, the last four costs (starting at the end of the period and moving forward) are two units at $149 each and two units at $130 each for a total of $558. Only after that cost is assigned to the ending inventory units can cost of goods sold be calculated as shown in Figure 9.6 “Periodic FIFO—Bathtub Model WET-5”.

Figure 9.6 Periodic FIFO—Bathtub Model WET-5

Under FIFO, the last costs for the period remain in ending inventory; the first costs have all been transferred to cost of goods sold. Based on the application of FIFO, Mayberry reports gross profit from the sale of bathtubs during this year of $1,020 (revenue of $1,950 minus the cost of goods sold figure of $930 calculated in Figure 9.6 “Periodic FIFO—Bathtub Model WET-5”).

Perpetual FIFO. Perpetual accounting systems are constructed so that costs can be moved from inventory to cost of goods sold at the time of each new sale. With modern computer processing, that is a relatively simple task. In Figure 9.7 “Perpetual FIFO—Bathtub Model WET-5”, one format is shown that provides the information needed for this store about the cost and quantity of its inventory of bathtubs. In this figure, at points A, B, and C, costs are moved from inventory on hand to cost of goods sold based on FIFO. The cost of the first goods in the “inventory on hand” is reclassified to cost of goods sold at each of those three points in time.

Figure 9.7 Perpetual FIFO—Bathtub Model WET-5

On this perpetual inventory spreadsheet, the final cell in the “inventory on hand” column ($558 or two units @ $130 and two units at $149) provides the cost of the ending inventory to be reported on the balance sheet. However, it is the summation of the entire “cost of goods sold” column that arrives at the expense for the period ($930 or $330 + $350 + $250).

One important characteristic of FIFO should be noted here. Under both periodic and perpetual FIFO, ending inventory is $558 and cost of goods sold is $930. The reported numbers are identical. The first cost for the period is always the first cost regardless of when the assignment to expense is made. Thus, the resulting amounts are the same when using either FIFO system.

For that reason, many companies that apply FIFO maintain perpetual records to track the units on hand throughout the period but ignore the costs. Later, when financial statements are prepared, a periodic computation is used to determine the cost of ending inventory in order to calculate cost of goods sold. That allows these companies to monitor their inventory quantities every day without the expense and effort of identifying the specific cost associated with each new sale.

Applying LIFO

Question: LIFO reverses the FIFO cost flow assumption so that the last costs incurred are the first reclassified to cost of goods sold. How is LIFO applied to the inventory of an actual business? If the Mayberry Home Improvement Store adopted LIFO, how would the reported figures for its inventory have been affected by this decision?

Answer: Periodic LIFO. In a periodic system, only the computation of the ending inventory is directly affected by the choice of a cost flow assumption.Because ending inventory for one period becomes the beginning inventory for the next, application of a cost flow assumption does change that figure also. However, the impact is only indirect because the number is simply carried forward from the previous period. No current computation of beginning inventory is made based on the cost flow assumption in use. Thus, for this illustration, beginning inventory remains $440 (4 units at $110 each), and the number of units purchased is still eight with a cost of $1,048. The figure that changes is the cost of the ending inventory. Four bathtubs remain in stock at the end of the year. According to LIFO, the last (most recent) costs are transferred to cost of goods sold. Only the cost of the first four units remains in ending inventory. That is $110 per unit or $440 in total.

Figure 9.8 Periodic LIFO—Bathtub Model WET-5

*If the number of units bought during a period equals the number of units sold (as is seen in this example), the quantity of inventory remains unchanged. In a periodic LIFO system, beginning inventory ($440) is then the same as ending inventory ($440) so that cost of goods sold ($1,048) equals the amount spent during the period to purchase inventory ($1,048). For that reason, company officials can easily keep track of gross profit during the year by subtracting purchases from revenues.

If Mayberry Home Improvement Store uses a periodic LIFO system, gross profit for the year will be reported as $902 (revenue of $1,950 less cost of goods sold of $1,048).

Note here that the anticipated characteristics of LIFO are present. Ending inventory of $440 is lower than that reported by FIFO ($558). Cost of goods sold ($1,048) is higher than under FIFO ($930) so that reported gross profit (and, hence, net income) is lower by $118 ($1,020 for FIFO versus $902 for LIFO).

Perpetual LIFO. The mechanical structure for a perpetual LIFO system is the same as that demonstrated previously for perpetual FIFO except that the most recent costs are moved into cost of goods sold at the time of each sale (points A, B, and C).

Figure 9.9 Perpetual LIFO—Bathtub Model WET-5

Once again, the last cell at the bottom of the “inventory on hand” column contains the asset figure to be reported on the balance sheet (a total of $538) while the summation of the “cost of goods sold” column provides the amount to be shown on the income statement ($950).

As can be seen here, periodic and perpetual LIFO do not necessarily produce identical numbers.

Although periodic and perpetual FIFO always arrive at the same results, balances reported by periodic and perpetual LIFO frequently differ. The first cost incurred in a period (the cost transferred to expense under FIFO) is the same regardless of the date of sale. However, the identity of the last or most recent cost (expensed according to LIFO) depends on the perspective.

To illustrate, note that two bathtubs were sold on September 9 by the Mayberry Home Improvement Store. Perpetual LIFO immediately determines the cost of this sale and reclassifies the amount to expense. On that date, the cost of the most recent two units ($130 each) came from the June 13 purchase. In contrast, a periodic LIFO system makes this same determination but not until December 31. As viewed from year’s end, the last bathtubs had a cost of $149 each. Although these items were bought on September 22, after the final sale, their costs are included in cost of goods sold when applying periodic LIFO.

Two bathtubs were sold on September 9, but the identity of the specific costs to be transferred (when using LIFO) depends on the date on which the determination is made. A periodic system views the costs from the perspective of the end of the year. A perpetual system determines the expense immediately when each sale is made.

In practice, many companies are unlikely to use perpetual LIFO inventory systems. They are costly to maintain and, as has been discussed previously, provide figures of dubious usefulness. For that reason, companies often choose to maintain a perpetual FIFO system for internal decision making and then use the periodic LIFO formula at the end of the year to convert the numbers for external reporting purposes.

For example, The Kroger Co. presented the following balances on its January 29, 2011, balance sheet:

• FIFO inventory: $5,793 million
• LIFO reserve: (827) million

Kroger apparently monitors its inventory on a daily basis using FIFO and arrived at a final cost of $5,793 million. However, at the end of that year, the company took a physical inventory and applied the LIFO cost flow assumption to arrive at a reported balance that was $827 million lower. The reduced figure was used for reporting purposes because of the LIFO conformity rule. However, investors and creditors could still see that ending inventory actually had a current cost of $5,793 million.

Applying Averaging as a Cost Flow Assumption

Question: Not surprisingly, averaging follows a path similar to that of the previous examples. Costs are either moved to cost of goods sold at the end of the year (periodic or weighted average) or at the time of each new sale (perpetual or moving average). The only added variable to this process is the calculation of average cost. In the operation of an averaging system, when and how is the average cost of inventory determined?

Answer: Periodic (weighted) average. In the problem being examined here, Mayberry Home Improvement Store eventually held twelve bathtubs. Four of these units were on hand at the start of the year and the other eight were acquired during the period. The beginning inventory cost $440 and the new purchases were bought for a total of $1,048.

These twelve units had a total cost of $1,488 ($440 + $1,048) or $124 per bathtub ($1,488/12 units). When applying a weighted average system, this single average for the entire period is the basis for both the ending inventory and cost of goods sold to be reported in the financial statements. No item actually cost $124 but that average is applied to all units.

Figure 9.10 Periodic (Weighted) Average—Bathtub Model WET-5

Perpetual (moving) average. In this final approach to maintaining and reporting inventory, each time that a company buys inventory at a new price, the average cost is recalculated. Therefore, a moving average system must be programmed to update the average whenever additional merchandise is acquired.

In Figure 9.11 “Perpetual (Moving) Average—Bathtub Model WET-5”, a new average is computed at points D, E, and F. This figure is found by dividing the number of units on hand after the new purchase into the total cost of those items. For example, at point D, the company now has four bathtubs. One cost $110 while the other three were newly acquired for $120 each or $360 in total. Total cost was $470 ($110 + $360) for these four units for an updated average of $117.50 ($470/4 units). That average is used until the next purchase is made on June 13. The applicable average at the time of sale is transferred from inventory to cost of goods sold at points A ($110.00), B ($117.50), and C ($126.88).

Figure 9.11 Perpetual (Moving) Average—Bathtub Model WET-5

Summary. The six inventory systems shown here for Mayberry Home Improvement Store provide a number of distinct pictures of ending inventory and cost of goods sold. As stated earlier, these numbers are all fairly presented but only in conformity with the specified principles being applied. Interestingly, gross profit ranges from $902.00 to $1,020.00 based on the system applied by management.

Figure 9.12 Reported Balances for Six Inventory Systems

Making Comparisons When LIFO Is Applied

Question: The point has been made several times in this chapter that LIFO provides a lower reported net income than does FIFO when prices are rising. In addition, the inventory figure shown on the balance sheet will be below current cost if LIFO is applied during inflation. Comparison between companies that are similar can become difficult, if not impossible, when one uses LIFO and the other FIFO.

For example, Rite Aid, the drug store giant, applies LIFO while its rival CVS Caremark applies FIFO to the inventory held in its pharmacies. How can an investor or creditor possibly evaluate these two companies to assess which has the brightest financial future? In this situation, the utility of the available information seems limited. How do experienced decision makers manage to compare companies that apply LIFO to other companies that do not?

Answer: Significant variations in reported balances frequently result from the application of different cost flow assumptions. Because of the potential detrimental effects, companies that use LIFO often provide additional information to help interested parties understand the impact of this choice. For example, in discussing the use of LIFO, a note to the financial statements for Rite Aid explains (numbers are in thousands): “At February 26, 2011 and February 27, 2010, inventories were $875,012 and $831,113, respectively, lower than the amounts that would have been reported using the first-in, first-out (‘‘FIFO’’) method.”

Here, the reader is informed that the company’s reported inventory balance would be nearly $900 million higher if FIFO was applied. That one sentence allows for a better comparison with a company like CVS Caremark that uses FIFO. The dampening impact of LIFO on reported assets can be removed by the reader as shown in Figure 9.13 “Adjusted Rite Aid’s Inventory Balances from LIFO to FIFO”. Restatement of financial statements in this manner is a common technique relied on by investment analysts around the world to make available information more usable.

Figure 9.13 Adjusted Rite Aid’s Inventory Balances from LIFO to FIFO

Adjusting Rite Aid’s inventory balance from LIFO to FIFO is not difficult because the relevant information is available. However, restating the company’s income statement to numbers in line with FIFO is a bit more challenging. Rite Aid reported an overall net loss for the year ended February 26, 2011, of $555,424,000. How would this number have been different with the application of FIFO?

As seen in the periodic inventory formula, beginning inventory is added to purchases in determining cost of goods sold while ending inventory is subtracted. With the LIFO figures reported by Rite Aid, $3,238,644,000 (beginning inventory) was added in arriving at this expense and then $3,158,145,000 (ending inventory) was subtracted. Together, the net effect is an addition of $80,499,000 in computing cost of goods sold for the year ended February 26, 2011. The resulting expense was $80,499,000 higher than the amount of inventory purchased.

If FIFO had been used by Rite Aid, $4,069,757,000 (beginning inventory) would have been added with $4,033,157,000 (ending inventory) subtracted. These two balances produce a net effect on cost of goods sold of adding $36,600,000.

Under LIFO, cost of goods sold is the purchases for the period plus $80,499,000. Using FIFO, cost of goods sold is the purchases plus only $36,600,000. The purchase figure is the same in both equations. Thus, cost of goods sold will be $43,899,000 lower according to FIFO ($80,499,000 less $36,600,000) so that net income is $43,899,000 higher. If FIFO had been used, Rite Aid’s net loss for the period would have been $511,525,000 instead of $555,424,000. Knowledgeable decision makers can easily make this adjustment to help in evaluating a company. They can determine the amount of net income to be reported if FIFO had been selected and can use that figure for comparison purposes.

Analyzing Vital Signs for Inventory

Question: When examining receivables in a previous chapter, the assertion was made that companies have vital signs that can be studied as an indication of financial well-being. These are ratios or other computed amounts considered to be of particular significance. In that coverage, the age of receivables and the receivable turnover were both calculated and explained. For inventory, do similar vital signs exist that decision makers should consider? What vital signs should be determined in connection with inventory when analyzing the financial health and future prospects of a company?

Answer: No definitive list of ratios and relevant amounts can be identified because different people tend to have their own personal preferences. However, several figures are widely computed and discussed in connection with inventory and cost of goods sold when the financial condition of a company and the likelihood of its prosperity are being evaluated.

Gross profit percentage. The first of these vital signs is the gross profit percentageFormula measuring profitability calculated by dividing gross profit (sales less cost of goods sold) by sales., which is found by dividing the gross profitDifference between sales and cost of goods sold; also called gross margin or markup. for the period by net salesSales less sales returns and discounts..

As has been mentioned, gross profit is also commonly referred to as gross margin or markup. In simplest terms, it is the difference between the amount paid to buy (or manufacture) inventory and the amount received from an eventual sale. The gross profit percentage is often used to compare one company to another or one time period to the next. If one book store manages to earn a gross profit percentage of 35 percent and another only 25 percent, questions should be raised about this difference and which percentage is better? One company is making more profit on each sale but, possibly because of higher sales prices, it might be making significantly fewer sales.

For the year ended January 29, 2011, Macy’s Inc. reported a gross profit percentage of 40.7 percent and reported net income for the year of $847 million on sales of approximately $25 billion. At the same time, Walmart earned a gross profit percentage of only 24.7 percent but managed to generate net income of nearly $17 billion on sales of just under $419 billion. With these companies, a clear difference in pricing strategy can be seen.

The gross profit percentage is also watched closely from one year to the next. For example, if this figure falls from 37 percent to 34 percent, analysts will be quite interested in the reason. A mere 1 percent drop in the gross profit percentage for Walmart in the previous year would have reduced gross profit by over $4 billion ($419 billion × 1 percent).

Such changes have a cause and any individual studying the company needs to consider the possibilities.

• Are costs rising more quickly than the sales price of the merchandise?
• Has a change occurred in the types of inventory being sold?
• Was the reduction in the gross profit offset by an increase in sales?

Amazon.com Inc., for example, reports that its gross profit was 22.6 percent in 2009 and 22.3 percent in 2010. That is certainly one piece of information to be included in a detailed investigation of this company.

Number of days inventory is held. A second vital sign is the number of days inventory is heldMeasures the average number of days that a company takes to sell its inventory items; computed by dividing average inventory for the period by the cost of inventory sold per day. on average. Companies want to turn their merchandise into cash as quickly as possible. Holding inventory for a length of time can lead to several unfortunate repercussions. The longer it sits in stock the more likely the goods are to get damaged, stolen, or go out of fashion. Such losses can be avoided through quick sales. Furthermore, as long as merchandise is sitting on the shelves, it is not earning any profit. Money is tied up with no return until a sale takes place.

Consequently, decision makers (both internal and external to the company) watch this figure closely. A change (especially any lengthening of the time required to sell merchandise) is often a warning of problems.

The number of days inventory is held is found in two steps. First, the cost of inventory that is sold each day on the average is determined.Some analysts prefer to use 360 instead of 365 days to make this computation simpler.

Second, this daily cost figure is divided into the average amount of inventory held during the period. The average amount of inventory can be based on beginning and ending totals, monthly balances, or other available figures.

If a company sells inventory costing $40,000 each day and holds an average inventory during the period of $520,000, the average item takes thirteen days ($520,000/$40,000) to be sold. Again, the significance of that figure depends on the type of inventory, a comparison to results reported by similar companies, and any change seen in recent periods of time.

Inventory turnover. A third vital sign that is often analyzed is the inventory turnoverRatio used to measure the speed at which a company sells inventory; computed by dividing cost of goods sold by average inventory for the period., which is simply another way to measure the speed by which a company sells inventory.

The resulting turnover figure indicates the number of times during the period that an amount equal to the average inventory was sold. The larger the turnover number, the faster inventory is selling. For example, Best Buy Co. Inc. recognized cost of goods sold for the year ending February 26, 2011, of $37,611 million. The company also reported beginning inventory for that period of $5,486 million and ending inventory of $5,897 million. Hence, the inventory turnover for this retail electronics giant was 6.61 times during that year.

The Reported Inventory Balance

Question: The asset section of the February 26, 2011, balance sheet produced by Best Buy Co. Inc. reports net accounts receivable of $2.348 billion. Based on coverage provided in the previous chapter, savvy decision makers should know that this figure reflects net realizable value—the estimation by officials of the cash amount that will be collected from the receivables owed to the company by its customers. Knowledge of financial accounting allows any individual to understand the information conveyed in a set of financial statements.

As is common, the next account that appears on Best Buy’s balance sheet is “merchandise inventories.” This asset includes all items held as of that date that were acquired for sales purposes—televisions, cameras, computers, and the like. The monetary figure disclosed by the company for this asset is $5.897 billion. Does this balance also indicate net realizable value—the cash expected to be generated from the company’s merchandise—or is different information reflected? On a balance sheet, what does the amount reported for inventory represent?

Answer: The challenge of analyzing the various assets reported by an organization would be reduced substantially if all account balances disclosed the same basic information, such as net realizable value. However, over the decades, virtually every asset has come to have its own individualized method of reporting, one created to address the special peculiarities of that account. Thus, the term “presented fairly” is often reflected in a totally different way for each asset. Reporting accounts receivables, for example, at net realizable value has no impact on the approach that is generally accepted for inventoryA current asset bought or manufactured for the purpose of selling in order to generate revenue..

Accounting for inventory is more complicated because reporting is not as standardized as with accounts receivable. For example, under certain circumstances, the balance sheet amount shown for inventory actually does reflect net realizable value. However, several other meanings for that balance are more likely. The range of accounting alternatives emphasizes the need for a careful reading of financial statement notes rather than fixating on a few reported numbers alone. Without study of the available disclosures, a decision maker simply cannot know what Best Buy means by the $5.897 billion figure reported for its inventory.

For all cases, though, the reporting of inventory begins with its cost. In contrast, cost is never an issue even considered in the reporting of accounts receivable.

Determining the Cost of Inventory

Question: Every item bought for sales purposes has a definite cost. The accounting process for inventory begins with a calculation of that cost. How does an accountant determine the cost of acquired inventory?

Answer: The financial reporting for inventory starts by identifying the cost paid to obtain the item. In acquiring inventory, officials make the considered decision to allocate a certain amount of their scarce resources. The amount of that sacrifice is interesting information. What did the company expend to obtain this merchandise? That is a reasonable question to ask since this information can be valuable to decision makers.

To illustrate, assume that a sporting goods company (Rider Inc.) acquires a new bicycle (Model XY-7) to sell. Rider’s accounting system should be designed to determine the cost of this piece of inventory, the price that the company willingly paid to obtain the asset. Assume that $250 was charged by the manufacturer (Builder Company) for the bicycle, and the purchase was made by Rider on credit. Rider spends $9 in cash to transport the item from the factory to one of its retail stores and another $6 to have the pieces assembled so that the bicycle can be displayed in the salesroom for customers to examine.

In accounting for the acquisition of inventory, cost is said to include all normal and necessary amounts incurred to get the item into condition and position to be sold. All such expenditures provide future value. Hence, as shown in Figure 8.1 “Monitoring the Cost of an Inventory Item—Subsidiary Ledger”, by the time this bicycle has reached Rider’s retail location and been readied for sale, the cost to the sporting goods company is $265.

Figure 8.1 Monitoring the Cost of an Inventory Item—Subsidiary Ledger

Charges for delivering this merchandise and assembling the parts were included in the asset account (the traditional term for adding a cost to an asset account, capitalizationThe process of recording a cost as an asset rather than an expense; for inventory, it includes all normal and necessary costs associated with getting the asset into position and condition to be sold., was introduced previously). Both of these expenditures were properly viewed as normal and necessary to get the bicycle into condition and position to be sold. Interestingly, any amount later expended by the company to transport inventory from the store to a buying customer is recorded as an expense because that cost is incurred after the sale takes place. At that point, no further future value exists since the merchandise has already been sold.

Occasionally, costs arise where the “normal and necessary” standard may be difficult to apply. To illustrate, assume that the president of a store that sells antiques buys a 120-year-old table for resell purposes. When the table arrives at the store, another $300 must be spent to fix a scratch cut across its surface. Should this added cost be capitalized (added to the reported balance for inventory) or expensed? The answer to this question is not readily apparent and depends on ascertaining the relevant facts. Here are two possibilities.

Scenario one: The table was acquired by the president with the knowledge that the scratch already existed and needed to be fixed prior to offering the merchandise for sale. In that case, repair is a normal and necessary activity to bring the table into the condition necessary to be sold. The $300 is capitalized, recorded as an addition to the reported cost of the inventory.

Scenario two: The table was bought without the scratch but was damaged when first moved into the store through an act of employee carelessness. The table must be repaired, but the scratch was neither normal nor necessary. The cost could have been avoided. This $300 is not capitalized but rather reported as a repair expense by the store.

As discussed in an earlier chapter, if the accountant cannot make a reasonable determination as to whether a particular cost qualifies as normal and necessary, the practice of conservatism requires the $300 to be reported as an expense. When in doubt, the alternative that makes reported figures look best is avoided so that decision makers are not encouraged to be overly optimistic about the company’s financial health and future prospects.

Offering Discounts for Quick Payment

Question: When inventory is sold, some sellers are willing to accept a reduced amount to encourage fast payment—an offer that is called a cash discount (or sales discount or purchases discount depending on whether the seller or the buyer is making the entry). Cash becomes available sooner so that the seller can quickly put it back into circulation to make more profits. In addition, the possibility that a receivable will become uncollectible is reduced if the balance due is not allowed to get too old. Tempting buyers to make quick payments to reduce their cost is viewed as a smart business practice by many sellers.

To illustrate, assume the invoice received by the sporting goods company (Rider) for the above bicycle indicates the proper $250 balance but also includes the notation: 2/10, n/45. What message is being conveyed by the seller? How do cash discounts impact the reporting of inventory?

Answer: Sellers—such as Builder Company in this example—can offer a wide variety of discount terms to encourage speedy payment. One such as 2/10, n/45 is generally read “two ten, net 45.” It informs the buyer that a 2 percent discount is available if the invoice is paid by the tenth day. The net amount that remains unpaid (after any merchandise returns or partial cash payments) is due on the forty-fifth day. Rider has the option to pay $245 for the bicycle within ten days of receiving the invoice by taking advantage of the $5 discount ($250 × 0.02). Or the sporting goods company can wait until the forty-fifth day but then is responsible for the entire $250. In practice, a variety of other discount terms are frequently encountered such as 1/10, n/30 or 2/10, n/30.

Many companies automatically take all cash discounts as a matter of policy because of the high rate of interest earned. If Rider does not submit the money after ten days, it must pay an extra $5 in order to hold onto $245 for an additional thirty-five days. This delay equates to a 2.04 percent interest rate over just that short period of time ($5/$245 = 2.04 percent [rounded]). There are over ten thirty-five-day periods in a year. Paying the extra $5 is the equivalent of an annual interest rate in excess of 21 percent.

That substantial rate of interest expense is avoided by making early payment, a decision chosen by most companies unless they are experiencing serious cash flow difficulties.

Assuming that Rider avails itself of the discount offer, the capitalized cost of the inventory is reduced to $260.

Figure 8.2 Cost of Inventory Reduced by Cash Discount—Subsidiary Ledger

Maintaining Inventory Costs in a Perpetual System

Question: In an earlier chapter, differences between a perpetual inventory system and a periodic inventory system were discussed briefly. Because of the availability of modern technology, most companies—but not all—maintain some type of perpetual inventory records. A perpetual system—which frequently relies on bar coding and computer scanning—provides an ongoing record of all items present, both in total and individually. How is the recording of an inventory purchase carried out in a perpetual system?

Answer: When a perpetual inventory systemAccounting system that maintains an ongoing record of all inventory items both in total and individually; records increases and decreases in inventory accounts as they occur as well as the cost of goods sold to date. is in use, all additions and reductions are monitored in the inventory T-account. Thus, theoretically, the balance found in that general ledger account at any point in time is identical to the merchandise physically on hand. In actual practice, recording mistakes as well as losses such as theft and breakage create some (hopefully small) discrepancies. Consequently, even with a perpetual system, inventory records must be reconciled occasionally with the items actually present to reestablish accuracy.

In a perpetual inventory system, the maintenance of a separate subsidiary ledger showing data about the individual items on hand is essential. On February 26, 2011, Best Buy reported inventory totaling $5.897 billion. However, internally the company also needs specific information as to the quantity, type, and location of all televisions, cameras, computers, and the like that make up this sum. That is the significance of a perpetual system; it provides the ability to keep track of the various types of merchandise. The total cost is available in the inventory T-account but detailed data about the composition (the quantity and frequently the cost) of merchandise physically on hand is found in a subsidiary ledger where an individual file can be available for each item as is shown in Figure 8.2 “Cost of Inventory Reduced by Cash Discount—Subsidiary Ledger”.

Assume that Rider Inc. (the sporting goods company) uses a perpetual inventory system. In Figure 8.3 “Rider Inc.—Journal Entries—Perpetual Inventory System”, journal entries are shown for the purchase of a bicycle to sell (Model XY-7). The bicycle is recorded at the $250 invoice amount and then reduced by $5 at the time the discount is taken. This approach is known as the “gross method of reporting discounts.” As an alternative, companies can choose to anticipate taking the discount and simply make the initial entry for the $245 expected payment. This option is referred to as the “net method of reporting discounts.” Under that approach, if the discount is not actually taken, the additional $5 cost is recorded as a loss or an expense rather than as a capitalized cost of the inventory because it is not normal or necessary to pay the extra amount.

Figure 8.3 Rider Inc.—Journal Entries—Perpetual Inventory System

After posting these entries, the inventory T-account in the general ledger reports a net cost of $260 ($250 − $5 + $9 + $6) and the separate subsidiary ledger shown previously indicates that one Model XY-7 bicycle is on hand with a cost of $260.

Recording Inventory Purchases in a Periodic System

Question: In a periodic system, no attempt is made to keep an ongoing record of a company’s inventory. Instead, the quantity and cost of merchandise is only determined periodically as a preliminary step in preparing financial statements. How is the actual recording of an inventory purchase carried out in a periodic system?

Answer: If a company uses a periodic inventory systemAccounting system that does not maintain an ongoing record of all inventory items; instead, ending inventory is determined by a physical count so that a formula (beginning inventory plus purchases less ending inventory) can be used to calculate cost of goods sold., neither the cost nor the quantity of the items on hand is monitored. Inventory amounts are unknown both in total and individually. These figures are not viewed by company officials as worth the cost and effort necessary to gather them. However, purchases are still made, and a record must be maintained of the costs incurred. This information is eventually used for financial reporting but also—more immediately—for control purposes. Regardless of the recording system, companies want to avoid spending unnecessary amounts on inventory as well as tangential expenditures such as transportation and assembly. If the accounting system indicates that a particular cost is growing too rapidly, alternatives can be investigated and implemented before the problem becomes serious. Periodic systems are designed to provide such information through the use of separate general ledger T-accounts for each cost incurred.

Assume that Rider uses a periodic inventory system. Its journal entries for the acquisition of the Model XY-7 bicycle are as shown in Figure 8.4 “Rider Inc.—Journal Entries—Periodic Inventory System”. No separate subsidiary ledger is maintained. The overall cost of this inventory item is not readily available in the accounting records and the quantity (except by visual inspection) is unknown. At any point in time, company officials do have access to the amounts spent for each of the individual costs (such as transportation and assembly) for monitoring purposes.

Because these costs result from the acquisition of an asset that eventually becomes an expense when sold, they follow the same debit and credit rules as those accounts.

Figure 8.4 Rider Inc.—Journal Entries—Periodic Inventory System

In a periodic system, when a sale occurs, the revenue entry is made as always. However, no journal entry is made for cost of goods sold. Because of the lack of information, the dollar amount of the cost is not known at this time so inventory is not reduced and cost of goods sold is not recognized. Instead, when a periodic system is in use, cost of goods sold is only determined and recorded when financial statements are prepared through the use of the following formula:

Note that the choice between using a perpetual and periodic system impacts the following:

• Information available to company officials on a daily basis
• Journal entries to be made
• Cost necessary to operate the accounting system (the technology required by a perpetual system is more expensive)

Regardless of the system in use, Rider holds one piece of inventory with a cost of $260. The decision as to whether to utilize a perpetual or periodic system is based on the added cost of the perpetual system and the difference in the available information generated for use by company officials. The company’s inventory is not physically affected by the method selected.

Actual Use of Periodic Inventory Systems

Question: Given the availability of sophisticated computers at moderate prices, do any companies still use periodic inventory systems? With bar coding and the advanced state of technology, are periodic inventory procedures so antiquated that they are no longer found in actual practice?

Answer: Obviously, in this computer age, perpetual inventory systems have come to dominate because they provide valuable and immediate information to company officials. However, some businesses are unlikely to ever change from the simplicity of a periodic system.

A beauty salon or barber shop, for example, where services are rendered but a small amount of inventory is kept on hand for occasional sales, would certainly not need to absorb the cost of a perpetual system. Visual inspection can alert employees as to the quantity of inventory on hand.

Restaurants, sandwich shops, ice cream stores, and the like might well choose to use a periodic system because customer purchases take place at a small establishment where quantities are easy to observe and manage. In such operations, the information provided by a perpetual system does not necessarily provide additional benefit.

“Dollar stores,” which have become particularly prevalent in recent years, sell huge quantities of low-priced merchandise. Goods tend to be added to a store’s inventory as they become available rather than based on a formal managed inventory strategy. Again, officials must decide whether keeping up with the amount of inventory on hand will improve their decision making. If not, the cost of a perpetual system is unnecessary.

Perhaps, most importantly, some companies use a hybrid system where the units on hand and sold are monitored carefully with a perpetual system. However, to reduce accounting costs, the dollar amounts for inventory and cost of goods sold are determined using a periodic system when financial statements are to be prepared. In that way, the company gains valuable information (the number of units on hand) but still utilizes a cheaper system.

Recording Purchases Based on the FOB Point

Question: Rider Inc. (the sporting goods company) buys a bicycle for sales purposes. The company can record the transaction using either a perpetual system (debit Inventory) or periodic system (debit Purchases of Inventory). When should an inventory purchase be recorded? Assume, for example, that Builder Company (the manufacturer of this bicycle) is located in Wisconsin, whereas the retail store operated by Rider is in Kentucky. Delivery takes several days at a minimum. The precise moment for recording the transaction is probably not critical except near the end of the year when the timing of journal entries will impact balances that are included on the financial statements.

To illustrate, assume this bicycle is ordered by Rider Inc. on December 27 of Year One. It is shipped by Builder Company from Wisconsin on December 29 of Year One and arrives at the retail store on January 4 of Year Two. When Rider produces financial statements for Year One, should the inventory cost and related payable be included even though the bicycle was not physically received until Year Two?

Answer: Documents prepared in connection with inventory shipments are normally marked with an “FOB” point. FOB stands for “Free On Board” (a traditional maritime term that has gained a wider use over the years) and indicates when legal title to property is transferred from seller to buyer. At that moment, ownership of the bicycle is conveyed. The FOB point signifies the appropriate date for recording.

If Builder Company specifies that the sale of this bicycle is made FOB shipping pointTerms of sale stipulating that legal title to shipped goods passes to the buyer at the time of shipment so that the buyer is responsible for transportation costs and any damages or losses in transit. and Rider Inc. agrees to this condition, conveyance occurs on December 29, Year One, when the bicycle leaves the seller. Consequently, both the asset and the liability appear on the December 31, Year One, balance sheet prepared by the buyer. For the same reason, Builder records sales revenue in Year One.

However, if the contract states that the transaction is made FOB destinationTerms of sale stipulating that legal title to shipped goods passes to the buyer when they arrive at the final destination so that the seller is responsible for transportation costs and any damages or losses in transit., the seller maintains ownership until the bicycle arrives at Rider’s store on January 4, Year Two. Neither party records the transaction until that date. The date of recognition is based on the FOB point.

The FOB point can be important for two additional reasons.

• The party that holds legal title to merchandise during its delivery from seller to buyer normally incurs all transportation costs. If no other arrangements are negotiated, “FOB shipping point” means that Rider Inc. as the buyer is responsible for the delivery. “FOB destination” assigns this cost to Builder, as the seller.
• Any losses or damages that occur in route affect the party holding legal title (again, unless other arrangements are agreed upon by the parties). If shipment from Wisconsin to Kentucky was noted as FOB shipping point and the bicycle breaks as the result of an accident in Illinois, it is the buyer’s inventory that was harmed. However, it is the seller’s problem if the shipment is marked as FOB destination. The legal owner bears the cost of any damages that occur during the physical conveyance of property.

Recording Cost Of Goods Sold: Perpetual and Periodic

Question: When a sale of inventory is made, the seller recognizes an expense that has previously been identified as “cost of goods sold” or “cost of sales.” For example, Best Buy reported “cost of goods sold,” for the year ended February 26, 2011, as $37.611 billion. When should cost of goods sold be determined?

To illustrate, assume that Rider Inc. begins the current year holding three Model XY-7 bicycles costing $260 each—$780 in total. During the period, another five units of this same model are acquired, again for $260 apiece or $1,300 in total. At this introductory stage, utilizing a single cost of $260 for all items eliminates a significant theoretical problem, one that will be discussed in detail in the following chapter.

Eventually, a customer buys seven of these bicycles for her family and friends paying cash of $440 each or $3,080 in total. No further sales are made of this model during the current period so that only a single bicycle remains (3 + 5 − 7). One is still in stock while seven have been sold. What is the proper method of recording the company’s cost of goods sold?

Answer: The answer here depends on whether a perpetual or a periodic system is used by the company.

Perpetual inventory system. The acquisition and subsequent sale of inventory when a perpetual system is in use was demonstrated briefly in an earlier chapter. The accounting records maintain current balances so that officials are cognizant of (a) the amount of merchandise on hand and (b) the cost of goods sold for the year to date. These figures are readily available in general ledger T-accounts. In addition, separate subsidiary ledger balances are usually established for the individual items in stock, showing the quantity on hand and the cost. When each sale is made, the applicable cost is reclassified from the inventory account on the balance sheet to cost of goods sold on the income statement. Simultaneously, the corresponding balance in the subsidiary ledger is lowered.

In this example, bicycles were acquired by Rider Inc. Seven of them, costing $260 each (a total of $1,820), are then sold to a customer for $440 apiece or $3,080. When a perpetual system is in use, two journal entries are prepared at the time of each sale: one for the sale and a second to shift the cost of the inventory from asset to expense.

Figure 8.5 Journal Entries for Sale of Seven Model XY-7 Bicycles—Perpetual Inventory System

Removing $1,820 from inventory leaves a balance of $260 ($780 + $1,300 – $1,820) representing the cost of the one remaining unit. The $1,260 difference between revenue and cost of goods sold ($3,080 minus $1,820) is the markup (also known as gross profitDifference between sales and cost of goods sold; also called gross margin or markup. or “gross margin”) earned on the sale.

Periodic inventory system. In contrast, a periodic system monitors the various inventory expenditures but makes no attempt to maintain a record of the merchandise on hand or the cost of goods sold during the year. Although cheap to create and operate, the information available to company officials is extremely limited.

At the time the sale of these seven bicycles takes place, the first journal entry shown in Figure 8.5 “Journal Entries for Sale of Seven Model XY-7 Bicycles—Perpetual Inventory System” is still made to recognize the revenue. Cash is debited for $3,080 and Sales Revenue-Merchandise is credited for $3,080. However, if a periodic system is in use, the second entry is omitted. Cost of goods sold is neither calculated nor recorded when a sale occurs. The available information is not sufficient to determine the amount. The inventory balance remains unadjusted throughout the year. Eventually, whenever financial statements are prepared, the figure to be reported for the asset (inventory) on that date must be determined along with the expense (cost of goods sold) for the entire period.

Because totals are not updated, the only accounts found in the general ledger relating to inventory show balances of $780 (beginning balance) and $1,300 (purchases of inventory).

Based on this information, total inventory available to be sold by Rider Inc. during this period is eight units costing $2,080 ($780 plus $1,300).

When using a periodic system, cost of goods sold is computed as a prerequisite step in preparing financial statements. Inventory on hand is counted (a process known as a physical inventoryA count of inventory on hand; necessary for reporting purposes when using a periodic system but also required for a perpetual system to ensure the accuracy of recorded information.), and all units that are no longer present are assumed to have been sold. The resulting figure is then reported as the company’s cost of goods sold for the period. Because complete inventory records are not available, any units that are lost, stolen, or broken cannot be separately derived. All missing inventory is grouped into one expense—cost of goods sold.

In this example, a physical inventory count will be taken by the employees of Rider Inc. on or near the last day of the year so that financial statements can be produced. Because eight bicycles (Model XY-7) were available during the year but seven have now been sold, one unit—costing $260—remains (if no accident or theft has occurred). This amount is the inventory figure that appears in the asset section of the balance sheet.

Cost of goods sold is then computed by the following formula.

Figure 8.6 Computation of Cost of Goods Sold in a Periodic SystemThe Purchases figure here could have also been shown by displaying the various cost components such as the invoice price, purchases discount, transportation-in, and assembly. That breakdown is important for internal decision making and control but probably of less interest to external parties.

In a periodic system, three costs are used to arrive at the amount reported as cost of goods sold. It is important to understand how each of these figures is derived.

• Beginning inventory was derived by a count taken at the end of the previous year. After determining the number of units on hand (three bicycles), the accountant inserts the cost of these items based on the amount paid during the period ($260 each). The resulting monetary balance was recorded in the inventory T-account at the end of that year and has remained unchanged until the end of the current year. A periodic system only updates general ledger accounts when financial statements are prepared.
• The purchases figure has been maintained throughout the year in the general ledger to provide a record of the amounts expended ($1,300) for all normal and necessary costs (invoice price, discounts, transportation-in, assembly costs, and the like) needed to get the inventory into position and condition to be sold.
• Ending inventory is found by making a new physical count at the end of the current period. The number of units that are still held (one, in this case) is multiplied by the unit cost ($260) to arrive at the proper inventory total reported on the balance sheet.

Periodic Inventory—Year-End Recording Process

Question: In a perpetual inventory system, cost of goods sold is determined at the time of each sale. Figures retained in a subsidiary ledger provide the cost of the specific item being surrendered so that an immediate reclassification from asset to expense is made.

With a periodic system, cost of goods sold is not calculated until financial statements are prepared. The beginning inventory balance (the ending amount from the previous year) is combined with the total acquisition costs for the current period. Merchandise still on hand is counted, and its cost is determined. All missing inventory is assumed to reflect the cost of goods sold. When a periodic inventory system is used, how are ending inventory and cost of goods sold for the year physically entered into the accounting records? These figures have not been recorded on an ongoing basis; the general ledger must now be updated to agree with the reported balances.

Answer: In the bicycle example, opening inventory for the period was three items costing $780. Another five were bought during the year for $1,300. The total cost of these eight units is $2,080. Because the financial impact of lost or broken units cannot be ascertained in a periodic system, the entire $2,080 is assigned to either ending inventory (one unit at a cost of $260) or cost of goods sold ($780 + $1,300 – $260 or $1,820). No other account exists in which to record inventory costs in a periodic system. The goods are assumed to be on hand or to have been sold.

For a periodic inventory system, a year-end adjusting entry is prepared so that these newly computed amounts are reflected as the final account balances. Transportation and assembly costs are included within the purchases figure in this entry for convenience.

Figure 8.7 Adjusting Entry—Recording Inventory and Cost of Goods Sold as Determined in Periodic Inventory SystemAs mentioned previously, if separate T-account balances are established for cost components such as transportation-in, assembly costs, and the like, they must be included in this entry rather than just a single Purchases figure.

In this entry, the cost of the beginning inventory and the purchases for the period are basically switched to cost of goods sold and ending inventory.

Note that the reported costs on the financial statements ($260 for ending inventory and $1,820 for cost of goods sold) are identical under both perpetual and periodic systems. As will be demonstrated in another chapter, this agreement does not always exist when inventory items are acquired during the year at differing costs.

Inventory—The Reporting of Cost or Market Value

Question: In the example of Rider Inc., Model XY-7 bicycles have been bought and sold, and one unit remains in stock at year’s end. The cost of this model has held steady at $260. However, its market value is likely to differ from that figure.

Assume that, because of the sales made during the period, company officials believe that a buyer will soon be found to pay $440 for this last bicycle. Is inventory always reported on a balance sheet at historical cost or is market (or fair) value ever taken into consideration? Should this bicycle be shown as an asset at $260, $440, or some other pertinent figure?

Answer: Under normal conditions, market value is rarely relevant in the reporting of inventory. For Rider Inc. this bicycle will likely appear as an asset at its cost of $260 until sold. Value is such a subjective figure that it is usually ignored in reporting inventory. The company has no reliable proof that the bicycle will bring in $440 until a sale actually occurs. The conservative nature of accounting resists the temptation to inflate reported inventory figures based purely on the anticipation of a profitable transaction at some future point in time.

An exception to this rule becomes relevant if the value of inventory falls below cost. Once again, the conservatism inherent in financial accounting is easily seen. If market value remains greater than cost, no change is made in the reported balance until a sale occurs. In contrast, if the value drops so that inventory is worth less than cost, a loss is recognized immediately. Accountants often say that losses are anticipated but gains are not.

As a note to the May 31, 2011, financial statements for Nike Inc. states, “inventories are stated at lower of cost or market.” Whenever inventory appears to have lost value for any reason, the accountant compares the cost of the item to its market value and the lower figure then appears on the balance sheet.

Arriving at a Figure for Market Value

Question: As mentioned, market value is a subjective figure. When applying the lower-of-cost-or-market approach to inventory, how does the owner of the merchandise ascertain market value?

Answer: The practical problem in applying the lower-of-cost-or-market approach arises from the difficulty in ascertaining an appropriate market value. There are several plausible ways to view the worth of any asset. For inventory, there is both a “purchase value” (replacement cost—the amount needed to acquire the same item again at the present time) and a “sales value” (net realizable value—the amount of cash expected from an eventual sale). When preparing financial statements, if either of these amounts is impaired, recognition of a loss is likely. Thus, the accountant must watch both values and be alert for potential problems.

Purchase Value. In some cases, often because of bad timing, a company finds that it has paid an excessive amount for inventory. Usually as the result of an increase in supply or a decrease in demand, replacement cost might drop after an item is acquired.

To illustrate, assume that Builder Company—the manufacturer of bicycle Model XY-7—has trouble selling the expected quantity of this particular style to retail stores because the design is not viewed as attractive. Near the end of the current year, Builder reduces the wholesale price offered for this model by $50 in hopes of stimulating sales. Rider Inc. bought a number of these bicycles earlier at a total cost of $260 each but now, before the last unit is sold, could obtain the same model for only $210. The bicycle held in Rider’s inventory is literally worth less than what the company paid for it. The purchase value, as demonstrated by replacement cost, has fallen to a figure lower than its historical cost.

When replacement cost for inventory drops below the amount paid, the lower (more conservative) figure is reported on the balance sheet, and the related loss is recognized on the income statement. In applying lower of cost or marketConservative approach to the reporting of inventory used when either the purchase value or the sales value has decreased; a reduction in the asset is recorded along with a loss to reflect the decline in market value if it falls below cost., the remaining bicycle is now reported by Rider Inc. at its purchase value. A loss of $50 is created by the reduction in the inventory account from $260 to $210.

Sales value. Inventory also has a sales value that is, frequently, independent of replacement cost. The sales value of an item can fall for any number of reasons. For example, technological innovation will almost automatically reduce the amount that can be charged for earlier models. This phenomenon is typically seen whenever a new computer, camera, or phone is introduced to the market. Older items still in stock must be discounted significantly to attract buyers.

Similarly, changes in fashions and fads will hurt the sales value of certain types of inventory. Swim suits usually are offered at reduced prices in August and September as the summer season draws to a close. Damage can also impact an owner’s ability to recoup the cost of inventory. Advertised sales tempt buyers by offering scratched and dented products, such as microwaves and refrigerators, at especially low prices.

For accounting purposes, the sales value of inventory is normally defined as estimated net realizable value. As discussed in the previous chapter, this figure is the amount of cash expected to be derived from an asset. For inventory, net realizable value is the anticipated sales price less any cost required to generate the sale. For example, the net realizable value of an older model digital camera might be the expected amount a customer will pay after money is spent to advertise the product. The net realizable value for a scratched refrigerator is likely to be the anticipated price of the item less the cost of any repairs that must be made prior to sale.

As with purchase value, if the sales value of an inventory item falls below its historical cost, the lower figure is reported along with a loss to mirror the impact of the asset reduction.

Applying Lower of Cost or Market

Question: Inventory records are maintained at the historical cost of each item. For reporting purposes, this figure is utilized unless market value is lower. A reduction in value can result because of a drop in replacement cost (a purchase value) or in net realizable value (a sales value). How is the comparison of cost and market value actually made when inventory is reported?

Assume that Rider Inc. is currently preparing financial statements and holds two bicycles in ending inventory. Model XY-7 cost the company $260 while Model AB-9 cost $380. As mentioned, Model XY-7 now has a replacement cost of only $210. Because of market conditions, the exact sales value is uncertain. The other unit, Model AB-9, has been damaged and can only be sold for $400 after $50 is spent for necessary repairs. This inventory has a cost of $640 ($260 + $380). What should Rider report for its asset inventory?

Answer: As a preliminary step in preparing financial statements, a comparison of the cost and market value of the inventory is made. Although other alternatives exist, assume that Rider compares the cost to the market value for each separate item.In applying the lower-of-cost-or-market approach to inventory, the comparison can be made on an item-by-item basis. For example, XY-7 can be valued based on the lower of cost and market for that one item and then, separately, a similar determination can be made for AB-9. A company can also group its inventory (all bicycles, for example, might comprise a group that is separate from all motorcycles) and report the lower amount determined for each group. A third possibility is to sum the cost of all inventory items and make a single comparison of that figure to the total of all market values. U.S. GAAP does not specify a mechanical approach to use in applying lower of cost or market. Market value used for the first item (XY-7) is its purchase value (replacement cost of $210) whereas the market value for the second item (AB-9) is the sales value of $350 (net realizable value of $400 minus $50). A problem with either value can lead to a reduction in the reported asset balance, which causes the recognition of a loss.

Figure 8.8 Recognition of a Loss on Impaired Inventory Value

Rider Inc. reports its inventory at the conservative $560 amount on its balance sheet with an $80 loss ($640 – $560) appearing in the income statement for this period. Such losses can be quite significant. Mitsui & Co. (U.S.A.) recognized a $25.3 million loss for the year ending March 31, 2011, that was attributed to applying the lower-of-cost-or-market approach to its inventory.

Counting Inventory in a Perpetual System

Question: In a periodic inventory system, a physical count is always taken at or near the end of the fiscal year. This procedure is essential in determining the final inventory figure and, hence, cost of goods sold for the period. When a company uses a perpetual system, is a count of the goods on hand still needed since both the inventory balance and cost of goods sold are maintained and available in the accounting records?

Answer: A physical inventory is necessary even if a company has invested the effort and cost to install a perpetual system. Merchandise can be lost, broken, or stolen. Errors can occur in the record keeping. Thus, a count is taken on a regular basis simply to ensure that subsidiary and general ledger balances are kept in alignment with the actual items held. Unless differences become material, this physical inventory can take place at a convenient time rather than at the end of the year. For example, assume that a company sells snow ski apparel. If an efficient perpetual system is in use, the merchandise could be inspected and counted by employees in May when quantities are low and damaged goods easier to spot.

An adjustment is necessary when the count does not agree with perpetual inventory figures. To illustrate, assume that company records indicate that 65 ski jackets are currently in stock costing $70 apiece. The physical inventory finds that only 63 items are actually on hand. The inventory account is reduced (credited) by $140 to mirror the shortfall (two missing units at $70 each).

The other half of the adjusting entry depends on the perceived cause of the shortage. For example, officials might have reason to believe that errors took place in the accounting process during the period. When merchandise is bought and sold, recording miscues do occur. Possibly two ski jackets were sold on a busy afternoon. The clerk got distracted and the cost of this merchandise was never reclassified to expense. This type of mistake means that the cost of goods sold figure is too low. The balance reported for these two jackets is moved to the expense account to rectify the mistake.

Figure 8.9 Adjusting Entry—To Bring Perpetual Inventory Records in Line with Physical Count, a Recording Error Is Assumed

Conversely, if differences between actual and recorded inventory amounts occur because of damage, loss, or theft, the reported balance for cost of goods sold should not bear the cost of these items. The two jackets were not sold. Instead, a loss occurred.

If the assumption is made that the missing jackets were lost or stolen, rather than sold, the following alternative adjustment is appropriate.

Figure 8.10 Adjusting Entry—To Bring Perpetual Inventory Records in Line with Physical Count, Theft or Loss Is Assumed

In practice, when an inventory count is made and the results differ from the amount of recorded merchandise, the exact cause is often impossible to identify. Whether a loss is reported or a change is made in reporting cost of goods sold, the impact on net income is the same. In such cases, construction of the adjustment is at the discretion of company officials. Normally, consistent application from year to year is the major objective.

Estimating the Amount of Inventory on Hand

Question: A periodic system is cheap and easy to operate. However, the lack of available information does present some practical problems. Assume that a company experiences a fire, flood, or other disaster and is attempting to gather evidence—for insurance or tax purposes—as to the amount of merchandise that was destroyed. If a periodic system has been used, how can the company support its claim? Or assume a company wants to produce interim financial statements for a single month or quarter (rather than a full year) without going to the cost and trouble of taking a complete physical inventory count. If the information is needed, how can a reasonable approximation of inventory on hand be derived when a periodic system is in use?

Answer: One entire branch of accounting—known as forensic accountingA branch of accounting specializing in investigating and reporting on situations where important information is limited or unavailable.—specializes in investigations where information is limited or not available (or has even been purposely altered to be misleading). For example, assume that a hurricane floods a retail clothing store in Charleston, South Carolina. Only a portion of the merchandise costing $80,000 is salvaged.For a full description of forensic accounting, see Frank J. Grippo and J. W. (Ted) Ibex, “Introduction to Forensic Accounting,” The National Public Accountant, June 2003. In trying to determine the resulting loss, the amount of inventory in the building prior to the storm needs to be calculated. A forensic accountant might be hired, by either the owner of the store or the insurance company, to produce a reasonable estimate of the merchandise on hand at the time of the flood. Obviously, if the company had used a perpetual rather than a periodic system, the need to hire the services of an accounting expert would be less likely unless fraud was suspected.

In some cases, arriving at a probable inventory balance is not extremely complicated even if periodic inventory procedures are utilized. When historical trends can be determined with assurance, a valid estimation of the goods on hand is possible at any point in time without the benefit of perpetual records. To illustrate, assume that the general ledger for the Charleston store is located after the disaster. A periodic system was in use and the T-account balances provide the following information.

Figure 8.11 Estimating Inventory—General Ledger Balances

If no sales had taken place prior to the flood, the inventory on hand would have cost $571,000 as shown by these ledger accounts. However, sales had occurred, and a significant amount of merchandise was removed by customers as a result of those transactions. The $480,000 balance shown in the sales T-account does not reflect the cost of inventory items that were surrendered. It is a retail amount, the summation of the price charged for all sales during the year to date.

To determine the cost of inventory held at the time of the catastrophe, cost of goods sold for the current year has to be approximated and then removed from the $571,000 total. Many companies use a fairly standard markup percentage to set retail prices. By looking at previously reported balances, the forensic accountant is often able to make a reasonable determination of that markup. For example, assume that in the preceding year, this company reported sales revenue of $500,000 along with cost of goods sold of $300,000 and, hence, gross profit of $200,000. In this earlier period, cost of goods sold was 60 percent of sales revenue ($300,000/$500,000) while gross profit was 40 percent ($200,000/$500,000).

If available evidence does not indicate any significant changes this year in the method used to set retail prices, the accountant can assume that cost of goods sold during the period prior to the storm was about $288,000 ($480,000 sales revenue × 60 percent). Because the cost of all inventory was $571,000, approximately $283,000 of those goods were still in stock at the store when the hurricane hit Charleston ($571,000 total cost less $288,000 estimated cost of goods sold). This residual figure then serves as the basis for the insurance or tax claim. Only goods costing $80,000 were saved. Thus, the estimated loss was $203,000 ($283,000 inventory in stock less $80,000 inventory saved).

An identical set of procedures could also be used if the company was preparing financial statements for a period of time of less than a year (for example, a month or a quarter). For such interim reporting, companies often determine inventory and cost of goods sold based on estimations to avoid the cost of frequent physical counts.

The biggest obstacle in this type calculation is the validity of the cost and markup percentages. Many companies offer an eclectic variety of products, each with its own typical gross margin. Other companies change their markups frequently based on market conditions. In these cases, determining a reliable percentage can be difficult and the accuracy of the resulting estimation is much more questionable.

Reporting Accounts Receivable

Question: The goal of financial accounting is to paint a fairly presented portrait that enables decision makers to make a reasonable assessment of an organization’s financial health and future prospects. This likeness should be communicated based on a set of generally accepted accounting principles (either U.S. GAAP or IFRS) with no material misstatements included. The success of the conveyance is dependent on the ability of the accountants to prepare financial statements that meet this rigorous standard.

Equally as important, every party analyzing the resulting statements must possess the knowledge necessary to understand the multitude of reported figures and explanations. If appropriate decisions are to result based on this information, both the preparer and the reader need an in-depth knowledge of the reporting standards.

For example, the asset section of the balance sheet produced by Dell Inc. as of January 28, 2011, indicates that the company held “accounts receivable, net” amounting to $6.493 billion. What does this figure reflect? What information is communicated to decision makers about a company and its accounts receivable when a single number such as $6.493 billion is reported?

Answer: One of the most satisfying results of mastering the terminology, rules, and principles of financial accounting is the ability to understand the meaning of amounts and disclosures reported about an organization. Such information is presented and analyzed daily in magazines, newspapers, radio, television, and the Internet. As with any language, failure to comprehend elements of the discussion leaves the listener lost and feeling vulnerable. However, with a reasonable amount of study, the informational content begins to make sense and quickly becomes useful in arriving at logical decisions.

In previous chapters, the asset accounts receivableAn asset that reports the amounts generated by credit sales that are still owed to an organization by its customers. was introduced to report monetary amounts owed to a reporting entity by its customers. Individual balances are generated by sales made on credit. Businesses sell on credit, rather than demanding cash, as a way to increase the number of customers and the related revenue. According to U.S. GAAP, the figure presented on a balance sheet for accounts receivable is its net realizable valueThe amount of cash that is expected to be generated by an asset after costs necessary to obtain the cash are removed; as related to accounts receivable, it is the amount an organization estimates will ultimately be collected from customers.—the amount of cash the company estimates will be collected over time from these accounts.

Consequently, officials for Dell Inc. analyzed its accounts receivable as of January 28, 2011, and determined that $6.493 billion was the best guess as to the cash that would be collected. The actual total of receivables was higher than that figure but an estimated amount of doubtful accounts had been subtracted in recognition that a portion of these debts could never be collected. For this reason, the asset is identified on the balance sheet as “accounts receivable, net” or, sometimes, “accounts receivable, net of allowance for doubtful accounts” to explain that future losses have already been anticipated and removed.

Lack of Exactness in Reporting Receivables

Question: As discussed in previous chapters, many of the figures reported in financial accounting cannot be absolutely correct. Although $6.493 billion is the asset balance shown by Dell, the cash eventually collected will likely be somewhat higher or lower. Should the lack of exactness in reporting receivables cause concern for decision makers?

Answer: No one will ever be able to predict the precise amount of cash to be received from nearly $6.5 billion in accounts receivable. In fact, Note One to Dell’s financial statements specifically states, “The preparation of financial statements in accordance with GAAP requires the use of management’s estimates. These estimates are subjective in nature and involve judgments that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at fiscal year-end, and the reported amounts of revenues and expenses during the fiscal year. Actual results could differ from those estimates.”

Knowledgeable decision makers understand that a degree of uncertainty exists in reporting all such balances. However, a very specific figure does appear on Dell’s balance sheet for accounts receivable. By communicating this one amount, company officials are asserting that they believe sufficient evidence is available to provide reasonable assurance that the amount collected will not be a materially different figure.The independent auditors will also analyze the same available evidence and must agree that it is sufficient to serve as the basis for rendering reasonable assurance that the financial statements are presented fairly before an unqualified opinion can be released.

This is the meaning of any accounts receivable balance presented according to U.S. GAAP. All parties involved should understand what the figure represents. Actual receipts are expected to be so close to $6.493 billion that an interested party can rely on this number in arriving at decisions about the reporting company’s financial health and future prospects. Officials believe that the discrepancy between this balance and the cash collected will be so small that the same decisions would have been made even if the exact outcome had been known. In other words, any difference between reported and actual figures will be inconsequential. Once again, though, absolute assurance is not given for the reported amount but merely reasonable assurance.

Clearly, the reporting of receivables moves the coverage of financial accounting into more complicated territory. In the transactions and events analyzed previously, uncertainty was rarely encountered. The financial impact of signing a bank loan or the payment of a salary can be described to the penny except in unusual situations. Here, the normal reporting of accounts receivable introduces the challenge of preparing statements where the ultimate outcome is literally unknown. The very nature of such uncertainty forces the accounting process to address such problems in some logical fashion.

Determining Net Realizable Value

Question: Inherent uncertainty is associated with the reporting of receivables. No one can know exactly how much cash will be collected. How do company officials obtain sufficient evidence to provide reasonable assurance that the balance is not materially misstated? How does any business ever anticipate the amount of cash that will be collected from what can be a massive number of accounts receivable?

Answer: In accounting, reported balances never represent random guesses. Considerable investigation and analysis goes into arriving at financial statement figures. To determine the net realizable value appropriate for accounts receivable, company officials consider the following relevant factors:

• Historical experience of the company in collecting its receivables
• Efficiency of the company’s credit verification policy
• Current economic conditions
• Industry averages and trends
• Percentage of overdue accounts at present
• Efficiency of company’s collection procedures

Dell Inc. explains this process within the notes to its financial statements by indicating that this estimation “is based on an analysis of historical bad debt experience, current receivables aging, and expected future write-offs, as well as an assessment of specific identifiable customer accounts considered at risk or uncollectible.”

Additional information disclosed by Dell indicates that the company actually held $6.589 billion in accounts receivable, but—at the date of the balance sheet—$96 million of these accounts were anticipated to be uncollectible. Thus, the amount of cash estimated from the receivables is the reported $6.493 billion net balance ($6.589 billion total less $96 million expected to be uncollectible). Quite obviously, decision makers studying the company will be interested in comparing such data to figures disclosed by Dell in previous years as well as the information disseminated by competing organizations such as Hewlett-Packard and Apple. Just determining whether $96 million in uncollectible accounts is a relatively high or low figure is quite significant in evaluating the efficiency of Dell’s current operations.

The Allowance for Doubtful Accounts

Question: Based on the information provided by Dell Inc., companies seem to maintain two separate ledger accounts in order to report accounts receivables at net realizable value. One is the sum of all accounts outstanding and the other is an estimation of the amount within the total that will never be collected. Interestingly, the first is a fact and the second is an opinion. The two are then combined to arrive at the net realizable value figure shown on the balance sheet. Is the amount reported for accounts receivable actually the net of the total due from customers less the anticipated doubtful accounts?

Answer: Yes, companies do maintain two separate T-accounts for accounts receivables, but that is solely because of the uncertainty involved. If the balance to be collected was known, one account would suffice for reporting purposes. However, that level of certainty is rarely possible.

• An accounts receivable T-account monitors the total due from all of a company’s customers.
• A second account (often called the allowance for doubtful accountsA contra asset account reflecting the amount of accounts receivable that the reporting company estimates will eventually fail to be collected, also referred to as the allowance for uncollectible accounts. or the allowance for uncollectible accounts) reflects the estimated amount that will eventually have to be written off as uncollectible.

Whenever a balance sheet is produced, these two accounts are netted to arrive at net realizable value, the figure to be reported for this particular asset.

The allowance for doubtful accounts is an example of a contra accountAn offset to a reported account that decreases the total balance to a net amount; in this chapter, the allowance for doubtful accounts reduces reported accounts receivable to the amount expected to be collected., one that always appears with another account but as a direct reduction to lower the reported value. Here, the allowance decreases the receivable balance to its estimated net realizable value. As a contra asset account, debit and credit rules are applied that are opposite of the normal asset rules. Thus, the allowance increases with a credit (creating a decrease in the net receivable balance) and decreases with a debit. The more accounts receivable a company expects to be bad, the larger the allowance. This increase, in turn, reduces the net realizable value shown on the balance sheet.

By establishing two T-accounts, Dell can manage a total of $6.589 billion in accounts receivables while setting up a separate allowance balance of $96 million. As a result, the reported figure—as required by U.S. GAAP—is the estimated net realizable value of $6.493 billion.

Anticipating Bad Debt Expense

Question: Accounts receivable and the offsetting allowance for doubtful accounts are netted with the resulting figure reported as an asset on the balance sheet.Some companies include both accounts on the balance sheet to indicate the origin of the reported balance. Others show only the single net figure with explanatory information provided in the notes to the financial statements. How does the existence of doubtful accounts affect the income statement? Sales are made on account, but a portion of the resulting receivables must be reduced because collection is rarely expected to be 100 percent. Does the presence of bad accounts create an expense for the reporting company?

Answer: Previously, an expense was defined as a measure of decreases in or outflows of net assets (assets minus liabilities) incurred in connection with the generation of revenues. If receivables are recorded that will eventually have to be decreased because they cannot be collected, an expense must be recognized. In financial reporting, terms such as bad debt expenseEstimated expense from making sales on account to customers who will never pay; because of the matching principle, the expense is recorded in the same period as the sales revenue., “doubtful accounts expense,” or “the provision for uncollectible accounts” are often encountered for that purpose.

The inherent uncertainty as to the amount of cash that will be received affects the physical recording process. How is a reduction reported if the amount will not be known until sometime in the future?

To illustrate, assume that a company makes sales on account to one hundred different customers late in Year One for $1,000 each. The earning process is substantially complete at the time of sale and the amount of cash to be received can be reasonably estimated. According to the revenue realization principle within accrual accounting, the company should immediately recognize the $100,000 revenue generated by these transactions.Because the focus of the discussion here is on accounts receivable and their collectability, the recognition of cost of goods sold as well as the possible return of any merchandise will be omitted at this time.

Figure 7.1 Journal Entry—Year One—Sales Made on Credit

Assume further that the company’s past history and other relevant information lead officials to estimate that approximately 7 percent of all credit sales will prove to be uncollectible. An expense of $7,000 (7 percent of $100,000) is anticipated because only $93,000 in cash is expected from these receivables rather than the full $100,000 that was recorded.

The specific identity and the actual amount of these bad accounts will probably not be known for many months. No physical evidence exists at the time of sale to indicate which will become worthless (buyers rarely make a purchase and then immediately declare bankruptcy or leave town). For convenience, accountants wait until financial statements are to be produced before making this estimation of net realizable value. The necessary reduction is then recorded by means of an adjusting entry.

In the adjustment, an expense is recognized. This method of presentation has a long history in financial accounting. However, recently FASB has been discussing whether a direct reduction in revenue might not be a more appropriate approach to portray bad debts. Financial accounting rules are under constant scrutiny, which leads to continual evolution.

Bad Debts and the Matching Principle

Question: This company holds $100,000 in accounts receivable but only expects to collect $93,000 based on available evidence. The $7,000 reduction in the asset is an expense. When should the expense be recognized? These sales were made in Year One but the specific identity of the customers who fail to pay and the actual uncollectible amounts will not be determined until Year Two. Should bad debt expense be recognized in the same year as the sales by relying on an estimate or delayed until the actual results are eventually finalized? How is the uncertainty addressed?

Answer: This situation illustrates how accrual accounting plays such a key role within financial reporting. As discussed previously, the timing of expense recognition according to accrual accounting is based on the matching principle. Where possible, expenses are recorded in the same period as the revenues they helped generate. The guidance is clear. Thus, every company should handle uncollectible accounts in the same manner. The expected expense is the result of making sales to customers who ultimately will never pay. Because the revenue was reported at the time of sale in Year One, the related expense is also recognized in that year. This handling is appropriate according to accrual accounting even though the $7,000 is only an estimated figure.

Therefore, as shown in Figure 7.2 “Adjusting Entry—End of Year One—Recognition of Bad Debt Expense for the Period”, when the company produces financial statements at the end of Year One, an adjusting entry is made to (1) reduce the receivables balance to its net realizable value and (2) recognize the expense in the same period as the related revenue.

Figure 7.2 Adjusting Entry—End of Year One—Recognition of Bad Debt Expense for the Period

After this entry is made and posted to the ledger, the Year One financial statements contain the information shown in Figure 7.3 “Year One—Financial Statements” based on the adjusted T-account balances (assuming for convenience that no other sales were made during the year):

Figure 7.3 Year One—Financial Statements

From this information, anyone studying these financial statements should understand that an expense estimated at $7,000 was incurred this year because the company made sales of that amount that will never be collected. In addition, year-end accounts receivable total $100,000 but have an anticipated net realizable value of only $93,000. Neither the $7,000 nor the $93,000 figure is expected to be exact but the eventual amounts should not be materially different. With an understanding of financial accounting, the reported information is clear.

The Need for a Separate Allowance Account

Question: When financial statements are prepared, an expense must be recognized and the receivable balance reduced to net realizable value. However, in the previous adjusting entry, why was the accounts receivable account not directly decreased by $7,000 to the anticipated balance of $93,000? This approach is simpler as well as easier to understand. Why was the $7,000 added to this contra asset account? In reporting receivables, why does the accountant go to the trouble of creating a separate allowance for reduction purposes?

Answer: When the company prepares the adjustment in Figure 7.2 “Adjusting Entry—End of Year One—Recognition of Bad Debt Expense for the Period” at the end of Year One, the actual accounts that will not be collected are unknown. Officials are only guessing that $7,000 will prove worthless. Plus, on the balance sheet date, the company does hold $100,000 in accounts receivable. That figure cannot be reduced directly until the specific identity of the accounts to be written off has been established. Utilizing a separate allowance allows the company to communicate the expected amount of cash while still maintaining a record of all balances in the accounts receivable T-account.

The Write-Off of an Uncollectible Account

Question: The company in the above illustration expects to collect cash from its receivables that will not materially differ from $93,000. The $7,000 bad debt expense is recorded in the same period as the revenue through a Year One adjusting entry.

What happens when an actual account is determined to be uncollectible? For example, assume that on March 13, Year Two, a $1,000 balance is judged to be worthless. The customer dies, declares bankruptcy, disappears, or just refuses to make payment. This $1,000 is not a new expense. A total of $7,000 was already anticipated and recognized in Year One. It is merely the first discovery. How does the subsequent write-off of an uncollectible receivable affect the various T-account balances?

Answer: When an account proves to be uncollectible, the receivable T-account is decreased. The $1,000 balance is simply removed. It is not viewed as an asset because it has no future economic benefit. Furthermore, the amount of bad accounts within the receivables is no longer anticipated as $7,000. Because this first worthless receivable has been identified and eliminated, only $6,000 remains in the allowance for doubtful accounts.

In Figure 7.4 “Journal Entry during Year Two—Write-Off of Specific Account as Uncollectible”, the journal entry is shown to write off this account. Throughout the year, this entry is repeated whenever a balance is found to be worthless. No additional expense is recognized. The expense was estimated and recorded in the previous period to comply with accrual accounting and the matching principle.

Figure 7.4 Journal Entry during Year Two—Write-Off of Specific Account as Uncollectible

Two basic steps in the recording of doubtful accounts are shown here.

1. Reporting of uncollectible accounts in the year of sale based on estimation. The amount of bad accounts is estimated whenever financial statements are to be produced. An adjusting entry then recognizes the expense in the same period as the sales revenue. It also increases the allowance for doubtful accounts (to reduce the reported receivable balance to its anticipated net realizable value).
2. Write-off of an account judged to be uncollectible. Subsequently, whenever a specific account is deemed to be worthless, the balance is removed from both the accounts receivable and the allowance-for-doubtful-accounts T-accounts. The related expense has been recognized previously and is not affected by the removal of a specific uncollectible account.

These two steps are followed consistently throughout the reporting of sales made on account and the subsequent collection (or write-off) of the balances.

Collecting Accounts Previously Written Off

Question: An account receivable is judged as a bad debt and an adjusting entry is prepared to remove it from the ledger accounts. What happens then? After a receivable has been written off as uncollectible, does the company cease in its attempts to collect the amount due from the customer?

Answer: Organizations always make every possible effort to recover money they are owed. Writing off an account simply means that the chances of collection are deemed to be slim. Efforts to force payment will continue, often with increasingly aggressive techniques. If money is ever received from a written off account, the company first reinstates the account by reversing the earlier entry (Figure 7.5 “Journal Entry—Reinstate Account Previously Thought to Be Worthless”). Then, the cash received is recorded in the normal fashion (Figure 7.6 “Journal Entry—Collection of Reinstated Account”). The two entries shown here are appropriate if the above account is eventually collected from this customer. Some companies combine these entries by simply debiting cash and crediting the allowance. That single entry has the same overall impact as Figure 7.5 “Journal Entry—Reinstate Account Previously Thought to Be Worthless” and Figure 7.6 “Journal Entry—Collection of Reinstated Account”.

Figure 7.5 Journal Entry—Reinstate Account Previously Thought to Be Worthless

Figure 7.6 Journal Entry—Collection of Reinstated AccountMany companies combine these two entries for convenience. The debit to accounts receivable in the first entry exactly offsets the credit in the second. Thus, the same recording impact is achieved by simply debiting cash and crediting the allowance for doubtful accounts. However, the rationale for that single entry is not always as evident to a beginning student.

Reporting an Incorrect Estimation

Question: In this illustration, at the end of Year One, the company estimated that $7,000 of its accounts receivable will ultimately prove to be uncollectible. However, in Year Two, that figure is likely to be proven wrong. It is merely a calculated guess. The actual amount might be $6,000 or $8,000 or many other numbers. When the precise figure is known, does a company return to its Year One financial statements and adjust them to the correct balance? Should a company continue reporting an estimated figure for a previous year even after it has been shown to be incorrect?

Answer: According to U.S. GAAP, if a number in an earlier year is reported based on a reasonable estimation, any subsequent differences with actual amounts are not handled retroactively (by changing the previously released figures). For example, if uncollectible accounts here prove to be $8,000, the company does not adjust the balance reported as the Year One bad debt expense from $7,000 to $8,000. It continues to report $7,000 on the income statement for that period even though that number is now known to be wrong.

There are several practical reasons for the accountant’s unwillingness to adjust previously reported estimations unless they were clearly unreasonable or fraudulent:

1. Most decision makers are well aware that many reported figures represent estimates. Discrepancies are expected and should be taken into consideration when making decisions based on numbers presented in a set of financial statements. In analyzing this company and its financial health, educated investors and creditors anticipate that the total of bad accounts will ultimately turn out to be an amount that is not materially different from $7,000 rather than exactly $7,000.
2. Because an extended period of time often exists between issuing statements and determining actual balances, most parties will have already used the original information to make their decisions. Knowing the exact number now does not allow them to undo those prior actions. There is no discernable benefit from having updated figures as long as the original estimate was reasonable.
3. Financial statements contain numerous estimations and nearly all will prove to be inaccurate to some degree. If exactness were required, correcting each of these previously reported figures would become virtually a never-ending task for a company and its accountants. Scores of updated statements might have to be issued before a “final” set of financial figures became available after several years. For example, the exact life of a building might not be known for 50 years or more. Decision makers want information that is usable as soon as possible. Speed in reporting is far more important than absolute precision.
4. At least theoretically, half of the differences between actual and anticipated results should make the reporting company look better and half make it look worse. If so, the corrections needed to rectify all previous estimation errors will tend to offset and have little overall impact on a company’s reported income and financial condition.

Thus, no change is made in financial figures that have already been released whenever a reasonable estimation proves to be wrong. However, differences that arise should be taken into consideration in creating current and subsequent statements. For example, if the Year One bad debts were expected to be 7 percent, but 8 percent actually proved to be uncollectible, the accountant might well choose to use a higher percentage at the end of Year Two to reflect this new knowledge.

Recording Receivable Transactions in Subsequent Years

Question: To carry the previous illustration one step further, assume that $400,000 in new credit sales are made during Year Two while cash of $330,000 is collected. Uncollectible receivables totaling $10,000 are written off in that year. What balances appear in the various T-accounts at the end of a subsequent year to reflect sales, collections, and the write-off of uncollectible receivables?

Answer: Sales and bad debt expense were reported previously for Year One. However, as income statement accounts, both were closed out in order to begin Year Two with zero balances. They are temporary accounts. In contrast, accounts receivable and the allowance for doubtful accounts appear on the balance sheet and retain their ending figures going into each subsequent period. They are permanent accounts. Thus, these two T-accounts still show $100,000 and $7,000 respectively at the beginning of Year Two.

Assuming that no adjusting entries have yet been recorded, these four accounts hold the balances shown in Figure 7.7 “End of Year Two—Sales, Receivables, and Bad Debt Balances” at the end of Year Two. Notice that the bad debt expense account remains at zero until the end-of-year estimation is made and recorded.

Figure 7.7 End of Year Two—Sales, Receivables, and Bad Debt Balances

Residual Balance in the Allowance for Doubtful Accounts

Question: In the T-accounts in Figure 7.7 “End of Year Two—Sales, Receivables, and Bad Debt Balances”, the balances represent account totals for Year Two prior to year-end adjusting entries. Why does a debit balance of $3,000 appear in the allowance for doubtful accounts before recording the necessary adjustment for the current year? When a debit balance is found in the allowance for doubtful accounts, what does this figure signify?

Answer: When Year One financial statements were produced, $7,000 was estimated as the amount of receivables that would eventually be identified as uncollectible. In Year Two, the actual total written off turned out to be $10,000. The original figure was too low by $3,000. This difference is now reflected by the debit remaining in the allowance account. Until the estimation for the current year is determined and recorded, the balance residing in the allowance account indicates a previous underestimation (an ending debit balance) or overestimation (a credit) of the amount of worthless accounts.The $3,000 debit figure is assumed here for convenience to be solely the result of underestimating uncollectible accounts in Year One. Several other factors may also be present. For example, the balance in the allowance for doubtful accounts will be impacted by credit sales made in the current year that are discovered to be worthless before the end of the period. Such accounts actually reduce the allowance T-account prior to the recognition of an expense. The residual allowance balance is also affected by the collection of accounts that were written off as worthless in an earlier year. As described earlier, the allowance is actually increased by that event. However, the financial reporting is not altered by the actual cause of the final allowance figure.

Two Methods for Estimating Uncollectible Accounts

Question: The final step in reporting receivables for Year Two is the estimation of the bad accounts incurred during this period. This calculation enables the preparation of the year-end adjusting entry. According to the ledger balances in Figure 7.7 “End of Year Two—Sales, Receivables, and Bad Debt Balances”, sales on credit for the year were $400,000, remaining accounts receivable amount to $160,000, and a $3,000 debit sits in the allowance for doubtful accounts. No recording has yet been made for the Year Two bad debt expense. How does the accountant arrive at the estimation of uncollectible accounts each year?

Answer: Much of financial accounting is quite standardized. However, estimations can be made by any method that is considered logical. After all, it is an estimate. Over the decades, two different approaches have come to predominate when predicting the amount of uncollectible receivables. As long as company officials obtain sufficient evidence to support the reported numbers, either way can be applied.

Percentage of sales methodAn income statement approach for estimating uncollectible accounts that computes bad debt expense by multiplying sales (or just credit sales) by the percentage that are not expected to be collected.. This approach computes the current period expense by anticipating the percentage of sales (or credit sales) that will eventually fail to be collected. The percentage of sales method is sometimes referred to as an income statement approach because the only number being estimated (bad debt expense) appears on the income statement.

Percentage of receivables methodA balance sheet approach for estimating uncollectible accounts that computes the allowance for doubtful accounts by multiplying ending accounts receivable by the percentage that are not expected to be collected.. Here, the proper balance for the allowance for doubtful accounts is determined based on the percentage of ending accounts receivable that are presumed to be uncollectible. This method is identified as a balance sheet approach because the only figure being estimated (the allowance for doubtful accounts) is found on the balance sheet. A common variation applied by many companies is the aging methodA variation of the percentage of receivables method where all receivables are first classified by age; the total of each category is then multiplied by an appropriate percentage and summed to determine the allowance balance to be reported., which first classifies all receivable balances by age and then multiplies each of those individual totals by a different percentage. Normally, a higher rate is used for accounts that are older because they are considered more likely to become uncollectible.

Applying the Percentage of Sales Method

Question: Assume that this company chooses to use the percentage of sales method. All available evidence is studied by officials who come to believe that 8 percent of the credit sales made during Year Two will prove to be worthless. In applying the percentage of sales method, what adjusting entry is made at the end of the year so that financial statements can be prepared and fairly presented?

Answer: According to the ledger account in Figure 7.7 “End of Year Two—Sales, Receivables, and Bad Debt Balances”, sales of $400,000 were made during Year Two. If uncollectible accounts are expected to be 8 percent of that amount, the expense for the period is $32,000 ($400,000 × 8 percent). Bad debt expense (the figure being estimated) must be raised from its present zero balance to $32,000. Bad debt expense must be reported as $32,000 when the process is completed.

Figure 7.8 Adjusting Entry for Year Two—Uncollectible Accounts Estimated as a Percentage of Sales

The adjustment in Figure 7.8 “Adjusting Entry for Year Two—Uncollectible Accounts Estimated as a Percentage of Sales” does increase the expense to the $32,000 figure, the proper percentage of the sales figure. However, prior to adjustment, the allowance account held a residual $3,000 debit balance ($7,000 Year One estimation less $10,000 accounts written off). As can be seen in Figure 7.9 “Resulting T-Accounts, Based on Percentage of Sales Method”, the $32,000 recorded expense for Year Two results in only a $29,000 balance for the allowance for doubtful accounts.

Figure 7.9 Resulting T-Accounts, Based on Percentage of Sales Method

After this adjustment, the figures appearing in the financial statements for Year Two are shown in Figure 7.10 “Uncollectible Accounts Estimated Based on 8 Percent of Sales”.

Figure 7.10 Uncollectible Accounts Estimated Based on 8 Percent of Sales

The Difference Between Bad Debt Expense and the Allowance for Doubtful Accounts

Question: Figure 7.10 “Uncollectible Accounts Estimated Based on 8 Percent of Sales” presents the financial statement figures for this company for Year Two. How can bad debt expense be reported on the income statement as $32,000, whereas the allowance for doubtful accounts on the balance sheet shows only $29,000? Should those two numbers not be identical in every set of financial statements?

Answer: The difference in these two accounts is caused by the failure of previous estimations to be accurate. In Year One, bad debt expense for this company was reported as $7,000 but accounts with balances totaling $10,000 actually proved to be uncollectible in Year Two. That caused an additional $3,000 reduction in the allowance as can be seen in Figure 7.7 “End of Year Two—Sales, Receivables, and Bad Debt Balances”. This amount carries through and causes the allowance for doubtful account to be $3,000 lower at the end of Year Two. The reported expense is the estimated amount ($32,000), but the allowance ($29,000) is $3,000 less because of the difference in the actual and expected amounts for Year One.

Students are often concerned because these two reported numbers differ. However, both are merely estimates. The actual amount of worthless accounts is quite likely to be a number entirely different from either $29,000 or $32,000. Therefore, the lingering impact of the $3,000 Year One underestimation should not be an issue as long as company officials believe that neither of the two reported balances is materially misstated.

Applying the Percentage of Receivables Method

Question: The percentage of receivables method handles the calculation of bad debts a bit differently. Assume that the Year Two adjusting entry has not yet been made so that bad debt expense remains at zero and the allowance for doubtful accounts still holds a $3,000 debit balance as shown in Figure 7.7 “End of Year Two—Sales, Receivables, and Bad Debt Balances”. Also assume that the company has now chosen to use the percentage of receivables method rather than the percentage of sales method. Officials have looked at all available evidence and come to the conclusion that 15 percent of ending accounts receivable ($160,000 × 15 percent or $24,000) are likely to prove uncollectible. How does application of the percentage of receivables method affect the recording of doubtful accounts?

Answer: The percentage of receivables method (or the aging method if that variation is used) views the estimated figure of $24,000 as the proper total for the allowance for doubtful accounts. Thus, the accountant must turn the $3,000 debit balance residing in that contra asset account into the proper $24,000 credit. That change can only be accomplished by recognizing an expense of $27,000 as shown in Figure 7.11 “Adjusting Entry for Year Two—Uncollectible Accounts Estimated as a Percentage of Receivables”. Under the percentage of receivables method, after the adjustment has been recorded, the allowance balance will equal the estimate ($24,000). The bad debt expense is not computed directly; it is the amount needed to arrive at this allowance figure.

Figure 7.11 Adjusting Entry for Year Two—Uncollectible Accounts Estimated as a Percentage of Receivables

As shown in Figure 7.12 “Resulting T-Accounts, Based on Percentage of Receivables Method”, this entry successfully changes the allowance from a $3,000 debit balance to the desired $24,000 credit. Because bad debt expense had a zero balance prior to this entry, it now reports the $27,000 amount needed to establish the proper allowance.

Figure 7.12 Resulting T-Accounts, Based on Percentage of Receivables Method

After this adjusting entry has been posted, the balances appearing in Figure 7.13 “Uncollectible Accounts Estimated Based on 15 Percent of Receivables” appear in the financial statements for Year Two.

Figure 7.13 Uncollectible Accounts Estimated Based on 15 Percent of Receivables

Once again, the reported expense ($27,000) is $3,000 higher than the allowance ($24,000). As before, the difference is the result of the estimation being too low in the prior year. The additional write-offs led to this lower balance in the allowance T-account.

Either approach can be used as long as adequate support is gathered for the numbers reported. They are just two alternatives to arrive at an estimate. However, financial accounting does stress the importance of consistency to help make numbers comparable from year to year. Once a method is selected, it normally must continue to be applied in all subsequent periods.

• Under the percentage of sales method, the expense account is aligned with the volume of sales.
• In applying the percentage of receivables method, the uncollectible portion of ending receivables is determined and reported as the allowance for doubtful accounts.

Regardless of the approach, both bad debt expense and the allowance for doubtful accounts are simply the result of estimating the final outcome of an uncertain event—the collection of accounts receivable.

The Purpose of a Subsidiary Ledger

Question: A company such as Dell Inc. must have thousands or even hundreds of thousands of separate receivables. The accounts receivable T-account in the ledger maintains the total of all amounts owed to a company but does not indicate the balance due from each individual customer. How does an accounting system monitor all the specific receivable amounts? Those balances must be essential information for any organization for billing and collection purposes.

Answer: As indicated, a ledger account only reflects a single total at the present time. In many cases, as with accounts receivable, the composition of that balance is also essential information. For those T-accounts, the accounting system can be expanded to include a subsidiary ledgerA group of individual accounts whose sum agrees with (and, therefore, explains) a general ledger account balance. to maintain data about the various individual components making up the account total.

In the previous illustration, the company reports $160,000 as the total of its accounts receivable at the end of Year Two. A separate subsidiary ledger should also be in place to monitor the amounts owed by each customer (Mr. A, Ms. B, and so on). The general ledger figure is used whenever financial statements are to be produced. The subsidiary ledger allows the company to access individual balances so that appropriate action can be taken when collection is received or if specific receivables grow too large or become overdue.

When a subsidiary ledger is maintained, the accounting system can be programmed so that each entry into the general ledger T-account requires an immediate parallel increase or decrease to the appropriate individual account. Thus, a $75 sale on credit to Mr. A raises the accounts receivable T-account total by that amount while also increasing the balance listed specifically for Mr. A in the subsidiary ledger.

Subsidiary ledgers can be established in connection with any general ledger account where the availability of component information is helpful. Other than accounts receivable, subsidiary ledgers are commonly set up for inventory, equipment, and accounts payable. As might be imagined, large enterprises maintain additional records for virtually every T-account, whereas small companies are likely to limit use to accounts receivable and—possibly—a few other significant balances.

Before computer systems became common, manually keeping the total of thousands of individual accounts in a subsidiary ledger in agreement with the corresponding general ledger T-account balance was an arduous task. Mechanical errors (mathematical problems as well as debit and credit mistakes) tended to abound. However, current electronic systems are typically designed so that the totals reconcile automatically.

Reporting Balances Denominated in a Foreign Currency

Question: In today’s global economy, many U.S. companies make a sizable portion of their sales internationally. The Coca-Cola Company, for example, generated 69.7 percent of its revenues in 2010 outside of the United States. For McDonald’s Corporation, foreign revenues were 66.4 percent of the reported total.

In such cases, U.S. dollars might still be the currency received. However, U.S. companies frequently make sales that will be settled in a foreign currency such as the Mexican peso or the Japanese yen. For example, a sale made today might call for the transfer of 20,000 pesos in two months. What reporting problems are created when a credit sale is denominated in a foreign currency?

Answer: This situation is a perfect example of why authoritative standards, such as U.S. GAAP, are so important in financial accounting. Foreign currency balances are common in today’s world. Although a company will have a functional currency in which it normally operates (probably the U.S. dollar for a U.S. company), transactions often involve a number of currencies. For many companies, sales, purchases, expenses, and the like can be denominated in dozens of different currencies. A company’s financial statements may report U.S. dollars because that is its functional currency, but underlying amounts to be paid or received might be set in another currency such as the euro or the pound. Mechanically, many methods of reporting such foreign balances have been developed, each with a significantly different type of impact.

Without standardization, a decision maker would likely face a daunting task trying to analyze similar companies if they employed different approaches for reporting foreign currency figures. Assessing the comparative financial health and future prospects of organizations that do not use the same accounting always poses a difficult challenge for investors and creditors. That problem would be especially serious if optional approaches were allowed in connection with foreign currencies. Therefore, U.S. GAAP has long had an authoritative standard for this reporting.

The basic problem with reporting foreign currency balances is that exchange rates are constantly in flux. The price of one euro in terms of U.S. dollars changes many times each day. If these rates remained constant, a single conversion value could be determined at the time of the initial transaction and then used consistently for reporting purposes. However, currency exchange rates are rarely fixed; they often change moment by moment. For example, if a sale is made on account by a U.S. company with the money to be received in a foreign currency in 60 days, the relative worth of that balance in terms of U.S. dollars will probably move up and down countless times before collection. Because such values float, the reporting of these foreign currency amounts poses a challenge with no easy resolution.

Accounting for Changes in Currency Exchange Rates

Question: Exchange rates that vary over time create a reporting problem for companies operating in international markets. To illustrate, assume a U.S. company makes a sale of a service to a Mexican company on December 9, Year One, for 100,000 Mexican pesos that will be paid at a later date. Assume also that the exchange rate on the day when the sale was made was 1 peso equal to $0.08. However, by the end of Year One when financial statements are produced, the exchange rate is different: 1 peso is now worth $0.09. What reporting does a U.S. company make of transactions that are denominated in a foreign currency if the exchange rate changes as time passes?As has been stated previously, this is an introductory textbook. Thus, a more in-depth examination of many important topics, such as foreign currency balances, can be found in upper-level accounting texts. The coverage here of foreign currency balances is only designed to introduce students to basic reporting problems and their resolutions.

Answer: At the time of the sale, reporting is easy. The 100,000 pesos has an equivalent value of $8,000 (100,000 pesos × $0.08); thus, the journal entry in Figure 7.14 “Journal Entry—December 9, Year One—Sale of Services Made for 100,000 Pesos” is appropriate. Even though 100,000 pesos will be received, $8,000 is reported so that all balances on the seller’s financial statements are stated in terms of U.S. dollars.

Figure 7.14 Journal Entry—December 9, Year One—Sale of Services Made for 100,000 Pesos

By the end of the year, the exchange rate has changed so that 1 peso is equal to $0.09. The Mexican peso is worth a penny more in terms of the U.S. dollar. Thus, 100,000 pesos are more valuable and can now be exchanged for $9,000 (100,000 × $0.09). There are numerous reasons why the relative value of these two currencies might have changed, but the cause is not important from an accounting perspective.

When adjusting entries are prepared in connection with the production of financial statements at the end of Year One, one or both of the account balances (accounts receivable and sales of services) could remain at $8,000 or be updated to $9,000. The sale took place when the exchange rate was $0.08 but, now, before the money is collected, the peso has risen in value to $0.09. Accounting needs a standard rule as to whether the historical rate ($0.08) or the current rate ($0.09) is appropriate for reporting such foreign currency balances. Communication is difficult without that type of structure. Plus, the standard needs to be logical. It needs to make sense.

For over 25 years, U.S. GAAP has required that monetary assets and liabilitiesAmounts that are held by an organization as either cash or balances that will provide receipts or payments of a specified amount of cash in the future. denominated in a foreign currency be reported at the current exchange rate as of the balance sheet date. All other balances continue to be shown at the historical exchange rate in effect on the date of the original transaction. That is the approach that all organizations adhering to U.S. GAAP follow. Both the individuals who produce financial statements as well as the decision makers who use this information should understand the rule that is applied to resolve this reporting issue.

Monetary assets and liabilities are amounts currently held as cash or that will require a future transfer of a specified amount of cash. In the coverage here, for convenience, such monetary accounts will be limited to cash, receivables, and payables. Because these balances reflect current or future cash amounts, the current exchange rate is viewed as most relevant. In this illustration, the value of the receivable (a monetary asset) has changed in terms of U.S. dollars. The 100,000 pesos that will be collected have an equivalent value now of $0.09 each rather than $0.08. The reported receivable is updated to a value of $9,000 (100,000 pesos × $0.09).

Cash, receivables, and payables denominated in a foreign currency must be adjusted for reporting purposes whenever exchange rates fluctuate. All other account balances (equipment, sales, rent expense, dividends, and the like) reflect historical events and not future cash flows. Thus, they retain the rate in effect at the time of the original transaction and no further changes are ever needed. Because the sales figure is not a monetary asset or liability, the $8,000 balance continues to be reported regardless of the relative value of the peso.

The Income Effect of a Change in Currency Exchange Rates

Question: Changes in exchange rates affect the reporting of monetary assets and liabilities. Those amounts are literally worth more or less U.S. dollars as the relative value of the currency fluctuates over time. For the two balances above, the account receivable has to be remeasured on the date of the balance sheet because it is a monetary asset whereas the sales balance remains reported as $8,000 permanently. How is this change in the receivable accomplished? When monetary assets and liabilities denominated in a foreign currency are remeasured for reporting purposes, how is the increase or decrease in value reflected?

Answer: In this example, the value of the 100,000-peso receivable is raised from $8,000 to $9,000. When the amount reported for monetary assets and liabilities increases or decreases because of changes in currency exchange rates, a gain or loss is recognized on the income statement. Here, the reported receivable is now $1,000 higher. The company’s financial condition has improved and a gain is recognized. If the opposite occurs and the reported value of monetary assets declines (or the value of monetary liabilities increases), a loss is recognized. The adjusting entry shown in Figure 7.15 “Adjusting Entry at December 31, Year One—Remeasurement of 100,000 Pesos Receivable” is appropriate to reflect this change.

Figure 7.15 Adjusting Entry at December 31, Year One—Remeasurement of 100,000 Pesos Receivable

On its balance sheet, this company now reports a receivable as of December 31, Year One, of $9,000 while its income statement for that year shows sales revenue of $8,000 as well as the above gain of $1,000. Although the transaction was actually for 100,000 Mexican pesos, the company records these events in terms of its functional currency (the U.S. dollar) according to the provisions of U.S. GAAP.

Current Ratio and Working Capital

Question: Individuals analyze financial statements to make logical and appropriate decisions about a company’s financial health and well being. This process is somewhat similar to a medical doctor performing a physical examination on a patient. The doctor often begins by checking various vital signs, such as heart rate, blood pressure, weight, cholesterol level, and body temperature, looking for any signs of a serious change or problem. For example, if a person’s heart rate is higher than expected or if blood pressure has increased significantly since the last visit, the doctor will investigate with special care. In analyzing the financial statements of a business or other organization, are there vital signs that should be measured and studied by a decision maker?

Answer: Financial statements are extremely complex and most analysts have certain preferred figures or ratios that they believe are especially significant when investigating a company. For example, in a previous chapter, both the current ratioFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities. and the amount of working capitalFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by subtracting current liabilities from current assets. were computed using the balances reported for current assets (those that will be used or consumed within one year) and current liabilities (those that will be paid within one year):

These figures reflect a company’s liquidity, or its ability to pay its debts as they come due and still have enough monetary resources available to generate profits in the near future. Both investors and creditors frequently calculate, study, and analyze these two amounts. They are vital signs that help indicate the financial health of a business and its future prospects.

For example, on December 31, 2010, Avon Products reported a current ratio of 1.42 to 1.00 (current assets of $4.184 billion divided by current liabilities of $2.956 billion), which was down from 1.84 to 1.00 at the end of 2009. On the same date at the end of 2010, Caterpillar disclosed working capital of $9.790 billion (current assets of $31.810 billion less current liabilities of $22.020 billion). Caterpillar’s working capital increased by over $1.5 billion from the previous year when it was reported as $8.242 billion.

Whether these numbers are impressive or worrisome almost always depends on a careful comparison with other similar companies and results from prior years.

Computing the Age of Accounts Receivable

Question: This chapter deals with the financial reporting of accounts receivable. What other vital signs might be studied in connection with a company’s receivable balance?

Answer: One indication of a company’s financial health is its ability to collect receivables in a timely fashion. Money cannot be put to productive use until it is received. For that reason, companies work to encourage customers to make payments as quickly as possible. Furthermore, as stated previously in this chapter, the older a receivable becomes, the more likely it is to prove worthless.

Thus, interested parties (both inside a company as well as external) frequently monitor the time taken to collect receivables. Quick collection is normally viewed as desirable, whereas a slower rate can be a warning sign of possible problems. However, as with most generalizations, exceptions do exist so further investigation is always advised.

The age of a company’s receivables is determined by dividing the receivable balance by the average sales made per day. Credit sales are used in this computation if known, but the total sales figure often has to serve as a substitute because of availability. The sales balance is first divided by 365 to derive the amount of sales per day. This daily balance is then divided into the reported receivable to arrive at the average number of days that the company waits to collect its money. A significant change in the age of receivables will be quickly noted by almost any interested party.

For example, if a company reports sales for the current year of $7,665,000 and currently holds $609,000 in receivables, it requires 29 days on the average to collect a receivable.

As a practical illustration, for the year ended January 28, 2011, Dell Inc. reported net revenue of $61.494 billion. The January 28, 2011, net accounts receivable balance for the company was $6.493 billion, which was up from $5.837 billion the year before. The daily sales figure is $168.5 million ($61.494 billion/365 days). Thus, the average age of Dell’s ending receivable balance at this time was 38.5 days ($6.493 billion/$168.5 million). By itself, this figure is neither good nor bad. An assessment depends on the terms given to customers, the time of collection in other recent years, and comparable figures for companies in the same industry as Dell.

A similar figure is referred to as the receivables turnoverFormula measuring speed of an organization’s collection of its accounts receivable; calculated by dividing sales by the average accounts receivable balance for the period. and is computed by the following formula:

For Dell Inc., the average receivable balance for this year was $6.165 billion ([$6.493 billion + $5.837]/2). The receivables turnover for Dell for this period of time was 9.97 times:

The higher the receivable turnover, the faster collections are being received.

Reducing the Time It Takes to Collect Receivables

Question: If members of management notice that the average age of accounts receivable Formula measuring the average length of time it takes to collect cash from sales; calculated by dividing either accounts receivable at a point in time or the average accounts receivable for the period by the average sales made per day. for their company is getting older, what type of remedial actions can be taken? How does a company reduce the average number of days that are required to collect receivables so that cash is available more quickly?

Answer: A number of strategies can be used by astute officials to shorten the time between a sale being made and cash collected. The following are just a few common examples. Unfortunately, all such actions have a cost and can cause a negative impact on the volume of sales or create expenses that might outweigh the benefits of quicker cash inflows. Management should make such decisions with extreme care.

• Require a tighter review of credit worthiness before selling to a customer on credit. If sales on account are only made to individuals and companies with significant financial strength, the quantity of delayed payments should decline.
• Work to make the company’s own accounting system more efficient so that bills (sales invoices) are sent to customers in a timely manner. Payments are rarely made—even by the best customers—before initial notification is received. If the billing system is not well designed and effectively operated, that process can be unnecessarily slow.
• Offer a discount if a customer pays quickly. This action has an obvious cost, but such reductions provide a strong incentive to the customer for fast action.
• Send out second bills more quickly. Customers often need reminding that a debt is due. An invoice marked “late” or “overdue” will often push the recipient into making payment. A company might decide to send out this notice after 30 days—as an example—rather than wait for 45 days.
• Instigate a more aggressive collection policy for accounts that are not paid on time. Companies use numerous strategies to “encourage” payment and begin applying these steps at an earlier point in time.

Most companies monitor the age of receivables very carefully and use some combination of these strategies whenever any sign of problem is noted.

Financial Reporting and the Need for Trust

Question: The importance of financial statements to any person who is analyzing a business or other organization appears rather obvious. The wide range of information provides a portrait of the reporting entity that reflects both its financial health and potential for future success. However, a degree of skepticism seems only natural when studying such statements because they are prepared by the company’s own management, hardly an impartial group.

Decision makers are not naïve. They must harbor some concern about the validity of figures and other data that are self-reported. Company officials operate under pressure to present positive financial results consistently, period after period. What prevents less scrupulous members of management from producing fictitious numbers just to appear especially profitable and financially strong? Why should any investor or creditor be willing to risk money based on financial statements that the reporting organization itself has prepared?

Answer: The possible presence of material misstatements (created either accidentally or on purpose) is a fundamental concern that should occur to every individual who studies a set of financial statements. Throughout history, too many instances have arisen where information prepared by management ultimately proved to be fraudulent causing decision makers to lose fortunes. In fact, the colorful term “cooking the books” reflects the very real possibility of that practice. Enron, WorldCom, and Madoff Investment Securities are just a few examples of such scandals.

The potential for creating misleading financial statements that eventually cause damage to both investors and creditors is not limited to a particular time or place. Greed and human weakness have always rendered the likelihood of a perfect reporting environment virtually impossible. In addition, fraud is never the only cause for concern. Often a company’s management is simply overly (or occasionally irrationally) optimistic about future possibilities. That is human nature. Therefore, financial information should never be accepted blindly, especially if monetary risk is involved.

Over the decades, numerous laws have been passed in hopes of creating a system to ensure that all distributed financial statements fairly present the underlying organization they profess to report. Because of the need for economic stability, this is an objective that governments take seriously. Under capitalism, the financial health of the entire economy depends on the ability of worthy businesses to gain external financing for both operations and expansion. Without trust in the reporting process, people simply will not invest so that the raising of large monetary amounts becomes difficult, if not impossible. As has been seen in recent times, hesitancy on the part of investors and creditors restricts the growth of businesses and undermines the strength of the entire economy.

In the United States, ultimate responsibility for the availability of complete and reliable information about every organization that issues publicly traded securitiesFor this introductory textbook, a security will include ownership shares of a company as well as debt instruments such as bonds that can be sold from one party to another. A debt instrument is a promise to pay a stated amount plus a specified rate of interest at a particular point in time. lies with the Securities and Exchange Commission (SEC)Federal government agency holding legal responsibility over the reporting made by companies that issue publicly traded securities in the United States; works to ensure that this entire reporting process functions as intended by the government; has opted to leave development of authoritative accounting principles to FASB, although a change to IFRS produced by the IASB may be required in the future.. The SEC is an independent agency within the federal government established by the Securities Exchange Act of 1934. Its mission, as stated at its Web site (http://www.sec.gov), “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Virtually all U.S. companies of any significant size—as well as many foreign companies—fall under the jurisdiction of the SEC because their securities (either ownership shares or debt instruments such as bonds) are traded publicly within the United States. Financial statements and numerous other formal filings have to be submitted regularly to the SEC by these companies. A Form 10-K, which includes financial statements as well as a substantial amount of additional data, must be submitted each year. A Form 10-Q serves the same purpose each quarter. This information is then made available to the public through a system known as EDGAR (Electronic Data Gathering and Retrieval)SEC reporting system requiring companies to file their financial statements and other information electronically to allow current and potential investors access quickly and easily over the Internet..Considerable information on accessing the financial data filed with the SEC can be found at http://www.sec.gov/edgar.shtml. Any student considering a career in financial analysis or the like should visit this site to become familiar with its contents, especially the tutorial, so that the EDGAR system can be used to gain information provided by publicly traded companies. All such statements and other released data must conform precisely to the extensive rules and regulations of the SEC.

Companies that do not issue even a minimum amount of securities to the public normally are required to comply with state laws rather than with the SEC and federal laws. Financial statements for such companies, although not as likely to be public information, are often required by financial institutions and other interested parties. For example, a bank might insist that a local convenience store include financial statements as part of a loan application. The form and distribution of that financial information must conform to state laws (often referred to as “blue sky laws”).

The Relationship of the SEC to Official Accounting Standards

Question: Companies such as General Electric or Starbucks that issue securities to the public are required to satisfy all applicable federal laws and regulations. The SEC has authority over the amount and nature of the information that must be provided and the actions that can be taken by both the buyer and the seller of the securities. Does the SEC develop the specific accounting principles to be followed in the production of financial statements that are issued by public companies?

Answer: Legally, the SEC has the ability to establish accounting rules for all companies under its jurisdiction simply by specifying that certain information must be presented in a particular manner in the public filings that it requires. However, for decades the SEC has opted to leave the development of authoritative accounting principles to the Financial Accounting Standards Board (FASB). As discussed in an earlier chapter, for nearly 40 years FASB has had the primary authority for producing U.S. GAAP. Because FASB is a private (rather than government) organization, this decision has, at times, been controversial. Some view it as an abdication of an important responsibility by the federal government so that the public is at risk. The assumption by the SEC is that the members of FASB can be trusted to study each reporting issue meticulously before arriving at a reasoned resolution.

The SEC does allow certain companies to follow International Financial Reporting Standards (IFRS) so that, in those cases, the same reliance is being placed on the work of the International Accounting Standards Board (IASB) in London. As indicated previously, movement to a single set of global standards over the next few years is constantly under debate. One of the arguments about the possible move by the SEC from U.S. GAAP to IFRS is whether the IASB as it is currently structured can be trusted as much in the future as FASB has been in the past.

At present, FASB produces accounting rules to be applied by all for-profit and not-for-profit organizations in the United States, while state and local governments follow accounting standards produced by a sister organization, the Governmental Accounting Standards Board (GASB)Nonprofit organization that holds the authority for establishing accounting standards for state and local government units in the United States; sister organization to FASB.. In July, 2009, FASB Accounting Standards Codification was released to serve as the single source of authoritative nongovernmental U.S. GAAP. As a result, all the previous individual rules that had been created over several decades were reclassified into a logical framework. According to a FASB news release, “The Codification reorganizes the thousands of U.S. GAAP pronouncements into roughly 90 accounting topics and displays all topics using a consistent structure. It also includes relevant Securities and Exchange Commission (SEC) guidance that follows the same topical structure in separate sections in the Codification.”News release by FASB, July 1, 2009.

Groups other than FASB also contribute to accounting standards but in a much less significant fashion. The most important of these is the Emerging Issues Task Force (EITF)A group formed to assist FASB by examining new accounting issues as they arise in hopes of arriving at quick agreement as to the appropriate method of reporting based on existing U.S. GAAP., which was created in 1984 to assist FASB.In Chapter 2 “What Should Decision Makers Know in Order to Make Good Decisions about an Organization?”, http://www.fasb.org was mentioned as an excellent source of information about FASB. One of the tabs available at this Web site discusses the role of the EITF. The EITF examines new problems when they initially arise in hopes of coming to quick agreement as to an appropriate method of reporting based on existing U.S. GAAP. Thus, the EITF is not forming U.S. GAAP as much as helping to apply it to newly emerging situations. If consensus is achieved (that is, no more than three members object), the conclusions rendered by the EITF are considered to be authoritative until such time—if ever—as FASB provides its own formal guidance. In this way, FASB does not have to issue hasty pronouncements to resolve every unique reporting concern when it first appears.

The SEC itself is not totally absent from the formation of U.S. GAAP. It occasionally issues guidelines to ensure that adequate information is being disclosed to the public through its own rules and interpretive releases. That is especially true in situations where reporting concerns have emerged and adequate official guidance does not exist. The SEC tends to restrict its own power over financial reporting to those areas where U.S. GAAP—for whatever reason—has not yet been well constructed. Assume, for example, that a new type of transaction arises and the EITF is unable to arrive at a consensus resolution. The SEC might specify relevant data to be included in the notes to financial statements to better describe these events or could prohibit certain methods of reporting until FASB has the opportunity to provide a studied ruling.

The Need for an Independent Audit of Financial Statements

Question: The SEC allows FASB to set U.S. GAAP. Does the SEC physically visit each company that issues securities to the public to ensure that periodic financial statements properly follow the rules and guidelines of U.S. GAAP?

Answer: A detailed examination of the financial statements produced by thousands of publicly traded companies around the world would require a massive work force with an enormous cost. Therefore, this essential role in the financial reporting process has been left by the SEC to auditing (also known as public accounting) firms that operate both inside and outside the United States. Before submitting statements to the SEC and then to the public, reporting companies such as IBM and Wells Fargo must hire an independent auditing firm to do the following:

• Perform an auditAn examination carried out by an independent CPA of the evidence underlying the information presented in a set of financial statements followed by the issuance of a report as to whether the statements contain material misstatements in accordance with U.S. GAAP; this opinion is intended to provide reasonable assuranace that the statements are fairly presented, which adds credibility to the information provided. (examination) of the company’s financial statements
• Provide a report stating whether sufficient supporting evidence was obtained to enable the auditor to provide reasonable assurance that the statements are presented fairly because they contain no material misstatements according to U.S. GAAP

The independent auditor’s written report is then attached to the financial statements for all to read. This expert opinion is essential to the integrity of the reporting process because it tells decision makers whether they should feel safe relying on the financial information. Even many companies that are not affected by the rules of the SEC have their statements audited by an independent firm to enhance credibility. For example, a convenience store seeking a bank loan could pay for an audit in hopes of increasing the chances that the application will be approved (or because bank officials have required the audit for the bank’s own protection).

Not surprisingly, companies that have independent audits performed on their financial statements are able to get loans at lower interest rates than comparable organizations that do not have such examinations.David W. Blackwell, Thomas R. Noland, and Drew B. Winters, “The Value of Auditor Assurance: Evidence from Loan Pricing,” Journal of Accounting Research, Spring 1998, 57–70. The audit and the related audit report serve to reduce the lender’s risk of loss. Thus, banks and other institutions require a lower rate of interest to compensate for their risk of default.

In the United States, independent auditing firmsOrganizations operated by individuals recognized by a state government as Certified Public Accountants (CPAs) to provide independent auditing and other accounting services to the public; also known as CPA firms or public accounting firms. can only be operated by individuals who have been formally recognized by a state government as Certified Public Accountants (CPAs)Individuals who have met state requirements of education, practical experience, and passing the Uniform CPA Examination; the CPA designation is a license that allows a person to provide auditing and other accounting services to the public and serves as a symbol of technical expertise..The rules for becoming a CPA vary by state but usually include a specific amount and level of education as well as a passing grade of at least 75 or above on the four parts of the uniform CPA Exam. Some states also require a defined length of practical experience such as one or two years. Considerable information about the auditing profession and the possibility of becoming a CPA can be found at http://www.thiswaytocpa.com. Such firms range in size from massive (KPMG employs 137,000 individuals working in 144 countries and generated revenues of approximately $20.6 billion for the year ended September 30, 2010See http://www.kpmg.com as of August 12, 2011.) to organizations comprised of only one or two people.

Obviously, for the financial statements of the biggest organizations (the ExxonMobils and Walmarts of the world), only a public accounting firm of truly significant size could effectively perform an audit engagement. Consequently, four firms (known collectively as the Big FourTerm used to encompass the four largest CPA firms operating internationally: Deloitte Touche Tohmatsu, Ernst & Young, KPMG, and PricewaterhouseCoopers; these four firms perform independent audits on most of the world’s largest companies.) have become huge global organizations:

• Deloitte Touche Tohmatsu
• Ernst & Young
• KPMG
• PricewaterhouseCoopers

However, thousands of smaller independent CPA firms exist providing numerous services, such as audit, tax planning and preparationOne of the professional services performed by many CPA firms, including the preparation of tax returns and the creation of tax strategies to help minimize tax payments., and advisory workOne of the professional services performed by many CPA firms to assist businesses in operating more effectively and efficiently, and, therefore, more profitably. for a wide range of clients. Ernst & Young indicates on its Web site (http://www.ey.com) that the following services are provided to its clients with each explained in detail: advisory, assurance, tax, transactions, strategic growth markets, and specialty services.

Standards for a Proper Audit

Question: FASB creates U.S. GAAP, the official standards for the preparation of financial statements. What group sets the examination and reporting rules to be followed by independent auditors?

The work performed by auditors is not in accordance with accounting principles. Instead, these experts are seeking to determine whether U.S. GAAP was applied properly when financial statements were created. Auditing firms provide a vital service by adding credibility to that reported information. How do independent auditors know what actions should be taken in assessing the data disclosed by a company such as Xerox or Bank of America?

Answer: When an audit is performed on the financial statements of any organization that issues securities to the U.S. public, the examination and subsequent reporting is regulated by the Public Company Accounting Oversight Board (PCAOB)Private sector, nonprofit corporation brought into existence by the U.S. Congress through the Sarbanes-Oxley Act of 2002 to oversee the audits of public companies in hopes of protecting and better serving investors.. The PCAOB was brought into existence by the U.S. Congress through the Sarbanes-Oxley Act of 2002Federal securities law passed by the U.S. Congress in response to the Enron, WorldCom, and other major accounting scandals; it brought about many changes in the audit process and in the relationship between reporting companies and their independent auditors., legislation passed in response to a number of massive accounting scandals, including Enron and WorldCom. Members of Congress apparently felt that the auditing profession had failed to provide adequate protection for decision makers who were relying on published financial information. Consequently, the federal government became more involved.

The PCAOB was established under the oversight and enforcement authority of the SEC. It holds wide-ranging powers that include the creation of official guidelines for the performance of a proper audit. Its vision is stated as follows: “Using innovative and cost-effective tools, the PCAOB aims to improve audit quality, reduce the risks of auditing failures in the U.S. public securities market, and promote public trust in both the financial reporting process and auditing profession.”See http://www.pcaob.org.

If an audit is performed on financial statements that are produced by an organization that does not issue securities to the public, the PCAOB holds no authority. For such smaller engagements, the Auditing Standards Board (ASB)Technical body within the AICPA that holds the authority to set the rules for appropriate audits of organizations that do not issue securities to the public (often referred to as privately held organizations). officially sets the rules for an appropriate audit. The ASB is a technical committee within the American Institute of Certified Public Accountants (AICPA)A national professional organization of CPAs that sets ethical requirements, conducts research, and helps set a high standard for the profession., a national professional organization of CPAs.

A local convenience store, a medical practice, or a law firm (for example) might choose to have an audit on its financial statements. These audits fall under the guidelines provided by the ASB rather than the PCAOB because the organizations do not issue securities that are publicly traded. Thus, the rules for performing an audit on a large company can differ somewhat from those applied to a smaller private one.

The Role of the SEC

Question: FASB sets U.S. GAAP. The PCAOB (and the ASB) establishes rules for performing an audit. What function does the SEC actually serve?

Answer: The goal of the work done by the SEC is summed up in the following statement from its Web site: “The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.”See http://www.sec.gov.

Thus, the SEC strives to make certain that the organizations that fall under its jurisdiction are in total compliance with all laws so that decision makers have ready access to information that is viewed as relevant. It reviews the required filings submitted by each organization to ensure that the rules and regulations are followed. The SEC also has the power to enforce securities laws and punish companies and individuals who break them. For example, if a company fails to disclose a significant transaction or other event that the SEC believes is necessary, all trading of that company’s securities can be halted until the matter is resolved. Such regulatory actions can cause a huge financial loss for a business. Thus, compliance is viewed as vital.

In addition, if corporate officials provide false or misleading data, fines and jail time are also possible: “L. Dennis Kozlowski, the former CEO of Tyco International, acquired hundreds of companies between 1996 and 2002 and created a conglomerate that made everything from fire suppression systems to health-care products, with worldwide sales of $40 billion. Now, while serving up to 25 years in jail for misleading investors and stealing money from Tyco, he’s watching the breakup of all he built.”John Kostrzewa, “After the Scandal, a New Tyco,” The Providence Journal, July 15, 2007, F-1.

Auditing a Reported Balance

Question: A company creates a set of financial statements for the most recent year. It hires an independent firm of CPAs to audit those statements and prepare a report that will be attached to them. Perhaps this action is required of the company by the SEC or maybe by a local bank or other lender. What work does an independent auditor perform in examining a set of financial statements? The audit firm hopes to be able to provide reasonable assurance to decision makers that these statements are presented fairly and, thus, contain no material misstatements according to U.S. GAAP. How is the auditor able to gain sufficient evidence to make that assertion?

Answer: An independent audit is a complicated activity that often requires scores of experienced CPAs many months to complete. Serious knowledge of the audit process is best achieved by taking upper-level college courses as well as through years of practical experience. However, a general understanding of the process is important because of its relevance to almost all businesses as well as investors and creditors. For that reason, coverage here will include a limited overview of a financial audit.

The numbers found on a set of financial statements do not appear by magic. For example, if receivables are disclosed on a balance sheet as $12.7 million, a legitimate reason has to exist for reporting that particular figure. In preparing statements, company accountants should document the steps taken to arrive at each balance and the work performed to determine the appropriate method of reporting according to U.S. GAAP. The statements are the representation of the company; thus, the burden of proof is on that organization and its officials. The independent auditors then examine the available evidence to ascertain whether reliance on the reported information should be advised.

As an illustration, assume that a business presents a list of 1,000 customers and claims that the total amount due from them is $12.7 million. This figure is reported as “accounts receivable” under the asset section of the year-end balance sheet. The independent audit firm seeks to accumulate sufficient, competent evidence to substantiate that this reported balance is not materially misstated in accordance with U.S. GAAP.

For these receivables, the auditor carries out a number of possible testing procedures to gain the assurance needed. Such techniques might include the following:

• Add the individual account balances to ensure that the total really is $12.7 million.
• Examine sales documents for a sample of individual customers to determine that the amounts sold to them are equal to the figures listed within the receivable. For example, if the sales document indicates that Mr. A bought goods at a price of $1,544, is that same amount found in the company’s receivable balance?
• Examine cash receipts documents for a sample of individual customers to ensure that no unrecorded payments were collected prior to the end of the year. If Mr. A paid cash of $1,544 on December 30, was the corresponding receivable balance reduced by that amount prior to the end of the year?
• Contact a sample of the customers directly to confirm that the balance shown is, indeed, appropriate. “Mr. A: Company records show that you owe $1,544 as of December 31. Is that amount correct?”

Through these and other testing procedures, the auditor hopes to ascertain that $12.7 million is a fairly presented amount for this asset. All other reported balances are also examined in a similar manner during the independent audit. The actual quantity and type of testing varies considerably based on the nature of the account. Auditing $12.7 million in receivables requires different steps than investigating a building bought for that same amount. Not surprisingly, large monetary balances often require especially extensive testing. In addition, certain accounts (such as cash or inventory) where the risk of misstatement is particularly high will draw particular attention from the independent auditors.

If the auditor eventually concludes that sufficient evidence has been obtained to reduce the risk of a material misstatement in the financial statements to an acceptably low level, an audit report can be issued with that opinion. Assuming no problems were encountered, reasonable assurance is provided by the independent auditor that the statements are presented fairly and, thus, contain no material misstatements according to U.S. GAAP.

As mentioned, the independent auditor’s report is then attached to the financial statements. Upon reading this opinion, investors and creditors should feel confident relying on the information provided by those statements to make their financial decisions about the reporting organization.

Reasonable Assurance and not Perfect Assurance

Question: One aspect of the audit process seems particularly puzzling. The independent auditor merely provides reasonable assurance. The risk that a material misstatement is included in the accompanying financial statements is only reduced to a low level and not to zero. Why do decision makers who may be risking significant amounts of money not insist on absolute and complete assurance? Because of the potential for financial loss, investors and creditors surely want every possibility of incorrect reporting to be eliminated by the work of the independent auditor. Is reasonable assurance that no material misstatements are present truly adequate for decision makers who must rely on a set of financial statements for information?

Answer: As has been stated, independent auditors provide reasonable assurance but not absolute assurance that financial statements are presented fairly because they contain no material misstatements according to U.S. GAAP. A number of practical reasons exist as to why the level of assurance is limited in this manner.

First, many of the figures found on any set of financial statements are no more than estimations. Auditors do not possess reliable crystal balls that allow them to predict the future. The uncertainty inherent in these estimations immediately eliminates the possibility for absolute assurance. For example, reporting the amount of cash that will be collected from a large group of accounts receivable is simply a carefully considered guess. It is presented according to the rules of U.S. GAAP, but it is still an estimate. No one can provide absolute assurance about any estimation.

Second, organizations often take part in so many transactions during a period (millions for many large companies) that uncovering every potential problem or issue during an audit is impossible. Usually, in analyzing most account balances, the independent auditor only has time to test a sample of the entries and adjustments. Without examining every individual event, absolute assurance is not possible. Even with extreme vigilance, material misstatements can always be missed if less than 100 percent of the transactions are tested.

Third, an independent auditor visits a company for a few weeks or months each year to carry out testing procedures. Company officials who want to hide financial problems are sometimes successful at concealment. Auditors can never be completely certain that they have not been victimized by an elaborate camouflage scheme perpetrated by management. Thus, they are not comfortable providing absolute assurance.

Fourth, informed decision makers should understand that independent auditors can only provide reasonable assurance. Through appropriate testing procedures, risk of a material misstatement is reduced to an acceptably low level but not eliminated entirely for the reasons that have been named. Investors and creditors need to take that limitation into consideration when assessing the financial health and future well being of an organization as presented through a set of financial statements. Although the risk is small, their decisions should factor in the level of uncertainty that is always present.

Internal Controls Within an Organization

Question: In the previous discussions, the role of the independent auditor was described as the addition of credibility to financial statements. All reported figures, though, are still the responsibility of management. How can a company and its officials make certain that the information displayed in a set of financial statements is fairly presented?

Businesses like Barnes & Noble and RadioShack participate in millions of transactions each year in geographically distant store locations as well as through their Web sites. Working with that enormous amount of data, gathered from around the world, must be a daunting technological challenge. Some organizations are able to accumulate and organize such massive quantities of information with few—if any—problems; others seem to be overwhelmed by the task. How do companies ensure that their own information is free of material misstatements?

Answer: The human body is made up of numerous systems that perform specific tasks, such as breathing air, circulating blood, and digesting food. Each system serves its own particular purpose that contributes to the good of the body as a whole. Organizations operate in much the same manner. Numerous systems are designed and set in place by management to carry out essential functions, such as paying employees, collecting cash from customers, managing inventory levels, and monitoring receivable balances. Within each system, individuals are charged with performing specific tasks, often in a preordained sequence. For example, a cash payment received in the mail from a customer should be handled in a set way every time that it occurs to ensure that the money is properly recorded and protected from theft.

To be efficient and effective, these systems must be carefully designed and maintained. They need to keep company assets secure and do so at a minimum cost. In addition, appropriate record keeping is a required aspect of virtually every system. For example, if the payroll system is designed properly, employees are paid when their salaries come due, and adequate documentation is maintained of the amounts distributed. The entire function is performed according to guidelines carefully established by company officials.

Well-designed systems generate information with fewer errors, which reduces the threat of material misstatements. However, simply having systems in place—even if they are properly designed and constructed—is not sufficient to guarantee both the effectiveness of the required actions and the reliability of the collected data.

Thus, extra procedures should be built into each system by management to help ensure that every operation is performed as intended and the resulting financial information is reliable. All the redundancies added to a system to make certain that it functions properly are known collectively as internal controlA group of policies and procedures within the accounting and other systems of a company to provide reasonable assurance that they are operating efficiently and effectively as intended by management.. For example, a rule requiring two designated employees to sign any check for over $5,000 (or some other predetermined amount) is part of a company’s internal control. There is no inherent necessity for having a second signature; it is an added safeguard included solely to minimize the chance of theft or error. All actions like this comprise a company’s internal control.

Internal control policies and procedures can be found throughout the various systems of every company.

• One employee counts cash and a second verifies the figure.
• One employee requests the purchase of an asset and a second authorizes the request.

Internal control is made up of all the added procedures that are performed so that each system operates as intended. Systems cannot be considered well designed without the inclusion of adequate internal control. Management is responsible for the development of effective systems but also for all internal control rules and requirements created to ensure that these systems accomplish their stated objectives.

Internal Control and the Independent Auditor

Question: If a company creates and maintains good operating systems with appropriate internal control, the financial information that is produced is less likely to contain material misstatements. In performing an audit, is the work of the independent CPA affected by the company’s internal control? Does the quality of internal control policies and procedures impact the amount and type of audit testing that is performed?

Answer: As one of the preliminary steps in an audit examination, the CPA gains an understanding of the internal control procedures included within each of these systems that relates to reported financial accounts and balances.Some internal controls have nothing to do with a company’s financial statement accounts and are not of importance to the work of the independent auditor. For example, a company might establish a review procedure to ensure that only deserving employees receive promotions. This guideline is an important internal control for the operating effectiveness of the company. However, it does not relate to a reported account balance and is not evaluated by the independent auditor. The auditor then makes an evaluation of the effectiveness of those policies and procedures. In cases where internal control is both well designed and appears to be functioning as intended, a reduction is possible in the amount of audit testing that is needed. There is less risk involved; the likelihood of a material misstatement is reduced by the company’s own internal control.

To illustrate, assume that a company claims to hold accounts receivable totaling $12.7 million. The auditor plans to confirm 100 of the individual balances directly with the customers to substantiate the separate amounts listed in the accounting records. A letter will be written and mailed to each of these individuals asking whether the specified balance is correct. A stamped return envelope is included for the response.

This confirmation process is quite common in auditing financial statements. However, although effective, it is slow and expensive. During the year, assume that the reporting company consistently applied several internal control procedures within those systems that maintain the receivables balances. These controls are evaluated by the independent CPA and judged to be excellent. As a result of this assessment, the auditor might opt to confirm only 30 or 40 individual accounts rather than the 100 that had originally been planned. Because of the quality of internal control in the receivable area, the risk of a material misstatement is already low. Less audit testing is necessary. Both time and money are saved.

Thus, at the beginning of an independent audit, the design of the reporting company’s internal control and the effectiveness of its procedures are assessed. Only then does the auditor determine the amount of evidence needed to substantiate that each account balance is presented fairly because no material misstatements are included according to U.S. GAAP.

The Structure of an Independent Auditor’s Report

Question: At the conclusion of an audit, a report is issued by the CPA that will be attached to the financial statements for all to read. Much of this report is boilerplate: the words are virtually identical from one company to the next. What information is conveyed by an independent auditor, and what should a decision maker look for when studying an audit report?

Answer: The audit report accompanying the 2009 and 2010 financial statements for The Procter & Gamble Company is shown next.

To the Board of Directors and Shareholders of The Procter & Gamble Company

We have audited the accompanying Consolidated Balance Sheets of The Procter & Gamble Company and subsidiaries (the “Company”) as of June 30, 2010 and 2009, and the related Consolidated Statements of Earnings, Shareholders’ Equity, and Cash Flows for each of the three years in the period ended June 30, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in the accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such Consolidated Financial Statements present fairly, in all material respects, the financial position of the Company at June 30, 2010 and 2009, and the results of its operations and cash flows for each of the three years in the period ended June 30, 2010, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2010, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 13, 2010 expressed an unqualified opinion on the Company’s internal control over financial reporting.

Deloitte & Touche LLP

Cincinnati, Ohio

August 13, 2010

To understand the role of the independent audit within the financial reporting process, a considerable amount of information should be noted in the audit reportFormal written opinion issued by an independent auditor to communicate findings at the conclusion of an audit as to indicate whether a specific set of financial statements contains any material misstatements according to U.S. GAAP; if not, the statements are viewed as fairly presented. attached to the financial statements issued by Procter & Gamble.

1. The report is addressed to the board of directors (elected by the shareholders) and the shareholders. An audit is not performed for the direct benefit of the reporting company or its management but rather for any person or group studying the financial statements for decision-making purposes. The salutation stresses that external users (rather than the company itself) are the primary beneficiaries of the work carried out by the independent auditor.

   Interestingly, independent auditors are paid by the reporting company. The concern is raised periodically as to whether an auditor can remain properly independent of the organization that is providing payment for the services rendered. However, audit examinations can be quite expensive and no better method of remuneration has yet been devised.

2. To avoid any potential misunderstanding, the first (introductory) paragraph identifies the specific financial statements to which the report relates. In addition, both the responsibility of the management for those financial statements and the responsibility of the independent auditor for providing an opinion on those statements are clearly delineated. The statements are not created by the auditor; that is the job of management. The auditor examines the financial statements so that an expert opinion can be rendered.

3. The second (scope) paragraph provides information to explain the audit work. One key sentence in this paragraph is the second. It spells out the purpose of the audit by referring to the standards created by the PCAOB: “Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements.” This sentence clearly sets out the goal of an audit engagement and the level of assurance given by the auditor. No reader should expect absolute assurance.

   The remainder of the second paragraph describes in general terms the steps taken by the auditor, such as:

   • Examine evidence on a test basis to support reported amounts and disclosures.
   • Assess the accounting principles that were applied.
   • Assess significant estimations used in creating the statements.
   • Evaluate overall presentation.
4. The third (opinion) paragraph provides the auditor’s opinion of the financial statements. In this illustration, an unqualified opinionAn audit opinion informing the reader that attached financial statements are presented fairly, in all material respects, in accordance with U.S. GAAP; thus, the auditor is providing reasonable assurance that the statements contain no material misstatements according to U.S. GAAP and can be relied on by the reader in making financial decisions. is issued meaning that no problems worthy of note were discovered. The auditor provides the reader with reasonable assurance: “In our opinion, such consolidated financial statements present fairly, in all material respects…in conformity with accounting principles generally accepted in the United States of America.” Through this sentence, the independent auditor is adding credibility to the financial statements. The auditor believes readers can rely on these statements in making their financial decisions.
5. The fourth (explanatory) paragraph provides an additional opinion by the auditor, this time in connection with the company’s internal control. Such an assessment is required when an audit is performed on a company that is subject to the rules of the PCAOB. Not only is the auditor asserting that the financial statements are presented fairly in conformity with U.S. GAAP (paragraph 3) but also gives an unqualified opinion on the company’s internal control over its financial reporting (paragraph 4). This additional assurance provides the reader with another reason to place reliance on the accompanying financial statements.

Qualified Audit Opinions

Question: The audit report presented for Procter & Gamble is an unqualified opinion. The independent auditor is providing reasonable assurance to decision makers that the company’s financial statements are presented fairly, in all material respects, in conformity with U.S. GAAP. What can cause an independent auditor to issue an audit report that is less than an unqualified opinion and how is that report physically different?

Answer: An independent auditor renders an opinion that is not unqualified in two general situations:

• Lack of evidence. The auditor was not able to obtain sufficient evidence during the audit to justify an unqualified opinion. Perhaps the amount reported for a building or a liability could simply not be substantiated to the auditor’s satisfaction. The balance might well be fairly presented according to U.S. GAAP but evidence was not available to allow the auditor to make that assertion with reasonable assurance.
• Presence of a material misstatement. The auditor discovered the existence of a material misstatement in the financial statements, a balance or disclosure that does not conform to U.S. GAAP. Because of the potential damage to the credibility of the financial statements, reporting companies usually make any adjustments necessary to eliminate such misstatements. If not, though, the auditor must clearly warn readers of the reporting problems.

The physical changes made in the report depend on the type of problem that is involved and its magnitude. The key method of warning is that a new paragraph is added between the scope and the opinion paragraphs to describe the auditor’s concern. Decision makers often scan the audit report solely to see if such a paragraph is contained. If present, a careful reading of its contents (as well as related changes found in the wording of the opinion paragraph) should be made to determine the possible ramifications. Whether evidence was lacking or a material misstatement was uncovered, the auditor is responsible for letting the reader know. The presence of an added paragraph—prior to the opinion paragraph—always draws attention.

Accounting for the Passage of Time

Question: The first two steps of the accounting process were identified in Chapter 4 “How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?” as “analyze” and “record.” A transaction occurs and the resulting financial effects are ascertained through careful analysis. Once determined, the monetary impact on specific accounts is recorded in the form of a journal entry. Each of the debits and credits is then posted to the corresponding T-accounts located in the ledger. As needed, current balances can be determined for any of these accounts by netting the debits and credits. It is a system as old as the painting of the Mona Lisa.

The third step in this process was listed as “adjust.” Why do ledger account balances require adjustment? Why are the T-account totals found in the trial balance at the end of Chapter 4 “How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?” (Figure 4.21 “Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four”) not simply used by the accountant to produce Year Four financial statements for that business (Lawndale Company)?

Answer: Financial events take place throughout the year. As indicated, journal entries record the individual debit and credit effects that are then entered into the proper T-accounts. However, not all changes in these balances occur as the result of physical events. Some accounts increase or decrease because of the passage of time. The impact can be so gradual that producing individual journal entries is not reasonable.

For example, salary is earned by employees every day (actually every minute), but payment is not made until the end of the week or month. Many other expenses, such as utilities, rent, and interest, are incurred over time in much the same way. Accounting for supplies such as pens and envelopes is only slightly different. This asset is slowly depleted because of usage rather than time, but the impact on accounts is basically the same. As indicated in Chapter 4 “How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?”, unless an accounting system is programmed to record tiny incremental changes, none of these financial effects is captured as they occur.

Following each day of work, few companies take the trouble to record the equivalent amount of salary, rent, or other expense along with the related liability. When a pad of paper is consumed within an organization, debiting supplies expense for a dollar and crediting supplies for the same amount hardly seems worth the effort.

Therefore, prior to producing financial statements, the accountant must search for any such changes that have not yet been recognized. These incremental increases or decreases must also be recorded in a debit and credit format (called adjusting entriesChanges in account balances recorded prior to preparing financial statements to update T-accounts because some amounts have increased or decreased over time but have not been recorded through a journal entry. rather than journal entries) with the impact then posted to the appropriate ledger accounts. The updating process continues until all balances are presented fairly. These adjustments are a prerequisite step in the preparation of financial statements. They are physically identical to the journal entries recorded for transactions, but they occur at a different time and for a different reason.

Examples of Adjusting Entries

Question: Adjusting entries update ledger accounts for any financial changes that occur gradually over time so that they are not recorded through a journal entry. Large companies will make hundreds, if not thousands, of adjustments at the end of each fiscal period. What kinds of adjustments are normally needed before a set of financial statements is prepared?

Answer: A variety of adjusting entries will be examined throughout the remainder of this textbook. One of the accountant’s primary responsibilities is the careful study of all financial information to ensure that it is presented fairly before being released. Such investigation can lead to the preparation of numerous adjusting entries. Here, in Chapter 5 “Why Is Financial Information Adjusted Prior to the Production of Financial Statements?”, only the following four general types of adjustments are introduced to demonstrate the process and also reflect the importance of the revenue recognition principle and the matching principle. In later chapters, additional examples will be described and analyzed.

• Accrued expenses (also referred to as accrued liabilities)
• Prepaid expenses (including supplies)
• Accrued revenue
• Unearned revenue (also referred to as deferred revenue)

Usually, at the start of the adjustment process, the accountant prepares an updated trial balance to provide a visual, organized representation of all ledger account balances. This listing aids the accountant in spotting figures that might need adjusting in order to be fairly presented. Therefore, Figure 4.21 “Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four” is replicated here in Figure 5.1 “Updated Trial Balance for the Lawndale Company” because this trial balance holds the December 31, Year Four, account balances for the Lawndale Company determined at the end of Chapter 4 “How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?”. All transactions have been recorded and posted, but no adjustments have yet been made.

Figure 5.1 Updated Trial Balance for the Lawndale Company

Adjusting Entry to Recognize an Accrued Expense

Question: The first type of adjustment listed is an accrued expenseExpenses (and related liabilities) that grow gradually over time; if not recognized automatically by the accounting system, the monetary impact is recorded prior to preparing the company’s financial statements by means of an adjusting entry.. Previously, the word “accrue” was defined as “to grow.” Thus, an accrued expense is one that increases gradually over time. As has been indicated, some companies program their accounting systems to record such expenses as incurred. This accrual process eliminates the need for subsequent adjusting entries. Other companies make few, if any, accruals and update all balances through numerous adjustments when financial statements are to be prepared.

The mechanical recording process for such expenses should be designed to meet the informational needs of company officials. Some prefer to have updated balances readily available in the ledger at all times while others are inclined to wait for periodic financial reports to be issued. What are some typical accrued expenses, and what is the appropriate adjusting entry if they are not recorded as incurred by the accounting system?

Answer: If a reporting company’s accounting system recognizes an expense as it grows, no adjustment is necessary. The balances are recorded properly. They are ready to be included in financial statements. Thus, when statements are prepared, the accountant only needs to search for accrued expenses that have not yet been recognized.

Numerous expenses get slightly larger each day until paid, including salary, rent, insurance, utilities, interest, advertising, income taxes, and the like. For example, on its December 31, 2010, balance sheet, The Hershey Company reported accrued liabilities of approximately $593 million. In the notes to the financial statements, this amount was explained as debts owed by the company on that day for payroll, compensation and benefits ($219 million), advertising and promotion ($211 million), and other accrued expenses ($163 million).

Assume, for illustration purposes, that the accountant reviews the trial balance presented in Figure 5.1 “Updated Trial Balance for the Lawndale Company” and realizes that utility expenses (such as electricity and water) have not been recorded since the most recent payment early in December of Year Four. Assume that Lawndale Company currently owes $900 for those utilities. The following adjustment is needed before financial statements can be created. It is an adjusting entry because no physical event took place. This liability simply grew over time and has not yet been paid.

Figure 5.2 Adjusting Entry 1: Amount Owed for Utilities

Recording and Adjusting Prepaid Expenses

Question: The second adjustment to be considered here involves the handling of prepaid expensesA future economic benefit created when an expense is paid in advance; reported as an asset initially and then gradually reassigned to expense over time through adjusting entries.. For example, as of May 29, 2011, General Mills Inc. reported “prepaid expenses and other current assets” of $483.5 million. A decision maker studying this business needs to understand what information is conveyed by such balances.

In the transactions that were recorded in the previous chapter, Journal Entry 10 reported a $4,000 payment made by the Lawndale Company for four months of rent to use a building. An asset—prepaid rent—was recorded at that time through the normal accounting process. The resulting account is listed on the trial balance in Figure 5.1 “Updated Trial Balance for the Lawndale Company”. Such costs are common and often include payments for insurance and supplies.

Assume, at the end of Year Four, the company’s accountant examines the invoice that was paid and determines that this $4,000 in rent covered the period from December 1, Year Four, until March 31, Year Five. As a result, an adjusting entry is now necessary so that all balances are presented fairly. Why is a year-end adjusting entry often needed in connection with a prepaid expense?

Answer: During these four months, the Lawndale Company will use the rented facility to help generate revenue. Over that time, the future economic benefit established by the payment gradually becomes a past benefit. The asset literally changes into an expense day by day. In this example, one month of the rent from this payment has now been consumed. The benefit provided by using this building during December to gain revenue no longer exists. That portion of the rent ($1,000 or $4,000/four months) reflects a past benefit and should be reported as an expense in Year Four in accordance with the matching principle. Expenses are recognized in the same period as the revenue they help to generate.

As a preliminary step in preparing financial statements, an adjusting entry is needed to reclassify $1,000 from the asset (prepaid rent) into an expense (rent expense). This adjustment leaves $3,000 in the asset (for the remaining three months of rent on the building) while $1,000 is now reported as an expense (for the previous one month of rent).

Figure 5.3 Adjusting Entry 2 (Version 1): Use Is Made of a Rented Facility (Original Entry to Prepaid Rent)

Adjusting entries are created to take whatever amounts reside in the ledger and align them with the requirements of U.S. GAAP (or IFRS, if those standards are being applied). For this illustration, the original $4,000 payment was classified as a prepaid rent and the adjustment was created in response to that initial entry. After $1,000 is moved from asset to expense, the balances are presented fairly: an asset of $3,000 for the future benefit and an expense of $1,000 for the past.

In recording transactions, some accounting systems mechanically handle events in a different manner than others. Thus, construction of each adjusting entry depends on the recording that previously took place. To illustrate, assume that when this $4,000 payment was made, the company entered the debit to rent expense rather than prepaid rent. Perhaps an error was made or, more likely, a computerized accounting system was programmed to record all money spent for rent as an expense. For convenience, many companies prefer to automate the recording process wherever possible knowing that adjusting entries can then be made to arrive at proper balances. The initial accounting has no impact on the figures to be reported but does alter the adjustment process.

If a $4,000 expense was recorded here initially rather than a prepayment, an adjusting entry is still needed. The expense appearing on the income statement should be $1,000 (for the past one month) while the appropriate asset on the balance sheet should be $3,000 (for the subsequent three months). If the entire cost of $4,000 is located in rent expense, the following alternative is necessary to arrive at proper balances. This adjustment shifts $3,000 out of the expense and into the asset.

Figure 5.4 Adjusting Entry 2A (Version 2): Use Is Made of a Rented Facility (Original Entry to Rent Expense)

This adjusting entry leaves the appropriate $1,000 in expense and puts $3,000 into the asset account. Those are the proper balances as of the end of the year. Regardless of the account, the accountant first determines the balance that is present in the ledger and then creates the specific adjustment needed to arrive at fairly presented figures.

Recognizing Accrued Revenue

Question: The third general type of adjustment to be covered here is accrued revenue. As the title implies, this revenue is one that grows gradually over time. If not recorded by a company’s accounting system as earned, an adjusting entry to update the balances is necessary before financial statements are prepared. This process mirrors that of accrued expenses. What adjustment is used by a reporting organization to recognize any accrued revenue that has not previously been recorded?

Answer: Various types of revenue are earned as time passes rather than through a physical event such as the sale of inventory. To illustrate, assume that a customer visited the Lawndale Company five days before the end of Year Four to ask for assistance. The customer must be away from his ranch for thirty days and wanted company employees to feed, water, and care for his horses during the period of absence. Everything needed for the job is available in the customer’s barn. The Lawndale Company just provides the service. The parties agreed that the company will receive $100 per day for this work with payment to be made upon the person’s return.

No asset changes hands at the start of this task. Thus, the company’s accounting system is not likely to make any entry until payment is eventually received. However, after the first five days of this work, the Lawndale Company is ready to prepare Year Four financial statements. For that reason, the company needs to recognize all revenue earned to date. Service to this customer has been carried out for five days at a rate of $100 per day. The company has performed the work to earn $500 although the money will not be received until later. Consequently, a receivable and revenue for this amount should be recognized through an adjusting entry. The earning process for the $500 occurred in Year Four and should be recorded in this year.

Figure 5.5 Adjusting Entry 3: Revenue Earned for Work Done

The $500 receivable will be removed in the subsequent period when the customer eventually pays Lawndale for the services rendered. No recognition is needed in this adjusting entry for cost of goods sold because a service, rather than inventory, is being sold.

The Earning Process

Question: As discussed in a previous chapter, the revenue realization principle (within accrual accounting) provides formal guidance for the timing of revenue reporting. It states in part that the earning process must be substantially complete before revenue is recognized. That seems reasonable. In the previous example, the work has been performed for only five days out of a total of thirty. That does not appear to qualify as substantially complete. Is accrued revenue recognized if the earning process is not substantially complete?

Answer: This example draws attention to one of the most challenging questions that accountants face in creating a fair portrait of a business. When should revenue be recognized? The revenue realization principle is established by U.S. GAAP, but practical issues remain. For example, when does an earning process become substantially complete? Here, the simplest way to resolve this accounting issue is to consider the nature of the task to be performed by the Lawndale Company.

Is the job of caring for the horses a single task to be carried out by the company over thirty days or is it thirty distinct tasks to be performed each day over this period of time?

If the work is viewed as one large task like painting a house, then the earning process here is only one-sixth of the way finished and not substantially complete. No revenue should be recognized until the remainder of the work has been performed. In that case, the adjusting entry is not warranted.

Conversely, if this assignment is actually thirty separate tasks, then five of them are substantially complete at the end of the year, and revenue of $500 is properly recorded by the previous adjustment. Unfortunately, the distinction is not always clear. Because accounting is conservative, revenue should never be recognized unless evidence predominates that the individual tasks are clearly separate events.

The Revenue Recognition Principle

Question: In practice, how does an accountant determine whether a specific job is substantially complete? Because of the direct impact on net income, this judgment must be critical in financial reporting.

Answer: Accountants spend a lot of time searching for credible evidence as to the true nature of the events they encounter and report. Their goal is to ensure that all information included in financial statements is presented fairly according to U.S. GAAP (or IFRS). The timing of revenue recognition can be a special challenge that requires analysis and expertise.

Is a job substantially complete so that revenue should be recognized or not?

That question can often be difficult to answer. Here is one technique that might be applied in analyzing this particular example. Assume that after five days, Lawndale had to quit feeding the customer’s horses for some legitimate reason. Should the company be able to demand and collect $500 for the work done to that point? If so, then those five days are distinct tasks that have been completed. However, if no money would be due based on working just five days, substantial completion has not been achieved by the services performed to date. Thus, revenue recognition would be inappropriate.

In Adjusting Entry 3 (Figure 5.5 “Adjusting Entry 3: Revenue Earned for Work Done”), the assumption is made that the daily tasks are separate and that the company could collect for the work accomplished to date. However, this type of judgment can be extremely difficult in the real world. It is often the product of much thought and discussion. The impact on the financial statements can be material, which increases pressure on the accountant. Even with standard rules, painting a fairly presented portrait is not always easy.

Students frequently enroll in a financial accounting course believing that little is required other than learning set rules and then following them mechanically. As will be demonstrated many times in this textbook, nothing ever replaces the need for experienced judgment on the part of the accountant.

Unearned Revenue

Question: The last adjusting entry to be covered at this time is unearned (or deferred) revenue. Some companies operate in industries where money is received first and then earned gradually over time. Newspaper and magazine businesses, for example, are paid in advance by their subscribers and advertisers. The earning process becomes substantially complete by the subsequent issuance of their products.

For example, the January 2, 2011, balance sheet of The Washington Post Company reported deferred revenues as a liability of over $379 million. The notes to the company’s financial statement provided clear information about the accounting process: “Amounts received from customers in advance are deferred as liabilities” or “Revenues from newspaper subscriptions and retail sales are recognized upon the later delivery or publication date.”

In Journal Entry 13 in Chapter 4 “How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?”, the Lawndale Company reported receiving $3,000 in cash for services to be rendered at a later date. An unearned revenue account was recorded as a liability for that amount and appears in the trial balance in Figure 5.1 “Updated Trial Balance for the Lawndale Company”. When is an adjusting entry needed in connection with the recognition of previously unearned revenue?

Answer: As indicated by The Washington Post Company, unearned revenue represents a liability recognized when money is received before work is done. After the required service is carried out so that the earning process is substantially complete, an appropriate amount is reclassified from unearned revenue on the balance sheet to revenue on the income statement. For example, in connection with the $3,000 payment collected by Lawndale, assume that all the work necessary to recognize the first $600 was performed by the end of Year Four. Prior to preparing financial statements, an adjusting entry reduces the liability and recognizes the earned revenue.

Figure 5.6 Adjusting Entry 4: Money Previously Received Has Now Been Earned

Preparing Financial Statements

Question: The accounting process is clearly a series of defined steps that take a multitude of monetary transactions and eventually turn them into fairly presented financial statements. After all adjusting entries have been recorded in the journal and posted to the appropriate T-accounts in the ledger, what happens next in the accounting process?

Answer: After the adjusting entries are posted, the accountant should believe that all material misstatements have been removed from the accounts. Thus, they are presented fairly according to U.S. GAAP (or IFRS) and can be used by decision makers. As one final check, an adjusted trial balance is produced for a last, careful review. Assuming that no additional concerns are uncovered, the accountant prepares an income statement, a statement of retained earnings, and a balance sheet.

The basic financial statements are then completed by the production of a statement of cash flows. In contrast to the previous three, this statement does not report ending ledger account balances but rather discloses and organizes all of the changes that took place during the period in the composition of the cash account. As indicated in Chapter 3 “How Is Financial Information Delivered to Decision Makers Such as Investors and Creditors?”, cash flows are classified as resulting from operating activities, investing activities, or financing activities.

The reporting process is then finalized by the preparation of explanatory notes that accompany a set of financial statements.

The final trial balance for the Lawndale Company (including the four adjusting entries produced earlier) is presented in Figure 5.7 “Updated Trial Balance for Lawndale Company—December 31, Year Four (after posting four adjusting entries to “. The original trial balance in Figure 5.1 “Updated Trial Balance for the Lawndale Company” has been updated by the four adjusting entries that were discussed in this chapter.

Adjusting Entry 1

• Utilities expense increases by $900
• Utilities payable increases by $900

Adjusting Entry 2 (Version 1)

• Rent expense increases by $1,000
• Prepaid rent decreases by $1,000

Adjusting Entry 3

• Accounts receivable increases by $500
• Sales of services increases by $500

Adjusting Entry 4

• Unearned revenue decreases by $600
• Sales of services increases by $600

These changes are entered into Figure 5.1 “Updated Trial Balance for the Lawndale Company” to bring about the totals presented in Figure 5.7 “Updated Trial Balance for Lawndale Company—December 31, Year Four (after posting four adjusting entries to “.

Figure 5.7 Updated Trial Balance for Lawndale Company—December 31, Year Four (after posting four adjusting entries to Figure 5.1 “Updated Trial Balance for the Lawndale Company”)

After that, each of the final figures is appropriately placed within the first three financial statements. Revenues and expenses appear in the income statement, assets and liabilities in the balance sheet, and so on. The resulting statements for the Lawndale Company are exhibited in Figure 5.8 “Year Four Financial Statements for Lawndale Company”.

Figure 5.8 Year Four Financial Statements for Lawndale Company

To keep this initial illustration reasonably simple, no attempt has been made to record all possible accounts or adjusting entries. For example, no accrued expenses have been recognized for either income taxes or interest expense owed in connection with the notes payable. One example of an accrued expense is sufficient in this early coverage because both income taxes and interest expense will be described in depth in a later chapter. Likewise, depreciation expense of noncurrent assets with finite lives (such as the truck shown on the company’s trial balance) will be discussed subsequently. However, the creation of financial statements for the Lawndale Company should demonstrate the functioning of the accounting process as well as the basic structure of the income statement, statement of retained earnings, and balance sheet.

Several aspects of this process should be noted:

• The statements are properly identified by name of company, name of statement, and date. The balance sheet is for a particular day (December 31, Year Four) and the other statements cover a period of time (Year ending December 31, Year Four).
• Each account in the trial balance in Figure 5.7 “Updated Trial Balance for Lawndale Company—December 31, Year Four (after posting four adjusting entries to “ appears within only one statement. Accounts receivable is an asset on the balance sheet. Cost of goods sold is an expense on the income statement. Dividends paid is a reduction shown on the statement of retained earnings. Each account serves one purpose and appears on only one financial statement.
• There is no T-account for net income. Net income is a composition of all revenues, gains, expenses, and losses for the year. The net income figure computed in the income statements is then used in the statement of retained earnings. In the same manner, there is no T-account for the ending retained earnings balance. Ending retained earnings is a composition of the beginning retained earnings balance, net income, and dividends paid. The ending retained earnings balance computed in the statement of retained earnings is then used in the balance sheet.
• The balance sheet does balance. The total of the assets is equal to the total of all liabilities and stockholders’ equity (capital stock and retained earnings). Assets must always have a source.

The statement of cash flows for the Lawndale Company cannot be created based solely on the limited information available in this chapter concerning the changes in the cash account. Thus, it has been omitted. Complete coverage of the preparation of a statement of cash flows will be presented in Chapter 17 “In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?”.

The Purpose of Closing Entries

Question: Analyze, record, adjust, and report—the four basic steps in the accounting process. Is the work year complete for the accountant after financial statements are prepared?

Answer: One last mechanical process needs to be mentioned. Whether a business is as big as Microsoft or as small as the local convenience store, the final action performed each year by the accountant is the preparation of closing entriesEntries made to reduce all temporary ledger accounts (revenues, expenses, gains, losses, and dividends paid) to zero at the end of an accounting period so that a new measurement for the subsequent period can begin; the net effect of this process is transferred into the retained earnings account to update the beginning balance to the year-end figure.. Five types of accounts—revenues, expenses, gains, losses, and dividends paid—reflect the various increases and decreases that occur in a company’s net assets in the current period. These accounts are often deemed “temporary” because they only include changes for one year at a time. Consequently, the figure reported by Microsoft as its revenue for the year ended June 30, 2011, measures only sales during that year. T-accounts for rent expense, insurance expense, and the like reflect just the current decreases in net assets.

In order for the accounting system to start measuring the effects for each new year, these specific T-accounts must all be returned to a zero balance after annual financial statements are produced. Consequently, all of the revenue T-accounts maintained by Microsoft show a total at the end of its fiscal year (June 30, 2011) of $69.9 billion but contain a zero balance at the start of the very next day.

• Final credit totals existing in every revenue and gain account are closed out by recording equal and off-setting debits.
• Likewise, ending debit balances for expenses, losses, and dividends paid require a credit entry of the same amount to return each of these T-accounts to zero.

After these accounts are closed at year’s end, the resulting single figure is the equivalent of net income reported for the year (revenues and gains less expenses and losses) reduced by any dividends paid. This net effect is recorded in the retained earnings T-account. The closing process effectively moves the balance for every revenue, expense, gain, loss, and dividend paid into retained earnings. In the same manner as journal entries and adjusting entries, closing entries are recorded initially in the journal and then posted to the ledger. As a result, the beginning retained earnings balance for the year is updated to arrive at the ending total reported on the balance sheet.

Assets, liabilities, capital stock, and retained earnings all start out each year with a balance that is the same as the ending figure reported on the previous balance sheet. Those accounts are permanent; they are not designed to report an impact occurring during the current year. In contrast, revenues, expenses, gains, losses, and dividends paid all begin the first day of each year with a zero balance—ready to record the events of this new period.

The Nature of a Transaction

Question: Information provided by a set of financial statements is essential to any individual analyzing a business or other organization. The availability of a fair representation of a company’s financial position, operations, and cash flows is invaluable for a wide array of decision makers. However, the sheer volume of data that a business such as General Mills, McDonald’s, or PepsiCo must gather in order to prepare these statements has to be astronomical. Even a small enterprise—a local convenience store, for example—generates a significant quantity of information virtually every day. How does an accountant begin the process of accumulating all the necessary data so that financial statements can be produced and distributed to decision makers?

Answer: The accounting process starts by analyzing the effect of transactionsEvents that have a financial impact on an organization; information on the resulting changes must be gathered, sorted, classified, and turned into financial statements by means of an accounting system.—any event that has an immediate financial impact on a company. Large organizations participate in literally millions of transactions each year. The resulting information must be gathered, sorted, classified, and turned into a set of financial statements that cover a mere four or five pages. Over the decades, accountants have had to become very efficient to fulfill this seemingly impossible assignment. Despite the volume of transactions, the goal remains the same: to prepare financial statements that are presented fairly because they contain no material misstatements according to U.S. GAAP or IFRS.

For example, all the occurrences listed in Figure 4.1 “Transactions Frequently Encountered by a Business” are typical transactions that any business might encounter. Each causes some measurable effect on the company’s assets, liabilities, revenues, expenses, gains, losses, capital stock, or dividends paid. The accounting process begins with an analysis of each transaction to determine the specific financial changes that took place. Was revenue earned? Did a liability increase? Has an asset been acquired? What changed as a result of this event?

Figure 4.1 Transactions Frequently Encountered by a Business

In any language, successful communication is only possible if the information to be conveyed is properly understood. Likewise, in accounting, transactions must be analyzed so that their impact is understood. A vast majority of transactions are relatively straightforward so that, with experience, the accountant can ascertain the financial impact almost automatically. Within this process, each individual asset, liability, revenue, expense, and the like is referred to as an account. For example, rent expense and salary expense are both expense accounts. The monetary amount attributed to an account is known as an account balance.

For transactions with greater complexity, the necessary analysis becomes more challenging. However, the importance of this initial step in the production of financial statements cannot be overstressed. The well-known computer aphorism captures the essence quite succinctly: “garbage in, garbage out.” There is little hope that financial statements can be fairly presented unless the entering information is based on an appropriate identification of the changes in account balances created by each transaction.

Analyzing the Impact of a Transaction

Question: Transaction 1—A company buys inventory on credit for $2,000. How does transaction analysis work here? What accounts are affected by the purchase of merchandise?

Answer: Inventory, which is an asset, increases by $2,000 because of the purchase. The organization has more inventory than it did previously. Because no money was paid for these goods when bought, a liability for the same amount has been created. The term accounts payableShort-term liabilities to pay for goods and services that have been acquired on credit. is often used in financial accounting to represent debts resulting from the acquisition of inventory and supplies.

Note that the accounting equation described in the previous chapter remains in balance here. Assets have gone up by $2,000 while the liability side of the equation has also increased by the same amount to reflect the source of this increase.

The Financial Impact of Paying an Employee

Question: Transaction 2—A company pays a salary of $300 to one of its employees for work performed during the past week. No amount had previously been recorded by the accounting system for this amount. What accounts are affected by payment of a salary?

Answer: Cash (an asset) is decreased here by $300. Whenever cash is involved in a transaction, identifying that change is a good place to start the analysis. Increases and decreases in cash are often obvious.

The cash balance declined because salary was paid to an employee. Assets were reduced as a result of the payment. That is a cost to the company. Recognizing an expense as a result is appropriate rather than an asset because the employee’s work reflects a past benefit. The person’s effort has already been carried out, generating revenues for the company in the previous week rather than in the future. Thus, a salary expense of $300 is reported.

The continued equilibrium of the accounting equation does exist here although it is less apparent. Assets are decreased. At the same time, an expense is recognized. This expense reduces reported net income. On the statement of retained earnings, current net income becomes a component of retained earnings. The reduction in income serves to decrease retained earnings. An expense ultimately reduces reported retained earnings. Because both assets and retained earnings go down by the same amount as a result of this transaction, the accounting equation continues to balance.

Recording Accrued Expenses

Question: In Transaction 2, the company paid a salary of $300 that it owed to a worker. Why does a payment to an employee not always reduce a salary payable balance?

Answer: Costs such as salary, rent, or interest increase gradually over time and are often referred to as accrued expenses because the term “accrue” means “to grow.” How should the very slow growth of an expense be recognized? An accounting system can be mechanically structured to record such costs in either of two ways. On the financial statements, reported results are the same but the steps in the process differ.

• Some companies simply ignore accrued expenses until paid. At that time, the expense is recognized and cash is reduced. No liability is entered into the accounting system or removed. Because the information provided specifies that nothing has been recorded to date, this approach was apparently used here. When financial statements are produced, any amount that is still owed must be recognized for a fair presentation.
• Other companies choose to program their computer systems so that both the expense and the related liability are recognized automatically as the amount grows. For salary, as an example, this increase could literally be recorded each day or week based on the amount earned by employees. At the time payment is finally conveyed, the expense has already been recorded. Thus, the liability is removed because that debt is being settled. Later, in Transaction 5, this second possible approach to recording accrued expenses is illustrated.

A company can recognize an accrued expense (such as a salary) as it is incurred or wait until payment is made. This decision depends on the preference of company officials. The end result (an expense is reported and cash decreased) is the same, but the recording procedures differ. As mentioned, if no entry has been made prior to the production of financial statements (the first alternative), both the expense and the payable have to be recognized at that time so that all balances are properly included for reporting purposes.

Borrowing Money from the Bank

Question: Transaction 3—A company borrows $9,000 from a bank on a long-term note. What is the financial impact of signing a loan agreement with a bank or other lending institution?

Answer: In this transaction, cash is increased by the amount of money received from the lender. The company is obligated to repay this balance and, thus, has incurred a new liability. As with many common transactions, the financial impact is reasonably easy to ascertain.

Recording the Sale of Inventory

Question: Transaction 4—Assume that the inventory items bought in Transaction 1 for $2,000 are now sold to a customer for $5,000 on credit. What account balances are impacted by the sale of merchandise in this manner?

Answer: Two connected events actually take place in the sale of inventory. First, revenue of $5,000 is generated by the sale. This account is frequently labeled as “Sales” or “Sales revenue.”

In this example, because the money will not be collected until a later date, accounts receivable (an asset) is initially increased. The reporting of a receivable balance indicates that this amount of money is due from a customer and should be collected at some subsequent point in time.

Second, the inventory is removed. Companies have an option in the method by which inventory balances are monitored. Here, a perpetual inventory systemAccounting system that maintains an ongoing record of all inventory items both in total and individually; records increases and decreases in inventory accounts as they occur as well as the cost of goods sold to date. is utilized. That approach is extremely common due to the prevalence of computer systems in the business world. It maintains an ongoing record of the inventory held and the amount that has been sold to date. All changes in inventory are recorded immediately. However, in a later chapter, an alternative approach—still used by some smaller businesses—known as a periodic inventory systemAccounting system that does not maintain an ongoing record of all inventory items; instead, ending inventory is determined by a physical count so that a formula (beginning inventory plus purchases less ending inventory) can be used to calculate cost of goods sold. will also be demonstrated.

Because a perpetual system is used here, the reduction in inventory is recorded simultaneously with the sale. Inventory costing $2,000 is taken away by the customer. The company’s net assets are reduced by this amount. Therefore, a $2,000 expense is recognized. That inventory no longer provides a future benefit for the company but rather is a past benefit. Cost of goods sold is reported to reflect this decrease in the amount of merchandise on hand.

As discussed in the previous chapter, the $3,000 difference between the sales revenue of $5,000 and the related cost of goods sold of $2,000 is known as the gross profit (or gross margin or mark up) on the sale.

The Dual Effect of Transactions

Question: In each of the events studied so far, two accounts have been affected. Are two accounts impacted by every possible transaction?

Answer: In every transaction, a cause-and-effect relationship is always present. For example, the accounts receivable balance increases because of a sale. Cash decreases as a result of paying salary expense. Cost of goods sold increases because inventory is removed. No account balance can possibly change without some identifiable cause. Thus, every transaction must touch a minimum of two accounts. Many transactions actually affect more than two accounts but at least two are impacted by each of these financial events.

Paying a Previously Recorded Expense

Question: Transaction 5—In this transaction, the reporting company pays $700 for insurance coverage relating to the past few months. The information provided indicates that the cost was previously recorded in the company’s accounting system as incurred. Apparently, the computers were programmed to accrue this expense periodically. What is the financial impact of paying an expense if the balance has already been recognized over time as the liability grew larger?

Answer: Several pieces of information should be noted in analyzing this example.

• Cash declined by $700 as a result of the payment.
• This cost relates to a past benefit. Thus, an expense must be recorded. No future economic benefit is created by the insurance payment. Cash was paid for coverage over the previous months.
• The company’s accounting system has already recorded this amount. Thus, $700 in insurance expense and the related liability were recognized as incurred. This is clearly a different mechanical procedure than that demonstrated in Transaction 2 for the salary payment.

The expense cannot be recorded again or it will be double counted. Instead, cash is reduced along with the liability that was established through the accrual process. The expense was recorded already so no additional change in that balance is needed. Instead, the liability is removed and cash decreased.

Note that accounting recognition is dependent on the recording that has already taken place. The final results to be reported should be the same (here an expense is recognized and cash decreased), but the steps in the process can vary.

Acquisition of an Asset

Question: Transaction 6—According to the original information, a truck is acquired for $40,000, but only $10,000 in cash is paid by the company. The other $30,000 is covered by signing a note payable. This transaction seems a bit more complicated because more than two accounts are involved. What is the financial impact of buying an asset when only a portion of the cost is paid on that date?

Answer: In this transaction, for the first time, three accounts are impacted. A truck is bought for $40,000 so the balance recorded for this asset is increased by that cost. Cash decreases $10,000 while the notes payable balance rises by $30,000. These events each happened. To achieve a fair presentation, the accounting process seeks to reflect the actual occurrences that took place. As long as the analysis is performed properly, recording a transaction is no more complicated when more than two accounts are affected.

Recording a Capital Contribution by an Owner

Question: Transaction 7—Assume that several individuals approach the company and offer to contribute $19,000 in cash to the business in exchange for capital stock so that they can join the ownership. The offer is accepted. What accounts are impacted by the issuance of capital stock to the owners of a business?

Answer: When cash is contributed to a company for a portion of the ownership, cash obviously goes up by the amount received. This money was not generated by revenues or by liabilities but rather represents assets given freely so that new ownership shares could be obtained. This inflow is reflected in financial accounting as increases in both the cash and capital stock accounts. Outside decision makers can see that this amount of the company’s net assets came from investments made by owners.

The Collection of an Account Receivable

Question: Transaction 8—A sale of merchandise was made previously in Transaction 4 for $5,000. No cash was received at that time, but the entire amount is collected now. What accounts are affected by the receipt of money from an earlier sale?

Answer: The revenue from this transaction was properly recorded in Transaction 4 when the sale originally took place and the account receivable balance was established. Revenue should not be recorded again or it will be double counted, causing reported net income to be overstated. In simple terms, revenue is recorded when earned, and that has already taken place. Instead, for recording purposes, the accountant indicates that this increase in cash is caused by the decrease in the accounts receivable balance established in Transaction 4.

Payment Made on an Earlier Purchase

Question: Transaction 9—Inventory was bought in Transaction 1 for $2,000 and later sold in Transaction 4. Now, however, the company is ready to make payment of the amount owed for this merchandise. When cash is delivered to settle a previous purchase of inventory, what is the financial effect of the transaction?

Answer: As a result of the payment, cash is decreased by $2,000. The inventory was recorded previously when acquired. Therefore, this subsequent transaction does not replicate that effect. Instead, the liability established in number 1 is now removed from the books. The company is not buying the inventory again but simply paying off the debt established for these goods when they were purchased.

Payment of Rent in Advance

Question: Transaction 10—The company wants to rent a building to use for the next four months and pays the property’s owner $4,000 to cover this cost. When payment is made for rent (or a similar cost) with a future economic benefit, what recording is appropriate in financial accounting?

Answer: In acquiring the use of this property, the company’s cash decreases by $4,000. The money was paid to utilize the building for four months in the future. The anticipated economic benefit is an asset, and that information should be reported to decision makers by establishing a prepaid rent balance. Money has been paid to use the property at a designated time in the future to help generate revenues.

Double-Entry Bookkeeping

Question: Transaction analysis determines the changes that occur in accounts whenever various events take place. Financial statements eventually provide a formal structure to communicate the resulting balances to an array of interested parties.

• Revenues, expenses, gains, and losses are presented on an income statement where they are combined to arrive at reported net income for the period.
• Total income earned and dividends distributed by the company over its entire life are netted to compute the retained earnings balance to be reported.
• Assets, liabilities, capital stock, and retained earnings are all displayed on a balance sheet.
• Changes in cash are separated into operating activities, investing activities, and financing activities and disclosed on a statement of cash flows.
• Notes offer pages of additional explanatory information.

The amount of financial data that is readily available to any decision maker is impressive.

Accountants for a business of any significant size face a daunting challenge in creating financial statements. They must gather, measure, and report the impact of the many varied events that occur virtually every day. As an example, for 2010, Xerox Corporation disclosed revenues of over $21.6 billion and operating expenses and other costs of $20.8 billion. At the end of 2010, the Kellogg Company reported holding $1.1 billion in inventory—which is a lot of cereal—and indicated that its operating activities that year generated a net cash inflow of approximately $1 billion. How can any organization possibly amass and maintain such an enormous volume of data so that financial statements can be produced with no material misstatements?

Answer: Over five hundred years ago, Venetian merchants in Italy developed a system that continues to serve in the twenty-first century as the basis for accumulating financial data throughout much of the world. Today, when every aspect of modern society seems to be in a constant state of flux, a process that has remained in use for over five centuries is almost impossible to comprehend. However, the double-entry bookkeepingA mechanical process created over five hundred years ago and documented by Fra Luca Bartolomeo de Pacioli that facilitates the gathering and reporting of financial information. procedures that were first documented in 1494 by Fra Luca Bartolomeo de Pacioli (a friend of Leonardo da Vinci) remain virtually unchanged by time. Organizations, both small and large, use the fundamentals of double-entry bookkeeping to gather the monetary information needed to produce financial statements that are fairly presented according to the rules of U.S. GAAP or IFRS.

Analyze, Record, Adjust, and Report

Question: This assertion sounds like science fiction. It hardly seems believable that Xerox keeps up with over $21.6 billion in revenue (approximately $59 million per day) using the same methods that Venetian merchants applied to their transactions during the Renaissance. How can a five-hundred-year-old bookkeeping system possibly be usable in today’s modern world?

Answer: State-of-the-art computers and other electronic devices are designed to refine and accelerate the financial accounting process, but the same basic organizing procedures have been utilized now for hundreds of years. In simplest terms, accounting systems are all created to follow four sequential steps:

• Analyze
• Record
• Adjust
• Report

The first two of these steps are studied in this chapter. As explained previously, financial accounting starts by analyzing each transaction—every event that has a monetary impact on the organization—to ascertain the changes created in accounts such as rent expense, cash, inventory, and dividends paid. Fortunately, a vast majority of any company’s transactions are repetitive so that many of the effects can be easily anticipated. A sale on credit always increases both accounts receivable and revenue. Regardless of the time or place, a cash purchase of a piece of equipment increases the balance reported for equipment while decreasing cash. Computer systems can be programmed to record the impact of these events automatically allowing the accountant to focus on analyzing more complex transactions.

Debits, Credits, and T-Accounts

Question: The second step in the financial accounting process is “record.” At the beginning of this chapter, a number of transactions were presented and their impact on individual accounts determined. Following this analysis, some method must be devised to capture the information in an orderly fashion. Officials could just list the effect of each transaction on a sheet of paper:

“Increase inventory $2,000 and increase accounts payable $2,000.”

“Increase salary expense $300 and decrease cash $300.”

“Increase cash $9,000 and increase note payable $9,000.”

However, this process is slow and poorly organized. A more efficient process is required for companies like Xerox and Kellogg. After all monetary changes are identified, how are these effects accumulated?

Answer: An essential step in understanding double-entry bookkeeping is to realize that financial information is accumulated by accountsDetailed records of the transactions and current balances of individual assets, liabilities, stockholders’ equity, revenues and expenses.. As mentioned previously, every balance to be reported in a set of financial statements is maintained in a separate account. Thus, for assets, an individual account is established to monitor cash, accounts receivable, inventory, and so on. To keep track of expenses, a number of additional accounts are needed, such as cost of goods sold, rent expense, salary expense, and repair expense. The same is true for revenues, liabilities, and other categories. A small organization might utilize only a few dozen accounts in its entire record-keeping system. A large business probably has thousands.

Based on the original Venetian model, the balance for each account is monitored in a form known as a T-accountMaintains the monetary balance for each of the accounts reported by an organization with a left (debit) side and a right (credit) side used to show increases and decreases. as displayed in Figure 4.2 “Examples of Common T-Accounts”. This structure provides room for recording on both the left side (known as the debitLeft side of a T-account; it indicates increases in assets, expenses, and dividends paid as well as decreases in liabilities, capital stock, and revenue and gains. side) and the right side (the creditRight side of a T-account; it indicates increases in liabilities, capital stock, retained earnings, and revenue and gains as well as decreases in assets, expenses, and dividends paid. side).

Figure 4.2 Examples of Common T-Accounts

One side of every T-account records increases; the other side records decreases. For over five hundred years, the following rules have applied.

In some accounts, debits indicate an increase and credits indicate a decrease. They are grouped together because they all refer to costs.

Increase Shown with a Debit:

• Expenses and losses
• Assets
• Dividends paidOne method to keep track of these accounts initially is to remember them as the “DEAD” accounts: debits increase, expenses and losses, assets, and dividends paid. Quickly, though, through practice, such mnemonic devices will not be needed.

In other accounts, credits indicate an increase and debits indicate a decrease. They are grouped together because they all reflect sources of funding.

Increase Shown with a Credit:

• Liabilities
• Capital stock
• Revenues and gains
• Retained earningsChanges in the balance reported for retained earnings normally do not come as a direct result of a transaction. As discussed previously, this account reflects all the net income earned to date reduced by all dividend payments. Income is made up of revenues, expenses, gains, and losses. Accounting recognition of revenues and gains (which increase with credits) lead to a larger retained earnings balance. Expenses, losses, and dividends paid (which all increase with debits) reduce retained earnings. Consequently, credits cause an increase in retained earnings whereas debits produce a decrease.

The debit and credit rules for these seven general types of accounts provide a short-hand method for recording the financial impact that a transaction has on any account. They were constructed in this manner so that the following would be true:

At first view, the debit and credit rules might seem completely arbitrary. However, they are structured to mirror the cause-and-effect relationship found in every transaction. This is the basis of what the Venetian merchants came to understand so long ago: every effect must have a cause.

• Assume an asset (such as cash) increases. As shown here, that change is recorded on the debit side of the T-account for that asset. What could cause an asset to become larger? A reason must exist. A liability—possibly a bank loan—could have been incurred (recorded as a credit); capital stock could have been issued to an owner (a credit); revenue could have been earned from a sale (a credit). The list of possible reasons is relatively short. In each case, the debit (increase) to the asset is caused by an equal and offsetting credit.
• Assume an asset (such as cash) decreases. This change is recorded on the credit side of the asset’s T-account. What might cause this reduction? An expense could have been paid (recorded as a debit); a dividend could have been distributed to shareholders (a debit); a liability could have been extinguished (a debit); another asset could have been acquired (a debit). Once again, the cause-and-effect relationship is reflected; the debits equal the credits. Each effect is set equal and opposite to its cause.

There are only seven types of accounts. Therefore, a mastery of debit and credit rules can be achieved with a moderate amount of practice. Because of the fundamental role that debits and credits play within every accounting system, this knowledge is well worth the effort required to obtain it.

The Purpose of a Journal Entry

Question: In an accounting system, the impact of each transaction is analyzed and must then be recorded. Debits and credits are used for this purpose. How does the actual recording of a transaction take place?

Answer: The effects produced on various accounts by a transaction should be entered into an accounting system as quickly as possible so that information is not lost and mistakes have less time to occur. After each event is analyzed, the financial changes caused by a transaction are initially recorded as a journal entryThe physical form used in double-entry bookkeeping to record the financial changes caused by a transaction; each must have at least one debit and one credit and the total debit(s) must always equal the total credit(s)..In larger organizations, similar transactions are often grouped, summed, and recorded together for efficiency. For example, all cash sales at one store might be totaled automatically and recorded at one time at the end of each day. To help focus on the mechanics of the accounting process, the journal entries in this textbook will be prepared for transactions individually. A list of a company’s journal entries is maintained in a journalThe physical location of all journal entries; it is the financial diary of an organization capturing the impact of transactions as they took place; it is also referred to as the general journal. (also referred to as a general journalThe physical location of all journal entries; it is the financial diary of an organization capturing the impact of transactions as they took place; it is also referred to as the journal.), which is one of the most important components within any accounting system. The journal is a financial diary for a company. It provides a history of the impact of all financial events, recorded as they took place.

A journal entry is no more than an indication of the accounts and balances that were changed by a single transaction.

Practicing with Debits and Credits

Question: Debit and credit rules are best learned through practice. In order to master the use of debits and credits for recording purposes, where should the needed work begin?

Answer: When faced with debits and credits, everyone has to practice at first. That is normal and to be expected. These rules can be learned quickly but only by investing a bit of effort. Earlier in this chapter, a number of common transactions were presented (Figure 4.1 “Transactions Frequently Encountered by a Business”) and then analyzed to demonstrate their impact on account balances. Assume now that these same transactions are to be recorded as journal entries.

To provide more information for this illustration, the reporting company will be a small farm supply store known as the Lawndale Company that is located in a rural area. For convenience, assume that the business incurs each of these transactions during the final two days of Year Four, just prior to preparing financial statements.

Assume further that this company already has the various T-account balances as of December 29, Year Four, presented in Figure 4.3 “Balances From T-accounts in Ledger” before recording the impact of this last group of transactions. A company keeps its T-accounts together in a ledger (or general ledger). This listing of the account balances found in the ledger is known as a trial balanceList of account balances at a specific point in time for each of the T-accounts maintained in a company’s ledger; eventually, financial statements are created using these balances.. Note that the total of all the debit and credit balances do agree ($360,700) and that every account shows a positive balance. In other words, the current figure being reported is either a debit or credit based on what reflects an increase in that particular type of account. Few T-accounts contain negative balances.

Figure 4.3 Balances From T-accounts in Ledger

Journal Entry for Acquisition of Inventory on Credit

Question: After the balances in Figure 4.3 “Balances From T-accounts in Ledger” were determined, several additional transactions took place during the last two days of Year Four. The first transaction analyzed at the start of this chapter (Figure 4.1 “Transactions Frequently Encountered by a Business”) was the purchase of inventory on credit for $2,000. This acquisition increases the recorded amount of inventory while also raising one of the company’s liabilities (accounts payable). How is the acquisition of inventory on credit recorded in the form of a journal entry?

Answer: Following the transactional analysis, a journal entry is prepared to record the impact that the event has on the Lawndale Company. Inventory is an asset. An asset always uses a debit to note an increase. Accounts payable is a liability so that a credit indicates that an increase has occurred. Thus, the journal entry shown in Figure 4.4 “Journal Entry 1: Inventory Acquired on Credit” is appropriate.The parenthetical information is included here only for clarification purposes and does not appear in a true journal entry.

Figure 4.4 Journal Entry 1: Inventory Acquired on Credit

Notice that the word “inventory” is physically on the left of the journal entry and the words “accounts payable” are indented to the right. This positioning clearly shows which account is debited and which is credited. In the same way, the $2,000 numerical amount added to the inventory total appears on the left (debit) side whereas the $2,000 change in accounts payable is clearly on the right (credit) side.

Preparing journal entries is a mechanical process but one that is fundamental to the gathering of information for financial reporting purposes. Any person familiar with accounting could easily “read” the previous entry: Based on the debit and credit, both inventory and accounts payable have gone up so a purchase of merchandise for $2,000 on credit is indicated. Interestingly, with translation of the words, a Venetian merchant from the later part of the fifteenth century would be capable of understanding the information captured by this journal entry even if prepared by a modern company as large as Xerox or Kellogg.

Recording Payment of an Expense

Question: In Transaction 2, the Lawndale Company pays its employees salary of $300 for work performed during the past week. If no entry has been recorded previously for this amount, what journal entry is appropriate when a salary payment is made?

Answer: Because the information provided indicates that no entry has yet been made, neither the $300 salary expense nor the related salary payable already exists in the accounting records. Apparently, the $60,000 salary expense appearing in the trial balance reflects earlier payments made during the period to company employees.

Payment is made here for past work so this cost represents an expense rather than an asset. Thus, the balance recorded as salary expense goes up while cash decreases. As shown in Figure 4.5 “Journal Entry 2: Salary Paid to Employees”, increasing an expense is always shown by means of a debit. Decreasing an asset is reflected through a credit.

Figure 4.5 Journal Entry 2: Salary Paid to Employees

In practice, the date of each transaction could also be included here. For illustration purposes, this extra information is not necessary.

Journal Entry When Money Is Borrowed

Question: According to Transaction 3, $9,000 is borrowed from a bank when officials sign a note payable that will have to be repaid in several years. What journal entry is prepared by a company to reflect the inflow of cash received from a loan?

Answer: As always, recording begins with an analysis of the transaction. Cash—an asset—increases $9,000, which is shown as a debit. The notes payable balance also goes up by the same amount. As a liability, this increase is recorded through a credit. By using debits and credits in this way, a record of the financial effects of this transaction are entered into the accounting records.

Figure 4.6 Journal Entry 3: Money Borrowed from Bank

Recording Sale of Inventory on Credit

Question: In Transaction 1, inventory was bought for $2,000. That journal entry is recorded earlier. Now, in Transaction 4, these goods are sold for $5,000 to a customer with payment to be made at a later date. How is the sale of merchandise on credit recorded in journal entry form?

Answer: As discussed previously, two events happen when inventory is sold. First, the sale is made and, second, the customer takes possession of the merchandise from the company. Assuming again that a perpetual inventory system is in use, both the sale and the related expense are recorded immediately.

In the initial part of the transaction, the accounts receivable balance goes up $5,000 because the money from the customer will not be collected until a future point in time. The increase in this asset is shown by means of a debit. The new receivable resulted from a sale. Thus, revenue is also recorded (through a credit) to indicate the cause of that effect.

Figure 4.7 Journal Entry 4A: Sale of Inventory Made on Account

At the same time, inventory costing $2,000 is surrendered by the company. The reduction of any asset is recorded by means of a credit. The expense account that represents the outflow of inventory has been identified previously as “cost of goods sold.” Like any expense, it is entered into the accounting system through a debit.

Figure 4.8 Journal Entry 4B: Merchandise Acquired by Customers

The Role of Accrual Accounting

Question: In the previous transaction, the Lawndale Company made a sale but no cash was to be collected until some later date. Why is revenue reported at the time of sale rather than when cash is eventually collected? Accounting is conservative. Delaying recognition of sales revenue (and the resulting increase in net income) until the $5,000 is physically received seems logical. Why is the revenue recognized here before the cash is collected?

Answer: This question reflects a common misconception about the information conveyed through financial statements. As shown in Journal Entry 4A, the reporting of revenue is not tied directly to the receipt of cash. One of the most important components of U.S. GAAP is accrual accountingA method of accounting used by U.S. GAAP to standardize the timing of the recognition of revenues and expenses; it is made up of the revenue realization principle and the matching principle.. It serves as the basis for timing the recognition of revenues and expenses. Because of the direct impact on net income, such issues are among the most complicated and controversial in accounting. The accountant must constantly monitor events as they occur to determine the appropriate point in time for reporting each revenue and expense. Accrual accounting provides standard guidance for that process.

Accrual accounting is really made up of two distinct elements. The revenue realization principleThe component of accrual accounting that guides the timing of revenue recognition; it states that revenue is properly recognized when the earning process needed to generate the revenue is substantially complete and the amount to be received can be reasonably estimated. provides authoritative direction as to the proper timing for the recognition of revenue. The matching principleThe component of accrual accounting that guides the timing of expense recognition; it states that expense is properly recognized in the same time period as the revenue that it helped generate. establishes similar guidelines for expenses. These two principles have been utilized for decades in the application of U.S. GAAP. Their importance within financial accounting can hardly be overstated.

Revenue realization principle. Revenue is properly recognized at the point that (1) the earning process needed to generate the revenue is substantially complete and (2) the amount eventually to be received can be reasonably estimated. As the study of financial accounting progresses into more complex situations, both of these criteria will require careful analysis and understanding.

Matching principle. Expenses are recognized in the same time period as the revenue they help to create. Thus, if specific revenue is to be recognized in the year 2019, all associated costs should be reported as expenses in that same year. Expenses are matched with revenues. However, when a cost cannot be tied directly to identifiable revenue, matching is not possible. In those cases, the expense is recognized in the most logical time period, in some systematic fashion, or as incurred—depending on the situation.

Revenue is reported in Journal Entry 4A. Assuming that the Lawndale Company has substantially completed the work required of this sale and $5,000 is a reasonable estimate of the amount that will be collected, recognition at the time of sale is appropriate. Because the revenue is reported at that moment, the related expense (cost of goods sold) should also be recorded as can be seen in Journal Entry 4B.

Accrual accounting provides an excellent example of how U.S. GAAP guides the reporting process in order to produce fairly presented financial statements that can be understood by all possible decision makers.

Payment of a Previously Recognized Expense

Question: In Transaction 5, the Lawndale Company pays $700 for insurance coverage received over the past few months. Here, though, the amount has already been recognized. Both the insurance expense and an insurance payable were recorded as incurred. That information was provided in Figure 4.1 “Transactions Frequently Encountered by a Business”, and both amounts can be seen on the trial balance in Figure 4.3 “Balances From T-accounts in Ledger”. Apparently, Lawndale’s accounting system was programmed to recognize this particular expense as it grew over time. When an expense has already been recorded, what journal entry is appropriate at the time payment is made?

Answer: Because of the previous recognition, the expense should not now be recorded a second time. Instead, this payment eliminates the liability that was established by the accounting system. Cash—an asset—is decreased, which is shown in accounting by means of a credit. At the same time, the previously recorded payable is removed. Any reduction of a liability is communicated by a debit. To reiterate, no expense is included in this entry because that amount has already been recognized as incurred.

Figure 4.9 Journal Entry 5: Payment of Liability for Insurance Coverage

Note that Journal Entries 2 and 5 differ although the events are similar. As discussed previously, specific recording techniques are influenced by the manner in which the accounting system has handled earlier events. In Journal Entry 2, neither the expense nor the payable had yet been recorded. Thus, the expense was recognized at the time of payment. Conversely, in Journal Entry 5, both the expense and payable had already been entered into the records as the amount gradually grew over time. Hence, when paid, the liability is settled, but no further expense is recognized. The proper amount is already present in the insurance expense T-account.

Acquisition of an Asset

Question: In Transaction 6, a new truck is acquired by the Lawndale Company for $40,000. Cash of $10,000 is paid at the time of purchase but a note payable—due in several years—is signed for the remaining $30,000. This transaction impacts three accounts rather than just two. How is a journal entry constructed when more than two accounts are affected?

Answer: As has been discussed, every transaction changes at least two accounts because of the cause-and-effect relationship underlying all financial events. However, beyond that limit, any number of accounts can be impacted. Complex transactions often touch numerous balances. Here, the truck account (an asset) is increased and must be debited. Part of the acquisition was funded by paying cash (an asset) with that decrease recorded as a credit. The remainder of the cost was covered by signing a note payable (a liability). Any increase in a liability is recorded by means of a credit. Note that the debits do equal the credits even when more than two accounts are affected by a transaction.

Figure 4.10 Journal Entry 6: Truck Acquired for Cash and by Signing a Note

Issuance of Capital Stock

Question: In Transaction 7, the Lawndale Company needs additional financing so officials go to current or potential shareholders and convince them to contribute cash of $19,000 in exchange for new shares of the company’s capital stock. These individuals invest their money in order to join the ownership or increase the number of shares they already hold. What journal entry does a business record when capital stock is issued?

Answer: The asset cash is increased in this transaction, a change that is always shown as a debit. Capital stock also goes up because new shares are issued to company owners. As indicated in the debit and credit rules, the capital stock account increases by means of a credit.

Figure 4.11 Journal Entry 7: Capital Stock Issued for Cash

Collection Made on Account Receivable

Question: In Journal Entry 4A, a sale was made on credit. An account receivable was established at that time for $5,000. Assume that the customer now pays this amount to the Lawndale Company. How does the collection of an amount from an earlier sales transaction affect the account balances?

Answer: When a customer makes payment on a previous sale, the cash balance increases while accounts receivable decrease. Both are assets; one balance goes up (by a debit) while the other is reduced (by a credit).

Figure 4.12 Journal Entry 8: Money Collected on Account

Note that cash is collected here, but no additional revenue is recorded. Based on the requirements of accrual accounting, revenue of $5,000 was recognized previously in Journal Entry 4A. Apparently, the revenue realization principle was met at that time, the earning process was substantially complete, and a reasonable estimation could be made of the amount to be received. Recognizing the revenue again at the current date would incorrectly inflate reported net income. Instead, the previously created receivable balance is removed.

Paying for a Previous Purchase

Question: In Journal Entry 1, inventory was purchased on credit for $2,000. Assume, now, in Transaction 9, that Lawndale makes payment of the entire amount that is due. How is a cash outflow to pay for inventory previously acquired shown in a company’s journal?

Answer: Inventory was bought at an earlier time, and payment is now being made. The inventory was properly recorded when acquired and should not be entered again. The merchandise was only obtained that one time. Here, cash is reduced (a credit). The liability set up in Journal Entry 1 (accounts payable) is removed by means of a debit.

Figure 4.13 Journal Entry 9: Money Paid for Previous Purchase

Prepayment of an Expense

Question: Company officials like the building that is being used for operations and decide to rent it for four additional months at a rate of $1,000 per month. An immediate payment of $4,000 is made. This cost provides a future economic benefit rather than a past value. Recognition of an expense is not yet appropriate. What recording is appropriate when rent or other costs such as insurance or advertising are paid in advance?

Answer: Cash is decreased by the payment made here to rent this building. As an asset, a reduction in cash is reported by means of a credit. However, this rent provides a future value for Lawndale Company. The cost is not for past usage of the building but rather for the upcoming months. Therefore, the amount paid creates an asset. The probable economic benefit is the ability to make use of this facility over the next four months to generate new revenue. When the $4,000 is paid, an asset—normally called prepaid rent—is recorded through a debit.

Figure 4.14 Journal Entry 10: Money Paid for Future Rent

Note that Lawndale does not record the building itself because the company does not gain ownership or control (beyond these four months). The payment only provides the right to make use of the building for the specified period in the future so that a prepaid rent balance is appropriate.

Acquisition of Land

Question: Before this illustration of typical journal entries is completed, four additional transactions will be examined. In total, these fourteen provide an excellent cross-section of basic events encountered by most businesses and the journal entries created to capture that information. An understanding of the recording of these transactions is of paramount importance in mastering the mechanical rules for debits and credits.

Officials of the Lawndale Company decide to purchase a small tract of land by paying $8,000 in cash. Perhaps they think the space might be used sometime in the future as a parking lot. What recording is made to reflect the cash purchase of a plot of land?

Answer: The transaction here is straightforward. As an asset, land increases with a debit. The company’s cash balance goes down because of the acquisition. That drop is recorded using a credit. As stated earlier in this section, Venetian merchants would probably have made the same recording five hundred years ago (although not in U.S. dollars).

Figure 4.15 Journal Entry 11: Land Acquired for Cash

Sale of an Asset Other Than Inventory

Question: Now, assume that—for demonstration purposes—this same piece of land is sold almost immediately to an outside party for cash of $11,000. A sale occurs but the land is not inventory. It was not bought specifically to be resold within the normal course of business. As a farm supply store, selling land is not the primary operation of the Lawndale Company. Should revenue be recorded along with cost of goods sold when land rather than inventory is sold? These two accounts are used in journalizing the sale of inventory. Does the same reporting apply to the sale of other assets such as land or equipment?

Answer: Because the sale of land is not viewed as a central portion of this company’s operations, neither revenue nor cost of goods sold is reported as in the sale of inventory. An $11,000 increase in cash is recorded along with the removal of the $8,000 cost of the land that was conveyed to the new owner. However, to alert decision makers that a tangential or incidental event has taken place, a gain (if the sales price is more than the cost of the land) or a loss (if sales price is less than cost) is recognized for the difference. The effect on net income is the same (a net increase of $3,000), but the method of reporting has changed.

The resulting gain or loss is then separated from revenues and expenses on the income statement to more clearly communicate information as to the nature of the transaction. The decision maker can see the operating income earned by the reporting company from the normal sale of goods and services distinct from any other gains and losses. For example, if an investor or creditor is looking at the financial statements produced by an Italian restaurant, the amount of income from selling pizzas, spaghetti, and the like is important information apart from any gains and losses that were not part of typical operations. Consequently, neither revenue nor cost of goods sold is found in the following entry as was demonstrated in Journal Entries 4A and 4B.

Figure 4.16 Journal Entry 12: Land Sold for Cash in Excess of Cost

Receiving Cash before the Earning Process Is Complete

Question: Accrual accounting, as specified in the revenue realization principle, mandates that revenues should not be recognized until the earning process is substantially complete. Assume a customer gives the Lawndale Company $3,000 in cash for some type of service to be performed at a future date. The work has not yet begun. Thus, Lawndale cannot report revenue of $3,000. How is a cash inflow recorded if received for work before the earning process is substantially complete?

Answer: Although cash is received, accrual accounting dictates that revenue cannot be recognized until the earning process is substantially complete. Here, the earning process will not take place for some time in the future. As an asset, the cash account is increased (debit) but no revenue can yet be recorded. Instead, an unearned revenue account is established for the $3,000 credit. This balance is reported by the Lawndale Company as a liability. Because the money has been accepted, the company is obliged to provide the service or return the $3,000 to the customer. Recording this liability mirrors that responsibility.

Figure 4.17 Journal Entry 13: Money Received for Work to Be Done Later

Distribution of a Dividend

Question: Here is one final transaction to provide a full range of basic examples at this preliminary stage of coverage. Many additional transactions and their journal entries will be introduced throughout this textbook, but these fourteen form a strong core of the typical events encountered by most businesses.

Assume that the Lawndale Company has been profitable. As a result, at the end of the year, the board of directors votes to distribute a cash dividend to all owners, a reward that totals $600. Payment is made immediately. What recording is appropriate when a dividend is distributed to the owners of a corporation?

Answer: Cash is reduced by this payment to the company’s owners. As an asset, a credit is appropriate. The cause of the decrease in cash was a dividend. Hence, a “dividends paid” account is established to measure this particular outflow of net assets. According to the debit and credit rules, an increase in this account is shown through a debit. Thus, the recording of this last illustration is as follows.

Figure 4.18 Journal Entry 14: Dividend Distributed to Owners

To help visualize the components of an accounting system, all of the journal entries presented here have been gathered into an actual journal in Figure 4.19 “Lawndale Company Journal—Final Days of Year Four” as the accountant for the Lawndale Company might have kept. Normally, a date for each entry is included for reference purposes, but that has been omitted here.

Figure 4.19 Lawndale Company Journal—Final Days of Year Four

Current T-Account Balances

Question: With adequate practice, obtaining an understanding of the rules for debits and credits is a reasonable goal. However, these journal entries do not provide the current balance of any account. They record the effect of each transaction but not the updated account totals, figures that could change many times every day. How does an accountant keep track of the current balance of cash, inventory, rent expense, or the myriad other accounts that appear on a set of financial statements?

Answer: In an accounting system, the recording process is composed of two distinct steps.

1. After analyzing the financial impact of a transaction, a journal entry is created to reflect the monetary impact on relevant accounts.
2. Then, each individual debit and credit is added to the specific T-account being altered, a process known as “posting.” A debit to cash in a journal entry is listed as a debit in the cash T-account. A credit made to notes payable is recorded as a credit within the corresponding T-account. After all entries are posted, the current balance for any account can be determined by adding the debit and the credit sides of the T-account and netting the two.

Historically, posting the individual changes shown in each journal entry to the specific T-accounts was a tedious and slow process performed manually. Today, automated systems are designed so that the impact of each entry is simultaneously recorded in the proper T-accounts found in the ledger.

For illustration purposes, all of the journal entries recorded earlier have been posted into the ledger T-accounts shown in Figure 4.19 “Lawndale Company Journal—Final Days of Year Four”. Each account includes the previous balance (PB) found in the trial balance in Figure 4.3 “Balances From T-accounts in Ledger”. The new debits and credits are then posted for each of the fourteen sample transactions. For cross-referencing purposes, the number of the corresponding journal entry is included. The debit and credit sides of each account are summed and netted to determine the current balance (CB). For example, the cash T-account has $67,000 as the total of all debits and $25,600 for all credits, which net to a current balance of $41,400.

After all of the additional journal entries have been posted into the ledger, an updated trial balance can be drawn from the individual T-account balances. No change is created by this process, but, as can be seen in Figure 4.21 “Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four”, the accounts and their current balances are much easier to see. Simply the clarity of the information can help accountants spot accounts that may contain errors because of unusual or unexpected totals.

Figure 4.20 Lawndale Company Ledger—December 31, Year Four

Figure 4.21 Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four

Financial Statements Provide Physical Structure for Financial Reporting

Question: The revenues, expenses, assets, and liabilities reported by an organization provide essential data for decision making. These figures and related information enable a thorough analysis and evaluation of the organization’s financial health and future prospects. How do outsiders learn of these amounts? How do decision makers obtain this data? How is financial information actually conveyed to interested parties?

For example, a company such as Marriott International Inc. (the hotel chain) has millions of current and potential shareholders, creditors, and employees. How does such a business communicate vital financial information to all of the groups and individuals that might want to make some type of evaluation?

Answer: Businesses and other organizations periodically produce financial statements that provide a formal structure for conveying financial information to decision makers. Smaller organizations distribute such statements each year, frequently as part of an annual report prepared by management. Larger companies, like Marriott International, issue yearly statements but also prepare interim statements, usually on a quarterly basis.Financial statements for many of the businesses that have their capital stock traded publicly on stock exchanges are readily available on corporate Web sites. For example, the statements released by Marriott International can be located through the following path. The financial statements issued by most large companies will be found by using similar steps.•

1. Go to http://www.marriott.com.
2. Click on “About Marriott” (probably at the bottom of the homepage).
3. Click on “Investor.”
4. Click on “Financial Information.”
5. Click on “Financial Reports & Proxy.”
6. Click on “Annual Report” (for the year desired).

Regardless of the frequency, financial statements serve as the vehicle to report all monetary balances and explanatory information required according to the rules and principles of U.S. GAAP (or IFRS, if applicable). When based on these standards, such statements create a fairly presented portrait of the organization—one that contains no material misstatements. In simple terms, an organization’s revenues, expenses, assets, liabilities, and other balances are reported to outsiders by means of financial statements.

Typically, a complete set of financial statements produced by a business includes four separate statements along with pages of comprehensive notes. When financial statements and the related notes are studied with knowledge and understanding, a vast array of information is available to decision makers who want to predict future stock prices, cash dividend payments, and cash flows.

Financial Statements and Accompanying Notes

Because final figures shown on the income statement and the statement of retained earnings are necessary to produce subsequent statements, the preparation of financial statements is carried out in the sequential order shown here.

• Income statementA listing of all revenues earned and expenses incurred during a specific period of time as well as all gains and losses; also called statement of operations or statement of earnings. (also called a statement of operations or a statement or earnings)As will be discussed in a later chapter of this textbook, a statement of comprehensive income is also sometimes attached to or presented with an income statement.
• Statement of retained earningsA financial statement that reports the change in a corporation’s retained earnings account from the beginning of a period to the end; the account is increased by net income and decreased by a reported net loss and/or any dividends declared. (or the more inclusive statement of stockholders’ equity)
• Balance sheetA listing of all asset, liability, and stockholders’ equity accounts at a specific point in time; also called statement of financial position. (also called a statement of financial position)
• Statement of cash flowsA listing of all cash inflows (sources) and cash outflows (uses) during a specific period of time categorized as operating activities, investing activities, and financing activities.
• Notes to clarify and explain specified information further

The financial statements prepared by Marriott International as of December 31, 2010, and the year then ended were presented in just five pages of its annual report (pages 45 through 49) whereas the notes accompanying those statements made up the next twenty-eight pages. Although decision makers often focus, almost obsessively, on a few individual figures easily located in a set of financial statements, the vast wealth of information provided by the notes should never be ignored.

Reporting Revenues and Expenses on an Income Statement

Question: Assume that an individual is analyzing the most recent income statement prepared by a business in hopes of deciding whether to buy its capital stock or, possibly, grant a loan application. Or, perhaps, this person is a current employee who must decide whether to stay with the company or take a job offer from another organization. Regardless of the reason, the decision maker wants to assess the company’s financial health and future prospects. Certainly, all of the available financial statements need to be studied but, initially, this individual is looking at the income statement. What types of financial data will be available on a typical income statement such as might be produced by a business like IBM, Apple, Papa John’s, or Pizza Hut?

Answer: The main contents of an income statement are rather straightforward: a listing of all revenues earned and expenses incurred by the reporting organization during the period specified. As indicated previously in Chapter 2 “What Should Decision Makers Know in Order to Make Good Decisions about an Organization?”, revenue figures disclose increases in net assets (assets minus liabilities) that were created by the sale of goods or services. For IBM, revenues are derived from the sale and servicing of computers (a total of $99.9 billion in 2010) while, for Papa John’s International, the reported revenue figure for 2010 (a bit over $1.1 billion) measures the increase in net assets created by the sale of pizzas and related items.

Conversely, expenses are decreases in net assets incurred by a reporting organization in hopes of generating revenues. For example, salaries paid to sales people for the work they have done constitute an expense. The cost of facilities that have been rented is also an expense as is money paid for utilities, such as electricity, heat, and water.

For example, IBM reported selling, general, and administrative expenses during 2010 of $21.8 billion. That was just one category of expenses disclosed within the company’s income statement for this period.Financial information reported by large publicly traded companies tends to be highly aggregated. Thus, the expense figure shown by IBM is a summation of several somewhat related expenses. Those individual balances would be available within the company for internal decision making. During the same year, Papa John’s reported salaries and benefits as an expense for its domestic company-owned restaurants of $137.8 million. Financial accounting focuses on providing useful information about an organization, and both of these figures will help decision makers begin to glimpse a portrait of the underlying business.

Accounting is often said to provide transparency—the ability to see straight through the words and numbers to gain a vision of the actual company and its operations.

Reporting Gains and Losses

Question: Is nothing else presented on an income statement other than revenues and expenses?

Answer: An income statement also reports gains and losses for the same period of time. A gain is an increase in the net assets of an organization created by an occurrence that is outside its primary or central operations. A loss is a decrease in net assets from a similar type of incidental event.

When Apple sells or repairs a computer, it reports revenue because that is the sale of a good or service provided by this company. However, if Apple disposes of a piece of land adjacent to a warehouse, a gain is reported (if sold above cost) or a loss (if sold below cost). Selling computers falls within Apple’s primary operations whereas selling land does not.

If Pizza Hut sells a pepperoni pizza, the transaction increases net assets. Revenue has been earned and should be reported. If the company disposes of one of its old ovens, the result is reflected as either a gain or loss. Pizza Hut is not in the business of selling appliances. This classification split between revenues/expenses and gains/losses helps provide decision makers with a clearer portrait of what actually happened during the reporting period.

An example of an income statement for a small convenience store (Davidson Groceries) is shown in Figure 3.1 “Income Statement”. Note that the name of the company, the identity of the statement, and the period of time reflected are apparent. Although this is an illustration, it is quite similar structurally to the income statements created by virtually all business organizations in the United States and most other countries.

Figure 3.1 Income Statement

Cost of Goods Sold and Gross Profit

Question: A review of the sample income statement in Figure 3.1 “Income Statement” raises a number of questions. The meaning of balances such as salary expense, rent expense, advertising expense, and the like are relatively clear. These figures measure specific outflows or decreases in net assets that were incurred in attempting to generate revenue. However, the largest expense reported on this income statement is referred to as cost of goods sold. What does the cost of goods sold figure represent? What information is communicated by this $900,000 balance?

Answer: This convenience store generated sales of $1.4 million in Year 2XX4. Customers came in during that period and purchased merchandise for that amount. That is the first step in the sale and is reflected within the revenue balance. The customers then take their goods and leave the store. This merchandise no longer belongs to Davidson Groceries. In this second step, a decrease occurred in the company’s net assets; the goods were removed. Thus, an expense has occurred. As the title implies, “cost of goods sold” (sometimes referred to as “cost of sales”) is an expense reflecting the cost of the merchandise that customers purchased during the period. It is the amount that Davidson paid for inventory items—such as apples, bread, soap, tuna fish, and cheese—that were then sold. In the language of accounting, that is the meaning of “cost of goods sold.”

Note that the timing of expense recognition is not tied to the payment of cash but rather to the loss of the asset. As a simple illustration, assume Davidson Groceries pays $2 in cash for a box of cookies on Monday and then sells it to a customer for $3 on Friday. The income statement will recognize revenue of $3 (the increase in the net assets created by the sale) and cost of goods sold of $2 (the decrease in net assets resulting from the sale). Both the revenue and the related expense are recorded on Friday when the sale took place and the inventory was removed. That is when the change in net assets occurred. Apple, Pizza Hut, and thousands of other American businesses report the sale of merchandise in this manner because they all follow the same set of rules: U.S. GAAP.

The difference in revenue and cost of goods sold is often referred to as the company’s gross profitDifference between sales and cost of goods sold; also called gross margin or markup., gross marginDifference between sales price and cost of goods sold; also called gross profit or markup., or markupDifference between sales price and cost of goods sold on an item of inventory; also called gross profit or gross margin.. It is one of the reported figures studied carefully by decision makers. If a business buys inventory for $50 or $5,000, how much revenue can be generated by its sale? That difference is the gross profit.

As an example, assume that an investor or creditor is comparing two large home improvement companies: Lowe’s and Home Depot. For the year ended January 28, 2011, Lowe’s reported net sales revenues of $48.8 billion along with cost of goods sold of $31.7 billion. Thus, Lowe’s earned gross profit during that period of $17.1 billion. Sales of merchandise and services ($48.8 billion) exceeded the cost of those goods ($31.7 billion) by that amount. Lowe’s reported a gross profit that was 35.0 percent of sales ($17.1 million/$48.8 million). Thus, on the average, when a customer bought goods at Lowe’s for $100 during this period the markup above cost earned by the company was $35.00 (35.0 percent of $100 sales price). Any decision maker will find such numbers highly informative especially when compared with the company’s prior years or with competing enterprises.

For the year ended January 30, 2011, Home Depot reported net sales of $68.0 billion, cost of sales of $44.7 billion, and gross profit of $23.3 billion. Its gross profit percentage was 34.3 percent ($23.3 million/$68.0 million). On the average, when a customer bought goods at Home Depot for $100 during this period the markup above cost earned by the company was $34.30 (34.3 percent of $100 sales price). Home Depot is clearly a bigger business than Lowe’s, but during this year it earned a slightly smaller profit on each sales dollar than did its competitor.

Such reported information is studied carefully and allows decision makers to compare these two companies and their operations.

Placement of Income Taxes on an Income Statement

Question: In Figure 3.1 “Income Statement”, revenues and expenses are listed first to arrive at an operating income figure. That is followed by gains and losses. This sequencing is appropriate since revenues and expenses relate to the primary or central operations of the business and gains and losses are created by more incidental events. Why then is income tax expense listed last, by itself, on the bottom of the income statement and not with the other expenses?

Answer: State, federal, and international income taxes cost businesses considerable sums of money each year. Exxon Mobil Corp. reported income taxes of $21.6 billion at the bottom of its 2010 income statement. The income tax figure is segregated in this manner because it is not an expense in a traditional sense. As previously described, an expense—like cost of goods sold, advertising, or rent—is incurred in order to generate revenues. Income taxes do not create revenues. Instead, they are caused by a company’s revenues and related profitability.

Because the financial impact is the same as an expense (an outflow or decrease in net assets), “income tax expense” is often used for labeling purposes. A more appropriate title would be something like “income taxes assessed by government.” Because the nature of this “expense” is different, the income tax figure is frequently isolated at the bottom of the income statement, separate from true expenses.

Differentiating between an Asset and an Expense

Question: Previously, the term “asset” was defined as a probable future economic benefit owned or controlled by a reporting entity. On an income statement, items such as rent and advertising are listed as expenses. Why are such costs not grouped with the assets on the balance sheet? For example, rent paid for a building could provide a probable future economic benefit but it is included in Figure 3.1 “Income Statement” as an expense. The same is true for advertising. How does an organization determine whether a cost represents an asset or an expense?

Answer: Deciding whether a particular cost should be classified as an asset or an expense is not always easy for an accountant. If a business makes a $10,000 rent payment, an expense might have been incurred because an outflow of an asset (cash) has taken place. However, the cost of this rent could also be reported as an asset if it provides probable future economic benefit.

A cost is identified as an asset if the benefit clearly has value in generating future revenues whereas an expense is a cost that has already helped earn revenues in the past. With an asset, the utility associated with a cost is yet to be consumed completely. With an expense, the utility has already been consumed. To illustrate, assume that on December 31, Year One, a business pays $10,000 for rent on a building that was used during the previous month as a retail outlet. The benefit gained from occupying that space has already occurred. Use of the building helped the business make sales during December. The reduction in net assets to pay for the rent is reflected on the income statement as a rent expense. The benefit is in the past.

If on that same day, another $10,000 is paid to rent this building again during the upcoming month of January Year Two, the acquired benefit relates directly to the future. The building will be occupied in January in hopes of creating additional revenue. Until consumed, this second cost is shown as a $10,000 asset (referred to as “prepaid rent”).

• Expense. A cost that helped a business generate revenue in the past.
• Asset. A cost expected to help generate additional revenue in the future.

When a cost is incurred, the accountant must investigate its purpose to determine when the related benefit is expected. This timing—as guided by U.S. GAAP or IFRS—indicates whether an asset should be recognized or an expense.

Conservatism in Financial Accounting

Question: A business or other organization can face many complicated situations. Determining fair presentation is often not easy. For example, at times, the decision whether a cost will generate revenue in the future (and be reported as an asset) or has already helped create revenue in the past (and is, thus, an expense) is difficult. When an accountant encounters a case that is “too close to call,” what reporting is appropriate? To illustrate, assume that a business agrees to pay $24,000 but corporate officials cannot ascertain the amount of the related benefit that has already occurred versus the amount that will take place in the future. When clear delineation of a cost between asset and expense appears to be impossible, what reporting is made?

Answer: Working as an accountant is a relatively easy job when financial events are distinct and easily understood. Unfortunately, in real life, situations often arise where two or more outcomes seem equally likely. The distinction raised in this question between an asset and an expense is simply one of numerous possibilities where multiple portraits could be envisioned. At such times, financial accounting has a long history of following the practice of conservatismPreference of accountants to avoid making an organization look overly good; when faced with multiple reporting options that are equally likely, the worse possible outcome is reported to help protect the decision maker from information that is too optimistic..

The conservative nature of accounting influences many elements of U.S. GAAP and must be understood in order to appreciate the meaning of financial information conveyed about an organization. Simply put, conservatism holds that whenever an accountant faces two or more equally likely possibilities, the one that makes the reporting company look worse should be selected. In other words, financial accounting attempts to ensure that an organization never looks significantly better than it actually is.

Differentiating between an asset and an expense provides a perfect illustration of conservatism. If a cost is incurred that might have either a future value (an asset) or a past value (an expense), the accountant always reports the most likely possibility. That is the only appropriate way to paint a portrait of an organization that is the fairest representation. However, if neither scenario appears more likely to occur, the cost is classified as an expense rather than an asset because of conservatism. Reporting a past benefit rather than a future benefit has a detrimental impact on the company’s appearance to a decision maker. This handling reduces reported income as well as the amount shown as the total of the assets.

Conservatism can be seen throughout financial accounting. When the chance of two possibilities is the same, accounting prefers that the more optimistic approach be avoided.

The Reason for Conservatism

Question: Why does conservatism exist in financial accounting? Every organization must want to look as successful as possible. Why does a bias exist for reporting outcomes in a negative way?

Answer: Accountants are well aware that the financial statements they produce are relied on by decision makers around the world to determine future actions that will place significant amounts of money at risk. For example, if a company appears to be prosperous, an investor might decide to allocate scarce cash resources to obtain shares of its capital stock. Similarly, a creditor is more willing to make a loan to a business that seems to be doing well economically.

Such decision makers face potential losses that can be substantial. Accountants take their role in this process quite seriously. As a result, financial accounting has traditionally held that the users of financial statements are best protected if the reporting process is never overly optimistic in picturing an organization’s financial health and future prospects. Money is less likely to be lost if the accountant paints a portrait that is no more rosy than necessary. The practice of conservatism is simply an attempt by financial accounting to help safeguard the public.

The problem that can occur when a business appears excessively profitable can be seen in the downfall of WorldCom where investors and creditors lost billions of dollars. A major cause of this accounting scandal, one of the biggest in history, was the fraudulent decision by members of the company’s management to record a cost of nearly $4 billion as an asset rather than as an expense. Although any future benefit resulting from those expenditures was highly doubtful, the cost was reported to outsiders as an asset. Conservatism was clearly not followed.

Consequently, in its financial statements, WorldCom appeared to have $4 billion more in assets and be that much more profitable than was actually true. At the same time that its two chief rivals were reporting declines, WorldCom seemed to be prospering. Investors and creditors risked incredible amounts of their money based on the incorrect information they had received. Later, in 2002, when the misstatement was uncovered, the stock price plummeted, and WorldCom went bankrupt. Conservatism is designed to help prevent such unnecessary losses. If no outcome is viewed as most likely, the accountant should always work to prevent an overly optimistic picture of the reporting entity and its financial health.

Reporting Dividend Distributions

Question: Previously, the term “dividends” was introduced and discussed. Dividend distributions made to owners reduce the net assets held by an organization. In Figure 3.1 “Income Statement”, a number of expenses are listed, but no dividends are mentioned. Why are dividend payments not included as expenses of a corporation on its income statement?

Answer: Dividends are not expenses and, therefore, are omitted in preparing an income statement. Such distributions obviously reduce the amount of net assets owned or controlled by a company. However, they are not related in any way to generating revenues. A dividend is a reward paid by a corporation (through the decision of its board of directors) to the owners of its capital stock. A dividend is a sharing of profits and not a cost incurred to create revenue.

In Figure 3.1 “Income Statement”, Davidson Groceries reports net income for the year of $230,000. The board of directors might look at that figure and opt to make a cash dividend distribution to company owners. That is one of the most important decisions for any board. Such payments usually please the owners but reduce the size of the company and—possibly—its future profitability.

An income statement reports revenues, expenses, gains, and losses. Dividend distributions do not qualify and must be reported elsewhere in the company’s financial statements.

The Significance of Reported Net Income

Question: The final figure presented on the income statement is net income. This balance reflects the growth in an organization’s net assets during the period resulting from all revenues, expenses, gains, and losses. More specifically, it is the revenues and gains less the expenses and losses. For example, in 2010, the income statement reported by the Kellogg Company indicated that the size of that company’s net assets grew in that one year by $1.24 billion as a result of net income (revenues and gains less expenses and losses). In evaluating the operations of any business, this figure seems to be incredibly significant. It reflects the profitability for the period. Is net income the most important number to be found in a set of financial statements?

Answer: The net income figure reported for any business is an eagerly anticipated and carefully analyzed piece of financial information. It is the most discussed number disclosed by virtually any company. It is reported in newspapers and television, on the Internet and the radio.

However, financial statements present a vast array of data and the importance of any one balance should never be overemphasized. A portrait painted by an artist is not judged solely by the small section displaying the model’s ear or mouth but rather by the representation made of the entire person. Likewise, only the analysis of all information conveyed by a set of financial statements enables an interested party to arrive at the most appropriate decisions about an organization.

Some creditors and investors seek shortcuts when making business decisions rather than doing the detailed analysis that is appropriate. Those individuals often spend an exorbitant amount of time focusing on reported net income. Such a narrow view shows a fundamental misunderstanding of financial reporting and the depth and breadth of the information being conveyed. In judging a company’s financial health and future prospects, an evaluation should be carried out on the entity as a whole. Predicting stock prices, dividends, and cash flows requires a complete investigation. That is only possible by developing the capacity to work with all the data presented in a set of financial statements. If a single figure such as net income could be used reliably to evaluate a business organization, creditors and investors would never incur losses.

The Meaning of Retained Earnings

Question: The second financial statement is known as the statement of retained earnings.As indicated earlier, many businesses actually report a broader statement of changes in stockholders’ equity. At this initial point in the coverage, focusing solely on retained earnings makes the learning process easier. The term retained earnings has not yet been introduced. What information does a retained earnings balance communicate to an outside decision maker? For example, on May 1, 2010, Barnes & Noble reported retained earnings of aproximately $681.1 million, one of the largest amounts found in the company’s financial statements. What does that figure tell decision makers about this bookstore chain?

Answer: The retained earnings account (sometimes referred to as “reinvested earnings”) is one of the most misunderstood figures in all of financial reporting. As shown in Figure 3.2, this balance is the total amount of all net income earned by a business since it first began operations, less all dividends paid to stockholders during that same period of time. Retained earnings is a measure of the profits left in a business throughout its existence to create growth. For an organization like The Coca-Cola Company with a long history of profitability, much of its enormous expansion over the years has come from its own operations. That growth is reflected by the retained earnings balance, which is $49.2 billion for Coca-Cola as of December 31, 2010.

Figure 3.2

When a business earns income, it becomes larger because net assets have increased. Even if a portion of the profits is distributed to shareholders as a dividend, the company has grown in size as a result of its own operations. The retained earnings figure informs decision makers of the amount of that internally generated expansion. This reported balance answers the question: How much of the company’s net assets have been derived from operations during its life?

If a company reports an annual net income of $10,000 and then pays a $2,000 dividend to its owners each year, it is growing in size at the rate of $8,000 per year. After four years, for example, $32,000 ($8,000 × four years) of its net assets will have been generated by its own operating activities. That information is communicated through the retained earnings balance.

As of May 1, 2010, Barnes & Noble reported total assets of $3.7 billion and liabilities of $2.8 billion. Thus, the company had net assets of $900 million. Assets exceeded liabilities by that amount. Those additional assets did not appear by magic. They had to come from some source. One of the primary ways to increase the net assets of a business is through profitable operations. The balance for retained earnings shown by Barnes & Noble lets decision makers know that approximately $681 million of its net assets were generated by the total net income earned since the company’s inception, after all dividend distributions to shareholders were subtracted.

The Reporting of Retained Earnings

Question: In Figure 3.2, Davidson Groceries calculated its net income for 2XX4 as $230,000. Assume that this company began operations on January 1, 2XX1, and reported the balances shown in Figure 3.3 over the years:

Figure 3.3

How is the growth of this company’s net assets reported? What is the structure of the statement of retained earnings as it appears within a set of financial statements?

Answer: In the three prior years of its existence, Davidson Groceries’ net assets increased by $320,000 as a result of operating activities. As can be seen in Figure 3.3, the company generated total profit during this earlier period of $530,000 while distributing dividends to shareholders of $210,000, a net increase of $320,000. During the current year (2XX4), net assets continued to rise as Davidson Groceries made an additional profit (see also Figure 3.1 “Income Statement”) of $230,000 but distributed another $100,000 in dividends. Thus, the net assets of Davidson Groceries increased in 2XX4 by $130,000 ($230,000 less $100,000) as a result of business operations. For all four years combined, net assets went up by $450,000 ($320,000 + $130,000), all net income for these years minus all dividends.

Figure 3.4 “Statement of Retained Earnings” shows the format by which this retained earnings information is conveyed to the decision makers who are evaluating Davidson Groceries. As can be seen here, this structure first presents the previous growth in net assets ($320,000) followed by the net income ($230,000) and dividends ($100,000) for just the current year.

Figure 3.4 Statement of Retained Earnings

Assets Contributed to Gain Ownership Shares

Question: In the information provided, Barnes & Noble reported holding net assets of $900 million, but only $681 million of that amount was generated through operations as shown by the retained earnings balance. That raises an obvious question: How did Barnes & Noble get the rest of its net assets? Clearly, additional sources must have enabled the company to attain the $900 million reported total. Increases in net assets are not the result of magic or miracles. Other than through operations, how does a company derive net assets?

Answer: Beyond operations (as reflected by the retained earnings balance), a business accumulates net assets by receiving contributions from investors who become owners through the acquisition of capital stock.Other events can also impact the reported total of a company’s net assets. They will be discussed in other chapters. The two sources described here—capital stock and retained earnings—are shown by all corporations and are normally significantly large amounts. This is the other major method that an organization like Barnes & Noble uses to gather millions in net assets. In financial statements, the measure of this inflow is usually labeled something like capital stockOwnership (equity) shares of stock in a corporation that are issued to raise monetary financing for capital expenditures and operations., common stockA type of capital stock that is issued by every corporation; it provides rights to the owner that are specified by the laws of the state in which the organization is incorporated., or contributed capitalAmounts invested in a corporation by individuals or groups in order to attain ownership interests; balance indicates the amount of the corporation’s net assets that came directly from the owners.. Regardless of the exact title, the reported amount indicates the portion of the net assets that came into the business directly from stockholders who made the contribution to obtain an ownership interest.

The amount of a company’s net assets is the excess of its assets over its liabilities. For most businesses, two accounting balances indicate the primary sources of those net assets.

• Capital stock (or contributed capital). This is the amount invested in the business by individuals and groups in order to become owners. For example, as of September 25, 2010, Apple Inc. reported assets of $75 billion and liabilities of $27 billion. Thus, the company was holding $48 billion in net assets ($75 billion less $27 billion). How did Apple get that amount of net assets? That is a question that should interest virtually any investor or creditor analyzing this business. A reported capital stock balance of nearly $11 billion shows that this portion of the $48 billion came from owners contributing assets in order to purchase shares of the company’s stock directly from Apple.
• Retained earningsAccumulated total of the net income earned by an organization during its existence in excess of dividends distributed to the owners; indicates the amount of the net assets currently held that came from operations over the life of the organization.. This figure is the total net income earned by the organization over its life less amounts distributed as dividends to owners. On September 25, 2010, Apple Inc. reported a retained earnings balance of approximately $37 billion (see Figure 3.5 “Apple Inc.”). A growth in net assets of that amount resulted from the operating activities since the day Apple first got started.

Figure 3.5 Apple Inc.

These numbers reconcile because the total amount of net assets ($48 billion) must have a source of the same amount ($48 billion).

The Trading of Shares of Capital Stock

Question: A corporation issues (sells) ownership shares to investors to raise money. The source of the resulting inflow of assets into the business is reflected in financial accounting by the reporting of a capital stock (or contributed capital) balance. Thus, over its life, Apple has received assets of $11 billion in exchange for shares of capital stock. Does a company receive money when its shares are sold each day on the New York Stock Exchange, NASDAQ (National Association of Securities Dealers Automated Quotations), or other stock exchanges?

Answer: No, purchases and sales on stock markets normally occur between two investors and not directly with the company. Only the initial issuance of the ownership shares to a stockholder creates the inflow of assets reported by a capital stock or contributed capital account.

To illustrate, assume that Investor A buys one thousand shares of capital stock shares directly from Business B for $179,000 in cash. This transaction increases the net assets of Business B by that amount. The source of the increase is communicated to decision makers by adding $179,000 to the capital stock balance reported by the company. Business B is bigger by $179,000, and the capital stock account provides information about that growth.

Subsequently, these shares may be exchanged between investors numerous times without any additional financial impact on Business B. For example, assume Investor A later sells the 1,000 shares to Investor Z for $200,000 using a stock market such as the New York Stock Exchange. Investor A earns a $21,000 gain ($200,000 received less $179,000 cost), and Investor Z has replaced Investor A as an owner of Business B. However, the financial condition of the company has not been affected by this new exchange. Business B did not receive anything. From its perspective, nothing happened except for a change in the identity of an owner. Thus, a corporation’s capital stock balance only measures the initial investment contributed directly to the business.

Information Reported on a Balance Sheet

Question: The third financial statement is the balance sheet. If a decision maker studies a company’s balance sheet (on its Web site, for example), what information can be discovered?

Answer: The primary purpose of a balance sheet is to report a company’s assets and liabilities at a particular point in time. The format is quite simple. All assets are listed first—usually in order of liquidityLiquidity refers to the ease with which assets can be converted into cash. Thus, cash is normally reported first followed by investments in stock that are expected to be sold soon, accounts receivable, inventory, and so on.—followed by all liabilities. A portrait is provided of each future economic benefit owned or controlled by the company (its assets) as well as its debts (liabilities).

Figure 3.6 Balance SheetAs will be discussed in detail later in this textbook, noncurrent assets such as buildings and equipment are initially recorded at cost. This figure is then systematically reduced as the amount is moved gradually each period into an expense account over the life of the asset. Thus, balance sheet figures for these accounts are reported as “net” to show that only a portion of the original cost still remains recorded as an asset. This shift of the cost from asset to expense is known as depreciation and mirrors the using up of the utility of the property.

A typical balance sheet is reported in Figure 3.6 “Balance Sheet” for Davidson Groceries. Note that the assets are divided between current (those expected to be used or consumed within the following year) and noncurrent (those expected to remain with Davidson for longer than a year). Likewise, liabilities are split between current (to be paid during the upcoming year) and noncurrent (not to be paid until after the next year). This labeling is common and aids financial analysis. Davidson Groceries’ current liabilities ($57,000) can be subtracted from its current assets ($161,000) to arrive at a figure often studied by interested parties known as working capitalFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by subtracting current liabilities from current assets. ($104,000 in this example). It reflects short-term financial strength, the ability of a business or other organization to generate sufficient cash to pay debts as they come due.

Current assets can also be divided by current liabilities ($161,000/$57,000) to determine the company’s current ratioFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities. (2.82 to 1.00), another figure calculated by many decision makers as a useful measure of short-term operating strength.

The balance sheet shows the company’s financial condition on one specific date. All of the other financial statements report events occurring over a period of time (often a year or a quarter). However, the balance sheet discloses all assets and liabilities as of the one specified point in time.

The Accounting Equation

Question: Considerable information is included on the balance sheet presented in Figure 3.6 “Balance Sheet”. Assets such as cash, inventory, and land provide future economic benefits for the reporting entity. Liabilities for salaries, insurance, and the like reflect debts that are owed at the end of the fiscal period. The $179,000 capital stock figure indicates the amount of assets that the original owners contributed to the business. The retained earnings balance of $450,000 was computed earlier in Figure 3.4 “Statement of Retained Earnings” and identifies the portion of the net assets generated by the company’s own operations over the years. For convenience, a general term such as “stockholders’ equity” or “shareholders’ equity” usually encompasses the capital stock and the retained earnings balances.

Why does the balance sheet balance? This agreement cannot be an accident. The asset total of $1,206,000 is exactly the same as the liabilities ($577,000) plus the two stockholders’ equity accounts ($629,000—the total of capital stock and retained earnings). Thus, assets equal liabilities plus stockholders’ equity. What creates this monetary equilibrium?

Answer: The balance sheet will always balance unless a mistake is made. This is known as the accounting equationAssets = liabilities + stockholders’ equity. The equation balances because all assets must have a source: a liability, a contribution from an owner (contributed capital), or from operations (retained earnings)..

Accounting Equation (Version 1):

Or, if the stockholders’ equity account is broken down into its component parts:

Accounting Equation (Version 2):

As discussed previously, this equation stays in balance for one simple reason: assets must have a source. If a business or other organization has an increase in its total assets, that change can only be caused by (a) an increase in liabilities such as money being borrowed, (b) an increase in capital stock such as additional money being contributed by stockholders, or (c) an increase created by operations such as a sale that generates a rise in net income. No other increases occur.

One way to understand the accounting equation is that the left side (the assets) presents a picture of the future economic benefits that the reporting company holds. The right side provides information to show how those assets were derived (from liabilities, from investors, or from operations). Because no assets are held by a company without a source, the equation (and, hence, the balance sheet) must balance.

Accounting Equation (Version 3):

The Statement of Cash Flows

Question: The fourth and final financial statement is the statement of cash flows. Cash is so important to an organization and its financial health that a complete statement is devoted to presenting the changes that took place in this one asset. As can be inferred from the title, this statement provides a portrait of the various ways the reporting company generated cash during the year and the uses that were made of it. How is the statement of cash flows structured?

Answer: Decision makers place considerable emphasis on a company’s ability to generate significant cash inflows and then make wise use of that money. Figure 3.7 “Statement of Cash Flows” presents an example of that information in a statement of cash flows for Davidson Groceries for the year ended December 31, 2XX4. Note that all the cash changes are divided into three specific sections:

• Operating activitiesA statement of cash flow category relating to cash receipts and disbursements arising from the primary activities of the organization.
• Investing activitiesA statement of cash flow category relating to cash receipts and disbursements arising from an asset transaction other than one related to the primary activities of the organization.
• Financing activitiesA statement of cash flow category relating to cash receipts and disbursements arising from a liability or stockholders’ equity transaction other than one related to the primary activities of the organization.

Figure 3.7 Statement of Cash FlowsThe cash flows resulting from operating activities are being shown here using the direct method, an approach recommended by the FASB. This format shows the actual amount of cash flows created by individual operating activities such as sales to customers and purchases of inventory. In the business world, an alternative known as the indirect method is more commonly encountered. This indirect method will be demonstrated in detail in Chapter 17 “In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?”.

Classification of Cash Flows

Question: In studying the statement of cash flows, a company’s individual cash flows relating to selling inventory, advertising, selling land, buying a building, paying dividends and the like can be readily understood. For example, when the statement indicates that $120,000 was the “cash received from bank on a loan,” a decision maker should have a clear picture of what happened. There is no mystery.

All cash flows are divided into one of the three categories:

1. Operating activities
2. Investing activities
3. Financing activities

How are these distinctions drawn? On a statement of cash flows, what is the difference in an operating activity, an investing activity, and a financing activity?

Answer: Cash flows listed as the result of operating activities relate to receipts and disbursements that arose in connection with the central activity of the organization. For Davidson Groceries, these cash changes were created by daily operations and include selling goods to customers, buying merchandise, paying salaries to employees, and the like. This section of the statement shows how much cash the primary business function generated during this period of time, a figure that is watched closely by virtually all financial analysts. Ultimately, a business is only worth the cash that it can create from its normal operations.

Investing activities report cash flows created by events that (1) are separate from the central or daily operations of the business and (2) involve an asset. Thus, the amount of cash collected when either equipment or land is sold is reported within this section. A convenience store does not participate in such transactions as a regular part of operations and both deal with an asset. Cash paid to buy a building or machinery will also be disclosed in this same category. Such purchases do not happen on a daily operating basis and an asset is involved.

Like investing activities, the third section of this statement—cash flows from financing activities—is unrelated to daily business operations but, here, the transactions relate to either a liability or a stockholders’ equity balance. Borrowing money from a bank meets these criteria as does distributing a dividend to shareholders. Issuing stock to new owners for cash is another financing activity as is payment of a noncurrent liability.

Any decision maker can study the cash flows of a business within these three separate sections to receive a picture of how company officials managed to generate cash during the period and what use was made of it.

Financial Statements: The Portrait of an Organization

Question: In Chapter 1 “What Is Financial Accounting, and Why Is It Important?”, mention was made that financial accounting is somewhat analogous to the painting of a giant, complex portrait. How could financial accounting possibly be compared to an artistic endeavor such as the creation of a painted portrait?

Answer: The purpose of a portrait—as might have been created by Rembrandt, van Gogh, or even Picasso—is to capture a likeness of the artist’s model. In a somewhat parallel fashion, financial accounting attempts to present a portrait of an organization that can be used by interested parties to assess its financial health and future prospects. If well painted, this picture should enable individuals to estimate future stock prices, dividend payments, and cash flows. Accounting even has specific terms (such as representational faithfulnessA reasonable agreement between reported information and the event or balance it purports to represent; this term refers to the communication of an appropriate picture of an organization, which can serve as the basis for appropriate decisions. and presents fairlyFinancial information that contains no material misstatements in accordance with an accepted standard for financial reporting.) that are used to indicate that financial information successfully provides a reasonable likeness of the reporting organization.

In accounting, this portrait is most often presented in the form of financial statementsQuantitative reports and related verbal disclosures that convey monetary information describing the operations, financial position, and cash flows of an organization as a basis for representing its financial health and future prospects.. The accountant takes all appropriate monetary information and constructs a set of financial statements to be distributed to decision makers. Financial statements are a representation of an organization’s operations, financial position, and cash flows. These statements provide the form and structure for the conveyance of financial information that will create a likeness of the reporting organization. This textbook is about the preparation of those financial statements and the meaning of their contents.

A Likeness Does Not Have to Be Exact

Question: Financial accounting deals with numbers that are exact. A 3 is a 3 and nothing else. In describing the production of financial statements, why are the results not compared to a photograph rather than a painted portrait? After all, a photograph is a much more precise likeness than a painting.

Answer: A human portrait, even by a master such as Rembrandt, will not be completely accurate. The shape of the person’s chin or the turn of the neck may be off slightly. The color of the eyes and hair cannot possibly be a perfect replica of life. It is a painted portrait, not a photograph (which is much more mechanically accurate). Fortunately, absolute exactness is not necessary for capturing the essence of a model. A likeness is achieved when a viewer exclaims, “I know that person!” Exact precision is not required to meet that objective.

Despite public perception to the contrary, financial accounting information is rarely an exactly accurate portrait. The accountant’s goal is to create financial statements that present a likeness of an organization that can be used to make decisions. For example, the reported cost of constructing a building may be off slightly because of the sheer volume of money being spent on the many different aspects of the project. No one expects the reported cost of a $50 million manufacturing plant to be accurate to the penny. As with the painted portrait, that does not necessarily reduce the usefulness of the data. If financial information provides a fair representation, an interested party should be able to make use of it to arrive at the desired projections such as future stock prices. A potential investor or creditor does not need numbers that are absolutely accurate in order to assert, “Based on the information available in the financial statements, I understand enough about this business to make informed decisions. Even if I could obtain figures that were more accurate, I believe that I would still take the same actions.”

An artist applies oil paints, pastels, or watercolors to a canvas to present a likeness of a subject. An accountant does something quite similar in constructing financial statements with numbers and words. The goal is much the same: to produce a likeness that truly reflects the essence of the model, which, in this case, is an entire organization.

Material Misstatements

Question: This is a surprising, possibly shocking, revelation. Financial accounting information has universally been branded as exhibiting rigid exactness. In fact, accountants are often referred to as “bean counters” because of their perceived need to count every bean in the bowl to arrive at obsessively accurate numbers. Here, though, the assertion is made that accounting information is not a precise picture but merely a fair representation of an organization’s financial health and future prospects. How correct or exact is the financial information that is reported by a business or other organization?

Answer: In financial accounting, the data presented to decision makers by an organization should never contain any misstatementsErrors or frauds that cause reported financial information to differ from the approach required by an official standard for reporting such as the U.S. Generally Accepted Accounting Principles (U.S. GAAP) or International Financial Reporting Standards (IFRS). that are deemed to be materialThe magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by that omission or misstatement.. This basic standard has long served as the required level for accuracy in financial reporting. Decision makers want financial statements—such as those prepared by Starbucks or Intel—that they can trust and use. That requires the statements to be free of any material misstatements. In that condition, reported financial information will be viewed as a likeness of the organization that is presented fairly. Thus, financial statements do not need exact accuracy. However, they must be free of material misstatements in order to be of use to decision makers.

A misstatement is an errorAn unintentional misstatement of financial information. (made accidentally) or fraudAn intentional misstatement of financial information; it can result from misappropriation of assets (theft) or fraudulent financial reporting. (done intentionally) where reported figures or words actually differ from the underlying reality. In simple terms, the information is wrong.

For example, a corporate official could erroneously record a $100,000 expenditure that was made in connection with the construction of a new building as if it pertained to the purchase of land. Consequently, the building’s cost might be reported as only $2.3 million when it was actually $2.4 million. This reported number is misstated; it is wrong. The balance presented for the building contains a $100,000 error, as does the figure shown for land. This misstatement, though, might not be viewed as material.

A misstatement is deemed to be material if it is so significant that its presence would impact a decision made by an interested party. Using the previous illustration, assume the accidental $100,000 reduction in the reported cost of this building leads an outside decision maker to alter a choice being made (such as whether to buy or sell the business’s capital stock or whether to grant a loan). Because of the change in the decision, the misstatement is judged to be material by definition. If no decision is affected, a misstatement is not material, and its existence does not prevent the reported information from still being fairly presented. The reported information is usable for decision making.

Financial information can (and almost always does) contain misstatements. However, the reporting entity must take adequate precautions to ensure that reported information holds no material misstatements for the simple reason that it is no longer fairly presented. If any material misstatements exist within the information, the portrait of the organization is not a proper likeness of the model. The decision maker is being misled.

The concept of materiality can seem rather nebulous. For the financial statements of a small convenience store, a $10 misstatement is not material whereas a $10 million one certainly is. For a business with real estate holdings of $30 billion, even a $10 million misstatement is probably not material. The problem for the accountant is determining where to draw the line for a particular organization. That is one of the most difficult decisions for any financial accountant. An exact dollar amount for materiality is virtually impossible to identify because it is a measure of the effect of a misstatement on an external party’s judgment.

Other than sheer magnitude, the cause of the problem must also be taken into consideration. An accidental mistake of $100,000 is less likely to be judged material than one of $100,000 that resulted from a fraudulent act. Fraud occurs when someone wants to misrepresent reported numbers to make the organization look differently than it is or to cover theft. Fraud includes the intent to deceive and is more troublesome to decision makers than a mere error. Thus, both size and cause should be weighed in considering whether the presence of a misstatement has the ability to impact the actions of any decision makers.

Consequently, a financial accountant never claims that reported information is correct, accurate, or exact. Such precision is rarely possible and not needed when decision makers are analyzing the financial health and future prospects of an organization. However, the accountant must take all precautions necessary to ensure that reported data contain no material misstatements. Financial figures are never released without reasonable assurance being obtained that no errors or other mistakes are included that could be material, or in other words, that could impact the decisions that are made. All parties need to believe that reported information can be used with confidence because it presents a fair likeness of the organization as a whole.

When a company reports that a building was constructed at a cost of $2.3 million, the real message is that the actual cost was not materially different from $2.3 million. This figure is a fair representation of the amount spent, one that can be used in making decisions about the organization such as whether to invest in its capital stock or provide it with a loan.

Uncertainty, the True Challenge for Reporting

Question: Financial accounting figures can certainly be exact. If a cash register is bought for $836.54, the reported cost is $836.54. However, decision makers do not need financial figures with such absolute accuracy. If reported information is presented fairly, in other words if it contains no material misstatements, it can be used to estimate a corporation’s future stock prices, cash dividend payments, and cash flows. Even if not necessary for decision makers, what prevents reported financial information from being correct in an absolute sense? Why are all reported figures not as precise as the reporting of the cash register?

Answer: In truth, a reasonable percentage of numbers reported in a set of financial statements are exact. Materiality is not an issue in such cases. The cash register mentioned here has a reported cost of $836.54—a precise measure of the amount paid. Likewise, a cash balance shown as $2,785.16 is exact to the penny. However, many of the other figures reported by an organization do not lend themselves to such accuracy.

The primary reason that exactness is not a goal—often not even a possibility in financial accounting—can be summed up in a single word: uncertainty. Many of the events encountered every day by an organization contain some degree of uncertainty. Unfortunately, no technique exists to report uncertain events in precise terms.

When first introduced to financial accounting, many students assume that it is little more than the listing of cash receipts and disbursements in much the same way that elementary school children report how they spent their weekly allowances. That is a misconception. Financial accounting is a structured attempt to paint a fairly presented portrait of an organization’s overall operations, financial condition, and cash flows. This requires the reporting of many events where a final resolution might not occur for months or even years. Here are just a few examples of the kinds of uncertainty that virtually every business (and financial accountant) faces in creating financial statements.

• A business is the subject of a lawsuit. Perhaps a customer has filed this legal action claiming damage as a result of one of the company’s products. Such legal proceedings are exceedingly common and can drag on in the courts for an extended period of time before a settlement is reached. The actual amount won or lost (if either ever occurs) might not be known for years. What should the business report now?
• A sale of merchandise is made today for $300 with the money to be collected from the customer in several months. Until the cash is received, no one can be sure of the exact amount that will be collected. What should the business report now?
• An employee is promised a cash bonus next year that will be calculated based on any rise in the market price of the corporation’s capital stock. Until the time passes and the actual increase (if any) is determined, the amount of this bonus remains a mystery. What should the business report now?
• A retail store sells a microwave oven today with a warranty. If the appliance breaks at any time during the next three years, the store has to pay for the repairs. No one knows whether the microwave will need to be fixed during this period. What should the business report now?

Any comprehensive list of the uncertainties faced regularly by most organizations would require pages to enumerate. Many of the most important accounting rules have been created to establish requirements for the reporting of uncertain situations. Because of the quantity and variety of such unknowns, exactness simply cannot be an objective of financial reporting.

For many accountants, dealing with so much uncertainty is the most interesting aspect of their job. Whenever an organization encounters a situation of this type, the accountant must first come to understand what has happened and then determine a logical method to communicate a fair representation of that information within the framework provided by financial accounting rules. Thus, reporting events in the face of uncertainty is surely one of the major challenges of being a financial accountant.

Accounting as the Language of Business

Question: Accounting is sometimes referred to as the “language of business.” However, in this book, financial accounting has already been compared to the painting of a fairly presented portrait of an organization. Given the references throughout this chapter to painting, is accounting really a type of language? Is it possible for accounting to paint portraits and also be a language?

Answer: The simple answer to this question is that accounting is a language, one that enables an organization to communicate a portrait of its financial health and future prospects to interested parties by using words and numbers rather than oils or watercolors. The formal structure of that language becomes especially helpful when an organization faces the task of reporting complex uncertainties.

Any language, whether it is English, Spanish, Japanese, or the like, has been developed through much use to allow for the effective transfer of information between two or more parties. If a sentence such as “I drive a red car” is spoken, communication is successful but only if both the speaker and the listener have an adequate understanding of the English language. Based solely on the arrangement of these five words, information can be passed from one person to the another.

This process succeeds because English (as well as other languages) relies on relatively standardized terminology. Words such as “red,” “car,” and “drive” have defined meanings that the speaker and the listener both know with a degree of certainty. In addition, grammar rules such as syntax and punctuation are utilized to provide a framework for the communication. Thus, effective communication is possible in a language when

1. Set terminology exists
2. Structural rules and principles are applied

As will be gradually introduced throughout this textbook, financial accounting has its own terminology. Many words and terms (such as “LIFO” and “accumulated depreciation”) have very specific meanings. In addition, a comprehensive set of rules and principles has been established over the decades to provide structure and standardization. They guide the reporting process so that the resulting information will be fairly presented and can be readily understood by all interested parties, both inside and outside of the organization.

Some students who read this textbook will eventually become accountants. Those individuals must learn specific terminology, rules, and principles in order to communicate financial information about an organization that is presented fairly. Others (probably most readers) will become external decision makers. They will make financial decisions. They will evaluate loan applications, buy capital stock, grant credit, make employment decisions, provide investment advice, and the like. They will not present financial information with all of its uncertainties but rather they will need to make use of it. The more such individuals know about financial accounting terminology, rules, and principles, the more likely it is that they will arrive at appropriate decisions.

To communicate a portrait properly in any language, both the speaker and the listener must understand the terminology as well as the structural rules and principles. That holds true even if the language is financial accounting.

The Existence of Formal Accounting Standards

Question: Rules and principles exist within financial accounting that must be followed. They provide the structural guidance that is essential for achieving effective communication. For example, assume that a reporting organization encounters an uncertainty (such as a lawsuit) and is now preparing financial information to portray the reality of that event. When faced with such complexity, how does the financial accountant know which method of reporting is appropriate? How does a decision maker who analyzes that reported information know what guidelines were used in its preparation?

Answer: The existence of financial accounting standards is essential to ensure that all communicated information is understood properly. Both the accountants within the reporting organization and the decision makers analyzing the resulting financial statements must understand those rules. The question that has haunted the accounting profession in recent times is, who should have the authority to create those standards?

For decades, a wide variety of formal accounting principles were developed in the United States as well as throughout the rest of the world. Japanese accounting rules evolved differently from those in Australia while Australian standards were not consistent with those in the United States. In earlier times, such country-by-country rules caused few problems because most businesses operated solely within their country’s boundaries. During the past ten years or so, as a truly global economy became a reality, two primary systems of accounting rules emerged. U.S. Generally Accepted Accounting Principles (U.S. GAAP)A recognized set of accounting rules used and followed in the United States; it is created and updated by the Financial Accounting Standards Board (FASB). are applied to most financial information presented within the United States. International Financial Reporting Standards (IFRS) are now used almost exclusively in the rest of the world. In accounting at the present time, two languages exist rather than one.

Having two bodies of rules causes problems for decision makers. For example, on its Web site, BP presents a 2010 set of financial statements prepared according to IFRS. One of its biggest competitors, Exxon Mobil, posted its own 2010 financial statements, but those amounts and explanations were created by following U.S. GAAP. Clarity and understanding are not enhanced when different communication standards are applied by such similar businesses.

Not surprisingly, many corporate officials and decision makers would prefer to see one universal set of accounting standards. If that were to happen, a corporation in Michigan and a corporation in Germany would produce comparable financial information that could be utilized for all reporting purposes around the world.

Over the past few years, extensive progress has been made in bringing these two sets of standards into alignment. However, a number of significant differences continue to exist. Many interested parties want to see IFRS adopted exclusively in the United States. According to this group, it is unlikely that the rest of the world will choose to follow U.S. GAAP so harmony can only be achieved by a general acceptance of IFRS. Others believe that U.S. GAAP is a superior system and should not be abandoned.

The debate has been intense and promises to continue to be so until some type of official resolution occurs.

At the time of this writing, U.S. GAAP continues to be the required system for most of the financial reporting found in the United States although a mandated switch to IFRS (in some form) during the next few years is quite possible. Because of the current situation and the uncertainty as to how legal requirements will eventually change, this textbook is primarily a presentation of U.S. GAAP. For the most part, U.S. GAAP and IFRS are based on the same accounting principles. However, varying interpretations of those principles have resulted in differences between U.S. GAAP and IFRS standards. In areas where IFRS disagrees with U.S. GAAP in significant ways, both methods of reporting will be described in this textbook.

The Development of Accounting Standards

Question: Whether in the form of U.S. GAAP or IFRS, financial accounting standards must be created in some logical fashion. Who is in charge of the production of formal accounting standards? How often do these official standards come into existence?

Answer: The Financial Accounting Standards Board (FASB) has held the authority to develop U.S. GAAP since 1973. An abundance of information can be found about this board and its activities by going to http://www.fasb.org/ and clicking on “About FASB.”

IFRS are produced by the London-based International Accounting Standards Board (IASB). This group took over responsibility for international standards from a predecessor group in 2001. Information about the resulting official pronouncements and the standard setting process is available at http://www.iasb.org/ by clicking on “About us.”

Although some basic elements of accounting standards have been in use almost throughout history, many reporting rules are relatively new—often developed within the last few decades. Whether U.S. GAAP or IFRS, accounting standards evolve quite quickly as the nature of business changes and new reporting issues, problems, and resolutions arise. The growth of advanced technology speeds this process even more quickly. Fairly important changes in the formal structure of accounting rules occur virtually every year.

In the United States, the existence of U.S. GAAP means that a business in Seattle, Washington, and a business in Atlanta, Georgia, must account for financial information in much the same manner. As will be discussed later in this textbook, a few allowed alternatives do exist in connection with specific reporting challenges.

Because standardization exists in most areas of the reporting process, any decision maker with an adequate knowledge of financial accounting—whether located in Phoenix, Arizona, or in Portland, Maine—should be able to understand the fairly presented financial information conveyed by a wide variety of organizations. They all speak the same language. Put simply, the existence of accounting standards enables organizations and other interested parties to communicate successfully.

The Importance of Accounting Standards

Question: Several years ago, a front page article in the Wall Street Journal contained a controversial assessment of U.S. GAAP: “When the intellectual achievements of the 20th century are tallied, GAAP should be on everyone’s Top 10 list. The idea of GAAP—so simple yet so radical—is that there should be a standard way of accounting for profit and loss in public businesses, allowing investors to see how a public company manages its money. This transparency is what allows investors to compare businesses as different as McDonald’s, IBM and Tupperware, and it makes U.S. markets the envy of the world.”Clay Shirky, “How Priceline Became a Real Business,” Wall Street Journal, August 13, 2001, A-12.

Could formal accounting standards be so very important? Can the development of U.S. GAAP possibly be one of the ten most important intellectual achievements of the entire twentieth century? A list of other accomplishments during this period includes air travel, creation of computers, birth of the Internet, landing on the moon, and the development of penicillin. With that level of competition, U.S. GAAP does not seem an obvious choice to be in the top ten. How can it be so important?

Answer: The United States has a capitalistic economy, which means that businesses are (for the most part) owned by private citizens and groups rather than by the government. To operate and grow, these companies must convince investors and creditors to contribute huge amounts of their own money voluntarily. Not surprisingly, such financing is only forthcoming if the possible risks and rewards can be assessed and then evaluated with sufficient reliability. Before handing over thousands or even millions of dollars, decision makers must believe that they are using reliable data to make reasonable estimations of future stock prices, cash dividends, and cash flows. Otherwise, buying stocks and granting credit is no more than gambling. As this quote asserts, U.S. GAAP enables these outside parties to obtain the financial information they need to reduce their perceived risk to acceptable levels. Thus, money can be raised, and businesses can grow and prosper.

Without U.S. GAAP, investors and creditors would encounter significant difficulties in evaluating the financial health and future prospects of an organization.The wide-scale financial meltdown in the world economy that began to be evident in 2008 put a serious strain on the traditional capitalist model. The United States and other governments had to spend billions of dollars to bail out (and, in some cases, take over) major enterprises. Whether U.S. GAAP could have done a better job to help avoid this calamity will probably not be fully known for years. Because of that uncertainty, they would be more likely to hold on to their money or invest only in other, safer options. Consequently, if accounting standards did not exist, the development and expansion of thousands of the businesses that have become a central part of today’s society might be limited or impossible simply because of the lack of available resources. An expanding economy requires capital investment. That funding is more likely to be available when financial information can be understood because it is stated in a common language: U.S. GAAP.

By any method of measurement, the explosive development of the U.S. economy during the twentieth century (especially following World War II) has been spectacular, close to unbelievable. This growth has been fueled by massive amounts of money flowing from inside and outside the United States into the country’s businesses. Much of the vitality of the U.S. economy results from the willingness of people to risk their money by buying capital stock or making loans or extending credit to such companies as McDonald’s, IBM, and Tupperware. Without those resources, most businesses would be small or nonexistent, and the United States would surely be a radically different country.

The Evolution of Accounting Standards

Question: Accounting standards are important to businesses and decision makers alike. FASB is in charge of the creation of U.S. GAAP. As stated, all accounting standards tend to evolve over time. Official rules are modified, deleted, or added every year. How do new accounting standards come into existence?

Answer: As indicated earlier, since 1973, FASB has served as the primary authoritative body in charge of producing U.S. GAAP for nongovernmental entities such as businesses and private not-for-profit organizations. FASB is an independent group supported by the U.S. government, various accounting organizations, and many private businesses.

Typically, accounting problems arise over time within the various areas of financial reporting. New types of financial events can be created, for example, that are not covered by U.S. GAAP or, perhaps, weaknesses in earlier rules start to become evident. If such concerns grow to be serious, FASB steps in to study the issues and alternatives. After a period of study, the board might pass new rules or make amendments to previous ones. FASB is methodical in its deliberations, and the entire process can take years. Changes to U.S. GAAP are never made without proper consideration.

Several other official bodies also play important roles in the creation of U.S. GAAP. They are normally discussed in detail in upper-level accounting textbooks. However, the major authority for the ongoing evolution of U.S. GAAP lies with FASB and its seven-member board. It has released scores of official statements during its first four decades of existence. The impact that those rulings have had on U.S. GAAP and the financial reporting process in this country is almost impossible to overemphasize.

As just one example, FASB recently made a number of changes in the required reporting of receivables because of the chance that some (perhaps many) of these balances would not be collected. Possibly as a result of the current economic difficulties around the world, the members of FASB felt that more information was needed from organizations to inform decision makers about the risk involved with the collection of these receivables. This type of evolution takes place frequently in the language known as financial accounting. Whether U.S. GAAP or IFRS, financial accounting rules must be updated as needed to meet current informational needs.

In 2009, FASB combined all authoritative accounting literature into a single source for U.S. GAAP, which is known as the Accounting Standards Codification. By bringing together hundreds of authoritative documents, FASB has made U.S. GAAP both more understandable and easier to access. A multitude of pronouncements has been woven together in a logical fashion so that all rules on each topic are now gathered in one location.

Assets, Liabilities, Revenues, and Expenses

Question: Attaining a thorough understanding of financial accounting and its underlying standards is a worthwhile endeavor especially if a person hopes to become successful at making decisions about businesses or other organizations. Where should the journey to gain knowledge of financial accounting and its principles begin?

Answer: The study of a language usually starts with basic terminology. That is also an appropriate point of entry for an exploration into financial accounting. Consequently, four fundamental terms are introduced here in this section. Knowledge of these words is essential in gaining an understanding of accounting because they serve as the foundation for a significant portion of the financial information provided by any organization.

To illustrate, when examining the financial statements presented by Sears (formally known as Sears Holdings Corporation) for January 29, 2011, and the year then ended, four monetary balances immediately stand out because of their enormous size. On this date, the corporation reported $24.3 billion in assetsProbable future economic benefits owned or controlled by an organization. along with $15.6 billion in liabilitiesProbable future sacrifices of economic benefits arising from present obligations; the debts of an organization.. During that year, Sears generated revenuesMeasures of the increases in or inflows of net assets (assets minus liabilities) resulting from the sale of goods and services. of $43.3 billion and incurred expensesMeasures of decreases in or outflows of net assets (assets minus liabilities) incurred in connection with the generation of revenues. of $43.2 billion.

• Assets
• Liabilities
• Revenues
• Expenses

There are thousands of words and concepts found in accounting. No terms are more crucial to a comprehensive understanding of the reporting process than these four. Almost all discussions concerning financial information, whether practical or theoretical, come back to one or more of these words.

Definition of the Term “Asset”

Question: The first essential term presented here is “asset.” Is an asset a complicated accounting concept? What general information is conveyed to a decision maker by the term “asset”?

Answer: Simply put, an asset is a probable future economic benefit that an organization either owns or controls.This is one of the opening chapters in an introductory financial accounting textbook. Definitions are somewhat simplified here so that they will be more understandable to students who are just beginning their exploration of accounting. Many terms and definitions will be expanded in later chapters of this textbook or in upper-level financial accounting courses. On January 29, 2011, Sears reported holding over $24.3 billion of these economic benefits. If a customer walks into one of the company’s retail stores, many of these assets are easy to spot. The building itself may well be owned by Sears and certainly provides a probable future economic benefit by allowing the company to display merchandise and make sales. Other visible assets are likely to include cash registers, the cash held in those machines, available merchandise from jewelry to car tires to children’s clothing (usually referred to as inventoryA current asset bought or manufactured for the purpose of selling in order to generate revenue. in financial accounting), shopping carts, delivery trucks, and the shelves and display cases. Each of those assets is acquired with the hope that it will help Sears prosper in the future.

Examples of Typical Assets

Question: All decision makers who evaluate the financial health and future prospects of an organization should be interested in learning about its assets because those balances reflect the economic resources held at the present time. This is valuable information. What are some of the largest asset balances that a business like Sears is likely to report?

Answer: Every business has its own particular mix of assets. Virtually all have cash and accounts receivable (money due from customers). Many also have inventory (merchandise held for resale). The size and type of other assets will vary significantly based on the company and the industry in which it operates.

However, as a result of financial reporting and the existence of the Internet, such information is readily available to anyone wanting to learn about virtually any business. The assets are reported in the financial statements. As of January 29, 2011, the following four assets were reported by Sears as having the highest dollar amounts. Each of these asset categories will be discussed in detail later in this textbook.

Definition of the Term “Liability”

Question: As of January 29, 2011, Sears also reports owing more than $15.6 billion in liabilities. Does this figure reflect the total amount that the reporting company will eventually have to pay to outside parties? What does the balance reported as liabilities represent?

Answer: A more formal definition of a liability is that it is a probable future sacrifice of economic benefits arising from present obligations, but, for coverage here at the introductory level, liabilities can be viewed as the debts of the organization.

The $15.6 billion liability total disclosed by Sears most likely includes (1) amounts owed to the vendors who supply merchandise to the company’s stores, (2) notes due to banks as a result of loans, (3) income tax obligations, and (4) balances to be paid to employees, utility companies, advertising agencies, and the like. The amount of such liabilities owed by many businesses can be staggering. Walmart, for example, disclosed approximately $109 billion in liabilities as of January 31, 2011. Even that amount pales in comparison to the $627 billion liability total reported by General Electric at the end of 2010. To ensure that a fairly presented portrait is shown to decision makers, businesses such as Sears, Walmart, and General Electric must make certain that the reported data contain no material misstatements. Thus, all the information that is provided about liabilities should be based on the rules and principles to be found in U.S. GAAP.

Another term that is often encountered in financial reporting is “net assets.” The net asset total for an organization is simply its assets (future benefits) less its liabilities (debts). This balance is also known as “equity” in reference to the owners’ rights to all assets in excess of the amount owed on liabilities. A business’s net assets will increase if assets go up or if liabilities decrease. Changes in net assets show growth (or shrinkage) in the size of the organization over time. For example, IBM reported net assets of $22.7 billion at the end of 2009 (assets of $109.0 billion and liabilities of $86.3 billion). That number had risen to $23.2 billion by the end of 2010 (assets of $113.5 billion and liabilities of $90.3 billion). The ability of this business to increase its net assets by $500 million ($33.2 billion less $32.7 billion) during 2010 is certainly of interest to every decision maker analyzing the financial health and future prospects of IBM.

Definition of the Term “Revenue”

Question: In financial accounting, a business or other organization reports its assets, which are probable future economic benefits, such as buildings, equipment, and cash. Liabilities (debts) are also included in the financial information being disclosed. Both of these terms seem relatively straightforward. The third essential term to be discussed at this time—revenue—is one that initially appears to be a bit less clear. Sears reported that its stores generated revenues of $43.3 billion in 2010 alone. What does that tell a decision maker about Sears? What information is conveyed by the reporting of a revenue balance?

Answer: “Revenue” is a measure of the financial impact on an organization that results from a particular process. This process is a sale. A customer enters a Sears store at the local mall and pays $100 to purchase several items, such as hammers, shirts, socks, and scarves. Sears receives an asset—possibly $100 in cash. This asset inflow into the business results from a sale and is called revenue. Revenue is not an asset; it is a measure of the increase in net assets created by the sale of inventory and services. Thus, for The Coca-Cola Company, revenues are derived (net assets are increased) from the sale of soft drinks. For The Hershey Company, revenues come from sales of chocolate whereas The Walt Disney Company generates revenue by selling admission to its amusement parks and movies.

For timing purposes, as will be discussed in a later chapter, revenue is recognized when the earning process takes place. That is normally when the goods or services are delivered. Therefore, throughout each day of the year, Sears makes sales to customers and accepts cash, checks, or credit card payments. The reported revenue figure is merely a total of all sales made during the period, clearly relevant information to any decision maker attempting to determine the financial prospects of this company. During 2010, the multitude of Sears stores located both inside and outside the United States sold inventory and services and received $43.3 billion in assets in exchange. That is the information communicated by the reported revenue balance. To reiterate, this figure is not exact, precise, accurate, or correct. However, according to Sears, $43.3 billion is a fairly presented total determined according to the rules of U.S. GAAP so that it contains no material misstatement. Any outside party analyzing Sears should be able to rely on this number with confidence in making possible finanical decisions about this business as a whole.

Definition of the Term “Expense”

Question: That leaves “expense” as the last of the four essential accounting terms introduced at this point. Sears reported $43.2 billion in total expenses during 2010. This figure apparently is important information that helps paint a proper portrait of the company, a portrait that can be used by decision makers. What is an expense?

Answer: An expense is an outflow or reduction in net assetsAn expense often causes an immediate reduction in assets, especially if cash is paid. Frequently, though, an expense creates an increase in liabilities instead of a reduction in assets. That happens if the cost is incurred but payment is delayed until a later date. In either case—the reduction of an asset or the creation of a liability—the amount of net assets held by the organization decreases as a result of the expense. that was incurred by an organization in hopes of generating revenue. To illustrate, assume that—at the end of a week—a local business pays its employees $12,000 for the work performed during the previous few days. A $12,000 salary expense must be reported. Cash (an asset) was reduced by that amount, and this cost was incurred because the company employed those individuals to help generate revenues. That is an expense. The same general logic can be applied in recording insurance expense, rent expense, advertising expense, utility expense (such as for electricity and water), and many other similar costs. For each, net assets are reduced (assets go down or liabilities go up) to help create sales.

In some ways, expenses are the opposite of revenues that measure the inflows or increases in net assets that are created by sales. Expense figures reflect outflows or decreases in net assets incurred in hopes of generating revenues.

Four Essential Terms Encountered in Financial Accounting

Question: To reiterate, four terms are basic to an understanding of financial accounting. Almost any coverage of accounting starts with these four. What is the meaning of asset, liability, revenue, and expense?

Answer:

• Asset. A probable future economic benefit owned or controlled by the reporting company, such as inventory, land, or equipment.
• Liability. A probable future economic sacrifice or, in simple terms, a debt.
• Revenue. A measure of the inflow or increase in net assets generated by the sales made by a business. It is a reflection of the amounts brought in by the sales process during a specified period of time.
• Expense. A measure of the outflow or reduction in net assets caused by a business’s attempt to generate revenue and includes many common costs, such as rent expense, salary expense, and insurance expense.

Financial Accounting and Information

Question: In the June 30, 2011, edition of The Wall Street Journal, numerous headlines described the recent activities of various business organizations. Here are just a few:

“TMX and LSE Give Up on Planned Merger”

“Ally Financial Faces Charge for Mortgage Losses”

“HomeAway Jumps 49% in Debut”

“Ad-Seller Acquiring Myspace for a Song”

Millions of individuals around the world read such stories each day with rapt interest. From teen-agers to elderly billionaires, this type of information is analyzed obsessively. How are these people able to understand all the data and details being provided? For most, the secret is straightforward: a strong knowledge of financial accounting.

This textbook provides an introduction to financial accounting. A logical place to begin such an exploration is to ask the obvious question: What is financial accounting?

Answer: In simplest terms, financial accountingThe communication of financial information about a business or other type of organization to external audiences to help them assess its financial health and future prospects. is the communication of information about a business or other type of organization (such as a charity or government) so that individuals can assess its financial health and future prospects. No single word is more relevant to financial accounting than “information.” Whether it is gathering monetary information about a specific organization, putting that information into a format designed to enhance communication, or analyzing the information that is conveyed, financial accounting is intertwined with information.

In today’s world, information is king. Financial accounting provides the rules and structure for the conveyance of financial information about businesses (and other organizations) to maximize clarity and understanding. Although a wide array of organizations present financial information to interested parties, this book primarily focuses on the reporting of businesses because that is where the widest use of financial accounting occurs.

organization → reports information based on the principles of financial accounting → interested individuals assess financial health and future prospects

At any point in time, some businesses are poised to prosper while others teeter on the verge of failure. Many people want to be able to evaluate the degree of success achieved to date by a particular organization as well as its prospects for the future. They seek information and the knowledge that comes from understanding that information. How well did The Coca Cola Company do last year, and how well should this business do in the coming year? Those are simple questions to ask, but the answers can make the difference between earning millions and losing millions.

Financial accounting provides data that these individuals need and want.

Financial Accounting and Wise Decision Making

Question: Every semester, most college students are enrolled in several courses as well as participate in numerous outside activities. All of these compete for the hours that make up each person’s day. Why should a student invest valuable time to learn the principles of financial accounting? Why should anyone be concerned with the information communicated about an organization? What makes financial accounting important?

Answer: Many possible benefits can be gained from acquiring a strong knowledge of financial accounting because it provides the accepted methods for communicating relevant information about an organization. In this book, justification for the serious study that is required to master this subject matter is simple and straightforward. Obtaining a working knowledge of financial accounting and its underlying principles enables a person to understand the information conveyed about an organization so that better decisions can be made.

Around the world each day, millions of individuals make critical judgments about the businesses and other organizations they encounter. Developing the ability to analyze financial information and then making use of that knowledge to arrive at sound decisions can be critically important. Whether an organization is as gigantic as Walmart or as tiny as a local convenience store, individuals have many, varied reasons for studying the information that is available.

As just a single example, a recent college graduate looking at full-time employment opportunities might want to determine the probability that Company A will have a brighter economic future than Company B. Although such decisions can never be correct 100 percent of the time, knowledge of financial accounting and the information being communicated greatly increases the likelihood of success. As Kofi Annan, former secretary-general of the United Nations, has said, “Knowledge is power. Information is liberating.”See http://www.deepsky.com/~madmagic/kofi.html.

Thus, the ultimate purpose of this book is to provide students with a rich understanding of the rules and nuances of financial accounting so they can evaluate available information about organizations and then make good decisions. In the world of business, most successful individuals have developed this ability and are able to use it to achieve their investing and career objectives.

Common Decisions about Organizations

Question: Knowledge of financial accounting assists individuals in making informed decisions about businesses and other organizations. What kinds of evaluations are typically made? For example, assume that a former student—one who recently graduated from college—has been assigned the task of analyzing financial data provided by the Acme Company. What real-life decisions could a person be facing where an understanding of financial accounting would be beneficial?

Answer: The number of possible judgments that an individual might need to make about a business or other organization is close to unlimited. However, many of these decisions deal with the current financial health and prospects for future success. In order to analyze available data to make such assessments, a working knowledge of financial accounting is invaluable. The more in-depth the understanding is of those principles, the more likely the person will be able to use the information to arrive at the best possible choices. Common examples include the following:

• Should a bank loan money to the Acme Company? The college graduate might be employed by a bank to work in its corporate lending department. Assume, for example, that the Acme Company is a local business that has applied to the bank for a large loan so that it can expand. The graduate has been instructed by bank management to prepare an assessment of Acme to determine if it is likely to be financially healthy in the future so that it will be able to repay the borrowed money when due. A correct decision to provide the loan eventually earns a profit for the bank because Acme will be required to pay an extra amount (known as interestThe charge for using money over time, often associated with long-term loans; even if not specifically mentioned in the debt agreement, financial accounting rules require it to be computed and reported based on a reasonable rate.) on the money borrowed. Conversely, an incorrect analysis of the information could lead to a substantial loss if the loan is granted and Acme is unable to fulfill its obligation. Bank officials must weigh the potential for profit against the risk of loss. That is a daily challenge in virtually all businesses. The former student’s career with the bank might depend on the ability to analyze financial accounting data and then make appropriate choices about the actions to be taken. Should a loan be made to this company?
• Should another business make sales on credit to the Acme Company? The college graduate might hold a job as a credit analyst for a manufacturing company that sells its products to retail stores. Assume that Acme is a relatively new retailer that wants to buy goods (inventory) on credit from this manufacturer to sell in its stores. The former student must judge whether to permit Acme to buy merchandise now but wait until later to remit the money. If payments are received on a timely basis, the manufacturer will have found a new outlet for its merchandise. Profits will likely increase. Unfortunately, Acme could also make expensive purchases but then be unable to make payment, creating significant losses for the manufacturer. Again, the possibility of profit must be measured against the chance for loss.
• Should an individual invest money to become one of the owners of the Acme Company? The college graduate might be employed by a firm that provides financial advice to its clients. Assume that the firm is presently considering whether to recommend acquisition of ownership shares of Acme as a good investment strategy. The former student has been assigned to gather and evaluate relevant financial information as a basis for this decision. If Acme is poised to become larger and more profitable, its ownership shares will likely rise in value over time, earning money for the firm’s clients. Conversely, if the prospects for Acme appear to be dim, the value of these shares might start to drop (possibly precipitously) so that the investment firm should avoid suggesting the purchase of an ownership interest in this business.

Success in life—especially in business—frequently results from being able to make appropriate decisions. Many economic choices, such as those described earlier, depend on a person’s ability to understand and make use of financial information about organizations. That financial information is produced and presented in accordance with the rules and principles underlying financial accounting.

Financial Accounting versus Managerial Accounting

Question: A great number of possible decisions could be addressed in connection with any business. Is an understanding of financial accounting relevant to all decisions made about an organization? What about the following?

• Should a business buy a building to serve as its new headquarters or rent a facility instead?
• What price should a data processing company charge customers for its services?
• Should advertisements to alert the public about a new product be carried on the Internet or on television?

Answer: Decisions such as these three are extremely important for the success of any organization. However, these examples are not made about the reporting organization. Rather, they are made within the organization in connection with some element of its operations.

The general term “accounting” refers to the communication of financial information for decision-making purposes. Accounting is then further subdivided into (a) financial accounting and (b) managerial accountingThe communication of financial information within an organization so internal decisions can be made in an appropriate manner..Tax accounting is another distinct branch of accounting. It is less focused on decision making and more on providing information needed by a business to comply with all government rules and regulations. Even in tax accounting, though, decision making is important as businesses seek to take all possible legal actions to minimize tax payments. Financial accounting is the subject explored in this textbook. It focuses on conveying relevant data (primarily to external parties) about an organization (such as Motorola Mobility or Starbucks) as a whole so that wise decisions can be made. Thus, questions such as the following all fall within the discussion of financial accounting:

• Do we loan money to the Acme Company?
• Do we sell on credit to the Acme Company?
• Do we recommend that our clients buy the ownership shares of the Acme Company?

These decisions pertain to an overall evaluation of the financial health and future prospects of the Acme Company.

Managerial accounting is the subject of other books and other courses. This second branch of accounting refers to the communication of information within an organization so that internal decisions (such as whether to buy or rent a building) can be made in an appropriate manner. Individuals studying an organization as a whole have different goals than do internal parties making operational decisions. Thus, many unique characteristics have developed in connection with each of these two branches of accounting. Financial accounting and managerial accounting have evolved independently over the decades to address the specific needs of the users being served and the decisions being made. This textbook is designed to explain those attributes that are fundamental to attaining a useable understanding of financial accounting.

It is not that one of these areas of accounting is more useful or more important than the other. Financial accounting and managerial accounting have simply been created to achieve different objectives. They both do their jobs well, but they do not have the same jobs.

Financial Accounting Information and Company Employees

Question: Financial accounting refers to the conveyance of information about an organization as a whole and is most frequently distributed to assist outside decision makers. Does a person who is employed by an organization care about the financial accounting data that is reported? Why should an employee in the marketing or personnel department of the Acme Company be interested in the financial information that this business generates and distributes?

Answer: Financial accounting is designed to portray the overall financial condition and prospects of an organization. Virtually every employee should be interested in studying that information to judge future employment prospects. A business that is doing well will possibly award larger pay raises or perhaps significant end-of-year cash bonuses. A financially healthy organization can afford to hire new employees, buy additional equipment, or pursue major new initiatives. Conversely, when a business is struggling and prospects are dim, employees might anticipate layoffs, pay cuts, or reductions in resources.

Thus, although financial accounting information is directed to outside decision makers, employees should be keenly interested in the financial health of their own organization. No one wants to be clueless as to whether their employer is headed for prosperity or bankruptcy. In reality, employees are often the most avid readers of the financial accounting information distributed by employers because the results can have such an immediate and direct impact on their jobs and, hence, their lives.

The Ownership Shares of an Incorporated Business

Question: In discussing possible decisions that could be made about a business organization, ownership shares were mentioned. Virtually every day, on television, in newspapers, or on the Internet, mention is made that the shares of one company or another have gone up or down in price because of trading on one of the stock markets. Why does a person acquire ownership shares of a business such as Capital One or Intel?

Answer: In the United States, as well as in many other countries, owners of a business can apply to the state government to become identified as an entity legally set apart from its owners. This process is referred to as incorporationLegal process by which owners of an organization apply to a state government to have it identified as an entity legally separate from its owners (a corporation); corporations are the legal form of most businesses of any size in the United States.. Therefore, a corporationAn organization that has been formally recognized by the state government as a separate legal entity so that it can sell ownership shares to raise money for capital expenditures and operations. is an organization that has been formally recognized by the state government as a separate legal entity that can act independently of its owners. A business that has not been incorporated is either a sole proprietorshipAn unincorporated business created, owned, and operated by a single individual; the business is not legally separate from its owner. (one owner) or a partnershipAn unincorporated business created, owned, and operated by more than one individual; the business is not legally separate from its owners. (more than one owner). These businesses are not separate from their ownership.

As will be discussed in detail in a later chapter, several advantages are gained from incorporation. One is especially important in connection with the study of financial accounting. A corporation has the ability to obtain monetary resources by selling (also known as issuing) capital shares that allow investors to become owners. They are then known as stockholdersIndividuals or organizations that hold the ownership shares of capital stock of a corporation; same as shareholders. or shareholdersIndividuals or organizations that hold the ownership shares of capital stock of a corporation; same as stockholders..

Millions of corporations operate in the United States. The Walt Disney Company and General Electric are just two well-known examples of corporations. They exist as legal entities completely distinct from the multitude of individuals and organizations that possess their ownership shares (also known as equity or capital stockOwnership (equity) shares of stock in a corporation that are issued to raise monetary financing for capital expenditures and operations.).

Any investor who acquires one or more shares of the capital stock of a corporation becomes an owner and has all of the rights that are specified by the state government or on the stock certificate. The number of shares and owners can be staggering. At the end of 2010, stockholders held over 2.3 billion shares of The Coca-Cola Company. Thus, possession of one share of the capital stock of The Coca-Cola Company provided a person with approximately a 1/2,300,000,000th part of the ownership.

One of the great advantages of incorporation is the ease by which most capital stock can be exchanged. For most companies, investors are able to buy or sell ownership shares on stock exchanges in a matter of moments. In contrast, sole proprietorships and partnerships rarely sell capital shares. Without the separation provided by incorporation, a clear distinction between owner and business does not exist. For example, debts incurred by a business that is a sole proprietorship or partnership may ultimately have to be satisfied by the owner personally. Thus, individuals tend to avoid making investments in unincorporated businesses unless they can be involved directly in the management. However, partnerships and sole proprietorships still remain popular because they are easy to create and offer possible income tax benefits as will be described in a later chapter.

If traded on a stock exchange, shares of the capital stock of a corporation continually go up and down in value based on myriad factors, including the perceived financial health and future prospects of the organization. As an example, during trading on July 1, 2011, the price of an ownership share of Intel rose by $0.37 to $22.53, while a share of Capital One went up by $0.98 to $52.65.

For countless individuals and groups around the world, the most popular method of investment is through the purchase and sell of these capital shares of corporate ownership. Although many other types of investment opportunities are available (such as the acquisition of gold or land), few come close to evoking the level of interest of capital stock.The most prevalent form of capital stock is common stock so that these two terms have come to be used somewhat interchangeably. As will be discussed in a later chapter, the capital stock of some corporations is made up of both common stock and preferred stock. On the New York Stock ExchangeOrganized stock market that efficiently matches buyers and sellers of capital stock at a mutually agreed-upon price allowing ownership in companies to change hands easily. The New York Stock Exchange is the largest stock exchange in the world followed by NASDAQ, the London Stock Exchange, the Tokyo Stock Exchange, and the Shanghai Stock Exchange. alone, billions of shares are bought and sold every business day at a wide range of prices. As of June 30, 2011, an ownership share of Sprint Nextel was trading for $5.39, while a single share of Berkshire Hathaway sold for $116,105.00.

The Operational Structure of a Corporation

Question: The owners of most small corporations can operate their businesses effectively as both stockholders and managers. For example, two friends might each own half of the capital stock of a bakery or a retail clothing store. Those individuals probably work together to manage this business on a day-to-day basis.

Because of the number of people who can be involved, large corporations offer a significantly different challenge. How do millions of investors possessing billions of capital shares of a corporation ever serve in any reasonable capacity as the owners and managers of that business?

Answer: Obviously, a great many corporations like The Coca-Cola Company have an enormous quantity of capital shares held by tens of thousands of investors. Virtually none of these owners can expect to have any impact on the daily operations of the business. A different operational structure is needed. In a vast number of such organizations, stockholders vote to elect a representative group to oversee operations. This body—called the board of directorsA group that oversees the management of a corporation; the members are voted to this position by stockholders; it hires the management to run the company on a daily basis and then meets periodically to review operating, investing, and financing results and also to approve policy and strategy.A story produced by National Public Radio on the roles played by a board of directors can be found at http://www.npr.org/templates/story/story.php?storyId=105576374.—is made up of approximately ten to twenty-five knowledgeable individuals.

As shown in Figure 1.1 “Company Operational Structure”, the board of directors hires the members of management who run the business on a daily basis. The board then meets periodically (often quarterly) to review operating, investing, and financing results as well as to approve strategic policy initiatives.

Occasionally, the original founders of a business (or their descendants) continue to hold enough shares to influence or actually control operating and other significant decisions of a business. Or wealthy outside investors might acquire enough shares to gain this same level of power. Such owners have genuine authority within the corporation. Even that degree of control, though, is normally carried out through membership on the board of directors. For example, at the end of 2010, the Ford Motor Company had fifteen members on its board of directors, three of whom were named Ford. Except in rare circumstances, the hierarchy of owners, board of directors, management, and employees remains intact. Thus, most stockholders are not involved with the operating decisions of any large corporation.

Predicting the Appreciation of Capital Stock Values

Question: The acquisition of capital shares of a corporation is an extremely popular investment strategy for a wide range of the population. A buyer becomes one of the owners of the business. Why spend money in this way especially since very few stockholders can ever hope to hold enough shares to participate in managing or influencing operations? Ownership shares sometimes cost small amounts but can also require hundreds if not thousands of dollars. What is the potential benefit of buying capital stock issued by a business organization such as PepsiCo or Chevron?

Answer: Capital shares of thousands of corporations trade each day on markets around the world such as the New York Stock Exchange or NASDAQ (National Association of Securities Dealers Automated Quotations)An electronic market that allows for the trading of capital shares in approximately three thousand companies, providing instantaneous price quotations to efficiently match buyers and sellers allowing ownership in companies to change hands.. One party is looking to sell shares whereas another is seeking shares to buy. Stock markets match up these buyers and sellers so that a mutually agreed-upon price can be negotiated. This bargaining process allows the ownership interests of these companies to change hands with relative ease.

When investors believe a business is financially healthy and its future is bright, they expect prosperity and growth to continue. If that happens, the negotiated price for the capital shares of the corporation should rise over time. Investors around the world attempt to anticipate such movements in order to buy the stock at a low price and sell later at a higher one. Conversely, if predictions are not optimistic, then a business’s share price is likely to drop so that owners will experience losses in the value of their investments.

Financial accounting information plays an invaluable role in this market process as millions of investors attempt to assess the financial condition and prospects of various business organizations on an ongoing basis. Being able to understand and make use of reported financial data helps improve the investor’s knowledge of a corporation and, thus, the chance of making wise decisions about the buying and selling of capital shares. Ignorance often leads to poor decisions and much less lucrative outcomes.

In the United States, such investment gains—if successfully generated—are especially appealing to individuals when ownership shares are held for over twelve months before being sold. For income tax purposes, the difference between the buy and sale prices for such investments is referred to as a long-term capital gain or loss. Under certain circumstances, significant tax reductions are attributed to long-term capital gains.This same tax benefit is not available to corporate taxpayers, only individuals. The U.S. Congress created this tax incentive to encourage additional investment so that businesses could more easily obtain money for growth purposes. When businesses prosper and expand, the entire economy tends to do better.

The Receipt of Dividends

Question: Investors acquire ownership shares of selected corporations hoping that the stock price will rise over time. This investment strategy is especially tempting because long-term capital gains are often taxed at a relatively low rate. Is the possibility for appreciation in value the only reason that investors choose to acquire capital shares?

Answer: Many corporations—although certainly not all—pay cash dividendsDistributions made by a corporation to its shareholders as a reward when income has been earned; decision to pay is made by the board of directors; shareholders often receive favorable tax treatment when cash dividends are collected. to their stockholders periodically. A dividend is a reward for being an owner of a business that is prospering. It is not a required payment; it is a sharing of profits with the stockholders. As an example, for 2010, Duke Energy reported earning profits (net income) of $1.32 billion. During that same period, the corporation distributed total cash dividends of approximately $1.28 billion to the owners of its capital stock.The receipt of cash dividends is additionally appealing to stockholders because, in most cases, they are taxed at the same reduced rates as are applied to net long-term capital gains.

The board of directors determines whether to pay dividends. Some boards prefer to leave money within the business to stimulate future growth and additional profits. For example, Google Inc. reported profits (net income) for 2010 of $8.51 billion but distributed no dividends to its owners. Newer companies often choose to pay less dividends than older companies as they try to grow quickly to a desired size.

Not surprisingly, a variety of investing strategies abound. Many investors acquire ownership shares almost exclusively in hopes of benefiting from an anticipated appreciation of stock prices. Another large segment of the investing public is more likely to be drawn to the possibility of dividend payments. Unless an owner has the chance to influence or control the operations of a business, only these two potential benefits can accrue from the ownership of capital shares: appreciation in the value of the stock price and cash dividends.

Annual Rate of Return on an Investment in Capital Stock

Question: An investor can put money into a savings account at a bank and earn a small but relatively risk-free profit. For example, $100 could be invested on January 1 and then be worth $102 at the end of the year because interest is added to the balance. The extra $2 means that the investor earned an annual return of 2 percent ($2 increase/$100 investment). This computation helps in comparing one possible investment opportunity against another. How is the annual rate of return computed when the capital stock of a corporation is acquired as an investment and then held for a period of time?

Answer: Capital stock investments are certainly not risk free. Profits can be high, but losses always loom as a possibility. The annual rate of return measures those profits and losses in the past and is often anticipated for the future as a way of making investment decisions.

To illustrate, assume that on January 1, Year One, an investor spends $100 for one ownership share of the Ace Company and another $100 for a share of the Base Company. During the year, Ace distributes a dividend of $1.00 per share to each of its owners while Base pays a dividend of $5.00 per share. On December 31, the capital stock of the Ace Company is selling on a stock market for $108 per share whereas the stock of the Base Company has a price of only $91 per share.

This investor now holds a total value of $109 as a result of the purchase of the share of the Ace Company: the cash dividend of $1 and a share of capital stock worth $108. In one year, the total value has risen by $9 ($109 less $100) so that the annual rate return was 9 percent ($9 increase/$100 investment).

The shares of the Base Company did not perform as well. At the end of the year, the total value of this investment is only $96: the cash dividend of $5 plus one share of stock worth $91. That is a drop of $4 during the year ($96 less $100). The annual rate of return on this investment is a negative 4 percent ($4 decrease/$100 investment).

As a result of this first year, buying a share of Ace obviously proved to be a better investment than buying a share of Base because of the higher annual rate of return. However, a careful analysis of the financial accounting data available at the start of the year might have helped this investor realize in advance that the rate of return on the investment in Ace would be higher. An assessment of the financial health and future prospects of both businesses could have shown that a higher return was expected in connection with the investment in Ace.

Therefore, estimating the annual rate of return is important for investors because it helps them select from among multiple investment opportunities. This computation provides a method for quantifying the financial benefit earned in the past and expected in the future. Logically, investors should simply choose the investment that provides the highest anticipated rate of return. However, as with all predictions, the risk that actual actions will not follow the expected course must be taken into consideration. Investing often breaks down to anticipating profits while measuring the likelihood and amount of potential losses.

Financial Accounting Information and Investments in Capital Stock

Question: Investors are interested (sometimes almost obsessively interested) in the financial information that is produced by a business organization according to the rules and principles of financial accounting. They want to use this information to make wise investing decisions. What do investors actually hope to learn about a business by analyzing published financial information?

Answer: The information reported by financial accounting is similar to a giant, complex portrait painted of the organization. There are probably hundreds, if not thousands, of aspects of the picture that can be examined, analyzed, and evaluated to help assess the financial health and future prospects of the model. Theories abound as to which pieces of information are best to use when studying a business. One investor might prefer to focus on a particular portion of the data almost exclusively (such as profitability) whereas another may believe that entirely different information is most significant (such as the sources and uses of cash).

Ultimately, in connection with the buying and selling of capital stock, all investors are trying to arrive at the same two insights. They are attempting to use the provided financial accounting data to estimate the following:

1. The price of the corporation’s capital stock in the future
2. The amount of cash dividends that will be paid over time by the business

Despite the complexity of the information, these two goals are rather simplistic. If an investor owns capital shares of a business and feels that the current accounting information signals either a rise in stock prices or strong dividend distributions, holding the investment or even buying more shares is probably warranted. Conversely, if careful analysis indicates a possible drop in stock price or a reduction in dividend payments, sale of the stock is likely to be the appropriate action.

Interestingly, by the very nature of the market, any exchange of ownership shares means that the buyer has studied available information and believes the future to be relatively optimistic for the business in question. In contrast, the seller has looked at similar data and arrived at a different, more pessimistic outlook.

Financial Accounting Information and Other Interested Parties

Question: Are there reasons to analyze the financial accounting information produced by a particular business other than to help investors predict stock prices and cash dividend payments?

Answer: The desire to analyze an organization’s financial situation is not limited to investors in the stock market. For example, as discussed previously, a loan might be requested from a bank, or one business could be considering the sale of its merchandise to another on credit. Such obligations require eventual payment. Therefore, another portion of the individuals and groups that study the financial information reported by an organization wants to assess the likelihood that money will be available in the future to pay debts. Stock prices and cash dividend distributions are much less significant to a creditor.

The same financial data utilized by investors who are buying or selling capital stock will also be of benefit to current and potential creditors. However, this group is likely to focus attention on particular elements of the information such as the sheer amount of the debt owed, when that debt is scheduled to come due, and the perceived ability to generate sufficient cash to meet those demands in a timely fashion. Ultimately, creditors attempt to anticipate the organization’s future cash flows to measure the risk that debt principal and interest payments might not be forthcoming when due.Cash flows also influence stock prices and dividend payments and would, thus, be information useful for potential investors in the capital stock of a company as well as its creditors.

Therefore, millions of individuals and groups use reported financial information to assess business organizations in order to make three predictions:

• Future stock market prices for the capital shares issued by the business
• Future cash dividend distributions
• Future ability to generate sufficient cash to meet debts as they mature

The first two relate to investors in the capital stock issued by the corporation; the third is of more significance to the creditors of that organization.

The Nature of Financial Information

Question: The term “financial information” comes up frequently in these discussions. What is meant by financial information?

Answer: Financial information reported by and about an organization consists of data that can be measured in monetary terms. For example, if a building costs $4 million to acquire, that is financial information, as is the statement that a debt of $700,000 is owed to a bank. In both cases, relevant information is communicated to decision makers as a monetary balance. However, if a business has eight thousand employees, that fact might be interesting, but it is not financial information. The figure is not a dollar amount; it is not stated in the form that is most useful for decision-making purposes by either investors or creditors. Assuming that those workers were paid a total of $500 million during the most recent year, then that number is financial information because it reflects the amount of money spent.

Likewise, a men’s clothing store does not include in its financial accounting information that it holds ten thousand shirts to be sold. Instead, the business reports that it currently owns shirts for sale (frequently referred to as inventoryA current asset bought or manufactured for the purpose of selling in order to generate revenue.) with a cost of, perhaps, $300,000. Or, after having sold these items to customers, it could explain that total sales of $500,000 were made during the period.

Financial Accounting and Verbal Explanations

Question: The value of reported data seems somewhat restricted if only amounts measured in dollars is included. Is financial accounting information limited solely to figures that can be stated in monetary terms?

Answer: Although financial accounting starts by reporting balances as monetary amounts, the communication process does not stop there. Extensive verbal explanations as well as additional numerical data are also provided to clarify or expand the monetary information where necessary. To illustrate, assume that an organization is the subject of a lawsuit and estimates an eventual loss of $750,000. This is financial information that must be reported based on the rules of financial accounting. However, the organization should also communicate other nonfinancial information such as the cause of the lawsuit and the likelihood that the loss will actually occur. The dollar amount alone does not provide sufficient information for either investors or creditors.

Thus, accounting actually communicates to decision makers in two distinct steps:

1. Financial information is provided in monetary terms
2. Further explanation is given to clarify and expand on those monetary balances

The Annual Report

Question: Businesses and other organizations must have some structural method for conveying financial information and additional verbal explanations to outside decision makers. If a potential investor or creditor wants to assess a business organization such as Johnson & Johnson or Colgate-Palmolive, in what form is that information delivered?

Answer: Most companies regardless of size prepare and distribute an annual report shortly after the end of each year. For example, the 2010 annual report of the McDonald’s Corporation can be downloaded from the Internet at http://www.aboutmcdonalds.com/mcd/investors/annual_reports.html.The annual report for the McDonald’s Corporation can also be found by following these steps:

1. Go to http://www.mcdonalds.com.
2. Scroll to the bottom of the page and click on “Corporate.”
3. At the top of the next screen, click on “Investors” at the top of the page.
4. A picture of McDonald’s latest annual report should be on the next screen. Click on that picture for it to download.

This publication is over fifty pages in length and contains virtually any financial accounting information that a potential investor or creditor could need to make an estimation of the future stock price for the capital stock issued by McDonald’s as well as future dividend distributions and cash inflows and outflows. For example, here are some of the most relevant pieces of information included in the company’s 2010 annual report.

• Pages 1 through 3 is a letter to shareholders from the chief executive office, the person who is the head of McDonald’s management.
• Page 4 is a letter to shareholders from the chair of the board of directors.
• Pages 9 through 25 present management’s discussion and analysis of the company’s financial condition and results of operations.
• Pages 26 through 29 contain the financial accounting information formally reported by McDonald’s.
• Pages 30 through 42 provide verbal explanations and other additional information to help clarify the monetary balances reported on pages 26 through 29.
• Page 46 identifies the executive members of management and the officers who work for McDonald’s.
• Page 47 lists the members of the board of directors.

This textbook will focus on helping students gain an understanding of the financial accounting information that is produced by a business organization as exemplified by McDonald’s on pages 26 through 29 and then explained further in pages 30 through 42. Those seventeen pages form the heart of the financial reporting process for this organization. Here in Chapter 1 “What Is Financial Accounting, and Why Is It Important?”, most students will understand very little of the available data about McDonald’s. However, with careful reading, thought, and work, by the conclusion of Chapter 17 “In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?”, students should have a working knowledge of financial accounting and its rules and procedures. They will then be able to analyze a good percentage of the information reported by any business as a basis for making wise decisions about the buying and selling of its capital stock and the extension of credit and loans.